Section 7701(o) of the Internal Revenue Code incorporates the controversial judicial doctrine of economic substance into statutory language. In other words, it “codifies” the doctrine. (The economic substance doctrine generally provides that a tax benefit that goes beyond Congressional intent can be disallowed by the courts, even if the taxpayer meets all of the literal Code and regulatory requirements for claiming the benefit.)
This codification appears to have accidentally dissuaded the relevant agency (the Internal evenue Service, or IRS) from raising economic substance issues—an effect that is contrary to Congress’s intent in enacting the doctrine into legislation. Essentially, Congress imported a set of judicial principles into the Code, in order to make a particular judicial doctrine stronger, but then the agency effectively discarded those now-codified judicial rules.
The IRS response to codification raises bigger picture issues, such as an agency’s ability to disregard (or decline to enforce) a statute and the parameters of an agency’s ability to issue public guidance using informal means (rather than formal regulations). In addition, this codification raises structural issues, including the interaction between the three branches of government in this context and the impact of Congressional approval on arguments about the validity of this judicial doctrine. Lastly, such codification places new emphasis on distinguishing between the now-codified economic substance doctrine and other anti-abuse doctrines.
The economic substance doctrine has been the subject of recent litigation in the “STARS” cases. One of such cases has just been appealed to the Eighth Circuit, and that appeal may later result in a split between the circuits. In addition, the recent 2017 Tax Act (the Tax Cuts and Jobs Act) may lead to more emphasis on the economic substance doctrine, as taxpayers attempt to comply with the letter of new tax provisions while arguably circumventing such provisions’ intent. For these reasons, the economic substance doctrine is likely to become increasingly important in the near future. In addition, as the IRS attempts to implement and provide guidance on a massive new tax act, there are likely to be recurring issues regarding the limits of agency discretion to not enforce a statute, and the use of informal means to communicate guidance to the public.