Federal Circuit: Court of Federal Claims Misapplied Step Transaction Doctrine

(Parker Tax Publishing October 2023)

The Federal Circuit vacated a judgment of the Court of Federal Claims disallowing a partnership's deduction for a loss in connection with its sale of business assets as a loss on the sale of assets to a related party that was disallowed under Code Sec. 707(b)(1). The Federal Circuit found that the Claims Court erroneously applied a hybrid legal standard that improperly conflated the step transaction doctrine and the economic substance doctrine and therefore remanded for a determination under the correct legal standard. GSS Holdings (Liberty), Inc. v. U.S., 2023 PTC 249 (Fed. Cir. 2023).

Background

GSS Holdings (Liberty) Inc. (GSS) serves as the managing member and owner of Liberty Street Funding LLC (Liberty Street). In September 2006, Liberty Street purchased a note issued by Aaardvark IV Funding Limited (the Aaardvark Note) and entered into a liquidity asset purchase agreement (LAPA) for the Aaardvark Note (the Aaardvark LAPA). The Bank of Nova Scotia (BNS) was Liberty Street's counterparty for the Aaardvark LAPA, requiring BNS to purchase the Aaardvark Note at par value if Liberty Street exercised the LAPA.

In April 2007, in anticipation of the adoption of certain banking regulations, Liberty Street entered into a note purchase agreement with an unrelated investor, Reconnaissance Investors, LLC (Reconnaissance). Under that note purchase agreement, Liberty Street issued an Expected Loss Note (the First Loss Note) to Reconnaissance. Reconnaissance funded an account (the First Loss Note Account) in order to cover some of the risk of Liberty Street's assets. In other words, Reconnaissance's money paid into the First Loss Note Account would be used to compensate BNS in the event of a loss in value of Liberty Street's assets.

On December 29, 2011, BNS's subsidiary, Scotiabank (Ireland) Limited (Scotiabank Ireland), purchased the First Loss Note from Reconnaissance and succeeded Reconnaissance's rights and obligations. For tax purposes, Scotiabank Ireland's investment in the First Loss Note was treated as a partnership interest in Liberty Street. On December 30, 2011, Liberty Street exercised the Aaardvark LAPA, and BNS purchased the Aaardvark Note at a loss. BNS certified this loss to the First Loss Note holder, Scotiabank Ireland, causing Liberty Street to pay $24 million to BNS from the First Loss Note Account.

On an amended return for its 2009 tax year, GSS requested to carry back the allocated 2011 loss to deduct the loss from its 2009 tax year. The IRS disallowed the claimed loss deduction under Code Sec. 707(b)(1). The IRS focused on Liberty Street's Aaardvark Note sale to BNS and the $24 million payment to BNS to conclude that these transactions should be treated as a single transaction under the step transaction doctrine. Accordingly, the IRS disallowed the deduction under Code Sec. 707(b)(1) as a loss from the sale of property (the Aaardvark Note) between a partnership (Liberty Street) and a person owning more than 50 percent of the capital interest in the partnership (Scotiabank Ireland, the subsidiary of BNS).

GSS filed a complaint in the Court of Federal Claims, seeking a refund or credit for 2009 concerning its disallowed deduction. In GSS Holdings, Inc. v. U.S., 2021 PTC 240 (Fed. Cl. 2021), the Claims Court entered a judgment in favor of the government. GSS appealed to the Federal Circuit.

Various doctrines have been judicially developed to enforce the purposes of the tax code - two of which are the step transaction doctrine and the economic substance doctrine. Under the "end result test" of the step transaction doctrine, courts first determine whether the doctrine applies by examining the series of transactions at issue and analyzing 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. Separately, as the Federal Circuit explained in Coltec Indus., Inc. v. U.S., 454 F.3d 1340 (Fed. Cir. 2006), the application of the economic substance doctrine focuses solely on the transaction that gave rise to the alleged tax benefit, and analyzes whether that specific transaction had economic substance. GSS argued that the Claims Court improperly used the economic substance doctrine's rule looking only to the step that creates the tax benefit in analyzing the step transaction doctrine.

Analysis

The Federal Circuit agreed with GSS and held that the Claims Court applied a hybrid legal standard that improperly conflated the step transaction doctrine and the economic substance doctrine.

The Federal Circuit found that the Claims Court correctly recognized that the end result test, which determines whether the step transaction doctrine applies, involves assessing the "intent of the taxpayer" "from the outset." However, in the view of the Federal Circuit, rather than proceeding to assess intent from the outset as required under the end result test of the step transaction doctrine, the Claims Court instead focused on the transaction giving rise to the alleged tax benefit as taught by the economic substance doctrine.

The Federal Circuit found that the Claims Court, citing the Federal Circuit's Coltec decision (which analyzed the economic substance doctrine), incorrectly stated that "the transaction ... to be analyzed" here was "the one that gave rise to the alleged tax benefit." Applying this hybrid legal standard, the Claims Court concluded that "the relevant event" to determine intent "was the payment out of [the First Loss Note Account] to BNS at the end of 2011." Examining this 2011

timeframe, the Claims Court held that "there was no question that the 'taxpayer intended to reach a particular result' here, namely, to use the First Loss Note payment to offset some of the LAPA counterparty's losses." Accordingly, the Claims Court treated these two transactions as a single transaction that was properly disallowed under Code Sec. 707(b)(1).

The Federal Circuit therefore vacated the Claims Court's decision and remanded for a determination under the correct legal standard. Specifically, the Federal Circuit stated that under the end result test, the Claims Court must examine whether 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. The Federal Circuit noted that as part of this examination, the Claims Court must determine the outset of the series of transactions, keeping in mind that the series of transactions should be considered as a whole.

The Federal Circuit noted that the parties disputed the timeframe from the outset, with GSS advocating for the 2006 and 2007 timeframe when the Aaardvark LAPA and First Loss Note agreement were negotiated and entered, and the government advocating for the 2011 timeframe when the Aaardvark LAPA was renewed and exercised and when the First Loss Note Account payment was made to BNS. The Federal Circuit said that once the outset's timeframe has been assessed, the Claims Court must determine the intent from the outset, which is another disputed issue between the parties. The Federal Circuit explained that, if the Claims Court concludes that 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, then the step transaction doctrine applies.

In a dissenting opinion, one judge opined that the Court of Federal Claims correctly applied the doctrine of substance over form and that there was no basis in law or precedent for the panel majority's rejection of the substance over form standard.

For a discussion of the loss disallowance rule in Code Sec. 707(b), see Parker Tax ¶25,540. For a discussion of the economic substance doctrine, see Parker Tax ¶99,710.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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