Economic Substance Doctrine: Recent Cases and Legal Theories, Section 7701(o), Penalties, and More

This CLE/CPE webinar will provide tax counsel an in-depth analysis of the economic substance doctrine (ESD) as it has been applied by courts and the IRS. The panelists will discuss the history of the doctrine, key judicial developments, IRC § 7701(o), and the strict liability penalty of IRC § 6662(b)(6), among other topics.

IRC Section 7701(o), the ESD, continues to be a critical element of international tax planning. Generally, courts have interpreted the ESD to require that taxpayers show a substantial non-tax purpose and a change in economic position before tax benefits will be respected.

In 2010, the ESD was codified at IRC. § 7701(o) and contains a two-prong test for the application of the doctrine, commonly referred to as the "objective prong" and the "subjective prong." Under IRC § 7701(o)(1)(A) and (B), a transaction shall be treated as having economic substance only if the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position, and the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction. This could impose a stricter standard than the judicial approach in some cases.

IRC § 7701(o) also imposes a "relevancy requirement" which has been the focus of recent cases. In Patel v. Commissioner, 165 T.C. No. 10 (2025), the U.S. Tax Court recognized a threshold relevancy requirement in the context of sustaining the penalty under IRC § 6662(b)(6). In contrast, a federal district court in Liberty Global v. United States, No. 1:20-03501 (D. Colo. Oct. 31, 2023) (on appeal to 10th Circuit), held that there is no threshold inquiry.

Transactions that fail the ESD are subject to penalties under IRC § 6662 and the IRS Large Business & International Division has updated its procedures on asserting penalties for lack of economic substance. These changes include the removal of the requirement for executive approval, which appears to have lowered the internal threshold for asserting the ESD penalty.

Listen as our panel discusses the history of the ESD, key judicial developments, IRC § 7701(o), and the strict liability penalty of IRC § 6662(b)(6), as well as offers strategies to ensure compliance in the application of the doctrine.