The application of the economic substance doctrine after codification remains unsettled. Recent court cases continue to shape when Internal Revenue Code (IRC) Section 7701(o)’s threshold relevance inquiry applies, how courts evaluate the statute’s requirement for both meaningful economic effect and a substantial non-tax purpose, and the significant penalties that may accompany an adverse determination. This article delves into key developments and tax planning considerations for domestic and multinational enterprises undertaking internal restructurings, taxpayers using captive or other risk‑transfer arrangements, and businesses pursuing statutory tax incentives through multistep transactions.
Background
The economic substance doctrine is generally viewed as one of the federal income tax law’s most consequential anti-abuse tools for complex, multistep transactions, including cross‑border restructurings, captive and other risk‑transfer arrangements, and tax‑incentive‑driven planning. Congress codified the doctrine in 2010 through IRC §7701(o), but codification did not end the inquiry. Instead, the statute preserved a threshold question, whether the doctrine is relevant to the transaction, and imposed a more structured two-prong test once relevance has been established.
Recent cases show that courts are still defining the doctrine’s practical limits. Kadau v. Commissioner1 (Kadau) highlights how economic substance findings can drive enhanced penalty exposure in microcaptive-type insurance arrangements, particularly when disclosure is at issue. Liberty Global, Inc. v. United States2 (Liberty Global) illustrates the scrutiny applied to highly engineered international planning structured to produce tax-favorable results. Alternative Carbon Resources, LLC v. United States3 (Alternative Carbon Resources) serves as a reminder that tax incentives still require the taxpayer to satisfy the substantive statutory requirements tied to the qualifying activity.
What Did Codification Do?
IRC §7701(o) applies only to transactions “to which the economic substance doctrine is relevant.” Congress also directed that relevance must be determined “in the same manner as if” §7701(o) had never been enacted. Courts and the IRS continue to look to pre-codification principles to decide whether economic substance scrutiny applies at all.
Defining the “relevance” gateway is important because the doctrine is not intended to function as a free-floating override of every technically compliant tax result. Instead, the relevance inquiry asks whether the transaction is the type of arrangement that historically warranted economic substance review. Recent litigation, particularly Liberty Global, corroborates that this threshold issue is still contested rather than settled.4
Insight from Forvis Mazars: Consider whether literal compliance with detailed code provisions fully addresses the economic substance analysis. If a transaction relies on multiple coordinated steps, unusual timing, or promoted features, contemporaneous documentation may help explain why the doctrine is or is not relevant.
Economic Substance Doctrine Two-Prong Test Under IRC §7701(o)
Once the doctrine is relevant, IRC §7701(o)(1) imposes a conjunctive test. The transaction must meaningfully change the taxpayer’s economic position apart from federal income tax effects, and the taxpayer must have a substantial non-tax purpose for entering into it.5 Congress intentionally rejected earlier formulations that could be satisfied by meeting only one prong. Notice 2010-62 states that the IRS will not accept arguments that rely on pre-codification cases, suggesting a disjunctive approach.
In practice, courts consider both an objective and a subjective component, a two-prong test. The objective prong asks whether the transaction meaningfully changes the taxpayer’s economic position apart from federal income tax effects, e.g., via pre-tax risk, cost, or upside and downside economics. The subjective prong asks whether the taxpayer had a substantial non-tax purpose for entering into the transaction, based on contemporaneous facts rather than a post-closing narrative. Courts test both prongs against the transaction’s actual economics, timing, and implementation.
Section 7701(o)(2) addresses profit potential directly. If the taxpayer relies on profit as a principal non-tax justification, the expected pre-tax profit should be substantial in relation to the expected net tax benefits, and transaction costs need to be taken into account. The statute also recognizes that the relevant transaction may include a series of transactions. IRC §7701(o)(5)(D) and Notice 2014-58 support aggregation where multiple coordinated steps function together to create the claimed tax result, while also permitting disaggregation where a tax-motivated step can be isolated from a broader business arrangement.
The unit-of-analysis question can affect the outcome in practice. Taxpayers may seek to isolate a single step with a plausible business explanation, while the IRS and courts may instead examine the integrated sequence as a whole.
Insight from Forvis Mazars: Contemporaneous proof of business purpose can matter more than a post-closing narrative when considering a transaction under the economic substance doctrine. Board materials, internal memoranda, financial models, and third-party communications may show why the transaction mattered apart from federal income tax effects. A court may test the full sequence of events rather than the step the taxpayer selected.
How Do Recent Cases Apply the Doctrine?
Kadau v. Commissioner
In Kadau, the tax court addressed a microcaptive-type insurance arrangement that the IRS challenged as lacking economic substance. The structure involved a closely held business participating in a captive insurance arrangement promoted for federal income tax benefits associated with deductible premiums and favorable treatment at the captive level. Although marketed as insurance planning, the record indicated features commonly associated with tax-driven captive structures, including pricing and implementation choices that differed from ordinary commercial insurance practices.
The court focused on whether the arrangement involved genuine risk shifting, risk distribution, and non-tax business objectives, or whether it primarily functioned to generate deductions and related tax benefits. As in other promoted structures, the court considered the transaction’s practical economics, coverage design, relationship among the parties, use of premiums, and whether the arrangement made business sense apart from the anticipated tax results.
Kadau is also important because it highlights the penalty implications. The opinion sustained the IRS’ imposition of an enhanced accuracy-related penalty after concluding that the arrangement lacked economic substance under §7701(o). Therefore, the decision serves as a reminder that the economic substance doctrine can create exposure beyond the denial of deductions or other tax benefits, particularly where disclosure is disputed or incomplete.
The tax court upheld the IRS’ position that the arrangement lacked economic substance and sustained the related penalty consequences. The practical significance of the decision lies in its combination of substance and penalty analysis and suggests that courts may view microcaptive-type structures as appropriate vehicles for economic substance scrutiny and that the disclosure posture can materially affect the financial consequences once the doctrine is invoked.
Liberty Global, Inc. v. United States
Liberty Global was involved in “Project Soy,” a 2018 internal restructuring designed to create approximately $4.8 billion of earnings and profits in a controlled foreign corporation, allowing a later sale gain to be treated as a deemed dividend eligible for the 100% dividend-received deduction under IRC §245A. The restructuring involved several tightly timed internal steps, including a capital elimination, intra-group transfers, a reincorporation that caused instruments to become newly relevant for U.S. tax purposes, and a final sale step. The intended effect was to convert a gain that otherwise would have generated less favorable international tax consequences into income potentially eligible for deduction.
On relevance, the district court took an expansive view, concluding there was no threshold inquiry separate from the statutory factors. However, IRC §7701(o)(5)(C) preserves relevance as a distinct gatekeeping inquiry, and the case illustrates the continuing debate over how the standard would apply. The court also rejected the taxpayer’s attempt to isolate a single step and instead analyzed the integrated sequence as a whole. Applying the two-prong test, the court concluded that the steps did not meaningfully change the taxpayer’s economic position apart from tax effects and lacked a substantial non-tax business purpose. As a result, the court viewed the arrangement as tax-driven planning rather than ordinary business activity.
The U.S. Court of Appeals for the Tenth Circuit affirmed in a divided opinion, with one judge dissenting. Liberty Global is a significant modern application of the codified economic substance doctrine because it illustrates that highly technical international planning can fail when the transaction’s economics and purpose do not extend beyond the intended tax result. The decision also highlights two unresolved issues: the role of the relevance gateway and the extent to which courts will aggregate related steps.
Alternative Carbon Resources, LLC v. United States
In Alternative Carbon Resources, the taxpayer claimed nearly $20 million in alternative fuel mixture credits under IRC §6426(e) tied to a feedstock diesel mixture delivered to anaerobic digester operators. The taxpayer argued the transaction qualified under the statutory incentive regime, but the U.S. Court of Appeals for the Federal Circuit (Federal Circuit) held that the mixture was not “sold for use as fuel” as required and treated the transactions as transfers for disposal, affirming the denial of the credits.
Although Congress expressly authorized the credit, the dispute centered on whether the transaction satisfied the statute’s requirement that the mixture be sold for use as fuel rather than transferred for disposal. Both the Court of Federal Claims and the Federal Circuit concluded that the taxpayer had not satisfied this requirement. The case serves as a reminder that claiming a tax incentive is not enough by itself. The taxpayer still must undertake the qualifying activity Congress intended to reward.
Insight from Forvis Mazars: For captive and other risk-transfer arrangements, documentation may identify the business problem being addressed, compare market alternatives, and include support for pricing and anticipated claims experience. In addition, it may also describe how the structure changes economics apart from taxes, while addressing penalty and disclosure considerations during planning.
Cross-border restructurings that rely on timing mismatches, internal instrument classification changes, or earnings-and-profits steps may be supported by a clearly articulated non-tax business objective, with contemporaneous documentation explaining why a more direct structure did not meet the same objective. Consider documenting tax incentive transactions with the same rigor as more traditional shelter-sensitive structures, with a file demonstrating that the taxpayer undertook the qualifying investment, sale, or operational activity Congress intended to reward.
What Are the Main Penalty & Planning Implications?
Congress paired the codification with significant penalties. IRC §6662(b)(6) generally imposes a 20% accuracy-related penalty on an underpayment attributable to a transaction lacking economic substance, increasing to 40% under IRC §6662(i) when relevant facts are not adequately disclosed.6 ,7 Reasonable-cause relief is also limited. IRC 6664(c)(2) and IRC 6664(d) significantly narrow the ordinary good-faith defense in this setting.8 ,9 Notice 2010-62 further emphasizes that the codified doctrine and penalty provisions operate together for transactions entered into on or after March 31, 2010.
Actions to Consider for Economic Substance Documentation
- Document non-tax objectives contemporaneously, using materials created during planning rather than after the fact.
- Model pre-tax economics realistically, including transaction costs and downside risk.
- Consider whether a court is more likely to test a single step or an integrated series.
- Address penalty and disclosure analysis during planning, not as a downstream compliance exercise.
Kadau, Liberty Global, and Alternative Carbon Resources all show that economic substance after codification remains unsettled. Courts continue to shape the doctrine’s relevance gateway, the operation of the two-prong test, the unit of analysis, and the consequences of inadequate disclosure. Technical compliance with the code remains important, but it may not be enough when the underlying economics and substantial non-tax objectives do not support the claimed result.
Insight from Forvis Mazars: Businesses may benefit from contemporaneous documentation, including business-purpose memoranda, board or management approvals, pre-tax cash flow models, profit sensitivity analysis, descriptions of operational objectives, third-party benchmarking, and other relevant documentation.
How Forvis Mazars Can Help
Our experienced Tax team can assist in considering whether economic substance scrutiny may be relevant to a proposed transaction, reviewing non-tax objectives and pre-tax economics, and preparing contemporaneous documentation designed to support the intended tax treatment. We also can help address aggregation risk, disclosure considerations, and potential penalty exposure before implementation.
If you are evaluating a transaction that may raise economic substance questions, please reach out to a professional at Forvis Mazars to discuss planning, documentation, disclosure, and penalty considerations.
- 1Kadau v. Commissioner, T.C. Memo. 2025‑81 (U.S. Tax Ct. July 31, 2025).
- 2Liberty Global, Inc. v. United States, No. 23‑1410 (10th Cir. April 21, 2026).
- 3Alternative Carbon Resources, LLC v. United States, 939 F.3d 1320 (Fed. Cir. 2019).
- 4IRC §7701(o)(5)(C) relevance preserved as if not enacted.
- 5IRC §7701(o)(1) Conjunctive two-prong test; IRC §7701(o)(2) Profit potential and transaction costs.
- 6IRC §6662(b)(6) Accuracy-related penalty.
- 7IRC §6662(i) Nondisclosed noneconomic substance transaction.
- 8IRC §6664(c)(2) Reasonable cause limitation.
- 9IRC §6664(d) Special rules for noneconomic substance transactions.