An Instance Where the Business Taxpayer Can Win Despite the Absence of Economic Substance !!!
In Summa Holdings Inc. v. Commissioner, No. 16-1712 (Feb. 16, 2017), the Sixth Circuit Court of Appeals reversed the Tax Court decision below which held that payments a corporation made to a DISC were not DISC commissions but instead were to be characterized as dividends to shareholders followed by excess contributions to their Roth IRAs. Such recharacterization would have eliminated the tax benefits associated with the IC-DISC for the taxpayers.
General Background on Domestic International Sales Corporations (DISCs)
Before discussing the Summa Holdings case in depth, it would be fair to provide an overview of the DISC. Where a U.S. export operation seeks to enter a foreign market, the formation and use of a foreign based entity may not provide the greatest U.S. tax benefit to its shareholders or members since in many cases there will be no deferral of U.S. income tax on the foreign based export sales income, subject to an offset in the form of a foreign tax credit (or deduction). The controlled foreign sales corporations rules also come into play to deny deferral opportunities for Subpart F income. A better alternative may be available for a domestic company engaging in the export and sale of U.S. products to establish an interest charge domestic international sales corporation (IC-DISC). By establishing an IC-DISC under Section 992, deferral of U.S. income tax on DISC income and a reduced tax rate (as to individuals only) are available. A DISC’s shareholders often will be the same individuals who own the U.S. export company. In effect, the DISC is able to deflect or assign the burden of paying U.S. income tax on export sales income and further cause such income to be characterized as a qualified dividend. .
The deferral mechanism surfaces because IC-DISCs are not subject to taxation under Section 991. Instead, the IC-DISC's shareholders are subject to taxation on the IC-DISC's income (the rules provide a form of flow-through for the shareholders). In general, the IC-DISC shareholders are taxed on deemed distributions from the IC-DISC to the extent that the annual taxable income of the IC-DISC from qualified export receipts exceeds $10 million. §991(b)(1)(E). Corporate shareholders are additionally taxed on 1/17th on the remaining taxable income of the IC-DISC. An interest charge equal to the average investment yield of T-bills with one-year maturity dates sold over a one-year period is imposed on the deferred tax liability. Essentially, this interest charge is imposed on retained IC-DISC income that is not distributed within one year following the close of the IC-DISC's tax year. §995(f).
The benefit of a reduced rate of tax on DISC income is realized because the deemed distribution is treated as a dividend under Section 995(b)(1) which permits access to preferential dividend rate provided in Section 1(h) for individuals. Distributions of previously taxed IC-DISC income that flows through to the shareholders are not again taxed on the receipt of corresponding distributions. §966(a).
Benefits can still be achieved in spite of the application of the transfer pricing rules between the IC-DISC and its related manufacturer or supplier. Specific transfer pricing rules under the IC-DISC regime are contained in Section 994. Under applicable rules, a portion of the income that would otherwise be reallocated to the supplier under Section 482 is allowed to remain allocated to the IC-DISC thereby obtaining the benefits of the IC-DISC rules. Such IC-DISCS are allowed to include in gross receipts (gross income) the greatest of: (1) 4% of the qualified export receipts on the resale of the supplier's property plus 10% of the export promotion expenses of the IC-DISC attributable to the receipts; or (2) 50% of the combined taxable income of the IC-DISC and the supplier plus 10% of the export promotion expenses of the IC-DISC attributable to the receipts; or (3) the IC-DISC's taxable income based on the transfer pricing rules of Section 482.
The DISC avoids corporate income tax by the related affiliate’s payment to the DISC in paying commissions of up to 4% of its gross receipts or 50% of the net income from qualifies exports. The DISC pays no income tax on commission income up to $10,000,000 and may hold onto the accumulated profits indefinitely though DISC shareholders must pay annual interest on their shares of the DISC’s deferred income tax liability. §995(f). Once dividends are paid, certain shareholders may be eligible to have the dividends treated as “qualified dividends” under Section 1(h)(1)(D), etc. The current maximum rate of qualified dividends is 20% subject to potential application of the add-on Medicare HI tax. Perhaps with the planned repeal of Obamacare, the Section 1411 tax is on its way out as well.
Determination of whether a domestic corporation qualifies as an IC-DISC is made annual. In order to qualify and remain qualified as an IC-DISC, the following requirements must be met: (1) the corporation must be an eligible domestic corporation (for example, S corporations are ineligible). §§992(a)(1), 993(g); (2) at least 95% of the IC-DISC's gross receipts must be qualified export receipts. §992(a)(1)(A); (3) the adjusted basis of the IC-DISC's qualified export assets at the close of the tax year must be at least 95% of the adjusted basis of its total assets at the close of the taxable year. §992(a)(1)(B); (4) the IC-DISC cannot have more than one class of stock the stated value of which is not less than $2,500 on each day of the tax year. §992(a)(1)(C); (5) the IC-DISC must make a timely election under Section 992(b) to be treated as an IC-DISC. §992(a)(1)(D)(All of the corporation's shareholders must consent to the election); and (6) the IC-DISC may not be a member of any controlled group of which a foreign sales corporation is a member. §992(a)(1)(E). .
For IC-DISC purposes, gross receipts are the total receipts received in the ordinary course of business from the sale, lease, or rental of property held primarily for such purposes and gross income from all other sources. §993(f) This includes receipts from the sale, lease, or rental of the property even though the IC-DISC is only receiving commissions on such transactions. §993(f).
Qualified export receipts include gross receipts from the sale, lease, or rental of export property. §§ 993(a)(1)(A), 993(a)(1)(B). Export property is property that is manufactured, produced, grown, or extracted in the United States (by someone other than an IC-DISC) and which an IC-DISC holds primarily for sale, lease, or rental in the ordinary course of business for direct use, consumption, or disposition outside the United States.
In addition, not more than 50% of the fair market value of such property can be attributable to articles imported into the United States. §993(c). With respect to leased property, a predominant use test is applied that requires that the leased property be located outside the United States for at least 50% of the time in order for it to be considered as used outside the United States. Certain property, however, is expressly excluded from the definition of export property. This includes property leased or rented by an IC-DISC for use by a member of a controlled group that includes the IC-DISC. Numerous intangibles are also excluded (e.g., patents, formulas, and trademarks). Under Section 993(a)(1)(C)-(H), receipts that constitute qualified export receipts include: (1) gross receipts from services that are related and subsidiary to any qualified sale or lease of export property (e.g., maintenance, repair, installation, and transportation services); (2) gross receipts from sales, exchange, or other disposition of qualified export assets that are not export property (i.e., qualified export assets include assets that are ancillary to the generation of qualified export receipts (e.g., assets used for the storage of export property)); and (3) gross receipts for engineering or architectural services for construction projects located (or proposed for location) outside the United States. Gross receipts from sales, rents, or leases of property that are ultimately used within the United States are not qualified export receipts. .
Qualified export assets are defined in Section 993(b) and include: (1) business assets used in generating qualified export receipts other than those used primarily in the manufacture or production of property; (2) accounts receivables that arise from sales, leases, or rentals from transactions in which the IC-DISC acted as commission agent; (3) money, bank deposits, and similar temporary investments that are working capital; (4) loans from the IC-DISC to the producer made out of the IC-DISC's accumulated income (Treas. Reg. 1.994-4 provides rules relating to producer's loans); (5) stock or securities held by the IC-DISC in certain related foreign corporations; (6) certain Export-Import Bank of the U.S. and Foreign Credit Insurance Association obligations; (7) export sales finance obligations; and (8) U.S. deposits used to acquire other qualified export assets.
Shareholders Eligible to Own Shares of Stock in a IC-DISC
Ccrporations and other entities, including IRAs, may own shares in DISCs. §§ 246(d), 995(g). A corporation that owns DISC shares still has to pay the full corporate income tax on any dividends, which eliminates out any tax savings. § 246(d). For a time, tax-exempt entities like IRAs avoided income tax on DISC dividends, which enabled export companies to shield active business income from taxation by assigning DISC stock to controlled tax-exempt entities like pension and profit-sharing plans. But Congress closed this gap in 1989 and required tax-exempt entities to pay an unrelated business income tax, set at the same rate as the corporate income tax, on DISC dividends. §§ 511, 995(g).
In enacting Section 995(g), Congress made it less attractive for a traditional IRA to own shares in a DISC. Investment earnings (including dividends) generally accumulate tax-free in IRAs. § 408(e)(1). But DISC dividends, however, are subject to the unrelated business income tax when they go into an IRA and, like all withdrawals from a traditional IRA, are subject to personal income tax when they come out. § 408(d)(1). In 1997, Congress enacted the Roth IRA. Unlike traditional IRS where participants deduct allowable contributions and pay income tax on withdrawals, Roth IRAs work in the opposite manner. Contributors to Roth IRAs may not deduct the contributions but are not taxed on withdrawals, including accrue gains. §§408A(c)(1), 408(d)(1).
There are contribution limitations on traditional and Roth IRAs. See §§219(b)(5)(A), 408A(c)(2). The maximum annual contribution allowed to the participant in a Roth IRA decreases as the participants income increases. See §408(A)(c)(3).
So, the combination of a Roth IRA owning shares of stock in an IC-DISC could potentially yield favorable results so that there is no tax imposed on the dividends from the IC-DISC or on the capital gain resulting from a large dividend or from the sale of the IC-DISC stock. Of course the participant’s requisite retirement age must also be taken into account.
Ok, with the preceding summary of the IC-DISC rules set forth, let’s move onto the Sixth Circuit’s decision in Summa Holdings.
Facts In Summa Holdings
Summa Holdings is the parent corporation of a group of companies that manufacture a industrial products. Its two largest shareholders are James Benenson, Jr. (who owned 23.18% of the company in 2008, the applicable year) and the James Benenson III and Clement Benenson Trust (which owned 76.05% of the stock of Summa Holdings in 2008).
In 2001, James III and Clement each established a Roth IRA and contributed $3,500 apiece. Shortly thereafter, each Roth IRA paid $1,500 for 1,500 shares of stock in JC Export, a newly formed IC-DISC. The Service did not challenge the valuation of the shares. To prevent the Roth IRAs from incurring any tax-reporting or shareholder obligations by owning JC Export directly, the Benensons formed another corporation, JC Holding, which purchased the shares of JC Export from the Roth IRAs. From January 31, 2002 to December 31, 2008, each Roth IRA owned a 50% share of JC Holding, which was the sole owner of JC Export.
Summa Holdings paid commissions to JC Export, which distributed the money as a dividend to JC Holding, its sole shareholder. JC Holding paid a 33% income tax on the dividends, then distributed the balance as a dividend to its shareholders, the Benensons' two Roth IRAs. From 2002 to 2008, the Benensons transferred $5,182,314 from Summa Holdings to the Roth IRAs in this way, including $1,477,028 in 2008. By 2008, each Roth IRA had accumulated over $3 million.
In 2012, the Commissioner issued notices of deficiency to Summa Holdings, the Benensons, and the Benenson Trust for the 2008 tax year but did not do so for the earlier tax years. The IRS invoked the “substance over form” doctrine and reclassified the payments from Summa Holdings to JC Export as dividends and further required Summa Holdings to pay federal income tax on the DISC commissions it had previously deducted. JC Holding obtained a refund for the corporate income tax it paid on its dividend from JC Export. There was a third consequence; the commissions became dividends to Benenson Jr. and the Trust, all in proportion to their ownership shares. The Commissioner determined that each Roth IRA received a contribution of $1,119,503. Because James III and Clement both made over $500,000 in 2008, they were not eligible to contribute anything to their Roth IRAs. The Commissioner imposed a 6% excise tax penalty on the contributions. § 4973. The Commissioner also imposed a $56,182 accuracy-related penalty on Summa Holdings. See id. §§ 6662, 6662A.
Tax Court Decision
Summa Holdings and the Benenson’s filed petitions with the Tax Court challenging the proposed deficiencies in tax and additions to tax. The Tax Court agreed with the Commissioner on the recharacterization of the transactions but did not impose an accuracy related penalty on the deficiencies.
Summa Holdings appealed to the Sixth Circuit since its principal place of business is in Ohio. See 7482(a). The Benenson’s and related family trusts have appeals before the First and Second Circuits.
Sixth Circuit Court of Appeals Finds For The Taxpayer In Reversing The Tax Court
The Sixth Circuit, in an opinion written by Judge Sutton, reversed the Tax Court and held that the substance-over-form doctrine did not apply to DISC commissions that were followed by dividends to Roth IRAs by making disbursement from the parent corporation to either DISC or shareholders followed by transfer to Roth IRAs either as dividend or contribution, even if transactions did not have economic substance.
First the Court acknowledged that Section 995(g) specifically provides that tax-exempt entities, such as traditional IRAs, may own IC-DISC stock . Where the traditional IRA owns DISC stock it is subject to UBIT on any dividends received. Section 408A, the Court further noted, requires Roth IRAs to be treated in the same manner as traditional IRAs unless otherwise provided in the Code. There is no statement in the Code that denies Roth IRAs tax-free receipts of dividends as a shareholder of the IC-DISC. So, the transactions before the Court were permitted by the Code.
But the IRS invoked the “substance over form doctrine” to nullify the reported tax savings which in its view should not be allowed. The Commissioner, Appellee argued, allows it to nullify the DISC commissions and dividends to the Roth IRAs on the ground that the purpose of the transactions was to sidestep the contribution limits on Roth IRAs and lower the tax obligations of the Benenson sons in the process.
The Sixth Circuit disagreed. In its view the Service is not permitted to invoke a judicial doctrine, here the “substance over form” doctrine, to recharacterize the meaning of statutes, and not the economic substance of the transactions, in order to ignore their form. At times, the Commissioner has also invoked the “sham” transaction doctrine, which “comes to the same end, likewise looks to the economic realities of the business deal”. Citing Wells Fargo & Co. v. U.S., 641 F.3d 1319, 1325 (Fed. Cir. 2011). As with the “substance over form” doctrine, the “sham” transaction doctrine looks at the economic substance of the transactions involved. Noted was the codification of the economic substance doctrine for transactions after 2010 in Section 7701(o). The Sixth Circuit further noted in its analysis that the use of judicial precedent to recharacterize transactions in accordance with their economic substance (and business purpose) has long been recognized as a litigation tool that may be invoked by the Service and recognized and given substance by a court in review where appropriate. Gregory v. Helvering, 293 U.S. 465, 468-469 (1934); Minnesota Tea Co. v. Helvering, 302 U.S. 609, 612-613 (1938); Knetsch v. U.S., 364 U.S. 361, 365-366 (1960).
Therefore, the Sixth Circuit acknowledged that where a family sets up an ordinary corporation owned by Roth IRAs and pays the corporation fees for sham "services" that it never performed, the Commissioner may refuse to recognize the Roth IRA's gains as investment earnings and may reclassify them as contributions. See Repetto v. Comm'r, 103 T.C.M. (CCH) 1895, at *9 (2012).
The Sixth Circuit in this case held, however, that the Tax Court erroneously found for the Commissioner in applying the “substance over form” doctrine. Indeed such doctrine, in the eyes of the Court, did “not give the Commissioner purchasing power here”. Congress specifically designed DISCs to enable exporters to defer corporate income tax. The Code authorizes companies to create DISCs as shell corporations that can receive commissions and pay dividends that have no economic substance at all. Treas. Reg. § 1.994-1(a); Addison Int'l, Inc. v. Comm'r, 887 F.2d 660, 666 (6th Cir. 1989); Jet Research, Inc. v. Comm'r, 60 T.C.M. (CCH) 613 (1990). By congressional design, DISCs are all form and no substance, making it inappropriate to tag Summa Holdings with a substance-over-form complaint with respect to its use of DISCs. (emphasis added).
The Roth IRAs enacted into law by Congress were designed for tax-reduction purposes and that is exactly how the taxpayers used them. At the time, the Internal Revenue Code permitted traditional and Roth IRAs to own DISCs, and for reasons of its own Congress said that both types of IRAs should be treated the same. All IRAs are permitted to hold shares of stock, some of which may increase markedly in value over time and some of which may generate considerable dividends over time. Whether Congress's decision to permit Roth IRAs to own DISCs was an oversight makes no difference. It's what the law allowed.
So far so good. The Commissioner, Summa Holdings, and we share the same understanding of these versions of the substance-over-form doctrine, and we all agree that they don't apply here. None of these transactions was a labeling-game sham or defied economic reality.
That left the Commissioner with an argument based on a variant of the substance-over-form doctrine based on the fact that the result reached in this case was too-good to be true and therefore Congress intended that a more tax involved outcome must be the right result, i.e., the funds received were a taxable dividend to the taxpayers from the operating company.
In the Commissioner's defense, a kernel of this idea does not come out of left field. As support, he points to a seventy-two-year-old opinion of the Supreme Court. In Commissioner v. Court Holding Co., the taxpayers wound up their corporation, transferred its sole asset -- an apartment building -- to themselves as a liquidating dividend, then sold the building to a third party. 324 U.S. 331, 333 (1945). But in a real-world economic sense, the Court held, the corporation sold the building directly to the buyer. Justice Black's opinion for a unanimous court is brief, and it's hard to say whether the Court determined that the liquidation before the sale was a sham or recharacterized the transactions based solely on their tax-minimizing effect.
As Court Holding suggests, the line between disregarding a too-clever accounting trick and nullifying a Code-supported tax-minimizing transaction can be elusive. Compare, Estate of Kluener v. Comm'r, 154 F.3d 630, 636 (6th Cir. 1998) (recharacterizing sale of horses from closely held corporation as direct sale from the corporation's owner); see also Aeroquip-Vickers, Inc. v. Comm'r, 347 F.3d 173, 183 (6th Cir. 2003) (refusing to treat a series of transactions as a "corporate reorganization" where taxpayer intended to avoid reporting recaptured tax credits). The Sixth Circuit recognized that other circuits have had to straddle the line between holding that the transactions were a sham and suggesting that the Commissioner has a broad power to recharacterize transactions that minimize taxes, though none of them holds that a tax-avoidance motive alone may nullify an otherwise Code-compliant and substantive set of transactions. See, e.g., Feldman v. Comm'r, 779 F.3d 448, 457 (7th Cir. 2015) (disregarding sham loan designed to avoid income tax); Southgate Master Fund, LLC ex rel. Montgomery Capital Advisers, LLC v. United States, 659 F.3d 466, 491-92 (5th Cir. 2011) (disregarding sham partnership); Rogers v. United States, 281 F.3d 1108, 1113-18 (10th Cir. 2002) (recharacterizing a secured loan that had no likelihood of ever being repaid as a sale).
The substance-over-form doctrine makes sense only when it holds true to its roots -- when the taxpayer's formal characterization of a transaction fails to capture economic reality and would distort the meaning of the Code in the process. But who is to say that a low-tax means of achieving a legitimate business end is any less "substantive" than the higher-taxed alternative? There is no "patriotic duty to increase one's taxes," as Judge Learned Hand memorably told us in the case that gave rise to the economic-substance doctrine. Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934). "Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury." Id. If the Code authorizes the "formal" transactions the taxpayer entered into, then "it is of no consequence that it was all an elaborate scheme to get rid of income taxes." Id.; see also David P. Hariton, “Sorting Out the Tangle of Economic Substance,” 52 Tax Law. 235, 236-41 (1999).
In short, the Court held that the Commissioner's effort to reclassify Summa Holding's transactions as dividends followed by Roth IRA contributions does not capture economic reality any better than describing them as DISC commissions followed by dividends to the DISC's shareholders. In what way is this "substantively" a contribution? Sure, the transaction in one sense looks like a Roth IRA contribution given the flow of money through the DISC and into the IRAs. But on balance the transaction looks even more like what it was -- DISC commissions followed by dividends to the Roth IRAs. This is not a case where the taxpayers followed a "devious path" to a certain result in order to avoid the tax consequences of the "straight path,” (citations omitted). The Court held that substance-over-form doctrine does not authorize the Commissioner to undo a transaction just because taxpayers undertook it to reduce their tax bills.
The Commissioner pressed on with its argument before the Court that the "critical point" to observe is that the tax benefits Summa Holdings has enjoyed were "unintended by both the Roth IRA and DISC provisions." The Sixth Circuit responded that the Commissioner may be correct in making that allegation, i.e., that permitting these DISC-Roth IRA arrangements amounts to dubious tax policy. But the substance-over-form doctrine does not give the Commissioner a warrant to search through the Internal Revenue Code and correct whatever oversights Congress happens to make or redo any policy missteps the legislature happens to take. Congress created the DISC and empowered it to engage in purely formal transactions for the purpose of lowering taxes. And Congress established Roth IRAs and their authority to own shares in corporations (including DISCs) for the purpose of lowering taxes. That these laws allow taxpayers to sidestep the Roth IRA contribution limits may be an unintended consequence of Congress's legislative actions, but it is a text-driven consequence no less. Congress likewise did not expect it would increase the utility of DISCs when it lowered the qualified dividend rate in 2003, but no one would argue that DISC dividends should still be taxed at the old rate. See Michael S. Fried, Combined Effects of Recent Legislation Breathe New Life into the IC-DISC, 118 J. Tax'n 220, 224-25 (2013).
This is not the first time, for what it is worth, that DISCs have caused the Federal Government trouble. In the 1980s, some countries alleged that DISCs illegally subsidized U.S. exports in violation of the General Agreement on Tariffs and Trade. Congress responded by requiring shareholders to pay annual interest on their deferred tax liability. See Deficit Reduction Act of 1984, Pub. L. No. 98-369, § 801(a), 98 Stat. 494, 985. And Congress addressed one problem created by tax-exempt entities like IRAs by imposing the unrelated business income tax on their DISC dividends. If Congress sees DISC-Roth IRA transactions of this sort as unwise or as creating an improper loophole, it should fix the problem. Until then, the DISC will continue to provide tax savings to the owners of U.S. export companies, just as Congress intended -- even if subsequent changes to the Code have increased the scale of the savings beyond Congress's original estimation. The last thing the federal courts should be doing is rewarding Congress's creation of an intricate and complicated Internal Revenue Code by closing gaps in taxation whenever that complexity creates them.
So sayeth the Sixth Circuit Court of Appeals in Summa Holding, Inc.
 The first thought conveyed by the Sixth Circuit in its opinion was to recognize that “Congress designed DISCs to incentivize companies to export their goods by deferring and lowering their taxes on export income.
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