Monte A. Jackel is a contributing columnist for Tax Notes and a managing director in PricewaterhouseCoopers LLP in Washington. All views expressed herein are his own.
In this column, Jackel reviews the recent Third Circuit Schering-Plough decision and attempts to determine whether the court's express refusal to address the lower court's economic substance analysis provides any guidance for future cases under new section 7701(o).
Copyright 2011 Monte A. Jackel.
All rights reserved.
In Merck & Co. Inc. v. United States,1 the Third Circuit upheld the lower court's holding2 that a series of interest rate swaps were in substance loans subject to the rules of section 956. In its opinion, the Third Circuit did not address the lower court's application of the economic substance doctrine,3 although it never explains why. That refusal to address the economic substance doctrine stands in stark contrast to how the matter was handled by the district court, which acknowledged that it did not need to address the economic substance doctrine to resolve the case, but did so anyway.4
Is the Doctrine Relevant?
And so we are faced with this fundamental question: If one court deems it relevant to discuss the economic substance doctrine when the case can be decided on narrow technical grounds under the code and regulations, but the court to which the decision is appealed refuses to address the doctrine, does that mean the doctrine is or is not relevant in resolving future cases with similar facts and issues? Remember, section 7701(o)(1) requires that the doctrine be "relevant" to the transaction for the statute to apply. So if a trial court applies the doctrine and an appellate court does not, how does one know whether the doctrine is relevant to those facts, much less different facts? Given the strict liability penalty under section 6662(b)(6) and 6662(i), this is not just an academic question.
Although the government stated in Notice 2010-625 that taxpayers could rely on existing case law to determine whether and when the economic substance doctrine is relevant, one can readily see that this exercise, although reasonable in theory, is almost impossible in practice.
In that regard, consider Countryside Limited Partnership v. Commissioner,6 in which the court rejected the IRS's argument that the economic substance doctrine re-characterized the transaction at issue. The Service asserted that what was in form the distribution of a lower-tier partnership interest was instead, in substance, a distribution of money to the partner taxable under section 731. The court said:
We view the statement in respondent's amendment to answer that, pursuant to the liquidating distribution, Mr. Winn and Mr. Curtis each received an "I.R.C. section 731(c) distribution of money (Cash/Securities)" as respondent's allegation that the AIG notes constituted marketable securities as defined in section 731(c)(2) or, alternatively, that, even if they were nonmarketable, the lack of economic substance surrounding their purchase and distribution negates the ability of Mr. Winn and Mr. Curtis to achieve nonrecognition of gain under sections 731(a)(1) and 752(a) and (b).18 [Footnote 18: At this point, we use the term "economic substance" without attaching to it a precise meaning but only to encompass the various grounds advanced by respondent for disregarding the tax results claimed by participating partner, e.g., lack of "business purpose or economic effect," a "series of transactions * * * [amounting to] a sham," a "transaction * * * [that] makes no economic sense".] That alternative argument (lack of economic substance) is reiterated by respondent in opposing the motion. We will first address what we consider to be respondent's alternative argument that, even if the AIG notes constituted nonmarketable securities, the liquidating distribution must be considered, in substance, a distribution of cash to Mr. Winn and Mr. Curtis resulting in their recognition of gain. . . . [P]articipating partner concedes that the liquidating distribution was structured to defer tax by distributing to Mr. Winn and Mr. Curtis property rather than cash and that tax avoidance was the sole motivation for the formation of CLPP and MP, the CB & T loans, and the purchase of the AIG notes, all in furtherance of that plan. Because participating partner also concedes that the L.L.C.s may be disregarded for purposes of the motion, the question before us is whether the CB & T loans and the deemed purchase and distribution of the AIG notes by Countryside also must be disregarded for lack of economic substance with the result that the liquidating distribution must be treated as equivalent to a cash distribution to Mr. Winn and Mr. Curtis (despite its literal qualification for nonrecognition of gain under section 731(a)(1)). . . . In this case, the transactions that respondent seeks to disregard, the CB & T loans and the deemed purchase of the AIG notes by Countryside and their distribution to its majority-in-interest partners, Mr. Winn and Mr. Curtis, were the means employed by Mr. Winn and Mr. Curtis, and agreed to by Countryside, to allow Mr. Winn and Mr. Curtis to withdraw from the partnership before the anticipated sale of the Manchester property to Stone Ends. While the employed means were designed to avoid recognition of gain to Mr. Winn and Mr. Curtis, those means served a genuine, nontax, business purpose; viz, to convert Mr. Winn's and Mr. Curtis's investments in Countryside into 10-year promissory notes, two economically distinct forms of investment.21 [Footnote 21: While CLP Holdings, Inc., and Mr. Wollinger, Countryside's remaining partners, enjoyed 100 percent of the benefits associated with Countryside's ownership of the Manchester property following Mr. Winn's and Mr. Curtis's withdrawals as partners, they also bore 100 percent of the burdens associated with that ownership. In other words, their economic positions also changed as a result of the liquidating distribution.]. . . . [R]espondent, in finding a lack of economic substance, has erroneously focused on the tax-motivated means instead of the business-oriented end. The transaction requiring economic substance is Countryside's redemption of Mr. Winn's and Mr. Curtis's partnership interests therein. That the redemption of a partnership interest in exchange for bona fide promissory notes issued by an independent third party can serve a legitimate business purpose is beyond cavil. The question is whether such a redemption may be respected for tax purposes if the means undertaken to accomplish it are chosen for their tax advantage. On the facts before us, we conclude that the answer is yes. [Emphasis added.]
Here again we are presented with this fundamental question: Does the Tax Court's willingness to address the economic substance doctrine in connection with a partnership liquidating distribution mean that the economic substance doctrine is relevant to all those distributions, or just to those with facts similar to those in Countryside? What about partnership nonliquidating distributions? What about corporate liquidating and nonliquidating distributions? And last but not least, what about otherwise tax-free contributions to partnerships and corporations under sections 351 and 721?7
As noted earlier, the IRS and Treasury stated in Notice 2010-62:
Section 7701(o)(5)(C) provides that the determination of whether a transaction is subject to the economic substance doctrine shall be made in the same manner as if section 7701(o) had never been enacted. In addition, section 7701(o)(1) only applies in the case of any transaction to which the economic substance doctrine is relevant. Consistent with these provisions, the IRS will continue to analyze when the economic substance doctrine will apply in the same fashion as it did prior to the enactment of section 7701(o). If authorities, prior to the enactment of section 7701(o), provided that the economic substance doctrine was not relevant to whether certain tax benefits are allowable, the IRS will continue to take the position that the economic substance doctrine is not relevant to whether those tax benefits are allowable. [Emphasis added.]
Where does this leave us? Some judges decide cases by providing alternative rationales for the court's conclusion, even if they're unnecessary for the resolution of the case. In some situations, one of those alternative theories is the economic substance doctrine. Other judges decide cases on the narrowest grounds possible and tend to resolve them on their technical merits without resorting to common law doctrines, such as economic substance, which are not strictly necessary for the court's ultimate conclusion. And other courts -- such as the Tax Court in Countryside -- address the economic substance doctrine because it is raised by the government and, rightly or wrongly,8 discuss the issue instead of simply dismissing the government's assertion as lacking merit. Does the fact that the Tax Court entertained the government's economic substance argument mean the doctrine is relevant to all partnership liquidating distributions, or just some? Or does it mean merely that the judge thought it best to address the issue and not just summarily dismiss it, with no implication for future cases?
Many have called for guidance on the application of section 7701(o). To date, the government has declined to issue any.9 Apparently, the ultimate decision-makers at the IRS and Treasury see confusion and ambiguity in the law as good. Without administrative guidance, taxpayers and their advisers are left to analyze existing case law to determine the results in a post-codification world. Given the inability -- or at least the extreme difficulty -- of extracting from the case law meaningful guideposts, this situation is fraught with peril. It can only be hoped that the government will change its position and provide guidance on the application of this important statute.
1 No. 10-2775 (3d Cir. June 20, 2011), Doc 2011-13426, 2011 TNT 119-5. For related coverage, see p. 7. See also Amy S. Elliott, "Practitioners Express Worry and Confusion Over Ruling in Schering-Plough," Tax Notes, Oct. 12, 2009, p. 189, Doc 2009-21864, or 2009 TNT 190-2; Amy S. Elliott and Lee A. Sheppard, "Treasury Speaks Out About Schering-Plough Decision," Tax Notes, Nov. 9, 2009, p. 641, Doc 2009-24003, or 2009 TNT 209-3; Lee A. Sheppard, "Looking Through Derivatives to Find Substance," Tax Notes, Dec. 14, 2009, p. 1141, Doc 2009-26927, or 2009 TNT 237-2.
3 See note 10 of the Third Circuit opinion: "We do not reach [the district court's] alternative conclusion that the Transactions lacked economic substance." No reason is given for that statement.
4 The district court said, "Having found . . . the transactions were loans, the Court need go no further. . . . Nonetheless, the transactions also fail the related 'economic substance' analysis." This type of statement begs the question of why the district court went on to analyze the doctrine if it did not need to in order to resolve the case.
7 For an analysis of these issues, as well as others under subchapter K and the economic substance doctrine, see Monte A. Jackel, "Subchapter K and the Codified Economic Substance Doctrine," Tax Notes, July 19, 2010, p. 321, Doc 2010-13951, or 2010 TNT 138-4.
8 Wrongly, in my view.
9 See the New York State Bar Association Tax Section's report on the codification of the economic substance doctrine, Doc 2011-314, 2011 TNT 5-14; see also comments by the American Bar Association Section of Taxation, Doc 2011-1124, 2011 TNT 12-13, and the American Institute of Certified Public Accountants, Doc 2011-1334, 2011 TNT 14-20.
END OF FOOTNOTES
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