Law Firm Files Amicus Brief in WFC Holdings

A significant role of Alston & Bird's tax practice is to provide advice on the tax aspects of the structure and implementation of business transactions, both large and small. Tax planning matters handled by Alston & Bird involve virtually all forms of business transactions, from taxable and tax-free acquisitions, dispositions, and venture formations to financings and reorganizations, involving a variety of industries, including telecommunications, banking, real estate, insurance, manufacturing, financial services and the service industries generally.

Alston & Bird also maintains a national tax controversy practice defending client tax positions under challenge by the Internal Revenue Service ("IRS"). Tax controversy matters handled by Alston & Bird include audits, administrative appeals, trial and appellate tax litigation at all levels of the federal court system, and mediation of both docketed and non-docketed tax cases.

Since the mid-1990s, Alston & Bird's tax practitioners have been called upon to address the burgeoning reliance by the IRS and the lower federal courts on what is now generally known as the economic substance doctrine. Alston & Bird files this amicus brief not with reference to the particular facts of the case of the Petitioner, but with reference to the common plight of the Petitioner and thousands of other taxpayers, including our clients, who every year are faced with either assertions of this uncertain ground for tax assessments by the IRS, or the inability to know what the law is for purposes of planning their financial and business affairs.

Over the past approximately 30 years, however, lower federal courts and the IRS have conflated these two legal processes of statutory interpretation and common law fact finding, and have radically expanded the scope and reach of this Court's precedents, to create what is now commonly referred to as the economic substance doctrine ("ESD"). The business purpose rule of Gregory and the search for economic substance in fact of Frank Lyon have been melded into a two prong test (shorthanded as business purpose and economic substance) that a taxpayer must prove its way out of to avoid losing a claimed tax benefit under the ESD.

Consequently, lower courts have not limited the so-called ESD to specifi c tax code provisions that require a business purpose. Neither has the ESD been used as a traditional fact-finding methodology to ferret out the substance of transactions. Rather, as was true in the decision below, the IRS and the lower courts have applied the ESD to override the Internal Revenue Code by disregarding transactions that satisfy the Code's provisions. See ACM Partnership v. Commissioner, T.C. Memo. 1997-115 (internal citation omitted) ("The tax statutes apply only 'to transactions entered upon for commercial purposes and 'not to . . . transactions entered upon for no other motive but to escape taxation.''"); IRS Chief Counsel Memo AM2012-009, Nov. 15, 2012, (citing ACM Partnership for the proposition that the "common law" economic substance doctrine nullifies otherwise applicable tax statutes when the IRS decides the transaction was entered into for "tax avoidance" purposes).

Neither this Court nor Congress has ever authorized a sweeping rule that permits the IRS to override the Code anytime it unilaterally decides a transaction lacks a business purpose or economic substance. Section 7701(o), enacted after the years at issue in this case, does not authorize such a sweeping doctrine as it only clari fies the two factors the taxpayer is required to prove if the judge made ESD is found relevant, relevance being a concept wholly unde fined in the statute. The frequent citing of decisions of this Court as support for the judge made ESD, including in the Eighth Circuit opinion below,² constitute misreading and expansion of those decisions. The ESD itself directly contracts this Court's repeated insistence that once the facts are found using the full range of common law fact finding tools, and the statute is properly interpreted and construed, the tax laws apply as written. See United States v. Cumberland Pub. Serv. Co., 338 U.S. 451, 454-455 (1950) (rejecting an application of substance-over-form fact finding to deprive the taxpayer of the normal operation of the statute to facts as found by the court); Gitlitz v. Commissioner, 531 U.S. 206, 219-20 (2001) (refusing to apply the statute contrary to its terms, even though the taxpayer received a "double windfall. . . . Because the Code's plain text permits the taxpayers here to receive these benefits, we need not address this policy concern."); Hanover Bank v. Commissioner, 369 U.S. 672, 688 n. 23 (1962) ("Granting the government's proposition that these taxpayers have found a hole in the dike, we believe it one that calls for the application of the Congressional thumb, not the court's.").

The lack of authorization from this Court for a sweeping rule that permits the IRS to override the Code anytime it unilaterally decides a transaction is a tax loophole is evident in the growing conflict among the federal circuits over the meaning and applicability of the ESD. Many federal circuits have held that "a transaction ceases to merit tax respect when it has no economic effects other than the creation of a tax benefit." See, e.g., United Parcel Serv. of Am., Inc. v. Commissioner, 254 F.3d1014, 1018 (11^th Cir. 2001) (internal quotations omitted); see also, Sochin v. Commissioner, 843 F.3d 351, 354 (9thCir. 1988); Jacobson v. Commissioner, 915 F.2d 832, 837 (2d Cir. 1990); In re CM Holdings, Inc., 301 F.3d 96, 102 (3d Cir. 2002); Friedman v. Commissioner, 869 F.2d 785, 792 (4th Cir. 1989).

But this formulation masks fundamental ambiguities in the ESD: what is "the transaction" and when is the ESD relevant in the first place? In the decision below, the Eighth Circuit joined the Tenth Circuit in holding that even where an overall transaction is profitable and clearly has economic effects, it can still fall under the ESD for a variety of reasons. See WFC Holdings v. Commissioner, 728 F.3d 736, 746 (8 ^th Cir. 2013) (recognizing components of the transaction were economically beneficial, but disallowing deduction because other components were not and could have been simplified); Sala v. United States, 613 F.3d 1249, 1253-54 (10^th Cir. 2010) (reversing trial court decision upholding loss deduction where the transaction generated a profit, but the tax benefit exceeded the potential and actual profit).

The radical misreading of this Court's authorities by the IRS and the lower courts, and the conflict among the federal circuits regarding the ESD's meaning and applicability, effectively supplant the text of the Code with a malleable and undefined "I know it when I see it" approach to resolving tax disputes. See Jacobellis v. Ohio, 378 U.S. 184, 197 (1964) (Stewart, J., concurring); see also, ACM Partnership v. Commissioner, 157 F.3d231, 265 (3d Cir. 1998) (McKee, J., dissenting) (criticizing the economic substance doctrine as akin to a "smell test": "If the scheme is question smells bad, the intent to avoid taxes defines the result as we do not want the taxpayer to 'put one over.'")

Certiorari is necessary to reaf firm the primacy of the Code in determining what the tax law is and in resolving tax disputes. Ideally the Court will announce that there is no ESD, although its "two prongs" may describe a way to find facts in certain difficult fact finding situations (for example, cases addressing who owns property, as in Frank Lyon). If not, certiorari is necessary to preventinconsistent application of the ESD, and to establish when the doctrine is relevant.

In 2010 Congress enacted Code § 7701(o), which applies only to transactions occurring after March 30, 2010 and, therefore, is not applicable here. It purported to resolve uncertainty about whether the two factual showings a taxpayer must make to escape the ESD (according to certain lower court decisions) are conjunctive or disjunctive: going forward they will be conjunctive. See § 7701(o)(1); see also Health Care and EducationReconciliation Act of 2010, Pub. L. No. 111-152, § 1409(e) (1), 124 Stat. 1029, 1070. The section neither creates nor approves of an economic substance doctrine, but states that whatever it is the courts (referring to lower federal courts) have done under that rubric, the proof required of the taxpayer to escape the government's assertion of the doctrine shall be as speci fied in § 7701(o) in the future. The text of the statute twice refers to the necessity of the doctrine to be found relevant to the particular transaction, and states that a "determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted." See 26 U.S.C. §§ 7701(o)(1) & (5)(C).

But the fundamental problem for taxpayers is that neither the IRS nor the courts have squarely addressed the relevancy requirement of the ESD prior to or post-codification. Either they do not recognize it as an independent issue at all, or they suggest, without directly saying so, that because they find the taxpayer's actions to be contrary to the purposes of Congress, the taxpayer loses under the ESD. And to be clear, when they discern the purposes of Congress they are not doing so to interpret the statute to prevent the taxpayer's claim; they do so to justify saying the taxpayer loses under the ESD even though the Code has admittedly been satisfied. The Eighth Circuit below did not address the relevance of the doctrine. But it is clear from its analysis that it decided to deny the tax benefits sought not because it interpreted the statute to deny the benefit or because it found the required facts not to have occurred, but because the taxpayer failed to prove out of the two prong test of the ESD. WFC Holdings Corp. v. Commissioner, 728 F.3d 736, 738 (8th Cir. 2013)("We hold that WFC failed to adequately show that the transaction had either objective economic substance or a subjective, non-tax business purpose, and we affirm.").

However, as this Court stated nearly 80 years ago, "[t]he legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted." Gregory v. Helvering, 293 U.S. 465, 469 (1935). A necessary corollary of the right stated by Justice Sutherland in Gregory is the ability of taxpayers to know what the tax law permits. Absent an objectively understandable relevancy requirement, however, no amount of careful and reasonable tax planning will avoid the reach of the ESD. Neither the lower federal courts that have applied the ESD, nor the IRS, have shown any inclination to define the relevance of the doctrine, either globally or step by step. Therefore, lacking guidance from Congress, the ESD's relevance is wholly undefined. An undefi ned doctrine granting the IRS carte blanche authority to disregard the plain meaning of the Code serves no valid purpose, and instead serves only to instill fear in taxpayers seeking to lawfully reduce their tax burdens. See Yin, George K., The Problem of Corporate Tax Shelters: Uncertain Dimensions, Unwise Approaches, 55 Tax L. Rev. 405, 421-22 (Spring 2002)(noting the government often invokes the ESD for its in terrorem effect).

On some occasions, as in IRS Chief Counsel Memo AM2012-009, cited above, the IRS has asserted that it will apply the economic substance doctrine when it decides the transaction at issue does not comport with Congress' purposes in writing the statute. Certainly, Congress' purposes can sometimes be discerned and used to interpret the statute. See, e.g., United States v. Home Concrete & Supply, LLC, 132 S. Ct. 1836 (2012); United States v. Quality Stores, Inc., ___U.S._____ (2014) (interpreting theFICA withholding rules based on analysis of Congress' purposes). However, when the IRS makes this assertion in connection with the ESD it does not go on to interpret the statute, purposively or otherwise. Rather, it asserts the ambiguous ESD as a general anti-loophole rule, concludes that the taxpayer cannot meet the burden of proving out of the ESD, and then announces that the taxpayer loses. Indeed, because most cases applying the ESD go directly to the two prong test, that appears to have become a de facto standard of relevancy: if the taxpayer cannot prove out of the tests, the doctrine must be relevant, and the taxpayer necessarily loses.

Faced with a fundamentally ambiguous doctrine, unconstrained by any relevancy restriction, taxpayers and tax practitioners are rightfully concerned about the continued validity of traditional tax planning vehicles. For example, Code §§ 332(a) and 337(a) allow a parent corporation to receive property of a liquidating subsidiary with neither the parent nor the subsidiary recognizing gain on the transaction. The sections apply when the parent corporation owns at least 80% of the vote and value of the stock of the subsidiary. 26 U.S.C. § 1504(a)(2). If the 80% ownership test is not met, the subsidiary liquidation is taxable under §§ 331 and 336, or may produce a § 165 loss. Therefore, a minor change in stock ownership -- for example, a decrease in ownership from 80% to 79% -- can convert a non-taxable reorganization into a taxable reorganization, and vice versa.

For more than 50 years corporations have become accustomed to flexibility in asserting control over, or decontrolling, subsidiaries in anticipation of a liquidation in order to achieve the desired tax result -- either recognition (to utilize losses) or non-recognition (to avoid gain). Changing stock ownership in order to achieve the desired tax result was approved by the First Circuit in Granite Trust Co. v. U.S., 238 F.2d 670 (1st Cir. 1956), inreliance on Commissioner of Internal Revenue v. Day & Zimmermann, Inc., 151 F.2d 517 (3d Cir. 1945) and Avco Mfg. Co. v. Commissioner, 25 T.C. 975 (1956).

In Granite Trust, a bank ("parent") owned 100% of the stock of a subsidiary whose sole asset was the real property occupied by the parent. Because the fair market value of the property had declined and was less than the parent's basis in the stock of the subsidiary, the banking authorities pressed the parent to make reductions in the stock basis. To resolve the situation, the parent developed a plan to have the parent acquire the real property at fair market value and then liquidate the subsidiary. But for the non-recognition rule of § 332's predecessor, the acquisition and liquidation would trigger a beneficial tax loss that could be claimed by the parent. After informally deciding to liquidate the subsidiary, the parent sold or otherwise disposed of enough stock to fall below the 80% ownership threshold. The acknowledged purposes of the sale of stock was to avoid the predecessor of Code § 332, which provided that a loss could not be recognized on the liquidation of an 80% subsidiary. The government argued (1) that the "end result" of the transaction was a complete liquidation and that the intermediate steps involving the sales and gift should be disregarded and (2) that there were no valid sales or gift of the stock. The First Circuit rejected both arguments. In holding for the taxpayer, the First Circuit recognized that the facts showed that the transfers of stock were motivated solely by tax considerations, but also found that the transfers of the stock were "legal transactions not fictitious or so lacking in substance as to be anything different from what they purported to be." Granite Trust, 238 F. 2d at 678.

Subsequently the IRS acquiesced in another similar decision holding that taxpayers may structure liquidations in a way that makes Code § 332 either applicable or inapplicable. See Riggs v. Commissioner, 64 T.C. 474, 489 (1975), acq. 1976-2 C.B. 2 ("[S]ection 332 is elective in the sense that with advanced planning and properly structured transactions, a corporation should be able to render section 332 applicable or inapplicable."). And as recently as 2013, the IRS advised taxpayers, by way of private letter rulings, that they may structure liquidations to achieve desired tax benefits consistent with the Granite Trust line of authorities. See IRS Priv. Ltr. Rul. 87-13-041, 1986 WL 372821; IRS Priv. Ltr. Rul. 2010-14 -002, 2010 WL 1411503; IRS Priv. Ltr. Rul. 2013-30-004, 2013 WL 3856953; IRS Priv. Ltr. Rul. 2013-34-006, 2013 WL 4496006.

The decision below, which questioned the economic substance of a similar corporate non-recognition provision involving a § 351 exchange, raises concerns that the IRS and the lower courts may attempt to use the ESD to disregard long-accepted tax planning transactions, such as § 332 transactions upheld in Granite Trust. Those concerns were increased on January 2, 2014, when the IRS formally announced, for the first time, that it will no longer provide rulings on the "treatment of transactions in which stock of a corporation is transferred with a plan or intention that the corporation be liquidated." IRS Rev. Proc. 2014 -3, 2014-1 IRB 111, sec. 3.01(33). Although the procedure does not state that the reason for the change is due to potential application of the ESD, taxpayers and their advisors are hard pressed not to worry that, in light of the decision below and the general expansion of the ESD, the IRS has changed its view regarding the application of the ESD to corporate liquidations and reorganizations.

¹See also, Helvering v. F. & R. Lazarus & Co., 308 U. S. 252, 255 (1939) (finding a transaction which was "in written form a transfer of ownership with a lease back, was actually a loan secured by the property involved," and thereby ruling for the taxpayer); Higgins v. Smith, 308 U.S. 474, 477 (1940) (holding that a transaction may be disregarded "upon determination that the form employed . . . is unreal or a sham," and ruling against a taxpayer who attempted to realize losses upon sales of stock to his desk drawer corporation); see Knetsch v. United States, 364 U.S. 361, 366 (1960) (ruling against the taxpayer by finding a purported loan transaction was not actually a forbearance to collect money in exchange for interest payments, because neither party intended to loan, borrow, or pay back approximately four million dollars).

² "While the origin of the economic substance doctrine is generally traced to the Supreme Court's holding in Gregory v. Helvering, . . ., current application of the doctrine stems primarilyfrom the Supreme Court's decision in Frank Lyon Co. v. United States. . . ." WFC Holdings Corp. v. U.S., 728 F.3d 736, (8^th Cir.2013).