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Distinctions that Make a Difference: Federal Circuit Holds that Various Substance Over Form Doctrines are Not Interchangeable

By Anthony P. Daddino on September 22, 2023
There are various interactions of the substance over form doctrine, such as step-transaction, economic substance, sham, among others. As the Federal Circuit reminded us all yesterday, the iterations are not interchangeable.

I’m referring to the Federal Circuit’s September 21, 2023 decision in GSS Holdings (Liberty) Inc. v. the U.S., linked HERE. The underlying dispute involved the purchase of a note, followed by a liquidity asset purchase agreement with a bank, note repurchase agreement, and other transactions designed to minimize risk of loss. The facts are quite detailed, as you would expect in connection with transactions among sophisticated parties. Ultimately a loss was realized and claimed, but disallowed by the IRS, which perceived an overarching intent from the start. Specially, the IRS alleged that the transactions should be treated a single transaction under the step transaction doctrine, which would result in the loss being disallowed under IRC Section 707. This dispute eventually gave rise to refund litigation in the Court of Federal Claims.

The Court of Federal Claims correctly identified the step transaction doctrine and its formulation under the end result test, which involves assessing the intent of the taxpayer from the outset. The Court, however, thereafter cited to its decision in Coltec – which analyzed the economic substance doctrine – and proceeded to discern intent from the transaction that gave rise to the alleged tax benefit. This analysis prompted the Court to sustain the IRS’ loss disallowance. The taxpayer appealed, arguing that the Claims Court conflated the economic substance doctrine with the step transaction doctrine.

The Federal Circuit agreed with the taxpayer, and reversed and remanded the case for further consideration. The Federal Circuit held that the Claims Court applied an improper hybrid legal standard. Under the step transactions doctrine, a court must examine whether it appears that separate transactions were really component parts of a single transaction intended from the outset to be taken for the purpose of reaching the ultimate result. The Claims Court legally mis-stepped when it focused on the single transaction giving rise to the tax benefit, which occurs in connection with an economic substance analysis.

While this case involved a judicial oversight, the IRS commonly confuses the various substance-over-form doctrines in its attack of structured transactions. Such confusion, as the Federal Circuit reminds us, is legally improper and may give rise to opportunities for tax practitioners to narrowly hold the IRS’ feet to the fire on the specific iteration of the substance-over-form doctrine raised in the notice of deficiency. Any post-notice effort by the IRS to correct its prior misstep, and allege a new iteration of the substance-over-form doctrine, will not enjoy the presumption of correctness. And the tax practitioner may have secured a strategic advantage in shifting the burden of proof to the IRS on the newly-raised doctrine.

If you have any questions about this blog post or any other tax-related topic, feel free to contact me at (214) 749-2464 or adaddino@meadowscollier.com.