Altria lost an appeal from an adverse jury verdict on its SILO and LILO transactions. Altria Group Inc. v. United States; No. 10-2404 (2d Cir. Sept. 21, 2011). The news for other taxpayers is that the verdict was sustained under the substance over form “doctrine” rather than the economic substance doctrine, even though the jury ruled against the taxpayer on both theories. This decision is another indication that the courts are figuring out that the economic substance doctrine is a largely unneeded fifth wheel on the normal application of the tax law.
SILO and LILO transactions depend for their tax benefits on the taxpayer obtaining ownership of property or leases and also owing debts incurred to acquire the property or leases. The taxpayer deducts basis acquired through depreciation or otherwise, and also deducts interest. The trial court charged the jury on both the issues of the taxpayer’s ownership and liability on the debts and also on the economic substance doctrine.
The opinion of the Second Circuit largely was devoted to rejecting various challenges to the jury charge on the issues whether the taxpayer actually owned the property and actually owed the liabilities. The court rejected those challenges to the jury charge. The significance of the rejections is that the Second Circuit, at least, is not going to let the determination of ownership in the leasing/leaseback cases get hemmed in by a host of somewhat arbitrary rules about what can and what cannot be considered by the jury.
As usual, the opinion relied on Frank Lyon. That opinion cited 26 possible factors to be considered in deciding ownership in leasing situations. While even a Supreme Court Justice has stated that he was not sure what Frank Lyon meant, it certainly can mean that the sky is the limit to relevant facts in leaseback cases. Properly understood, Frank Lyon is a decision about fact finding as to ownership in leaseback cases and nothing more; at least the Second Circuit was applying it in an arena to which it is properly relevant.
Once the Second Circuit had upheld the verdict on what it called the substance over form doctrine, it said it need not reach the additional ground for the verdict, the economic substance doctrine. Three observations arise from this:
(1) Substance over form is just another way of saying that some “facts” that are relevant for tax purposes are mostly controlled by common law fact finding and not labels, with debt and to a lesser degree ownership being primary examples of facts that are so determined. It is not helpful to call this fact finding process the substance over form doctrine: outside the tax law the same conclusion would be reached, certainly as to liability on debt, using equitable fact finding principles and without calling the process a substance over form doctrine. This is more than a quibble over words. By introducing the word “substance,” the substance over form doctrine bleeds into the economic substance doctrine if you add the feature that it is the economics of the substance that are to be studied, which is necessarily the case in tax disputes. There is enough confusion about the economic substance doctrine without confusing it with the legitimate process of fact finding. Rather than fact finding, the economic substance doctrine is a positive rule of law that depends on finding certain facts (the two prongs); once they are found, the doctrine applies and the tax benefits are lost, whether or not the transaction actually occurred “in economic substance.”
(2) The Second Circuit chose to go to the fact finding prong of the verdict first, rather than going to the economic substance doctrine prong first. This is significant. In the middle of the first decade of this century the Chief Counsel was able to convince several courts, including particularly the Tax Court, to decide for the IRS on the basis of the economic substance doctrine, without dealing with ordinary fact finding. This approach might have seemed easier for the court – it only had to look for profit and business purpose – but in practice those economic substance doctrine bench trial opinions turned out to be 100-300 page monsters. Perhaps the courts are beginning to realize that the ESD really does not simplify the fact finding and they are more comfortable with facts that they know more about finding, such as does the taxpayer owe a debt (a Knetsch issue).
(3) The Second Circuit explained its mooting of the ESD issue by stating “The IRS . . . is entitled in rejecting a taxpayer's characterization of an [ownership] interest to rely on a test less favorable to the taxpayer, even [if] the interest has economic substance." The “test less favorable” is the garden variety inquiry whether the taxpayer owned the property and owed the liability. The “having economic substance” evidently refers to the taxpayer winning under the economic substance doctrine. This sort of terminology just causes confusion. If a transaction “has economic substance” normally that would (or should) be understood to mean it actually happened; and if it actually happened, the tax benefit still might be denied if the economic substance doctrine applied and no business purpose or profit potential were found. In other words, the proper decisional sequence is (1) what are the facts under normal fact finding, based on all the facts and circumstances, and (2) if the taxpayer appears to win it can still lose under the positive rule of law that is the economic substance doctrine. The Second Circuit should have said “The IRS . . . is entitled in rejecting a taxpayer's characterization of an [ownership] interest to test the economic substance of the transaction to determine the facts relevant for tax purposes, before applying the economic substance doctrine to deny tax benefits to which a taxpayer would otherwise be entitled."