LIBERTY GLOBAL AND ECONOMIC SUBSTANCE
The Liberty Global case is attracting widespread attention. Here’s why, and where it might lead.
THE DECISION
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In The United States District Court For The District Of Colorado: Senior Judge R. Brooke Jackson
https://assets.law360news.com/1739000/1739665/https-ecf-cod-uscourts-gov-doc1-039110955360.pdf
The United States now contends that LGI is not entitled to the tax refund that it seeks in this proceeding because the economic substance doctrine (or alternatively, the step transaction doctrine) dictates that Steps 1-3 of Project Soy should be disregarded when calculating LGI’s tax obligations. LGI argues that neither doctrine should apply, and therefore, that the E&P generating steps, which permitted the § 245A deduction for the TGH transaction, should be given effect. Both parties assert that the facts relevant to the analysis of whether and how the economic substance doctrine applies are not contested, and that this lawsuit can be resolved as a legal matter. See ECF No. 70 at 2 (joint letter of intent to file for summary judgment).
I find that the economic substance doctrine does apply, and that its application provides that LGI cannot properly claim the § 245A deduction. Therefore, I do not reach analysis as to the step transaction doctrine.
The economic substance doctrine is one variation of the common law doctrine of “substance over form,” which instructs courts to effectuate the “plain intent of the relevant statutory regime”—in this case, the tax code—by viewing transactions in terms of their “objective economic realities” rather than their technical compliance with statutory requirements. See Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978) (concluding that the economic substance doctrine applied to a saleand-leaseback transaction by looking “to the objective economic realities of a transaction rather than to the particular form the parties employed”). In the tax context, the doctrine permits courts to ignore transactions that are “mere device[s]” for tax avoidance. See Gregory v. Helvering, 293 U.S. 465, 468-70 (1935) (refusing to give effect to a corporate reorganization that “technically complied” with statutory requirements but that the Court found had “no business or corporate purpose” other than to transfer corporate shares to the petitioner).
The doctrine is codified in 26 U.S.C. § 7701(o), which provides in relevant part that “[i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.”
The legislative history of § 7701(o) clarifies that the doctrine “involves a conjunctive analysis.” H.R. Rep. 111-443 at 297. In other words, for the economic substance doctrine to apply, the transaction must satisfy both prongs of the statutory test—the transaction “must change in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and the taxpayer must have a substantial non-Federal-income-tax purpose for entering into such transaction.” Id. This clarification in the House Report was intended to “eliminate[] the disparity” in application of the doctrine between federal circuit courts that applied the test conjunctively and courts that applied the test disjunctively. See id
“The ultimate determination of whether a transaction lacks economic substance is a question of law.” Sala v. United States, 613 F.3d 1249, 1252 (10th Cir. 2010), as amended on reh’g in part, (10th Cir. Nov. 19, 2010) (citing James v. Comm’r, 899 F.2d 905, 909 (10th Cir. 1990) (“[W]e review de novo the ultimate characterization of the transactions as shams.”)); see also Frank Lyon, 435 U.S. at 581 n. 16 (“The general characterization of a transaction for tax purposes is a question of law….”).
Application of the provision here requires resolution of several issues: (1) whether the doctrine is “relevant” to this set of facts within the meaning of the statute’s prefatory clause; (2) the appropriate level of granularity to be used in selecting the transaction or set of transactions to be analyzed; (3) whether any exemptions exist, and if so, whether they apply here; and (4) whether the conjunctive test—the transaction had no meaningful non-tax effect and the taxpayer had no subjective non-tax purpose—is satisfied here.
…
…courts characterize the ultimate inquiry into economic substance as asking whether a transaction’s benefits violate the legislative intent. See, e.g., Gregory, 293 U.S. at 467 (disregarding a corporation’s “so-called reorganization” because it “was nothing more than a contrivance” to evade taxes, and therefore lay “outside the plain intent of the statute”). Certain circumstances raise “red flags” that a transaction lacks economic substance and correspondingly violates Congress’s intent, “such as when a transaction produces enormous tax savings without a concomitant economic loss, or when something ‘smack[s] of a too-good-to-be-true transaction’ and lacks ‘an appreciable effect, other than tax reduction.’” Blum, 737 F.3d at 1310 (quoting James, 899 F.2d at 908)
The two prongs enumerated in § 7701(o) reflect in the most inclusive terms the situations that violate congressional intent for lack of economic substance: when a taxpayer intentionally enters a transaction that serves no purpose other than tax evasion with the sole purpose of evading taxes. The statutory prongs are not inconsistent with the more specific “red flags” such as those described above, and in fact those red flags either rephrase the statutory factors or inform analysis of the two statutory prongs as useful sub-inquiries. For example, the fact that a transaction “lacks an appreciable effect, other than tax reduction” is equivalent to the statutory prong describing the inquiry into the transaction’s objective purpose (or lack thereof), and the fact that a transaction “produces enormous tax savings without a concomitant economic loss” is a fact suggestive of both the taxpayer’s subjective intent and the objective purpose of the transaction.
THE PENDING APPEAL
The filing on the pending appeal runs these arguments:
A. The economic substance doctrine is a tool for interpreting tax terms that require inquiry into economic reality and taxpayer motive — it cannot be used to override the Tax Code and regulations.
1. Section 7701(o) clarifies how courts should apply the economic substance doctrine and reaffirms that the doctrine isn't relevant to all statutes and regulations.
2. Caselaw makes clear that the economic substance doctrine is a tool for interpreting tax terms that make economic reality and taxpayer motive relevant.
3. The economic substance doctrine isn't relevant, and plays no role, when the statute or regulation doesn't require inquiry into economic reality and taxpayer motive.
B. The IRS cannot use the economic substance doctrine to disallow LGI's §245A deduction, because the applicable statutory and regulatory provisions don't make economic reality or taxpayer motive relevant to Project Soy.
1. The economic substance doctrine doesn't permit disregarding Telenet Group's conversion to a corporation or its capitalization choices in steps one through three, because the law permits taxpayers to make those choices based on tax consequences.
2. LGI satisfied §245A's requirements, and the government doesn't dispute that if steps one through three are respected, it cannot use the economic substance doctrine to disallow LGI's claimed §245A deduction.
C. The district court's reasoning lacks merit.
1. The district court wrote the relevance requirement out of §7701(o)
2. TGH's earnings and profits were not “artificial” — they were just as real as the gain the IRS seeks to tax.
3. The government cannot selectively apply the economic substance doctrine.
A and B are an interesting line of challenge. Essentially:
· There is an economic substance Doctrine for interpretation of tax statutes
· But the statute must actually call the Doctrine into effect: it is not a freestanding Doctrine.
If the premise is right, then that’s a home run argument.
THE STATUTE
https://www.taxnotes.com/research/federal/usc26/7701
(o) Clarification of economic substance doctrine.
(1) Application of doctrine.
In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if-- (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.
(2) Special rule where taxpayer relies on profit potential.
(A) In general. The potential for profit of a transaction shall be taken into account in determining whether the requirements of subparagraphs (A) and (B) of paragraph (1) are met with respect to the transaction only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected.
(B) Treatment of fees and foreign taxes. Fees and other transaction expenses shall be taken into account as expenses in determining pre-tax profit under subparagraph (A). The Secretary shall issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases.
(3) State and local tax benefits. For purposes of paragraph (1), any State or local income tax effect which is related to a Federal income tax effect shall be treated in the same manner as a Federal income tax effect.
(4) Financial accounting benefits. For purposes of paragraph (1)(B), achieving a financial accounting benefit shall not be taken into account as a purpose for entering into a transaction if the origin of such financial accounting benefit is a reduction of Federal income tax.
(5) Definitions and special rules. For purposes of this subsection—
(A) Economic substance doctrine. The term "economic substance doctrine" means the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.
(B) Exception for personal transactions of individuals. In the case of an individual, paragraph (1) shall apply only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income.
(C) Determination of application of doctrine not affected. The 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.
(D) Transaction. The term "transaction" includes a series of transactions.
So, the appeal rests on the words “In the case of any transaction to which the economic substance doctrine is relevant”
· The statute directs an enquiry into the transaction
· Not into whether a statute applies – or disapplies – the Doctrine.
This looks like a re-run of the argument Plaintiff lost in District Court:
1. Relevance of the doctrine.
LGI argues in effect that the prefatory clause in § 7701(o)—“[i]n the case of any transaction to which the economic substance doctrine is relevant”—should be distinguished from the operative clause—“a transaction is disregarded for tax purposes unless … [it meaningfully changes the taxpayer’s non-tax economic position and was conducted with a substantial non-tax purpose]”— and given independent effect. See ECF No. 75 at 7. LGI would have the Court view the prefatory clause as an instruction to conduct a threshold analysis into whether the doctrine is “relevant” to the transaction at issue, and then only if the threshold is met, to continue into the two-pronged inquiry set out in the operative clause of the statute. See id. (“For purposes of this motion, LGI is not arguing that the Entity Conversion satisfies that two-pronged test. Instead, LGI asks the Court to decide the threshold legal question of whether the ESD is ‘relevant’ to the Entity Conversion [step 3 of Project Soy]”).
The Court analyzed and rejected as follows:
LGI relies on a House Report for the proposition that the legislative intent was to explicitly limit the types of transactions to which the ESD would be “relevant”. See, e.g., ECF No. 75 at 4 (citing H.R. Rep. No. 111-443, 296 (2010). However, contrary to LGI’s interpretation, the House Report emphasizes that “the economic substance doctrine becomes applicable, and a judicial remedy is warranted, where a taxpayer seeks to claim tax benefits, unintended by Congress, by means of transactions that serve no economic purpose other than tax savings.” H.R. Rep. No 111-443, 292 (citing ACM P’ship v. Comm’r, 157 F.3d 231 (3d Cir. 1998), aff’d 73 T.C.M. (CCH) 2189 (1997), cert. denied 526 U.S. 1017 (1999)) (emphasis added). The ordinary meaning of the report’s statement that the doctrine “becomes applicable” under certain circumstances strongly suggests that the doctrine is “relevant” within the meaning of the statute under the same circumstances. This statement in turn suggests that the doctrine’s relevance is coextensive with the statute’s test for economic substance, provided by the operative clause.
Moreover, the conclusion that there is no threshold “relevance” inquiry that precedes the inquiry described in the operative clause—is consistent with the interpretations of the Supreme Court and courts in the Tenth Circuit. See, e.g., Blum v. Comm’r, 737 F.3d 1303, 1309 (10th Cir. 2013) (citing Jackson v. Comm’r, 966 F.2d 598, 601 (10th Cir. 1992)) (describing the “doctrinal framework” of the economic substance doctrine as “fairly straightforward” and instructing courts to “ask two questions: (1) what was the taxpayer's “subjective business motivation,” and (2) did the transaction have objective economic substance?”). The Tenth Circuit there conspicuously omits any mention of a threshold inquiry or a separate or additional question that courts must resolve in applying the economic substance doctrine. To manufacture an additional question here—which as LGI argues would then short-circuit the entire statutory analysis—would contravene the Tenth Circuit’s instructions and frustrate the purpose of the doctrine itself. Instead, courts characterize the ultimate inquiry into economic substance as asking whether a transaction’s benefits violate the legislative intent. See, e.g., Gregory, 293 U.S. at 467 (disregarding a corporation’s “so-called reorganization” because it “was nothing more than a contrivance” to evade taxes, and therefore lay “outside the plain intent of the statute”). Certain circumstances raise “red flags” that a transaction lacks economic substance and correspondingly violates Congress’s intent, “such as when a transaction produces enormous tax savings without a concomitant economic loss, or when something ‘smack[s] of a too-good-to-be-true transaction’ and lacks ‘an appreciable effect, other than tax reduction.’” Blum, 737 F.3d at 1310 (quoting James, 899 F.2d at 908).
At the risk of tautology, I proceed with the conclusion that the economic substance doctrine applies when a transaction lacks economic substance. The question of whether the doctrine lacks economic substance is equivalent to the question of whether the tax benefits achieved in the transaction violate congressional intent and is analyzed using the enumerated statutory prongs— which are in turn elaborated and informed by the “red flags” that courts have long described. See Blum, 737 F.3d at 1310 (quoting James, 899 F.2d at 908-09) (emphasizing that the “two [statutory] factors, rather than being independent prerequisites to finding an absence of economic substance, are simply ‘more precise factors to consider’ in that analysis”). There is no “threshold” inquiry separate from the statutory factors.
…
Just as the Second Circuit in Bank of New York Mellon Corp. v. Commissioner affirmed the district court’s authority there to segregate “a routine transaction [from] a transaction lacking economic substance” to avoid stymying the doctrine’s purposive application by an arid formalism, 801 F.3d 104, 121 (2d Cir. 2015), the Court here may use its authority to aggregate interrelated transactions to likewise avoid frustrating the doctrine’s purpose. Therefore, the Court rejects LGI’s invitation to conduct the economic substance analysis with an artificially narrow focus on Step 3 of Project Soy, and instead considers whether Steps 1, 2, and 3 together should be recognized for tax purposes (affording LGI the claimed deduction) or disregarded for lack of economic substance
HOLLAND KNIGHT COMMENT
Highlights
- The Liberty Global appeal has practitioners and taxpayers concerned that the economic substance doctrine will be applied to disallow the tax benefits of ordinary course of business decisions and disrupt basic tax planning.
- This trend will be particularly troubling for transactions that are motivated in significant part by tax credits or other tax benefits under the Inflation Reduction Act.
The Liberty Global Inc. v. United States appeal has practitioners and taxpayers concerned that the economic substance doctrine will be applied to disallow the tax benefits of ordinary course of business decisions and disrupt basic tax planning. The economic substance doctrine is a judicial doctrine that allowed courts to disregard tax benefits if the transaction lacked economic substance or a business purpose. Congress codified the economic substance doctrine in 2010.
Exceptions to the Economic Substance Doctrine
The legislative history to the codified economic substance doctrine provides that it does not apply to basic business transactions, even though the decisions are primarily – if not solely – driven by tax considerations. These basic business transactions include:
- decisions to capitalize a business with debt or equity
- choices between using a foreign or domestic entity
- tax classification of an entity
- choices to use related parties
In addition, the legislative history makes clear that if the tax benefits are consistent with Congress' purpose in enacting the statute, the tax benefit should be allowed. For example, tax credits should be allowed if the taxpayer makes the investment that the credit was intended to encourage.
Liberty Global
Liberty Global involves a series of intercompany transactions designed to leverage the different effective dates between two different provisions enacted in the Tax Cuts and Jobs Act. The regulations that would have prevented the tax result in Liberty Global were held invalid, so the government sought to disallow the tax benefits under the economic substance doctrine. The taxpayer responded that several of the steps in the transaction – including the tax classification of an entity – were exempt from the economic substance doctrine under the legislative history and prior case law. The district court disallowed the tax benefits under the economic substance doctrine and held that there is no separate threshold inquiry as to whether the economic substance doctrine applies to the transaction.
The decision has been appealed to the U.S. Court of Appeals for the Tenth Circuit, and Liberty Global filed its opening brief on April 30, 2024. Multiple amicus briefs were filed by business organizations supporting Liberty Global and asking the Tenth Circuit to reverse the decision. Each expressed significant concern that the district court's application of the economic substance doctrine creates uncertainty and confusion for routine transactions that Congress never intended to be covered.
Conclusion and Takeaways
If the district court's decision is upheld, there is a real risk that the IRS raises the economic substance doctrine in audits, appeals and litigation to disallow tax benefits of ordinary course of business transactions that taxpayers have long thought were exempt. This trend will be particularly troubling for transactions that are motivated in significant part by tax credits or other tax benefits under the Inflation Reduction Act.
NO POLE STAR
The basic problem with the economic substance doctrine is that you are comparing something that happened with a hypothetical that never happened.
Article I, Section 8, Clause 1:
The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States
We know from United States v. Ptasynski, 462 U.S. 74, 82 (1983) that:
https://www.law.cornell.edu/supremecourt/text/462/74
18 This general purpose, however, does not define the precise scope of the Clause. The one issue that has been raised repeatedly is whether the requirement of uniformity encompasses some notion of equality. It was settled fairly early that the Clause does not require Congress to devise a tax that falls equally or proportionately on each State. Rather, as the Court stated in the Head Money Cases, 112 U.S. 580, 5 S.Ct. 247, 28 L.Ed. 798 (1884), a "tax is uniform when it operates with the same force and effect in every place where the subject of it is found." Id., at 594, 5 S.Ct., at 252.
19 Nor does the Clause prevent Congress from defining the subject of a tax by drawing distinctions between similar classes. In the Head Money Cases, supra, the Court recognized that in imposing a head tax on persons coming into this country, Congress could choose to tax those persons who immigrated through the ports, but not those who immigrated at inland cities. As the Court explained, "the evil to be remedied by this legislation has no existence on our inland borders, and immigration in that quarter needed no such regulation." Id., at 595, 5 S.Ct., at 252. The tax applied to all ports alike, and the Court concluded that "there is substantial uniformity within the meaning and purpose of the Constitution." Ibid. Subsequent cases have confirmed that the Framers did not intend to restrict Congress' ability to define the class of objects to be taxed. They intended only that the tax apply wherever the classification is found. See Knowlton v. Moore, 178 U.S. 41, 106, 20 S.Ct. 747, 44 L.Ed. 969 (1900);11 Nicol v. Ames, 173 U.S. 509, 521-522, 19 S.Ct. 522, 527-528, 43 L.Ed. 786 (1899).
Now, there is a clear problem with putting the economic substance doctrine together with the Uniform requirement. Any taxable entity is located somewhere – but a hypothetical entity doing hypothetical transactions is not.
Also, these hypothetical transactions can’t be pulled under the Uniform umbrella. The whole basis of the economic substance doctrine is that: although you are following the actual rules laid out by the statute, you are to be taxed as if you weren’t.
There is another route, which the outcome of this Appeal may encourage use of. It is a fundamental facet of constitutional government that the law have an inherent quality of predictability.
The Courts have shown concern about this in matters of jurisdictional overlap. See:
https://judicature.duke.edu/articles/predictability-in-the-law/
But there is way more to it. How can the fundamental requirement of predictability by satisfied by hypothetical matters that sit only in the mind of some IRS officer, or ultimately a judge?
The Liberty Global case has brought attention. Maybe now routes are opening to argue that the economic substance doctrine has no predictable substance.