The Eleventh Circuit last week decided a tax case exploring the appropriate scope of factual review for the economic substance and business purpose doctrines. Curtis Investment Co. v. Commissioner, 2018 WL 6380325 (11th Cir. Dec. 6, 2018). These two doctrines allow courts and the IRS to make a substance-over-form review of suspected tax avoidance activities. In order to claim a tax benefit, the underlying transaction must have both economic substance and a business purpose. In an opinion by Judge Chuck Wilson, the court affirmed that transactions lacking a business purpose cannot create business purpose with subsequent acts.
This case involves a variation of the transaction known as the “custom adjustable rate debt structure” (CARDS). The typical CARDS transaction is a well-known tax avoidance scheme that the IRS has specifically declared to lack business purpose and economic substance. (IRS Notice 2002-21, 2002-1 C.B. 730.) The transaction here is similar to the typical CARDS transaction but with one major factual difference.
In both this case and the typical CARDS case, a foreign facilitating entity receives a loan (€35.3M in this case) from a foreign bank that is split into one large note (€30M) and one small note (€5.3M). The US taxpayer then acquires the small note from the foreign facilitating entity in exchange for a promise to assume joint liability for the entire loan. This allows the US taxpayer to claim a tax basis of the full value of the loan (€35.3M) on an asset worth substantially less (a €5.3M note). When the US taxpayer disposes of the small note, the taxpayer recognizes a large loss (€30M).
In the typical CARDS case, the US taxpayer and foreign facilitator use their proceeds from the notes to pay off the original loan. In this case, however, the US taxpayer actually invested the proceeds from its disposition of the note. When the bank called for repayment, the US taxpayer instead took out a different loan to pay back its €5.3M obligation.
The core question was whether that factual difference created sufficient economic substance and business purpose. Both the Tax Court and the Eleventh Circuit concluded that it did not. The taxpayer argued that investing the proceeds from the note meant that this transaction was a financing plan with a valid business purpose that just happened to create a tax benefit. After all, taxpayers are permitted to structure transactions with an eye towards tax benefits. The court rejected this argument, stating that the transaction had the sole purpose of tax avoidance.
The issue turned on how much of a taxpayer’s activity is included in the “transaction” reviewed for business purpose. The proper test, said the court, is to “exercise common sense, [look] at the totality of evidence and [focus] on the specific transactions at issue, not the activities of the entity as a whole.” Here, the “specific transaction” was the generation of a tax loss. This was the proper scope of “transaction” because the CARDS arrangement, with over €2M in fees and €35.3M in risk, was considerably inferior to “conventional financing” methods. More simply, the court pointed out that a tax return’s calculation of gain or loss on a “transaction” does not consider how the proceeds are subsequently used. Ultimately, the decision to re-invest the proceeds from the note was “collateral” to the actual transaction of generating a tax loss.
While taxpayers are allowed and expected to consider tax benefits during their finance planning, the court distinguished between a permissible tax-minded financing structure and an impermissible tax-avoidance scheme that merely plans to re-invest its “ill-gotten proceeds.”
Without economic substance or business purpose, the IRS disallowed a multi-million dollar loss, and imposed a gross valuation misstatement penalty. The taxpayer first argued that it reasonably relied in good faith on the advice of tax counsel. The court upheld the Tax Court’s ruling that, in light of the “business experience” of the taxpayer’s managers and investment committee, the taxpayer should have recognized that the $27.7M capital loss was “too good to be true.” Second, the taxpayer challenged the penalty under section 6751(b)(1), which requires penalties to be approved in writing by a supervisor. This challenge has recently grown in popularity in light of Graev v. Commissioner, which expanded its applicability. 149 T.C. No. 23 (2017). Like many active litigants, the taxpayer had failed to raise section 6751(b)(1) at its original trial. In light of the Graev decision, the taxpayer raised this challenge for the first time in an appellate supplemental brief. The court refused to consider this argument, noting that the taxpayer waived its challenge by failing to raise the section 6751(b)(1) issue until supplemental appellate briefing. However, the court may have left the door open for future appellate litigants that first raise a section 6751(b)(1) challenge at the lower court via post-trial brief.
Posted by Phil Ogea.