Economic Substance Doctrine Archives

Federal District Court Rules Codified Economic Substance Doctrine Vitiates Tax Transaction Benefits

by Timothy S. Shuman, Kevin Spencer and Samuel J. Preston | Nov 3, 2023 | Court Procedure Matters, Trial Courts

On October 31, 2023, the US District Court for the District of Colorado, in Liberty Global, Inc. v. United States, applied the codified economic substance doctrine and held—on summary judgment—that Liberty Global, Inc. (LGI) must recognize $2.4 billion in taxable gain. At issue was a four-step transaction that took place in 2018, as a result of which LGI took the position that a dividends received deduction offset a $2.4 billion taxable gain based on a purported “mismatch” between (1) the rules for taxation of global intangible low-taxed income (GILTI) or subpart F income of a controlled foreign corporation (CFC) and (2) the qualification of an entity as a CFC.

In rejecting what it described as LGI’s “scheme” to “exploit” the apparent mismatch, the Court made three preliminary holdings. First, LGI argued that the prefatory clause in Internal Revenue Code (IRC) section 7701(o)—“[i]n the case of any transaction to which the economic substance doctrine is relevant”—requires courts to conduct a threshold analysis into whether the economic substance doctrine is “relevant” to the transaction at issue, and only then can courts consider whether the transaction has “economic substance.” The Court rejected this argument, stating that “there is no threshold ‘relevance’ inquiry that precedes the inquiry” into a transaction’s economic substance. Instead, “the doctrine’s relevance is coextensive with the statute’s test for economic substance.” Second, the Court held that the proper unit of analysis is “the transaction in aggregate” and did not analyze any step or phase in isolation, even if it could be said that the tax benefit at issue was “created” because of a particular step. And third, the Court denied LGI’s contention that its transaction falls under any exception to the economic substance doctrine. The Court determined that LGI’s transaction was not a “basic business transaction” and, although a series of transactions that constitute a corporate organization or reorganization might fall outside the economic substance doctrine, a series of transactions that merely includes a reorganization is not necessarily exempt.

The Court then applied the economic substance doctrine. LGI conceded that steps one through three “did not change, in a meaningful way, LGI’s economic position,” so the Court considered whether the steps had a substantial, non-tax purpose. LGI asserted that the transaction was “in furtherance” of Belgian corporate law requirements, but the Court found LGI had failed to indicate how the transaction facilitated such compliance. Moreover, an action may be “in furtherance” of some end without being a “substantial purpose” of the action, as IRC Section 7701(o) requires. Even if an isolated step provided substantial, non-tax benefits for LGI, that does not suggest the existence of a non-tax purpose for “the entire scheme.” Thus, the Court held that “the only substantial purpose of the transaction was tax evasion.”

The Court concluded that steps one through three of the transaction must be disregarded under federal law, resulting in $2.4 billion of taxable gain on LGI’s sale of its subsidiary during step four without such gain being converted to a dividend and [...]

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Update on IRS Enforcement Efforts

by Kevin Spencer and McDermott Will & Emery | Nov 16, 2022 | IRS Audits, IRS Guidance, Tax Reform, Transfer Pricing Resource

We frequently post about the Internal Revenue Service’s (IRS) tax enforcement trends and announcements. Prior examples from this year include the release of a five-year strategic plan emphasizing enforcement, the plan to hire up to 200 additional attorneys to assist with litigation efforts, the implementation of the Large Partnership Compliance (LPC) Pilot Program, a focus on tax compliance of non-US citizens and residents, and the creation of a new Joint Strategic Emerging Issues Team to identify emerging “abusive transactions.” Over the past several weeks, the IRS has provided additional updates on its enforcement efforts and future plans, including the following:

The IRS is considering raising the economic substance doctrine more frequently in transfer pricing examinations—even those where taxpayers have transfer pricing documentation—and asserting penalties more often in transfer pricing cases. This follows the announcement last April that executive approval is no longer needed before asserting the codified economic substance doctrine under Internal Revenue Code Section 7701(o).

The IRS plans to grow the LPC program and envisions it functioning similar to corporate examinations conducted by the Large Business & International Division.

The IRS’s Criminal Investigation (CI) Division is highly focused on criminal digital asset cases and intends to make many of these cases public. This follows the recent release of the CI Division’s annual report.

The IRS intends to expend more resources on examinations of high-income/high-net-worth taxpayers.

The IRS has proposed to require the disclosure of more information regarding corporate taxpayers’ uncertain tax positions, including citations to contrary authorities, which, if finalized, will likely lead to more examinations and challenges to tax reporting positions.

Practice Point: Tax enforcement has been down over the past several years, including a slowdown in audit operations during the COVID-19 pandemic. With increased funding from the Inflation Reduction Act of 2022 and proposed restrictions on access to IRS Appeals for certain matters, we expect more examinations and tax disputes in the near future. Taxpayers and their advisors should prepare. Consider working with your tax controversy advisor to discuss your more vulnerable return positions to see how to better defend against the impending tax enforcement wave!

Santander Holdings USA Asks the Supreme Court to Address Economic Substance Doctrine

by Roger J. Jones | Apr 7, 2017 | Appellate Courts, Court Procedure Matters, Trial Courts, Uncategorized

From 2003 to 2007, Sovereign Bancorp, Inc. (Sovereign) – now known as Santander Holdings USA, Inc. (Santander) – engaged in a so-called STARS transaction with Barclays Bank. According to Santander, “[b]y engaging in the STARS transaction, Sovereign transferred some of its income tax liability from the United States to the United Kingdom,” it “secured a loan of $1.15 billion,” and it received a payment “which effectively reduced its lending costs.” On its Federal corporate income tax returns for those years, Sovereign claimed foreign tax credits (FTCs) for UK taxes it paid in connection with the STARS transaction. It also claimed deductions for the interest paid on the $1.15 billion loan.

In 2009, the Internal Revenue Service (IRS) issued a Notice of Deficiency disallowing Sovereign’s FTCs and its deductions for interest paid on the $1.15 billion loan. The IRS did not challenge Sovereign’s compliance with the statutory and regulatory rules governing FTCs, instead arguing that Sovereign’s STARS transaction lacked “economic substance.” Sovereign paid the deficiency and sued for a refund in the US District Court for the District of Massachusetts. When the district court held for Sovereign on both issues, the IRS appealed to the US Court of Appeals for the First Circuit, but only with respect to the FTC issue. The crux of the issue was how to treat the UK taxes and the related FTCs for purposes of the “economic substance” analysis. Relying on Salem Financial, Inc. v. U.S., 786 F.3d 932 (Fed. Cir. 2015), and Bank of New York Mellon Corp. v. Comm’r, 801 F.3d 104 (2d Cir. 2015), the IRS argued that the UK taxes should be treated as an expense but that the related FTCs should be ignored in determining pre-tax profit. Citing IES Indus., Inc. v. U.S., 253 F.3d 350 (8th Cir. 2001), and Compaq Computer Corp. v. Comm’r, 277 F.3d 778 (5th Cir. 2001), Sovereign argued that either both should be included in the profit analysis or both should be ignored. The First Circuit held that Sovereign’s STARS transaction lacked “economic substance,” and upheld the disallowance of the FTCs at issue. In doing so, it treated the UK taxes as expenses that reduced pre-tax profit and ignored the related FTCs, following the Federal and Second Circuit’s approach. Santander Holdings USA, Inc. v. U.S., 844 F.3d 15 (1st Cir. 2016).

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