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September 21, 2011
Economic Substance Doctrine and Tax-Motivated Investments

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By Monte A. Jackel

Monte A. Jackel is a managing director at PricewaterhouseCoopers LLP, Washington, and a contributing editor for Tax Notes.

In this column, Jackel discusses the Tax Court's recent decision in Superior Trading and its significance to the application of the codified economic substance doctrine under section 7701(o).

All views expressed herein are the personal views of the author and not necessarily those of any other person, firm, or organization.

Copyright 2011 Monte A. Jackel. All rights reserved.

Monte JackelIntroduction

In its recent decision in Superior Trading,1 the Tax Court addressed a distressed asset loss importation transaction known as DADs or DATs. The fundamental transaction involves a transfer of debt, which is in distress but not yet worthless to a partnership, between a tax-indifferent party and a taxpayer seeking losses from the imminent bad debt write-off. Before the changes of the American Jobs Creation Act of 2004,2 as long as the partnership did not make an election under section 754, the high inside basis of the loss assets survived the transfer by the tax-indifferent party to the partnership and through the partnership to the taxpayer.3 At this point, if the taxpayer has sufficient basis in its partnership interest to absorb the losses,4 it would be able to deduct the bad-debt losses on the distressed assets with a later offsetting gain when the partnership is ultimately liquidated.

In the transaction's first consideration in the courts, a district court found that the underlying investment in the distressed assets had economic substance but that the transaction used to create the tax basis in the partnership interest -- a so-called repo transaction -- lacked economic substance.5 The taxpayer was thus denied the loss deductions. Superior Trading was the second attempt by taxpayers to prevail on this transaction in the courts.

Other Grounds to Challenge Loss

In its opinion, the Tax Court went out of its way to explain why it wouldn't entertain the economic substance doctrine and apply it to the 2003 loss importation transaction:


    Respondent [argues] that the "deductions and losses, claimed in the years 2003 and 2004, should be disallowed for * * * [several] reasons." Among the grounds that respondent advances is the argument that "The transactions engaged in by the trading companies had no independent economic substance."

    We agree with petitioners that the mere fact that tax losses from a transaction exceed the accompanying economic losses does not render the transaction devoid of economic substance. Respondent contends at length that "Even assuming the most optimistic of revenue projections advanced by petitioners, the evidence is clear that the trading companies had no chance, let alone a realistic chance, of earning a single dollar of pre-tax profit." We are not so easily convinced. Petitioners introduced considerable evidence at trial, some of it quite credible, that servicing of distressed Brazilian consumer receivables was attracting the interest and investment dollars of legitimate and sophisticated U.S. investors during 2003 and 2004. Moreover, the actual receivables that the purported partnerships acquired had, in fact, generated nontrivial revenues, though it was not immediately apparent whether such revenues were large enough to justify the cash outlays.

    However, we need not resolve these fact-intensive issues in order to rule on Warwick's and the trading companies' claimed losses and decide these cases. [Footnote omitted.]


The Tax Court then addressed the two key issues in the case that the taxpayer needed to prevail on for the losses to be sustained:

    Two necessary conditions for the allocation of the built-in losses, in the Arapua receivables, away from Arapua and to the holding companies are: that Arapua be deemed to have formed a partnership with Jetstream; and that Arapua made a contribution, rather than a sale of the receivables, to that partnership.

The Tax Court then continued with its analysis, first holding that no valid partnership had been formed between the tax-indifferent party and the taxpayer, and then holding that a sale to the partnership, rather than a contribution, had taken place. In reaching those conclusions, the Tax Court applied the substance-over-form, sham, and step transaction doctrines but not the economic substance doctrine.

What Does This Case Mean?

Superior Trading did not cite section 7701(o), the codified economic substance statute. After all, why should the court have cited a statute that was not effective when the transaction at issue was entered into? Nevertheless, this case may well have major implications for the application of the economic substance doctrine under section 7701(o). The reason lies in the Tax Court's simple opening statement that it would not entertain the economic substance doctrine, because the transaction involved a real investment of cash or property by the taxpayer seeking the losses:


    The alphabet soup of tax-motivated structured transactions has acquired yet another flavor -- "DAD." DAD is an acronym for distressed asset/debt, the essential transaction at the core of these consolidated partnership-level proceedings. . . . It seems only fitting that after devoting countless hours in the last decade to adjudicating Son-of-BOSS transactions, we have now progressed to deciding the fate of DAD deals. And true to the poet's sentiment that "The Child is father of the Man," the DAD deal seems to be considerably more attenuated in its scope, and far less brazen in its reach, than the Son-of-BOSS transaction.

    A Son-of-BOSS transaction seeks to exploit the narrow definition of a partnership liability under section 752 to conjure up a tax loss. . . .

    By contrast, a DAD deal is more subtle. Instead of a claimed permanent tax loss manufactured out of whole cloth, a DAD deal synthesizes an evanescent one. The loss is proclaimed under authority of sections 723 and 704(c) from an alleged contribution of a built-in loss asset by a "tax indifferent" party to a purported partnership with a "tax sensitive" one. However, this loss is preordained to be nullified by a matching gain upon the dissolution of the venture. Consequently, the tax benefits sought by the tax sensitive party are, absent other factors, confined to timing gains. Moreover, claiming these benefits requires sufficient "outside basis," which, in turn, entails an investment of real assets.

    Because of a DAD deal's comparatively modest grab and highly stylized garb, we can safely address its sought-after tax characterization without resorting to sweeping economic substance arguments. . . . Unlike the stilted single-entity Son-of-BOSS transaction, a DAD deal requires a minimum of two parties, with one willing to give up something of substantive value. In an arm's-length world, this would happen only if adequate compensation changed hands. Consequently, we need only look at the substance lurking behind the posited form, and where appropriate, step together artificially separated transactions, to get to the proper tax characterization. (Emphasis added.)


Taken at its word, the Tax Court is making a clear statement about the role of the economic substance doctrine for future cases that come before it. It appears to be saying that the economic substance doctrine should not be applied to real investments that as a matter of the technical application of the code and regulations lead to the desired tax benefit and that common law doctrines other than the economic substance doctrine may be more appropriately applied to deny the sought-after tax benefits based on the facts of the case. In Superior Trading, the substance-over-form, sham, and step transaction doctrines were applied to deny the taxpayer its loss.

Conclusion

This case could be quite meaningful in the post-section 7701(o) world of economic substance. The court appears to have gone out of its way to make a statement about when the economic substance doctrine should not be applied. In the words of section 7701(o)(1), the court explained why the doctrine was not "relevant" to the transaction at issue. In the court's view, the economic substance doctrine should not be applied to real investment transactions that actually occurred.

That doesn't mean the taxpayer wins these cases. Rather, it means that other common law doctrines with a more defined role to play will police the taxpayer's behavior. And that is the way courts should address these cases. We shall see what effect Superior Trading has on the application of the economic substance doctrine to future disputes with the government on cases with different facts.6


FOOTNOTES

1 Superior Trading LLC v. Commissioner, 137 T.C. No. 6 (Sept. 1, 2011), Doc 2011-18650, 2011 TNT 171-13.

2 See sections 704(c)(1)(C), 734(d), and 743(d).

3 This is basically the transaction described in reg. section 1.701-2(d), Example 8.

4 See section 704(d).

5 See Southgate Masterfund LLC v. United States, 651 F. Supp.2d 596 (N.D. Tex. 2009), Doc 2009-18785, 2009 TNT 160-6. See also Long Term Capital Holdings v. U.S., consolidated, Conn. D.C. (2004), Doc 2004-17390, 2004 TNT 169-15.

6 See Marie Sapirie and Shamik Trivedi, "Economic Substance Directive Limits Strict Liability Penalties," Tax Notes, July 25, 2011, p. 339, Doc 2011-15504, or 2011 TNT 137-1, for a discussion of LB&I-04-0711-015 (Doc 2011-15491, 2011 TNT 137-17) and its list of factors that should be applied in evaluating whether the economic substance doctrine should be asserted by the IRS.


END OF FOOTNOTES


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