Section 7701(o) Archives - TAX CONTROVERSY 360

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

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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IRS Changes Position on Approval for Assertion of Codified Economic Substance Doctrine

In March 2010, Congress codified the economic substance doctrine in Internal Revenue Code (Code) Section 7701(o). The codification clarified that a conjunctive analysis applies in determining if the doctrine applies. The codified economic substance doctrine applies when a transaction does not have economic substance or lacks a business purpose. When the doctrine applies, a taxpayer is subject to a 20% strict liability penalty (40% in the case of undisclosed transactions) on any underpayment attributable to the disallowed tax benefit claimed.

Congress acknowledged that the codified economic substance doctrine should be applied sparingly, and the Joint Committee on Taxation, in a report issued prior to the enactment of the doctrine, provided detailed guidance on when the doctrine should apply. The Internal Revenue Service (IRS) issued guidance shortly after the codification acknowledging these points. The IRS also put in place detailed procedures for examiners to follow in determining whether to assert the codified economic substance doctrine.

One of the procedures put in place was the approval by the Director, Field Operation before the codified economic substance doctrine could be formally asserted. An approval request was to be made after consultation with the revenue agent’s manager and local counsel. Additionally, taxpayers were to be provided “the opportunity to explain their position.”

On April 22, 2022, the IRS’s Large Business & International (LB&I) Division issued a memorandum—LB&I-04-0422-0014—to all LB&I and Small Business/Self Employed examination employees (Updated Guidance). The Updated Guidance removes the requirement to obtain executive approval before asserting the codified economic substance doctrine. The Updated Guidance states that this change aligns penalties for lack of economic substance with other assessable penalties which do not require executive approval. However, the changes do not remove the supervisory approval requirement under Code Section 6751.

In connection with the Updated Guidance, revisions are being made to the relevant provisions of the Internal Revenue Manual (IRM). The IRM revisions eliminate some of the considerations previously set forth in the four-step process that revenue agents were required to undertake in determining whether the doctrine should be applied.

Practice Points: Although the Updated Guidance has no impact on the substance of the codified economic substance doctrine itself, the change is disappointing news. As a result of the relaxed rules for the doctrine’s assertion, taxpayers can reasonably assume that the doctrine may more frequently be asserted on audit. Thus, it is now even more important to properly document transactions to demonstrate they have sufficient economic substance and a business purpose.