In a recent decision, GSS Holdings (Liberty) Inc. v. United States, the Court of Federal Claims applied the step-transaction and the substance-over-form doctrines in the context of the related party rules in a manner that should put taxpayers on alert as they structure their financial transactions. This case demonstrates that the IRS and the courts look to all relevant agreements between related parties in evaluating the substance of a transaction, including whether there was a related party sale generating a disallowed capital loss.1
Taxpayers need to understand the implications of the aforementioned doctrines as they relate to financial agreements, each of which has independent economic substance and legitimate business purposes, but are intended to function in tandem. More so, taxpayers need to pay particular attention when dealing with financial agreements between related parties as the court will scrutinize all outstanding agreements as they pertain to a substance over form analysis.
In GSS Holdings, the court was less concerned with ‘why’ the Taxpayer entered into a series of financial transactions as opposed to ‘how’ the transactions were intended to function. The Taxpayer was unable to show that their independent economic transactions were not functionally linked, and therefore the court collapsed the transactions into a single transaction for tax purposes.
GSS Holdings (Liberty) Inc.
GSS Holdings Inc. (“Taxpayer”) was a regarded corporation for U.S. federal income tax purposes and was the sole legal owner of Liberty Street Funding LLC (“Liberty”).2 For U.S. federal income tax purposes, Liberty was taxed as a partnership in which Taxpayer and Scotiabank (Ireland) Limited (“Scotiabank”), were partners for tax purposes. Scotiabank was a subsidiary of the Bank of Nova Scotia (“BNS”) which, as administrator, controlled the operations of Liberty and absorbed most of the benefit and risk of the operation.3
This case looked at two distinct financial transactions (the exercise of a put contract, and a payment under a note) both of which were separately executed at different times; however, were intended to work in coordination to provide an economic hedge. This case dealt with a loss sustained by the Taxpayer, the deductibility of which, depended on whether or not the two transactions (as discussed below) were appropriately stepped-together by the IRS.
Exercise of Put
The first relevant transaction alluded to above, was the exercise by Liberty of a Liquidity Asset Purchase Agreement (“Put”) which required BNS to purchase certain distressed financial assets from Liberty at a par value equal to Liberty’s basis in the assets. In other words, Liberty exercised a put right that required BNS to purchase the distressed financial assets from Liberty at a preset value equal to Liberty’s tax basis in the assets, regardless of their market value.4
In conjunction with the exercise of the Put, Liberty was required, under the terms of a separately executed note (“First Loss Note”), to transfer cash to BNS. This payment was from an account the funds of which originated from a loan to Liberty from Scotiabank and was held for the benefit of the first party (either Liberty or BNS) to suffer a loss upon the exercise of the Put.
When Liberty exercised the Put there was a substantial loss on the sale, thereby triggering the contractually required transfer of cash. Simultaneous with this transfer, Liberty received related insurance proceeds, which netted against the amount paid to BNS, resulted in the reported loss which was at dispute.
The IRS argued that the payment under the First Loss Note was “inextricably linked” to the exercise of the Put and, as such, the two events must be viewed collectively under the step-transaction doctrine.5 The Taxpayer argued that the independent business purposes for each agreement preclude the application of the step transaction doctrine and that the two could not be collapsed because at the time of the creation of the Put, the First Loss Note was not yet in place. The Taxpayer further argued that the “end results” test, shouldn’t apply because they could never have intended to make the payment required under the First Loss Note since, Liberty never intended to invest in assets that would become financially distressed.
The court broadened the step-transaction doctrine approach that the IRS used, and instead applied the general substance over form doctrine. In quoting the United States Court of Appeals for the Federal Circuit, the court pointed out that when applying the substance over form doctrine the transaction scrutinized is “the one that gave rise to the alleged tax benefit.”6 The court in GSS Holdings reasoned that “[t]he focus of analysis thus needs to be on the sale in question, not the underlying business purposes that created the framework that enabled the transaction.” Thus, even with legitimate independent business purposes for each step, the substance over form doctrine can still be applied.
Specifically regarding the application of the step-transaction doctrine, the court used the end-results test and noted that the intent of the First Loss Note was to “compensate the first party to experience losses” as a result of the exercise of the Put. The court paid no attention to the Taxpayer’s arguments and addressed the point that the Taxpayer focused on the wrong transaction entirely, mentioning that the creation of the First Loss Note and the intention behind such was irrelevant to the analysis. The event that was relevant for purposes of the end-results test was the ultimate payment out of Liberty to BNS as a result of the exercise of the Put.
The court held that, regardless of the timing of the necessary steps and independent legitimate business purposes for each step, the fact that the payment under the First Loss Note was always intended to be made in coordination with the Put made the steps “inextricably linked.” The court further stated that “[w]hether we consider the two transactions ‘stepped together’ or if we analyze the substance (purpose) of the transactions as a unified whole, the result is the same.” Ultimately, the Taxpayer’s claim of independent business purpose was to no avail, because unlike the case7 they relied on, their independent business purpose was not regulatory compliance.8
1GSS Holdings (Liberty) Inc. v. United States, No. 19-728T (Fed. Cl. 2021).
2Taxpayer is the legal owner of Liberty however, their equity is “nominal,” totaling only $25,000; so it requires additional financial support to operate. Furthermore, the Taxpayer does not have any decision-making ability, nor is it required to absorb any expected losses or receive any expected residual returns.
3Much of the history around the transactions have to do with shifting credit risk and consolidation concerns, however these points are beyond the scope of this article.
4Important to note, Liberty was a commercial paper conduit, which as described in the case, is a financial vehicle that makes investments funded by the issuance of short-term notes. It then reinvests the proceeds in longer term investments and makes profits off the spread, or the rate of return on its investments that are in excess of the interest rate paid on the commercial paper that it issues. To hedge against the liquidity risk, Liberty attained a put right for each package of longer-term investments it purchased. These puts guaranteed liquidity by giving Liberty the ability to sell the investment package to BNS at a preset price, regardless of the investments’ market value. In exchange for this put, Liberty paid a fee to BNS.
5The IRS also argued that since, Liberty originally reported the payment under the First Loss Note netted together with the Put, the Danielson rule would preclude the Taxpayer from later re-characterizing the transactions. However, this issue is beyond the scope of this article.
6Coltec Indus. v. United States, 454 F.3d 1340, 1356 (Fed. Cir. 2006).
7Falconwood Corp. v. United States, 422 F.3d 1339 (Fed. Cir. 2005).
8Unlike the Taxpayer, in Falconwood the independent business purpose of the questioned transactions that drove them, was compliance with regulatory requirements.