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January 14, 2024 At Court

GSS Holdings Inc. and the Substance Over Form Doctrines

Linda Jellum

On September 21, 2023, the United States Court of Appeals for the Federal Circuit decided GSS Holdings (Liberty) Inc. v. United States. The decision was not earth shattering, but the disagreement between the majority and the dissent about the substance-over-form doctrines demonstrates their indistinct boundaries and the difficulty judges have understanding and applying these related doctrines.

In GSS Holdings, the Federal Circuit reversed the United States Court of Federal Claims decision in GSS Holdings (Liberty) Inc. v. United States, reasoning that the Claims Court had inappropriately conflated the step transaction and economic substance doctrine, which are “two separate doctrines.” Under the step transaction doctrine, a trial court assesses the intent of the taxpayer when entering the transactions “from the outset.” In doing so, the court determines whether the 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.” In contrast, under the economic substance doctrine, a court focuses solely on the transaction that led to the alleged tax benefit, then analyzes whether that specific transaction had “economic substance.” The Claims Court claimed it was applying the step transaction doctrine, but the Federal Circuit found that it focused on the wrong transaction. Surprisingly, neither party disagreed that the Claims Court had conflated the two doctrines. On appeal, the parties’ only disagreement was about which transaction was the “outset” transaction for application of the step transaction doctrine. The Federal Circuit vacated the Claims Court’s judgment granting the government summary judgment and remanded the case, leaving that choice to the lower court.

While the majority and the litigants all agreed that the Claims Court had conflated the doctrines, the dissent disagreed. The dissent argued that the correct doctrine to apply was the substance-over-form doctrine because the step transaction doctrine is merely “a judicial manifestation of the more general tax law ideal that effect should be given to the substance, rather than the form, of a transaction.” In other words, the dissent disagreed that the Claims Court had applied an incorrect doctrine because the doctrines are merely different methods of arriving at a substance-over-form analysis.

As I explained many years ago, substance over form serves as a background principle supporting a group of related doctrines, including the step transaction doctrine and the economic substance doctrine. Collectively, these doctrines permit courts and the IRS to reject a taxpayer’s characterization of a business transaction that arguably meets the precise terms of a tax statute but simultaneously seeks tax benefits Congress did not intend. It is not surprising that judges would conflate these doctrines: the doctrines’ boundaries are indistinct and judicial terminology is inconsistent. The general principle underlying all these judicially created, anti-abuse doctrines is that the IRS should give effect to the substance of a transaction rather than its form--hence, the name “substance over form.”

In 1935, the Supreme Court decided Gregory v. Helvering. While all the common law anti-abuse doctrines can trace their roots to Gregory, this case is perhaps best known for birthing the business purpose doctrine. In Gregory, the taxpayer, a wealthy businesswoman, was the sole shareholder of a corporation that owned stock in a second corporation. Mrs. Gregory wanted to sell the second corporation’s block of stock; however, she did not want to pay the higher ordinary income tax rate on the dividend distributions. To avoid doing so, Mrs. Gregory took the following steps: (1) formed a third corporation; (2) exchanged the block of stock in the second corporation for shares in the newly formed third corporation; (3) liquidated the third corporation; and (4) claimed that the dividend resulted from a reorganization, thus entitling her to substantially reduce her tax liability under reorganization tax laws. The IRS refused to recognize the transaction as a valid reorganization because the taxpayer’s sole motive was tax avoidance. Literally interpreting the term “reorganization” in the Revenue Act of 1928, the Board of Tax Appeals agreed with Mrs. Gregory. Despite the taxpayer’s motivation, the tax court upheld the reorganization on appeal because it complied literally with the law. The United States Court of Appeals for the Second Circuit reversed.

Rejecting literalism, the Supreme Court affirmed. After noting that tax avoidance and minimization are indeed legitimate, the Court criticized Mrs. Gregory’s reorganization as an

operation having no business or corporate purpose—a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character, and the sole object and accomplishment of which was the consummation of a preconceived plan, not to reorganize a business or any part of a business ….

Although acknowledging that the transaction was conducted in accordance with the literal Code language, the Court nevertheless refused to recognize the transaction as a legitimate tax-free reorganization under the statute. “To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.” Asking “whether what was done, apart from the tax motive, was the thing which the statute intended,” the Court crafted the judicial business purpose doctrine.

Like the business purpose doctrine, the substance-over-form doctrine (or principle) is also a judicially created interpretive tool that allows the IRS and courts to require more than literal compliance with the tax laws. Although referenced in early case law, the substance-over-form principle similarly had its start in Gregory. When denying Mrs. Gregory the tax benefits she claimed, the Supreme Court criticized her transaction as “a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character.” Two later cases built on this idea. In Higgins v. Smith, the Supreme Court stated that “[t]he Government may look at actualities and upon determination that the form employed for doing business or carrying out the challenged tax event is unreal or a sham may sustain or disregard the effect of the fiction ….” Then, in Commissioner v. Court Holding Co., the Court refused to “permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities,” because “[t]he incidence of taxation depends on the substance of a transaction.”

From this substance-over-form concept emerged at least two different but related doctrines: the economic substance doctrine and the step transaction doctrine. The economic substance doctrine allows the IRS to deny tax benefits if the purported pretax economic profit is significantly less than the value of the expected tax benefits from the transaction. Likewise, the step transaction doctrine permits the IRS to disregard steps in a transaction when those steps lack independent significance and to assess the results instead of the integrated transaction. Both doctrines are based on the idea that if two transactions have the same economic outcome, they should have the same tax outcome.

The requirement that a transaction have economic substance originated from Gregory’s substance-over-form language. In Gregory, the taxpayer had an independent business purpose for conducting the transaction (she wanted to sell her stock); thus, only the form of the transaction (a reorganization) was tax-motivated.

In contrast, in Knetsch v. United States, the taxpayer did not have an independent business purpose for conducting the transaction: the taxpayer was only seeking tax benefits. Knetsch involved tax arbitrage—“whereby [a taxpayer] profit[s] after-tax from both paying and receiving a dollar because the dollar … pa[id] is treated more favorably than the dollar … receive[d].” In Knetsch, the taxpayer paid $91,570 to reduce its tax obligation by $233,297.68. The taxpayer was able to reduce the tax obligation by accelerating deductions, postponing income, and converting ordinary income into capital gain. Had the tax benefits been allowed, the taxpayer would have profited by $141,727.68. Referencing Gregory, and again acknowledging that tax avoidance was indeed legitimate, the Supreme Court nevertheless called the taxpayer’s transaction a “fiction,” a “sham,” and a “facade.” The Court noted that the transaction did “‘not appreciably affect [the taxpayer’s] beneficial interest except to reduce his tax.’ For it is patent that there was nothing of substance to be realized by [the taxpayer] from this transaction beyond a tax deduction.” Accordingly, the Court denied the tax benefits. Thus, unlike in Gregory, in Knetsch, both the purpose for the transaction (its existence) and the form of the transaction (tax arbitrage) were tax motivated. Hence, the Court’s analysis focused on the economic effect of the transaction (the form) rather than the taxpayer’s motivation for the transaction. I will call this the economic substance principle to distinguish it from the economic substance doctrine described below. Pursuant to the economic substance principle, a court examines whether the purported economic activity would have occurred absent any tax benefits the taxpayer is now claiming: stated differently, the court asks whether there was a prospect of profit before taxes (pretax-profit prospect). A transaction must have a meaningful economic purpose or investor risk to be legitimate: the IRS can invalidate a transaction if it lacks economic substance independent of tax considerations. Simply put, “the transaction [must have] practical economic effects other than the creation of income tax losses.”

Subsequently, the Supreme Court combined the business purpose doctrine and the economic substance principle into one test in Frank Lyon Co. v. United States. Frank Lyon involved a sale/lease-back transaction of a building. The issue for the Court was whether the taxpayer, Frank Lyon, was entitled to claim depreciation and other deductions on a building when it acted more like a lender than a lessor. Frank Lyon had entered into an arrangement at below market value to finance a building. While it faced possible financial loss if its business partner went bankrupt, Frank Lyon could realize up to $1.5 million in tax benefits if all went well. The transaction in its essence was simple: the business partner effectively sold nontransferable depreciation deductions to the highest bidder, which in this case was Frank Lyon.

Like the taxpayer in Knetsch, the taxpayer in Frank Lyon did not have a business purpose for the transaction; thus, both the existence and the form of the transaction were entirely tax-motivated. For this reason, both business purpose and economic substance were at issue. Unlike the taxpayer in Knetsch, however, Frank Lyon had a business partner, and that partner had a legitimate business reason for entering into and structuring the transaction as the parties did. Although Frank Lyon had neither a business purpose nor the possibility of economic gain absent tax considerations, the Court nevertheless concluded that because the taxpayer had undertaken a transaction with a “genuine economic risk,” the deductions were allowable. In crafting this new doctrine, the Court stated:

[W]here, as here, there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties.

Thus was born the economic substance doctrine. The economic substance doctrine combines the business purpose doctrine and the economic substance principle into a single two-pronged test. Under the business purpose prong, a court assesses the underlying motivation for the transaction. Under the economic substance prong, a court determines whether the purported economic activity would have occurred absent the tax benefits. While the business purpose prong focuses on the taxpayer’s intent, the economic substance prong focuses on the transaction’s effect.

Another substance-over-form doctrine, the step transaction doctrine, allows the IRS to treat “a series of formally independent steps … as a single, integrated transaction” for tax purposes: the result is to assess the tax effects of the integrated transaction and ignore the tax effects of the transaction’s intermediate steps. The step transaction doctrine first came into play in Minnesota Tea Co. v. Helvering when the taxpayer sold some of its assets for stock in another company and the remainder of its assets for cash in pursuance of a plan of reorganization. Under the relevant statute at the time, the sale of the assets would result in a taxable gain unless the proceeds were “distributed” to the taxpayer’s shareholders. Instead of using the cash to directly pay creditors, the taxpayer disseminated the cash to its shareholders in return for their agreement to assume the taxpayer’s debts. The Court ignored the steps of the transaction and held that there was no distribution within the meaning of the statute, finding that the dissemination was, instead, the taxpayer’s payment to its creditors. The Court allowed the IRS to tax the gain from the sale of the assets.

A given result at the end of a straight path is not made a different result because reached by following a devious path. The preliminary distribution … was a meaningless and unnecessary incident in the transmission of the fund to the creditors, all along intended to come to their hands.

Later, in Commissioner v. Court Holding Co., two shareholders orally agreed to sell an apartment building to a third party. Following the advice of legal counsel, the taxpayer-corporation first liquidated the property to its shareholders, who subsequently sold the building to the true buyer. Affirming the Tax Court’s finding against the taxpayer-corporation, the Supreme Court ignored the shareholders’ participation in the transaction, stating that a “transaction must be viewed as a whole, and each step, from the commencement of negotiations to the consummation of the sale, is relevant [to the whole].”

In sum, the step transaction doctrine allows the IRS to eviscerate meaningless steps in a multi-step transaction. “Under the step-transaction doctrine, a particular step in a transaction is disregarded for tax purposes if the taxpayer could have achieved its objective more directly, but instead included the step for no other purpose than to avoid U.S. taxes.”

Returning to the case that started this discussion, GSS Holdings (Liberty) Inc. v. United States, I believe the majority correctly understood that the economic substance doctrine and the step transaction doctrine are related but separate doctrines that fall within the substance-over-form umbrella. The Claims Court wrongly conflated them, and the dissent wrongly concluded that substance over form replaced them.

    Linda Jellum

    Professor, University of Idaho College of Law

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