The Broad Reach of the Economic Substance Doctrine

Congress provides tax incentives to change taxpayer behavior. If a taxpayer changes their behavior to take advantage of the incentive, they have to do so carefully. The IRS and the courts can apply the economic substance doctrine to take away the tax benefit. This doctrine can apply to more transactions than what one would consider a “tax shelter.” The Alternative Carbon Resources v. United States, No. 2018-1948 (Fed. Cir. 2019) case is an example of how the economic substance doctrine can be applied to a business structured to take advantage of a tax credit.

Facts & Procedural History

This case involves alternative fuel mixture credits. The taxpayer structured their business to take the credits. This tax credit is available for those who sell alternative fuel mixtures to third parties to use the mixtures to make fuel.

The taxpayer’s business was structured as follows:

1. It purchased feedstock from its suppliers.
2. It paid a trucking company to add diesel to the feedstock.
3. It paid a disposal fee to third parties who used the feedstock to generate electricity.
4. The third party disposal companies paid a nominal annual fee to the taxpayer.

The taxpayer characterized this transaction as a sale on its tax returns. It reasoned that paying the disposal fee was tantamount to a sale of the feedstock to the disposal companies, which allowed it to qualify for the tax credits.

The IRS audited the tax return. It concluded that the taxpayer simply engaged in a contrived transaction performing no economic or business function other than to generate tax benefits.

The court sided with the IRS. The court record included employee and expert testimony that the diesel was not needed, but only added to take advantage of the tax credits and that the taxpayer’s business was structured to take advantage of the tax credits.

The question for the court was whether the taxpayer was entitled to the tax credits. The IRS argued that the taxpayer was not entitled to tax credits and cited the economic substance doctrine as its rationale for disallowing the tax credits.

The Economic Substance Doctrine, Generally

The economic substance doctrine allows the IRS and courts to unwind an otherwise valid transaction for tax purposes. It applies when the transaction is tax motivated.

The economic substance doctrine was created by the courts. It provided the courts with a means for disallowing the tax benefits for tax shelters, etc. There have been several tax court cases where the IRS raised this doctrine to disallow tax deductions, credits, etc.

The doctrine was later codified in Sec. 7701(o), which says that a transaction shall be treated as having economic substance only if:

1. The transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and
2. The taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.

Both requirements have to be met for a transaction to have economic substance.

What is the “Transaction”?

The Code notes that a “transaction” includes a series of transactions.

The IRS had previously issued Notice 2014-58 which adopts the definition of the term “transaction” from the reportable transaction rules. These rules define the term “transaction” broadly, as including:

all of the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement and also includes any series of steps carried out as part of a plan.

With this broad definition, just about any steps can count as a transaction. In theory it can apply to any business structure or transaction and to any tax deduction, credit, or savings that results from the transaction.

For example, in this case the “transaction” was the taxpayer’s business of buying feedstock, adding diesel to the feedstock, and paying to dispose of the feedstock. This shows how complex steps can be considered a single transaction if they are connected in some way.

What About the Profit Motive Requirement?

The taxpayer did not earn a profit. Does this show that the transaction lacked economic substance?

The Code says that the lack of a profit for the transaction is only to be considered if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected.

The court noted that the taxpayer included a fee to the disposal companies to try to comply with this rule. This was part of the taxpayer’s tax planning. However, the fee it received was not significant. The court noted that “the annual fees Alternative Carbon collected were nominal—$8,950—compared to the millions it paid in fees.” Had the fee been more substantial, it appears that the profit motive would not have been in question. How much more is open for debate.

Since the fee was nominal, the court had to contend with the prior case law cited by the taxpayer. The taxpayer cited prior case law that says that the “[a]bsence of pre-tax profitability does not show whether the transaction ha[s] economic substance beyond the creation of tax benefits where Congress has purposely used tax incentives to change investors’ conduct.” This is the general rule that Congress intended taxpayers to get a benefit for engaging in certain activities.

The court in this case noted that a lack of a profit is not necessarily fatal, but that the lack of a profit warrants careful review. The court distinguished the facts in the present case from those in the court case cited by the taxpayer. The court seemed to believe the taxpayer in the other case had a specific plan for making a profit. The court offered this language from the prior court case:

If energy prices rise faster than the price of solar water heaters fall, Mr. Sacks stands to make more money. After 53 months, when the units are still well within Amcor’s warranty period and their useful life by any measure, Mr. Sacks owns them free and clear and can negotiate whatever deal the market will bear.”

The evidence in the current case included similar testimony about what might happen in the future. Specifically, the court heard testimony from the taxpayer that it could have earned a profit if its customers had acted quicker which, would have increased the demand for methane and led to a profit. The court dismissed the testimony in the present case as being speculative.

This shows that those whose transactions only generate an after-tax profit need to document the method for making a profit. This documentation should include specific steps within the taxpayer’s control that will be taken over time to lead to profitability.