In Otay Project LP v. Commissioner, the Tax Court disallowed a $714 million deduction based on its rejection of the taxpayer's claimed section 743(b) basis adjustment. The court concluded that the taxpayer not only computed its section 743(b) basis adjustment incorrectly but also that such adjustment should be rejected under the common-law economic substance doctrine. The court's review of the technical requirements under section 743(b) are controversial and prompted a recent motion for reconsideration . However, the aspect of the decision with potentially wider implications is the court's application of the economic substance doctrine. 

The taxpayer in the case is a real estate development partnership (Otay Project LP (OPLP)) owned by two brothers and other family members. OPLP was engaged in various projects for which it adopted the Completed Contract Method under section 460 which had the effect of deferring the profits from the respective projects. Disputes arose between the brothers that ultimately led to a 2005 arbitration proceeding and a restructuring of the business to separate the interests and activities of the two brothers. 

The restructuring triggered a technical termination of OPLP in 2007 under the since-repealed provisions of section 708. OPLP had a section 754 election in place and, upon its technical termination, computed a section 743(b) basis step-up of over $866 million. Then, in 2012, the year at issue in the Tax Court proceeding, OPLP liquidated and thereby triggered recognition of approximately $716 million of income under the Completed Contract Method. The taxpayer, however, also reported almost $745 million of "other deductions" attributable to its prior section 743(b) basis adjustment. The Internal Revenue Service (IRS) disallowed $714 million of this deduction on various grounds.

The Tax Court first addressed the IRS's technical arguments under section 743. The court rejected the taxpayer's section 743(b) adjustment. The court reviewed the partnership's balance sheet, focusing in particular on the liabilities OPLP included (or excluded) from its calculation, and concluded that OPLP's calculation was "illogical" and "engineered." Ultimately, the court "determined [that the taxpayer] has not met its burden here and has failed to correctly establish the Basis Deduction under section 743(b), as claimed." The court did not go the next step to determine what would be the correct section 743(b) basis adjustment if one was properly allowed.

Perhaps of wider interest is the Tax Court's determination that OPLP's section 743(b) basis adjustment should be rejected under the common law economic substance doctrine. Interestingly, the court looked to the law in effect in 2007, when the section 743(b) adjustment occurred, and applied the common law economic substance doctrine, despite the fact that the codified economic substance doctrine in section 7701(o) was in effect during the tax year at issue (2012). 

First, the court rejected OPLP's argument that the economic substance doctrine does not apply in the context of a highly detailed statutory or regulatory scheme such as section 743(b). This view, which found support from a Texas district court in ExxonMobil  Corp. vs. United States in the context of carved-out productions payments under section 636, posits that Congress dictates both the form and substance of transactions that fall within certain mechanical statutory rules. Coming only a few months after the Tax Court held in Patel v. Commissioner  that the codified economic substance doctrine includes a threshold relevance inquiry, some hoped that Otay presented the Tax Court with an opportunity to elaborate on when the doctrine was relevant, particularly given the mechanical operation of the section 743(b). That did not happen. Rather, the Tax Court declined to articulate any limiting principle, holding that "federal courts have long recognized that the economic substance doctrine has required disregarding, for tax purposes, transactions that comply with the literal terms of the tax code but lack economic reality." The court did not reference Patel in reaching this conclusion.

Next, given its application of the common law economic substance doctrine, the Tax Court looked to the Court of Appeals for the Ninth Circuit's precedent (under the Golsen rule) and its own precedent to apply an "integrated approach" to the two-prongs of the economic substance test (objective economic effect and a non-tax business purpose) to determine if the claimed deduction lacked economic effect. The court identified certain cash flows that it described as "circular," and identified certain steps in the overall restructuring that were not necessarily needed to achieve the goal of separating the business between the two brothers. The court also examined the tax opinions rendered by the taxpayer's advisors and concluded that "it seems rather apparent that the transactions at issue were predetermined and engineered principally to create substantial inside-outside basis disparity... which in turn sought to achieve indefinite tax deferral." Ultimately, the court accepted the IRS's arguments, as additional grounds, to disallow the deduction claimed.

Finally, the court determined that OPLP was not liable for accuracy-related penalties under section 6662 because it reasonably relied on its advisors and took reasonable care to comply with the provisions of the Internal Revenue Code. Had the court applied the codified economic substance doctrine, OPLP would have been subject to a strict liability penalty.

The IRS's assertion of economic substance arguments has increased recently, and key questions are currently being watched closely in various cases. Of particular concern is the question of whether there is a threshold "relevance" inquiry to determine if the economic substance doctrine is even available as a tool for the government for whatever issue is in dispute. The Tax Court held last fall in Patel that there is a threshold relevance test in section 7701(o). However, a split Tenth Circuit decision in Liberty Global labeled the issue a "red herring" and refrained from clearly articulating when the doctrine may be considered. 

Even in the Tax Court, the question of when the economic substance doctrine is relevant remains largely unanswered. Otay cannot be read as a rejection of the court's recent holding in Patel that there is a threshold relevance question because Patel was a reviewed decision and Otay is a memorandum decision. Otay must be read as implicitly concluding that the doctrine is relevant merely because it applied the doctrine. That conclusion, and the court's analysis, ends up disappointing taxpayers and tax practitioners (and hopefully our colleagues in the government) who are eager for additional guidance from the courts at to when the doctrine is relevant.

For more information, please contact:

George A. Hani, ghani@milchev.com, 202-626-5953

Samuel A. Lapin, slapin@milchev.com, 202-626-5807

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