A divided Tenth Circuit affirmed the District of Colorado’s ruling against the taxpayer in Liberty Global v. United States, holding that the economic substance doctrine overrode the taxpayer’s reliance on the literal language of Internal Revenue Code (IRC) § 245A. Liberty Global is the first decision by a federal appellate court on the codified economic substance doctrine, which was added to the IRC as § 7701(o)in 2010.
Regardless of the merits of the decision, the case may provide the Internal Revenue Service (IRS) with even more incentive to argue that a wide swath of tax planning should be disqualified as lacking economic substance. It therefore highlights the need for taxpayers to carefully document the economic rationale and effect of transactions that result in tax savings and to ensure that IRS examiners and judges clearly understand the economic basis for their transactions.
The Tenth Circuit upheld the district court’s conclusion that the codified economic substance doctrine is “relevant” in situations where the taxpayer “mechanically utilize[s] the provisions of the Tax Code to obtain a benefit not intended by Congress.” The facts of the case concerned LGI, a taxpayer who, as framed by the Tenth Circuit, had benefitted from a statutory “mismatch” expressly present in the 2017 Tax Cuts and Jobs Act to take a deduction under IRC § 245A. The IRS disallowed LGI’s deduction on the grounds that the transaction giving rise to the deduction lacked economic substance.
Section 7701(o) codified a longstanding caselaw-based test, albeit a test that was applied differently by various courts. The codification of economic substance was thus an attempt to standardize the test. The codified economic substance doctrine states on its face that it only applies to any transaction to which the economic substance doctrine is relevant. Beyond this threshold relevancy requirement, a transaction is treated as having economic substance only if it satisfies two tests. Under the first prong (the “objective test”), the transaction must meaningfully change the taxpayer’s economic position apart from federal income tax effects. Under the second prong (the “subjective test”), a taxpayer must have a substantial non-tax purpose for entering into the transaction. Section 7701(o) states that “[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted.”
On appeal, LGI argued that the district court erred in disregarding the relevancy requirement for applying the codified economic substance doctrine. (LGI conceded that if the relevancy threshold was satisfied, then the two prongs of the economic substance test were also satisfied.) The district court in Liberty Global had held that the relevance requirement was coextensive with the two prongs of the codified economic substance doctrine test described above. LGI, on the other hand, argued that the transaction at issue, Project Soy, was made up of “basic business transactions” as to which the common law economic substance doctrine had not previously been relevant, such as a check-the-box election to incorporate a foreign subsidiary.
Notably, the U.S. Tax Court in Patel v. Commissioner (a unanimous, reviewed decision) recently considered the relevancy test. In Patel, the Tax Court disagreed with the district court in Liberty Global and expressly rejected that the relevancy test was coextensive with the two prongs of the codified economic substance doctrine, holding that it constituted a separate, threshold inquiry.
The Tenth Circuit, however, held that the codified economic substance doctrine was relevant to LGI’s 245A deduction. The court of appeal agreed with the district court that the proper framing or what it termed “unit of measurement” was Project Soy as a whole, not the individual steps contained in the plan. Even if Project Soy’s steps included “basic business transactions,” the economic substance doctrine was relevant to the overall plan. Thus, the Tenth Circuit upheld the district court’s decision, stating that “Project Soy was an elaborate tax-avoidance scheme designed to shield billions in income … based on economically meaningless transactions.”
The Tenth Circuit also rejected LGI’s argument that the economic substance doctrine is a “mere interpretive tool that cannot be used to override the literal terms of the tax code.” The court points to the fact that Project Soy was “specifically designed” to take advantage of the statutory mismatch. And the court pointed to the district court’s factual finding that LGI had generated “artificial” earnings and profits to do so, rejecting (like the district court) the taxpayer’s claim that the transactions constituted basic business transactions. It is also notable that the appeals court decision attached the planning deck to its filed opinion.
In a lengthy dissent, Judge Allison H. Eid stated she would hold that the relevance reference in § 7701(o) makes it “clear that there exists a mandatory relevancy determination before the government may invoke the economic substance doctrine to disallow tax benefits.” She would have reversed and remanded, because the district court’s failure to engage in this threshold analysis constituted reversible error. In addition, she noted that the § 245A deduction stemmed from realization of a real economic gain in LGI foreign subsidiary TGH’s assets. The government did not argue, the dissent noted, that the “earnings and profits” were a façade; this was the same gain that the government sought to tax. As in Cottage Savings, the taxpayer decided when to realize this economic gain. The dissent thus concluded that LGI’s formal characterization of the transaction did not fail to capture economic reality, which is the proper scope for application of the economic substance doctrine. Nor did the dissent believe it was the court’s job to rescue Congress from its drafting errors.
As a next step, the taxpayer may either petition for an en banc rehearing (by the entire Tenth Circuit, rather than merely a panel of three judges), or petition for certiorari at the U.S. Supreme Court.