Overview
This article discusses two discrete tax cases involving Liberty Global, Inc. (Liberty Global). In Liberty Global, Inc. v. Commissioner, the Tax Court held that Liberty Global inflated its allowable foreign tax credit by overstating its foreign-source income from the sale of stock in a controlled foreign corporation (CFC).[1] Liberty Global’s position was based on a novel interpretation of how section 904(f)(3) operates to recapture an overall foreign loss (OFL).
In Liberty Global v. United States, the US District Court for the District of Colorado found that the temporary regulations under section 245A were invalid.[2] The court also upheld the government’s right to bring a common-law suit for collection.[3] Lastly, the court held that the economic-substance doctrine applied to disallow Liberty Global’s tax benefits from a transaction that exploited a loophole under the Tax Cuts and Jobs Act (TCJA).[4] Liberty Global plans to appeal the decision to the United States Court of Appeals for the Tenth Circuit.
Overall Foreign Loss Dispute
An overall foreign loss is the amount by which the taxpayer's foreign-source gross income is exceeded by the deductions allocable or properly apportioned to foreign-source gross income in a particular tax year.[5] Generally, if a taxpayer sells CFC stock that generates income in a limitation category with an OFL account, some or all of the gain from the sale is recharacterized as foreign-source income for the purpose of recapturing the OFL.[6]
At the beginning of 2010, Liberty Global had an OFL of $474 million. Later that year, Liberty Global realized gain of roughly $3.25 billion from the sale of CFC stock. Liberty Global reported $438 million of gain as a dividend under section 1248 and $2.8 billion (the “excess gain”) as foreign-source income on its 2010 tax return.
The IRS determined that Liberty Global overstated its foreign-source income and its allowable foreign tax credit. The parties disagreed about how section 904(f)(3)(A) treats Liberty Global’s gain in excess of the amount needed to recapture the OFL (the $2.8 billion that Liberty Global reported as foreign-source income on its 2010 return).
Was Liberty Global entitled to treat the excess gain as exempt from US taxation under section 904(f)(3)? Alternatively, was Liberty Global entitled to treat the entire amount of gain from the sale of CFC stock as foreign-source income under section 904(f)(3)?
Liberty Global’s Spin on the Law
Liberty Global argued that section 904(f)(3) exempts gain in excess of the OFL recapture amount from US taxation altogether. Liberty Global insists that when section 904(f)(3)(A) applies, it “is the only mechanism for recognizing gain” and overrides all other gain recognition provisions in the Code.[7] Under Liberty Global’s reading, section 904(f)(3) recaptures Liberty Global’s 2010 OFL balance of $474 million and exempts the remaining $2.8 billion of gain in excess of the OFL from US federal income tax entirely.[8]
Liberty Global’s argument is that the prefatory language of the statute—which provides that section 904(f)(3)(A)(i) applies “notwithstanding any other provision of this chapter”—turns off all other gain recognition provisions under the Code. According to Liberty Global’s interpretation, the statute’s silence about how it treats gain in excess of the amount needed to recapture the OFL balance precludes the taxation of any gain in excess of that amount.[9]
The Tax Court rejected this argument, finding that “[i]n statutes, the word [notwithstanding] ‘shows which provision prevails in the event of a clash.’”[10] The court held that because section 904(f)(3) does not conflict with section 1001 or any other gain recognition provisions, it does not prevent recognition of additional gain in excess of the OFL under other Code sections. Liberty Global’s interpretation of section 904(f)(3) was that it’s silence about how the excess gain is treated meant that the excess gain is exempt from taxation altogether. The court rejected this interpretation, reasoning that “[i]f the text does not speak to the excess gain, then it does not control the treatment of that gain . . . [s]ilence is insufficient to create a new exclusion.”[11] Applying this reasoning, the court explained that adopting Liberty Global’s interpretation would require the court to infer a gain limitation rule that is plainly not present in section 904(f)(3). The court held that section 904(f)(3)’s silence simply leaves other gain recognition provisions to operate as they normally would with respect to the excess gain.
Liberty Global’s Alternative Argument
Liberty Global’s alternative argument was that section 904(f)(3) and the regulations recharacterize the entire amount of gain from the sale of CFC stock as foreign-source income. According to Liberty Global, section 904(f)(3) is ambiguous and Treas. Reg. § 1.904(f)-2(d)(1) treats the entire amount of gain as foreign-source income (not merely the amount needed to recapture the OFL). This view would result in Liberty Global being allowed a much larger foreign tax credit.[12]
Liberty Global argued that the statutory language, which provides that upon disposing of some kinds of property, “the taxpayer . . . shall be deemed to have received and recognized taxable income from [foreign-sources] . . .” equal to the lesser of the gain or the OFL balance.[13] Liberty Global argued that because the statute says nothing about how to treat any gain in excess of the OFL balance, it necessarily follows that the excess gain must be foreign source. Liberty Global insisted that it correctly treated the $2.8 billion of excess gain (in addition to the $474 million of gain needed to recapture the OFL amount) as foreign source.
The Tax Court rejected this argument, and reasoned that a more natural inference is that the deeming applies only with respect to the amount needed to recapture the OFL balance, and “that existing Code provisions continue to apply with respect to the excess gain.”[14] The Tax Court therefore found that the statute was not ambiguous, and rejected Liberty Global’s argument that Treas. Reg. § 1.904(f)-2(d)(1) treats the entire amount of gain from the sale of CFC stock as foreign-source income, and concluded that the regulation does not recharacterize gain in excess of the amount needed to recapture the OFL balance as foreign source. [15]
In reaching its conclusion, the court questioned the results under both of Liberty Global’s interpretations of section 904(f)(3). The court queried how a rule titled “Recapture of overall foreign loss,” that was adopted to limit the allowable foreign tax credit, could be construed to exempt billions of dollars from US tax.[16]
Having rejected both of Liberty Global’s interpretations of section 904(f)(3), the Tax Court held that the gain in excess of the amount needed to recapture the OFL balance was subject to US taxation and not recharacterized as foreign-source income. However, Liberty Global was entitled to deduct foreign taxes under section 164(a)(3).
GILTI Donut Transaction
Liberty Global’s case in district court arises from changes to US taxation of foreign-source income implemented by the TCJA.[17] The TCJA shifted the United States from a worldwide system of taxation to a quasi-territorial system of taxation. Under the TCJA, foreign-source income earned by a foreign corporation would be taxed currently, but could be repatriated to a corporate US shareholder tax free. The TCJA achieved this by enacting (inter alia) section 951A (GILTI), section 965 (the transition tax), and section 245A. Section 245A provides a deduction for foreign-source dividends received by a corporate US shareholder from specified 10% owned foreign corporations, including CFCs (the section 245A DRD).
What Congress contemplated was that either (1) amounts would be subject to the transition tax with the taxpayer then allowed to repatriate the untaxed balance tax-free via operation of the section 245A DRD, or (2) amounts that were not subject to the transition tax would be subject to GILTI. What they did not contemplate was that an effective-date mismatch between section 951A, section 245A, and section 965 made it possible for certain taxpayers to generate income that was exempt from the transition tax and GILTI but also eligible for the 245A DRD (the GILTI donut).
Liberty Global engaged in a series of transactions (code name “Project Soy”) to exploit the GILTI donut by generating income that was exempt from GILTI and the transition tax, but nonetheless qualified for a 100% dividends received deduction under section 245A, and could therefore be repatriated tax free.
In June 2019, Treasury and the IRS tried to fix the effective-date mismatch with temporary regulations that retroactively disallowed a section 245A DRD for some kinds of distributions, including the distribution in Project Soy.
In October 2019, Liberty filed its 2018 tax return but did not claim the section 245A DRD. In December 2019, Liberty filed an amended return claiming a refund for the section 245A DRD in connection with Project Soy.
The IRS issued several information document requests (IDRs) in connection with the refund claim. Liberty Global did not respond to those IDRs and filed a refund suit against the Government in the US District Court for the District of Colorado challenging the validity of the temporary regulations under Chevron and the Administrative Procedure Act (APA).[18] Specifically, Liberty Global argued (inter alia) that the section 245A temporary regulations:
- Were substantively invalid under Chevron step-one because they contravened the plain unambiguous statutory language of section 245A; and
- Were procedurally invalid under the APA because they were issued without an opportunity for notice and comment and failed to satisfy other APA requirements for retroactive regulations.[19]
The district court granted partial summary judgment in favor of Liberty Global, holding that the temporary regulations failed to meet the APA’s notice-and-comment requirements and were therefore invalid.[20] The court did not reach the Chevron argument. But the court denied summary judgment with respect to unresolved factual questions about Project Soy and whether it complied with the tax law.[21]
The Government’s Novel Approach to Collect Unassessed Taxes
In an extraordinary departure from the ordinary deficiency procedures, the Government affirmatively filed a common-law suit to collect taxes and penalties before issuing a notice of deficiency.[22] The Government argued that “[t]he tax benefits generated by Project Soy should be disregarded” because it lacked economic substance.[23]
Liberty Global moved to dismiss the case, arguing that “the Government was required to mail to [Liberty Global] a ‘notice of deficiency … before bringing a civil action for the collection of taxes.’”[24] By failing to do so, the Government was barred from assessing the tax or initiating a civil action for collection.[25]
Liberty Global argued that section 6213(a)’s statutory language—which provides that “no assessment of a deficiency in respect of any [federal income tax] … and no levy or proceeding in court for its collection shall be made, begun, or prosecuted until [a notice of deficiency] has been mailed to the taxpayer”—unambiguously requires a notice of deficiency for every deficiency assessment, including any litigation to recover a tax deficiency.[26]
The district court rejected Liberty Global’s interpretation. Instead, the court held that while section 6213(a) may require that the Government issue a notice of deficiency before an administrative assessment, that requirement does not apply to a common-law suit for unpaid taxes.[27] The district court held that the Government has two options for collecting unpaid taxes—“the administrative route (assessment and collection) and the common-law route (filing suit on the debt).”[28] Because there was “no indication that section 6213(a) was intended to supplant the existing common-law [route],” the court upheld the Government’s common-law right to sue taxpayers directly.[29]
Some tax controversy practitioners have opined that the court’s holding erodes taxpayer protections, including the taxpayer’s right to petition the Tax Court for judicial review of a deficiency.[30] Specifically, they have argued that with this direct-to-court route, “the Government could strip the taxpayer of its right to choose the venue by going straight to district court before the Tax Court can obtain deficiency jurisdiction.”[31] They likewise argue that the Government could strip the taxpayer of its right to go to IRS Appeals by filing a civil suit and taking the case “out of the administrative process and into litigation directly.”[32]
Other practitioners believe that the court’s holding will not have far-reaching implications. There are several downsides for the Government when it pursues taxes like it did in Liberty Global.[33] First, the Government would have to bring a civil collection suit before the expiration of a much shorter statute of limitations period, which is difficult because large audits often take years to conclude.[34] Second, in a civil suit like this, the Government bears the burden of proof.[35] With the typical deficiency procedures, the IRS’s notice of deficiency usually carries a presumption of correctness. And in refund actions, the taxpayer typically bears the burden of showing it is entitled to a refund. Third, by filing a civil collection suit, the Government forgoes the ability to thoroughly examine the taxpayer’s position through an audit and charge hot interest (both of which are only available through the normal administrative IRS process).[36] In light of these drawbacks, some practitioners do not anticipate the Government regularly invoking its common-law right to file a suit for collections.[37]
Economic Substance Issue
After denying Liberty Global’s motion to dismiss, the court considered the Government’s position that Project Soy lacked economic substance. A simple explanation of Project Soy’s steps and their intended results is useful to understand the Government’s economic-substance challenge.
Step 0: Before Project Soy, Liberty Global’s structure was as follows: UK Corporation (“UK Parent”) owned a US Corporation (“US Sub”), US Sub owned a foreign corporation (“CFC 1”), and CFC 1 owned a foreign disregarded entity (“FDE”).
Step 1: FDE issued a $100 note to CFC 1.
Step 2: US Sub checked FDE closed, thereby converting FDE into CFC 2, and causing the $100 note to “spring to life” as boot in a section 351 transaction, generating $100 of earnings (“E&P”) that is subpart F income.
Step 3: On the second to last day of the tax year, US Sub sold CFC 1 to UK Parent, generating $100 of capital gain that was recharacterized as a dividend to the extent of E&P and qualified for the 100% section 245A DRD. In addition, CFC 1 remained a CFC post-sale (by virtue of upward and downward attribution rules). Because UK Parent owned CFC 1 on the last day of the taxable year, all $100 of Subpart F income generated in Step 2 is allocated to UK Parent and not subject to US tax.
The Government argued that this series of transactions lacked economic substance and that Steps 1 and 2 should be disregarded under either section 7701(o) (the codified economic-substance doctrine), or other judicial doctrines such as the business-purpose, step-transaction, or substance-over-form doctrines.[38]
Disregarding Steps 1 and 2 results in no generation of E&P. Consequently, this prevents the recharacterization of the capital gain from the stock transfer in Step 3 as a dividend eligible for the section 245A DRD. In simpler terms, ignoring Steps 1 and 2 means Liberty Global fails to obtain the tax benefit of a section 245A DRD because there is no dividend.
Liberty Global insists that Step 2—an entity conversion via a check-the-box election—is widely understood to be a transaction without substance where form is nonetheless respected. A check-the-box-election/entity conversion is, by definition, merely a federal tax classification with no economic substance. Liberty Global compared an entity conversion to other elections in the code where form controls substance, such as when married taxpayers file a joint return. Liberty Global argued that the entity conversion in Step 2 was truly the transaction that gave rise to the tax benefit—the generation of E&P—and therefore must be viewed in isolation from the other steps.
Liberty global further argued that the legislative history of section 7701(o) (the codified economic substance doctrine) clearly indicates it is not relevant to basic business transactions, such as entity conversions. For these reasons, Liberty Global argued that the court cannot disregard Step 2.[39]
The Court rejected Liberty Global’s arguments, holding that “there is no threshold ‘relevance’ inquiry that precedes the inquiry” into whether a transaction has economic substance.[40] Instead, the court found that the appropriate level of analysis is the transaction in the aggregate.[41] The court also determined that Liberty Global’s transaction was not a basic business transaction and was not outside the scope of section 7701(o).[42]
The court held that Steps 1 and 2 must be viewed together. The court reasoned that “the steps of Project Soy were executed in a four-day period … and were ‘so integrated’ that [Liberty Global] admits that it is ‘unlikely that Steps [1 and 2] would have been taken except in contemplation of [Step 3].’”[43]
The court found that all the steps were necessary for realizing the tax benefits and therefore analyzed them together. Disregarding these steps, the court held that Liberty Global could not claim a section 245A DRD and was required to recognize the resulting $2.4 billion of taxable gain.[44]
The court’s decision in Liberty Global is a classic example of bad facts making bad law.[45] Some practitioners readily conclude that the court’s decision “is further proof that the economic-substance doctrine has become the IRS’s ‘go-to defense’ against tax planning that relies on a statute’s words.” [46]
According to other practitioners, the central question in Liberty Global is whether a taxpayer should be allowed to affirmatively engage in a series of transactions to exploit a clear mistake by Congress that the IRS lacks the power to fix through regulations.[47] Others argue that the central question in Liberty Global is really whether the economic-substance doctrine can be applied to correct a clear mistake by Congress that the IRS does not have the power to fix through regulations.
But this latter argument seems disingenuous. Consider a taxpayer who did not affirmatively engage in a transaction like Project Soy, but instead did something that simply led to them receiving a section 245A DRD for a distribution that was not subject to GILTI or the transition tax. Presumably the IRS could not challenge the section 245A DRD under the economic-substance doctrine. In that sense, Liberty Global is not simply a question of whether the IRS can fix Congress’s mistake with the economic-substance doctrine.
In Liberty Global, the taxpayer affirmatively engaged in a series of transactions for the principal purpose of exploiting this mistake in order to avoid tax. In situations such as this, it may seem appropriate to invalidate the transaction based on economic substance. But what about innocent taxpayers who did not affirmatively plan into the loophole? Is it appropriate to deny them the unintended benefits that Congress mistakenly conferred? Could the economic-substance doctrine even apply in those situations?
Whatever the answers may be, two things are certain. First, taxpayers should not draw any sweeping conclusions from the Liberty Global decision, as it involves unique facts. Second, taxpayers who affirmatively plan into a tax loophole should expect the IRS to come after them. In fact, the IRS has retracted and replaced its directive which stated that it would not invoke the economic substance doctrine penalty statute except in extraordinary circumstances.[48] The new directive significantly frees up IRS examiners to assert the economic substance doctrine. Executive approval is no longer required to raise economic substance or assert the penalty and the penalty may be asserted when an issue is of importance to tax administration, such as a case of first impression, or involves a large number of taxpayers. Accordingly, we should anticipate a significant increase in cases involving the codified economic substance doctrine.
Liberty Global has appealed its $109 million refund suit to the Tenth Circuit.
[1] Liberty Glob., Inc. v. Comm'r of Internal Revenue, 2023 WL 7398735, at *9 (T.C. Nov. 8, 2023).
[2] See Order on Cross-Motions for Summary Judgment, Liberty Global v. United States, No. 1:20-cv-03501, 2022 WL 1001568, at *7 (D. Colo. 2022).
[3] See Order on Motion to Dismiss, United States v. Liberty Glob., Inc., No. 1:22-CV-02622-RBJ, 2023 WL 4603954, at *2 (D. Colo. June 1, 2023).
[4] See Order on Cross-Motions for Summary Judgment, Liberty Global v. United States, No. 1:20-cv-03501 (D. Colo. October 31, 2023).
[5] Section 904(f)(2).
[6] Section 904(f)(3); Treas. Reg. § 1.904(f)-2(d)(1); FSA 200041004; FSA 199938007.
[7] Liberty Glob., Inc. v. Comm'r of Internal Revenue, 2023 WL 7398735 (T.C. Nov. 8, 2023).
[8] Id.
[9] Id.
[10] Id., at *10 (quoting Antonin Scalia & Bryan A. Garner, Reading Law: The Interpretation of Legal Texts 126–27 (2012)).
[11] Id., at 8.
[12] Id., at *7.
[13] Section 904(f)(3)(A)(i).
[14] Liberty Glob., Inc. v. Comm'r of Internal Revenue, 2023 WL 7398735, at *9 (T.C. Nov. 8, 2023).
[15] Id.
[16] Id.
[17] See Order on Cross-Motions for Summary Judgment, Liberty Global v. United States, No. 1:20-cv-03501 (D. Colo. October 31, 2023).
[18] See Liberty Global’s Complaint, Liberty Global v. United States, No. 1:20-cv-03501 (D. Colo. 2020).
[19] See Liberty Global’s Complaint, Liberty Global v. United States, No. 1:20-cv-03501 (D. Colo. 2020).
[20] See Order on Cross-Motions for Summary Judgment, Liberty Global v. United States, No. 1:20-cv-03501, 2022 WL 1001568, at *7 (D. Colo. 2022).
[21] Id.
[22] United States v. Liberty Global Inc., No. 1:22-cv-02622 (D. Colo. 2023).
[23] See United States’ Complaint, United States v. Liberty Global Inc., No. 1:22-cv-02622 (D. Colo. 2023).
[24] See Liberty Global’s Motion to Dismiss, United States v. Liberty Global Inc., No. 1:22-cv-02622 (D. Colo. 2023).
[25] Id.
[26] Id., citing section 6213(a).
[27] See Order on Motion to Dismiss, United States v. Liberty Glob., Inc., No. 1:22-CV-02622-RBJ, 2023 WL 4603954, at *2 (D. Colo. June 1, 2023).
[28] Id. (citation omitted).
[29] Id.
[30] Liberty Global Turns the Deficiency Procedures Upside Down, Jenny A. Austin, Anthony D. Pastore, and
Jeremy D. Himmelstein (June 26, 2023).
[31] Id.
[32] Id.
[33] Rediscovering the Road Less Traveled in Liberty Global, Saul Mezei and Jonathan C. Bond, (Nov. 6, 2023).
[34] Id.
[35] Id.
[36] Id.
[37] Id.
[38] See Order on Cross-Motions for Summary Judgment, Liberty Global v. United States, No. 1:20-cv-03501 (D. Colo. October 31, 2023).
[39] Id.
[40] Id.
[41] Id.
[42] Id.
[43] Id.
[44] Id.
[45] Liberty Global May Have Ominous Implications for US Tax Planning, Jeffrey L. Gould (Nov. 14, 2023).
[46] Economic Substance Doctrine Constrains Liberty Global, Andrew Velarde (Nov. 3, 2023) (quoting Jasper Cummings).
[47] Id. (referencing quote by Monte Jackel).
[48] LB&I-04-0422-0014 (Apr. 22, 2022)