The Court instructed the jury to analyze the transactions under the two common law disallowance methods relied on by the Government: the "substance over form" doctrine, and the "economic substance" doctrine. With respect to substance-over-form, the Court instructed the jury to put aside the labels used or names given to the documents and transactions, and decide whether Altria actually acquired and retained a genuine ownership interest in the Seminole, Oglethorpe, and Vallei facilities, and a genuine leasehold interest in the MTA facility. The jury was to consider "all the relevant facts and circumstances surrounding the transactions," including eight non-exclusive factors identified by the Court. 4 (Charge to the Jury, at 33-34 (Docket No. 146).) At the same time, the Court cautioned the jury that its analysis should turn on the facts as it found them, including its understanding of how the transactions were designed to unfold: "You must consider and give the appropriate weight to all the relevant facts and circumstances. In the end, the question is whether Altria retained significant and genuine attributes of traditional owner (or lessor) status." (Id. at 34.)
n4 The factors, as they appeared in the Court's charge, are as follows:
1. Control Over the Facility. Whether Altria acquired and retained significant and genuine attributes of an owner/lessor, or whether the other party in the transaction -- Seminole, Oglethorpe, Vallei, or the MTA -- retained significant control over the facility;
2. Equity Investment. Whether Altria made a meaningful equity investment in the facility, and whether Altria was at risk of losing its equity investment;
3. Cash Flows. Whether there were significant cash flows between the parties to the transaction;
4. Business Realities. Whether the transaction was motivated by legitimate business purposes, or solely by a desire to create tax benefits;
5. Regulatory Realities. Whether the transaction was motivated by the regulatory or legal environment in which the parties to the transaction were operating;
6. Residual Useful Life. Whether, at the time the transaction began, the facility had an expected useful life beyond the leaseback that Altria could benefit from. In considering this factor, you may consider the options available to the parties at the end of the initial leaseback, including the likelihood that the lessee would exercise its purchase option;
7. Residual Value. Whether, at the time the transaction began, it was reasonable to expect that the facility would have meaningful value at the end of the leaseback that Altria could benefit from. In considering this factor, you may consider the options available to the parties at the end of the initial leaseback, including the likelihood that the lessee would exercise its purchase option; and
8. Residual Value Risk. Whether, at the time the transaction began, Altria had the potential to benefit from an increase in the facility's [*28] value and suffer a loss of its equity investment in the facility as a result of a decrease in the facility's value. In considering this factor, you may consider the options available to the parties at the end of the initial leaseback, including the likelihood that the lessee would exercise its purchase option. [END OF FOOTNOTE]
With respect to the economic substance doctrine, the Court instructed the jury that "[a] transaction lacks economic substance if it has no business purpose or economic effect other than the creation of tax deductions." (Id. at 38.) The jury was to give greater weight to objective facts about the transactions than to a participant's statement of intent. In addition, the Court instructed the jury not to consider the present value of future cash flows in determining whether the "economic effect" prong was satisfied. (Id. at 40.) While the jury could consider the present value of future cash flows in determining whether Altria acted with a legitimate business purpose, it was to find for Altria on the economic effect prong if "the amounts Altria reasonably expected to receive exceed the amounts Altria invested in the transaction." (Id. at 40.)Judge Holwell then addressed Altria's complaints about considering present value as follows:
The Court further instructed the jury that the economic substance test was flexible. If the jury found with respect to a particular transaction that Altria lacked a business purpose other than tax avoidance, or lacked a potential for profit beyond the creation of tax benefits, it was entitled to find that the transaction should not be respected for tax purposes. The jury, however, was to consider both the "business purpose" and "economic effects" inquiries before reaching a conclusion as to the economic substance of a transaction. (See id. at 38-39.)
As noted, the jury returned a verdict for the Government. The verdict forms clearly indicated that the jury accepted the Government's basic contention that the transactions had no purpose, substance, or utility apart from their anticipated tax consequences. Using separate forms for each transaction, the jury found that: (i) Altria did not acquire a genuine ownership interest in the leased facilities (or a genuine leasehold interest in the MTA facility), which would entitle it to depreciation, amortization, and transaction expense deductions, and (ii) the transactions did not have economic substance.
The economic substance doctrine permits the Commissioner to disallow deductions arising out of transactions that do not "appreciably affect [a taxpayer's] beneficial interest except to reduce his tax." Knetsch v. United States, 364 U.S. 361, 366, 81 S. Ct. 132, 5 L. Ed. 2d 128, 1961 C.B. 34, 1961-1 C.B. 34 (1960) (quoting Gilbert v. Commissioner, 248 F.2d 399, 411 (2d Cir. 1957) (L. Hand, J., dissenting)). Under the doctrine, a claimed deduction may be disallowed if a transaction "has no business purpose or economic effect other than the creation of tax deductions." Nicole Rose Corp. v. Commissioner, 320 F.3d 282, 284, 52 Fed. Appx. 545 (2d Cir. 2003) (quoting DeMartino v. Commissioner, 862 F.2d 400, 406 (2d Cir. 1988)). As understood by the Courts of Appeals, the doctrine has two components: "business purpose" and "economic effect." The business purpose inquiry "concerns the motives of the taxpayer in entering the transaction;" it asks whether the taxpayer's "sole motivation" for entering a transaction was to realize tax benefits. Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 92 (1985). The economic effect inquiry "requires an objective determination of whether a reasonable possibility of profit from the transaction existed apart from tax benefits." Id. at 94.
1. A Flexible Analysis
The Court begins with the question of whether it was appropriate to consider whether Altria acted with a bona fide business purpose once it established that it stood to earn a non-tax-based return. As Altria accurately notes, the opinions of the Courts of Appeals reflect a degree of disagreement as to whether a transaction must satisfy both the business purpose and economic effects tests to support a deduction. While some courts have held that a transaction can fail for lack of either business purpose or economic effect, others have suggested that the Government may only disallow a deduction if a transaction lacks both a legitimate business purpose and an economic effect. Compare, e.g., Boca Investerings P'ship v. United States, 314 F.3d 625, 631, 354 U.S. App. D.C. 184 (D.C. Cir. 2003) ("[W]hile taxpayers are allowed to structure their business transactions in such a way as to minimize their tax, these transactions must have a legitimate non-tax avoidance business purpose to be recognized as legitimate for tax purposes."), with Rice's Toyota World, 752 F.2d at 91 ("To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of a profit exists." [*64] (emphasis added)); see generally Jeff Rector, A Review of the Economic Substance Doctrine, 10 Stan. J.L. Bus. & Fin. 173 (2004) (summarizing decisions and arguing that semantic differences in doctrine have little practical significance).
For substantially the reasons explained by Judge Arterton in Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122 (D. Conn. 2004), aff'd, 150 Fed. App'x 40 (2d Cir. 2008), the Court understands Second Circuit law to require an analysis under which the factfinder must consider both aspects of the economic substance inquiry, and may (but need not) find against the taxpayer if a transaction lacks either a legitimate business purpose or an economic effect. As Judge Arterton noted, the Circuit's most detailed opinion on the question, Gilman v. Commissioner, 933 F.2d 143 (2d Cir. 1991), endorsed the Tax Court's application of a "flexible" analysis that considered whether a prudent investor would have entered into the challenged transaction apart from tax benefits. Gilman thus suggests, without holding, that "consideration of business purpose and economic substance are simply more precise factors to consider in the application of [a] traditional sham analysis" focused on "whether the transaction had any practical economic effects other than the creation of income tax losses." Long Term Capital Holdings, 330 F. Supp. 2d at 171 n.68 (quoting Casebeer v. Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990)). See also Long Term Capital Holdings, 330 F. Supp. 2d at 172-73 ("The Second Circuit rejected the taxpayer's contentions that (1) the relevant standard for determining economic substance is whether the transaction may cause any change in the economic positions of the parties (other than tax savings) and (2) that where a transaction changes the beneficial and economic rights of the parties it cannot be a sham.").
This understanding of Second Circuit precedent is consistent with Frank Lyon's teaching that the parties' allocation of rights and duties should be respected for tax purposes if "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 . . . ." Frank Lyon, 435 U.S. 561, 583-84, 98 S. Ct. 1291, 55 L. Ed. 2d 550 (emphasis added). It also is consistent with the Circuit's leading decision in Goldstein, which approved disallowance if a challenged transaction "can not with reason be said to have purpose, substance, or utility apart from [its] anticipated tax consequences." 364 F.2d at 740.
Altria does not directly challenge this understanding of Second Circuit law (see Altria Mem. 16 n.1), but it contends that the business purpose inquiry becomes superfluous if a transaction generates "substantial non-tax based profit"--here, non-tax-based profits of between 2.5% and 3.8%. (Altria Mem. 27). Thus, even in a transaction that otherwise appears to be dominated by tax-avoidance motives, the presence or absence of a legitimate business purpose becomes irrelevant upon a showing of a substantial economic effect. (Id.) Depending on how one interprets this argument, Altria is advocating either an evidentiary presumption, whereby proof of economic effect irrebutably demonstrates business purpose, or a substantive legal rule, under which business purpose becomes irrelevant once an economic effect is established. The Court is not persuaded that either argument does, or should, reflect the law.
Beginning with the evidentiary argument, it is indeed strange that an investor would act solely out of tax avoidance in entering into a transaction that combined tax-and non-tax-based sources of profit. But to put the point mildly, there are other strange features to the transactions in this case (consider the Vallei transaction, in which an American manufacturer of consumer goods acquired a facility used to treat sewage), and there was an ample evidentiary basis to support the jury's finding that Altria acted solely out of tax avoidance. Absent a compelling reason to disregard this evidence, the Court is at a loss as to why Altria's business purpose should be determined via an evidentiary presumption instead of actual evidence.
Turning to the substantive legal argument, the Court acknowledges that some authority supports Altria's position. See, e.g., Rosenfeld v. Commissioner, 706 F.2d 1277, 1282 (2d Cir. 1983). 12 But for reasons that have already been explained, the better reading of Second Circuit precedent is that a transaction may fail for lack of a legitimate business purpose or economic effect. See supra p. 39. This understanding makes good sense. By reading the business purpose inquiry out of the economic substance analysis, Altria would encourage shelter designers to incorporate just enough non-tax-based profit into a transaction to avoid economic-substance scrutiny, even in essentially wasteful transactions that are beyond any reasonable understanding of the activity Congress sought to promote by enacting specific deductions. Interestingly, this appears to have happened in this case; no one has offered a good explanation for why Altria entered into the transactions, aside from its expectation of a net profit that barely exceeded the then-prevailing risk-free rate. Yet, the substantial spread between the tax- and non-tax-based sources of profits in the transactions (five percent, on average), as well as the contemporaneous documentary record, overwhelmingly suggest that the transactions served little practical purpose beyond reducing Altria's tax liabilities.
n12 Altria also maintains that no case has disallowed tax benefits for lack of a business purpose where the underlying transaction satisfied the economic effect component of the economic substance doctrine. (Altria Mem. 27.) The decided cases generally address transactions that generated a loss, although certain profit-generating transactions in ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), and Sheldon v. Commissioner, 94 T.C. 738 (1990), appear to been held invalid solely for lack of a legitimate business purpose. See ACM P'Ship, 157 F.3d at 258; Sheldon, 94 T.C. at 769.
Concededly, an understanding of the economic substance doctrine that allows transactions to be held invalid for lack of a legitimate business purpose has the undesirable side effects of generating litigation and introducing uncertainty into tax-motivated transactions. But as the D.C. Circuit has cogently explained, the alternatives are worse:
It is uniformly recognized that taxpayers are entitled to structure their transactions in such a way as to minimize tax. When the business purpose doctrine is violated, such structuring is deemed to have gotten out of hand, to have been carried to such extreme lengths that the business purpose is no more than a facade. But there is no absolutely clear line between the two. Yet the doctrine seems essential. A tax system of rather high rates gives a multitude of clever individuals in the private sector powerful incentives to game the system. Even the smartest drafters of legislation and regulation cannot be expected to anticipate every device. The business purpose doctrine reduces the incentive to engage in such essentially wasteful activity, and in addition helps achieve reasonable equity among taxpayers who are similarly situated--in every respect except for differing investments in tax avoidance.
ASA Investerings P'ship v. Commissioner, 201 F.3d 505, 513, 340 U.S. App. D.C. 55 (D.C. Cir. 2000).
Furthermore, the parade of horribles that Altria predicts if such an understanding is adopted -- that every leveraged lease will be subject to invalidation, that the Commissioner will deny deductions for home mortgage interest, and so forth -- is unlikely to materialize. (See Altria Mem. 13.) Leaving aside the Government's limited enforcement resources, the economic substance doctrine simply has no application if it is clear that a claimed deduction is within the intent of a provision of the Code. See, e.g., Sacks v. Commissioner, 69 F.3d 982, 991 (9th Cir. 1995) ("Absence of pre-tax profitability does not show 'whether the transaction had economic substance beyond the creation of tax benefits,' where Congress has purposely used tax incentives to change investors' conduct." (citation omitted)). Accordingly, the Court concludes that the jury's finding that Altria lacked a legitimate business purpose for entering the transactions, even if at the limits of what present doctrine allows, was sufficient to support its economic substance verdict.
2. The Relevance of the Present Value of Future Cash Flows
The foregoing conclusion leaves Altria with a secondary argument -- that the present value of the future cash flows it stood to receive through the transactions was irrelevant to whether it acted with a bona fide business purpose.
Under Federal Rule of Evidence 401 "relevant evidence" is "evidence having any tendency to make the existence of any fact that is of consequence to the determination of the action more probable or less probable than it would be without the evidence." As noted above, the business purpose inquiry asks whether the taxpayer acted out of a legitimate business purpose, or was motivated solely by tax avoidance. Present value analysis, in turn, seeks to determine whether an investment's expected returns exceeds the costs of pursuing the investment, including the investor's cost of capital. E.g., Richard A. Brealey, Stewart C. Myers, & Franklin Allen, Fundamentals of Corporate Finance cp. 7 (9th ed. 2008).
Such analysis easily meets Rule 401's liberal test of relevancy. If the present value of an investment's net returns is barely positive and the present value of its pretax returns is negative, a reasonable factfinder may find it "less probable" that the investor was motivated by a legitimate business purpose. Alternatively, the factfinder might conclude from the fact that a transaction is cashflow negative on a pretax basis that the tax avoidance was the primary, perhaps the only, factor motivating the transaction.
Altria contends that allowing the factfinder to draw this inference is inconsistent with the principle that mere consideration of tax benefits provides no basis for disallowing a claimed deduction. See, e.g., Commissioner v. Brown, 380 U.S. 563, 579-80, 85 S. Ct. 1162, 14 L. Ed. 2d 75 (1965) (Harlan, J., concurring). But the objection is misplaced, at least where, as here, the jury was specifically charged that "[a] transaction lacks economic substance if it has no business purpose or economic effect other than the creation of tax deductions." (Charge to the Jury 38; see also id. ("For each transaction, you should ask: Was Altria's sole motivation for purchasing (or in the case of MTA, leasing) and then leasing back the facility to achieve large tax deductions during the early years of the subleases?") (emphasis added)).
Altria also contends that consideration of the present value of cash flows generated by the transactions is inconsistent with the profit test under the "economic effect" component of the economic substance doctrine. But this depends on a false dichotomy -- that realizing transactional profit is the only legitimate objective a business may pursue. And again, the Court's instructions specifically addressed Altria's concern, providing that the objective prong is satisfied if a transaction is profitable on a cash in-cash out basis.
Altria finally argues that this approach is inconsistent with the Tax Court's about-face on the utility of present-value analysis in Hilton v. Commissioner, 74 T.C. 305 (1980), and Estate of Thomas v. Commissioner, 84 T.C. 412 (1985). But in Hilton, the court considered whether the objective prong of the economic substance doctrine required a particular threshold of profit, not whether a factfinder could consider such evidence as part of its business purpose inquiry. See Hilton, 74 T.C. 305, 353 n.23. Thus, the Court does not find the Tax Court's dueling dicta controlling here.My comments:
1. I have previously blogged my concern about submitting the economic substance issue to a jury in a criminal case. Those same concerns exist in a civil case. What is a jury to make of this type of instruction? Even a jury who can follow the instruction will find little in the way of solid legal guidance; a decision ultimately will come forth from the collective jury gut.
2. I am surprised that the taxpayer brought this case before a jury. Did the taxpayer really think that it could convince a jury to find sympathy in its collective gut for such hokey deals? In this regard, I noted in Saturday's blog Judge Holwell's negative comments about the taxpayer's attempted reliance upon alleged Tax Court refinements of Frank Lyon. If the taxpayer really believed the Tax Court authority was favorable, why did it not take the case to the Tax Court? As I said before, the reason is obvious. And this taxpayer would not have found any sympathy from the Court of Federal Claims. (See my blog titled Court Finds Tax Motivated Transactions are Bullshit.)
3. I am a bit surprised that "the Court instructed the jury not to consider the present value of future cash flows in determining whether the 'economic effect' prong was satisfied." Under the instructions, the economic effect prong was the objective prong of the test, and present value analysis is pretty objective. Take this example. Say I put $100,000,000 into a hokey tax shelter that, in 10 years will return me $100,000,001, but give me great tax benefits in the interim. Does that have objective economic effect? Would it make any difference if it returned $100,001,000? The Court, of course, took away what it appeared to give by instructing the jury that it could consider discounted present value in determining whether the taxpayer had a business purpose for the hokey deals -- excuse me, for the deals.
4. Readers might want to compare Judge Holwell's instructions on the objective prong ("economic effect") with Judge Kaplan's instructions in the remnants of the KPMG criminal case, United States v. Larson. I have just posted Judge Kaplan's instructions as a separate blog here. Readers might also want to review the test, perhaps narrower than the broader imagination of the economic substance test, in the Virgin Island's residency criminal case here.