In a 2–1 ruling against the taxpayer, the United States Court of Appeals for the Tenth Circuit upheld the federal government’s use of the Economic Substance Doctrine in Liberty Global v. United States. NTUF’s Taxpayer Defense Center filed an amicus curiae (“friend of the court”) brief in the case, arguing the doctrine should be applied narrowly and only when clearly needed.
The Economic Substance Doctrine is a judge-created principle of the tax law that requires that a transaction must have both a “substantial purpose” aside from reduction of tax liability and the transaction must change in a “meaningful way” the economic position of the taxpayer. Congress later placed the Economic Substance Doctrine in the tax code, 26 U.S.C. § 7701(o), but said it should be used only where it is “relevant.”
This threshold relevance determination is necessary to avoid unjustly penalizing taxpayers for legitimate activity. Many ordinary activities, such as buying a home, investing in environmental improvements, or starting a small business, are structured in a certain way for tax purposes. Merely seeking these benefits should not automatically invalidate a transaction as lacking economic substance.
But, calling the relevance question a “red herring,” the majority opinion instead says the only threshold determination is whether a transaction’s use of the tax code is in accordance with congressional purpose in enacting these rules. The majority opinion took issue with Liberty Global’s use of a combination of multiple provisions of 2017’s Tax Cuts and Jobs Act to lower the taxes due from Liberty Global and its subsidiaries. Liberty Global repatriated foreign-corporate income by changing the corporate form and capital structure of one of its subsidiaries, and then later selling the interest in this subsidiary before the last day of the tax year to generate a deduction under 26 U.S.C. § 245A. Called “Project Soy” by the consultants at Deloitte who developed this plan, the Tenth Circuit majority held that the Economic Substance Doctrine applies to “attempts by taxpayers to mechanically utilize the provisions of the Tax Code to obtain a benefit not intended by Congress.”
Judge Allison Eid, a short-lister for nomination to the Supreme Court, wrote a strong dissent focused on the text of the statute governing the Economic Substance Doctrine, IRC § 7701(o). In her view, the congressional mandate “ma[d]e clear that there exists a mandatory relevancy determination before the government may invoke the economic substance doctrine to disallow tax benefits.” She cautioned against “improperly casting our court into the role of creating rather than construing legislation.” The majority opinion, in Judge Eid’s view, “effectively hand[ed] the government a blank check to declare any transactions it does not like to be within” the Economic Substance Doctrine.
Tax law has a long history of “technically correct” being “the best kind of correct.” That is because, as the United States Supreme Court recognized in 2008, it has long been the rule that a taxpayer holds the “legal right . . . to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits.”
And the Tenth Circuit’s decision is now in tension with other circuits. The Sixth Circuit held that, if the tax code “authorizes the ‘formal’ transactions the taxpayer entered into, then it is of no consequence that it was all an elaborate scheme to get rid of income taxes.” The Eleventh Circuit similarly ruled that while “[t]here may be no tax-independent reason for a taxpayer to choose between different ways of financing the business [i.e., through debt or equity],” it does not follow that the decision is invalid under the Economic Substance Doctrine. There can still be a “business purpose” of a decision. “To conclude otherwise would prohibit tax-planning.”
The Tenth Circuit decision in Liberty Global, however, reduced the relevance question to something subjective to the minds of government officials wary of complex business operations. Lack of objective criteria on when the Economic Substance Doctrine applies leaves taxpayers in the dark to know what the rules are beforehand. As we said to the Wall Street Journal, “‘I know it when I see it’ isn’t viable in tax law.”