This transcript has been edited for length and clarity.
David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: substantial disagreement.
In recent months, we've seen cases that challenge what we think we know about established tax concepts. In a previous episode, we discussed the Moore v. United States case that is currently pending at the Supreme Court. That case challenges assumptions on whether realization is required for the taxation of income.
This week, we're looking at the case of Liberty Global v. U.S. Now, this is in a much earlier stage in litigation, but the taxpayer and government are pushing conflicting perspectives on the economic substance doctrine.
Here to talk more about this is Tax Notes managing legal reporter Andrew Velarde. Andrew, welcome back to the podcast.
Andrew Velarde: Thank you, Dave. It's good to be back.
David D. Stewart: Now, before we get into the details of the case, could you tell us a bit about this economic substance doctrine?
Andrew Velarde: Sure. Let's just go high-level here. It's similar to the longtime common-law substance-over-form doctrine, and it can disallow tax benefits for transactions lacking economic substance. It was codified in section 7701(o) in 2010. For a transaction to which the doctrine is relevant, that transaction is treated as having economic substance only if it meaningfully changes a taxpayer's economic position apart from the tax effects and the taxpayer has a substantial business purpose for the transaction.
David D. Stewart: Now, you mentioned that this economic substance doctrine was codified in 2010. Did that change how it was applied?
Andrew Velarde: Well, it was an endorsement of one common-law approach, the two-pronged test. You need an objective and a subjective purpose for the doctrine.
David D. Stewart: All right, so what's happening here in this Liberty Global case?
Andrew Velarde: Well, the government is going after Liberty Global, also referred to as LGI, for what it views as an attempt to exploit a loophole in the Tax Cuts and Jobs Act's international provisions.
So Liberty Global, using a series of maneuvers, had a transaction that avoided GILTI [global intangible low-taxed income] and also treated its gain on a transfer of its Belgian corporation to its U.K. parent corporation as a dividend that could avail itself of the dividend's received deduction. This was all made possible by different effective dates for the DRD [dividends received deduction] and GILTI for non-calendar year taxpayers. The dispute here is a very large one, and the government is going after Liberty Global for $284 million after the shifting of $4.8 billion in earnings and profits to a foreign subsidiary.
Now, to get a little bit more into the nitty-gritty of the specifics of this transaction, as it is relevant to the economic substance doctrine, the restructuring was labeled Project Soy by the company, and it involved four steps.
In step one, the company initiated and executed profit certificates, which led to a claim against the Belgian entity (TGH) for €4.3 billion. In step two, there was the springing to life debt step with the transfer of another related entity to TGH. In step three, there was the E&P generation step, involving the conversion of the transferor, another Belgian entity, from a disregarded BVBA to an NV. That's similar to a corporation. This caused the previously disregarded intercompany debt to be regarded. Then in step four, Liberty Global sold TGH to its U.K. entity for a note leading to a $2.4 billion gain.
Before the other steps, TGH's E&P would not have sheltered the gain, but the government alleged the unnecessary steps were implemented to generate more E&P, which could then be deducted under the 245 DRD.
David D. Stewart: Now, I understand this isn't the only dispute going on between Liberty Global and the government over this restructuring.
Andrew Velarde: Yeah, that's right, Dave. This actually goes back a while. Before we get to the economic substance doctrine litigation, we had a $109 million refund suit filed by Liberty Global, which is also in the District of Colorado. In April, 2022 the court granted a partial motion for summary judgment in the company's favor after it found that temporary regs designed to limit the section 245A DRD for transactions, such as the sale of its Belgian affiliate to the U.K. entity, were invalid.
The court held that the regs, which were issued in June 2019 with a retroactive date, improperly ignored public notice and comment requirement of the Administrative Procedure Act. Now, in this case, the government had argued that it had a good-cause exception to excuse notice and comment, and they provided four reasons.
First, because notice and comment would enable taxpayers to engage in the very transaction the rules were meant to stop. Second, delaying the effective date of the temporary regs could increase compliance costs through required return amendments. Third, public comment was considered before finalization of the regs. And fourth, section 7805(b)(2) provides that regs may apply retroactively if issued within 18 months of the statutory deadline.
Now, the court dismissed all these points one by one and found that the government had had enough time to issue temporary regs. That decision alone would've made this controversy a notable one, as it was the first time a court had evaluated Treasury's good cause exception to the APA requirements. But it was only after this loss that the government decided to go after Liberty Global using the economic substance doctrine. They filed suit in that case in October 2022.
David D. Stewart: So let's get into that question of the economic substance doctrine. What arguments are we seeing from both sides here?
Andrew Velarde: They could not be further apart. The company argued that the government failed to understand that the codified doctrine is not relevant to many transactions that were exempted by Congress, including the entity conversion at issue in this litigation. They cited to a 2010 House report and argued that Project Soy was squarely in the corporate organization exemption to which section 351 applies and the choice to conduct business through various entities.
They also argued that the doctrine has never been held applicable to an entity's choice of tax classification. Essentially, there was a threshold inquiry about relevance that the court should examine before the doctrine can be invoked, according to the company.
The government, on the other hand, argued there is no angel list under the doctrine and that courts have applied it in situations where companies use check-the-box regs to manipulate CFCs [controlled foreign corporations]. A congressional committee report can't trump clear statutory text to create an exemption, the government argued.
Further, even if there was one, Project Soy was not a run-of-the-mill section 351 transaction. Steps one through three should therefore be disregarded, according to the government. They were not necessary to the entity's transfer under step four. Without these first three steps, Liberty Global would not have had the E&P necessary for step four to be tax free, the government put forth.
David D. Stewart: So this case went to the U.S District Court for the District of Colorado. What was decided there?
Andrew Velarde: Well, the court ruled for the government on October 31, granting its summary judgment. And as appropriate for that date, Halloween, it was a scary holding for the taxpayers. To quote from Senior Judge R. Brooke Jackson's holding: "LGI has not created a genuine issue as to whether the entire multistep transaction took place for any substantial reason other than tax evasion. The direct and circumstantial evidence establish only the tax-avoidant purpose for the scheme. LGI's suggested alternative for nontax purposes for the individual steps are contradicted by the testimony of its own representatives and, in any event, simply do not make sense as justifications for the full transaction."
The court held that there's no threshold relevance inquiry necessary in applying the economic substance doctrine before examining the operative clause of the statute. That would frustrate the purpose of the doctrine, according to the court. It need only examine a taxpayer's subjective business motivation and whether the transaction had an objective economic substance.
The transaction was not a basic business transaction of a mere entity conversion, the court held, another relevant quote here. "It is absurd to imagine that Deloitte would be consulted to devise and carry out a basic business transaction within any ordinary or comprehensible use of the phrase. And no reasonable fact-finder could characterize Project Soy as such. To apply the exemption for basic business transactions here would allow the exception to swallow the rule."
There were no express exceptions to the doctrine under the statute. And exemptions pointed to by LGI only appear in the House committee report "as illustrations of the broader concept of basic business transactions," according to the court. Also, compliance with Belgian law was not enough of a substantial purpose to save the transaction, the court said. There is some disagreement among practitioners about how widely the court's analysis could apply, if adopted by more courts.
Some argue that the tax avoidance transactions, like Liberty Global's, are frequently structured by firms. More optimistic practitioners see the case as more constrained to its unique facts. Still other experts argue the case should serve as a warning to taxpayers. Don't rely exclusively on high-level business purpose when trying to validate a transaction. Saying the steps were undertaken for Belgian corporate law purposes without much further elaboration was not sufficient in this case.
So one final quote from the court here: "First, LGI's response provides no indication what the Belgian law was or how the entity conversion, the issuance of profit certificates, or the restructuring of subsidiary entities was necessary to promote compliance with that law. Second, the statements that an action was 'in furtherance' of some end does not suggest that the end was substantial purpose for the action or that the actor even knew of the end when initiating the action. It seems here that LGI carefully worded its response to the government's request for admission to say the former, while suggesting the latter."
David D. Stewart: So this decision came out a bit ago. What's happened since then?
Andrew Velarde: Well, almost immediately following the decision, the company announced that it would be appealing and that it remained confident in its position. In late December the company formally appealed to the Tenth Circuit. This, of course, raises the stakes substantially, as if the government were to prevail again, the reach of the authority on the doctrine would expand.
David D. Stewart: So what would happen? What could potentially happen? What other issues would be affected if the government's interpretation of the economic substance doctrine is accepted?
Andrew Velarde: Well, if the pessimistic practitioners are to be believed, it could be a blow to a considerable amount of tax planning, as the IRS could use the doctrine, backed up by reasoning of the court, to undo transactions that may have previously been thought of as viable. But it's too early to make predictions about that, and the language of an appellate court decision would need to be parsed carefully. Even a government victory could be narrowly tailored to the transaction at hand.
David D. Stewart: Well, all right, I guess this is going to be one that we're going to have to keep an eye on for a good while now. Andrew, thank you so much for being here.
Andrew Velarde: Thank you, Dave.
David D. Stewart: And now, coming attractions. Each week, we highlight new and interesting commentary in our magazines. Joining me now is Senior Executive Editor for Commentary Jasper Smith. Jasper, what will you have for us?
Jasper B. Smith: Thanks, Dave. In Tax Notes Federal, Karen Burke addresses the proper application of the general antiabuse rule in Tribune Media. Hale Sheppard examines the IRS’s recent efforts to narrow taxpayers’ access to claiming the employee retention credit.
In Tax Notes State, Kathleen Wright examines the federal and state tax treatment of state film incentives, focusing on changes in California. Alysse McLoughlin and Kathleen Quinn review the implications of New York City's business corporation tax for certain C corporations.
In Tax Notes International, Michelle Markham examines the methods different countries are using to enhance tax certainty. Mindy Hertzfeld examines whether Treasury's recent efforts to clarify when U.S. taxpayers may claim a foreign tax credit contradicts U.S. law.
And finally, in Featured Analysis, Nana Ama Sarfo considers whether public tax reporting could render companies vulnerable to potential greenwashing claims.
David D. Stewart: That's it for this week. You can follow me online @TaxStew, that's S-T-E-W. And be sure to follow @TaxNotes for all things tax. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.
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