Last October, a District Court in Colorado turned the economic substance doctrine on its head. In Liberty Global, Inc. v. US, a District Court granted the Government’s motion for summary judgement and found that contrary to the plain language of IRC § 7701(o), there is no prerequisite requirement that the economic substance doctrine even be relevant before the IRS can apply it.

Prior to Liberty Global, tax professionals, and even Congress, viewed the codified economic substance doctrine as a three-step inquiry. The first question is, is the economic substance doctrine relevant? This question comes from the plain language of IRC § 7701(0)(1), which says the doctrine applies to “any transaction to which the economic substance doctrine is relevant” (emphasis added). If it is relevant, then the next questions are 1) does the transaction change the taxpayer’s non-tax economic position (i.e. the objective test) and 2) does the taxpayer have a non-tax business purpose (i.e. the subjective test)?

The Court in Liberty Global held that there is no initial question of relevancy. The Court skipped the plain language of the statute and went straight to a skewed reading of a 2010 House Report. The Court also reasoned that if a transaction lacks economic substance then the economic substance doctrine by definition applies. It seems that the Court believes that the question of whether Congress intended to allow for a transaction is imbedded in the objective or subjective tests. Regardless, the District Court seemed to bypass the plain language of the statute in a manner similar to the D.C. Circuit Court of Appeals in Farhy v. Commissioner.

However, there appears to be some hope that the Tax Court may correct this dangerous finding. In a July 19^th order, Judge Jones asked the parties in Patel v. Commissioner, to brief the issue of relevancy. A number of amicus briefs were recently filed in support of the plain language view that relevance is the first question in the economic substance inquiry.

So why is relevancy so important? The most direct guidance we have on when the economic substance doctrine is relevant comes from the Joint Committee on Taxation (“JCT”) (which also highlights how Congress intended for relevancy to be the preliminary step). According to the JCT, the doctrine “becomes applicable [i.e. ‘relevant’] where a taxpayer seeks to claim tax benefits, unintended by Congress, by means of transactions that serve no economic purpose other than tax savings.” The doctrine is not relevant “[i]f the realization of the tax benefits of a transaction is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate.” Therefore, if Congress intends for a transaction to yield certain tax benefits, then the economic substance doctrine will not be relevant. Also, the JCT laid out when the test may not be relevant: (1) the choice between capitalizing a business enterprise with debt or equity; (2) a U.S. person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; and (4) the choice to utilize a related-party entity in a transaction, provided that the arm’s length standard of section 482 and other applicable concepts are satisfied.

In sum, the economic substance doctrine is relevant when Congress did not intend for a certain transaction to generate tax benefits. In Patel, the Court previously disallowed captive insurance deduction claimed by the taxpayer under IRC § 162. Whether the payments were deductible as such is a question for a different article. But now the issue is whether penalties apply because the transaction lacked economic substance. The Patels, and anyone insured by an IRC § 831(b) captive, would argue that Congress intended for people to benefit from IRC §§ 831(b) and 162. As in, these are benefits created by Congress, and are not phantom Son-of-Boss like transactions. Thus, the conversation would begin and end with relevancy for captives and any other taxpayer that claims a benefit created by Congress.

Judge Jones’ order is promising. It shows that the Court is interested in the District Court’s holding and is not blindly following it, but rather wants the parties to fully brief the issue. The Court’s analysis and whether the opinion is rendered through conference will be an issue to follow.