The government’s recent win on a motion for summary judgment against Liberty Global Inc. could further embolden the IRS’s use of a long-standing doctrine in pursuit of tax avoidance transactions. In Liberty Global Inc. v. United States, No. 20-cv-03501-RBJ, the government asserted that a post-Tax Cuts and Jobs Act transaction undertaken by the taxpayer that was designed to permanently avoid U.S. taxation on certain earnings lacked economic substance or was otherwise subject to the step transaction doctrine. This ruling follows a prior decision by the same court in which the court ruled in Liberty Global’s favor that the “extraordinary reduction rules” in Treasury Regulation section 1.245A-5T (the “Section 245A Temporary Regulations”) were procedurally invalid. While it remains to be seen if the government is going to begin to more liberally assert the economic substance doctrine (“ESD”), taxpayers should take note that the government has successfully used the ESD to combat transactions it considers abusive in a case in which the regulation has been challenged as invalid.
In the immediate term, if taxpayers undertook transactions (so called “extraordinary reductions” and “extraordinary dispositions”) to which the government asserts the Section 245A Temporary Regulations apply, those taxpayers that are also challenging the regulations as invalid, should consider whether their position may have additional exposure under the ESD. In addition, taxpayers that undertook such transactions and complied with the temporary regulations should consider whether they have grounds for a refund claim based on the decisions in the Liberty Global case. On a go-forward basis, taxpayers should consider how they can mitigate any potential exposure under the ESD through, for example, ensuring transaction documentation clearly reflects the economic impact and business purpose of the transaction.
The reach of the court’s decision in Liberty Global is still unclear. The company has indicated its intent to appeal. If the Tenth Circuit Court of Appeals overturns the lower court’s ruling, the government’s use of the ESD in cases involving multi-step transactions could be seriously curtailed. However, if the appellate court upholds the lower court’s ruling, it remains to be seen the extent to which the government will apply the ESD in cases in which it finds the transaction troubling. It should also be noted that any decision by the Tenth Circuit is not binding on any court (or taxpayer) located outside the circuit. Nevertheless, if the government prevails in the likely appeal by Liberty Global, it is likely to direct IRS Appeals Officers to this decision if they find the facts particularly egregious.
On October 31, 2023, the U.S. District Court for the District of Colorado held that a series of transactions undertaken by Liberty Global lacked economic substance, resulting in a $2.4 billion taxable gain. This case originates from a refund claim made by Liberty Global based on the position the company took on an amended return that the Section 245A Temporary Regulations are invalid. On cross-motions for summary judgment, the court ruled in Liberty Global’s favor, finding the Section 245A Temporary Regulations were invalid because they did not adhere to the notice and comment requirements of the Administrative Procedure Act. The ruling on validity did not conclude all matters in the case.
In July of this year, the government filed a motion for summary judgment on the grounds that the transaction lacked economic substance and that Liberty Global only undertook the transaction to avoid tax on certain income (subpart F and global intangible low-taxed income) and to reduce or eliminate capital gain. Specifically, in its motion, the government asserted that Liberty Global and its tax advisor, Deloitte LLC, designed a series of transactions among related parties that culminated in the company transferring its interest in a Belgium controlled foreign corporation (“CFC”) to a U.K. corporation that wholly owned Liberty Global. The government argued that the three steps undertaken before the transfer were unnecessary and undertaken for the purpose of generating earnings and profits for the Belgium CFC. These earnings are at the heart of the dispute as Liberty Global took the position on its amended return that these earnings were eligible for the dividends received deduction under section 245A by application of section 964(e) upon the transfer of the stock of the Belgium CFC in step four. Section 964(e) provides that when a CFC sells stock in a lower-tier foreign corporation, gain on such sale is treated as a dividend to the extent of certain earnings of the CFC for which a section 245A dividends received deduction is permitted. The government argued that because the added transaction steps had no substantial purpose, the tax benefits generated (the earnings) should be disregarded.
In addition to its ESD argument, the government argued the transaction was subject to the step transaction doctrine. However, the court did not address the government’s step transaction argument as it had already determined the transaction lacked economic substance.
In 2010, Congress codified the common law ESD in section 7701(o). Under the ESD, as provided in section 7701(o)(5)(A), the tax benefits “with respect to a transaction are not allowable if the transaction does not have economic substance or lacks business purpose.” Under section 7701(o)(1):
[i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if—
(A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and
(B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.
Liberty Global argued that the ESD did not apply to its transaction because the statute expressly limits the application to transactions for which the doctrine is relevant. In that regard, Liberty Global argued that section 7701(o) does not apply to certain “basic business transactions” based on the statute’s legislative history, such as the decision to operate through a corporate entity or to capitalize a business entity with debt or equity. The court, however, dismissed Liberty Global’s argument, finding that the economic substance doctrine applies if prongs (A) and (B) above are satisfied, meaning there is no threshold analysis (i.e., relevancy) that otherwise limits the application of the statute.
The court also dismissed Liberty Global’s argument that the economic substance analysis should only apply to the transfer of the Belgium CFC. Because of the interrelatedness of the steps and Liberty Global’s admission that it was unlikely that the first three steps would have been taken other than in contemplation of the last step, the court exercised its authority to aggregate the steps “to avoid frustrating the doctrine’s purpose.”
Taxpayers that engaged in a transaction subject to the Section 245A Temporary Regulations and were looking to the Liberty Global case for some assurance should re-evaluate their level of comfort and assess any potential exposure or potential refund opportunity. Further, taxpayers should confirm on a go-forward basis that they are documenting the economic impact and business purpose of the transactions and tax planning strategies they implement.
Additionally, significant questions have arisen regarding the application of the court’s analysis to other transactions. Specifically, it has been common practice for taxpayers to take the position that certain transactions are simply not subject to the ESD, such as check-the-box and Granite Trust liquidations.
As a final point, this case is instructive as to a prudent approach for claiming tax benefits that may be subject to penalties if denied. Liberty Global filed its original return for the tax year in question and paid its tax in compliance with the Section 245A Temporary Regulations (including making a closing of the year election). It then filed an amended return taking the position the Section 245A Treasury Regulations were invalid and filed a refund claim on that basis. Because of this procedural maneuver, Liberty Global was not exposed to an underpayment of taxes penalty. Note further that substantial underpayment penalties can apply in cases in which the ESD applies.
A&M will continue to monitor this case and its implications, including Liberty Global’s inevitable appeal and the government’s future use of the ESD. If you have any questions about this case, the economic substance doctrine, the Section 245A Temporary Regulations, or the dividends received deduction in general, please reach out to Kevin M. Jacobs or Logan M. Kincheloe.