Background

GSS Holdings (“GSS”) brought a tax refund action in the Court of Federal Claims requesting an allowance of a loss of $22.54 million claimed under section 165, which the IRS previously disallowed. GSS claimed the loss on its 2011 return and carried it back to 2009. 

In disallowing the loss, the IRS asserted that it was not an ordinary business loss under section 165 but instead was incurred as part of a series of transactions that resulted in a sale of capital assets between related parties. Thus, it was a capital loss that should be disallowed under the related party rules of section 707(b)(1). The Court affirmed the IRS adjustment, and GSS appealed the case to the Federal Circuit.  

The entity that incurred the $22 million dollar loss in the first instance was Liberty Street Funding LLC (“Liberty”). Liberty was a commercial paper conduit, a financial vehicle that made investments funded by the issuance of short-term notes (commercial paper). Although Liberty was a wholly owned subsidiary of GSS, GSS had a nominal equity interest in Liberty totaling only $25,000. GSS also did not have decision-making authority over Liberty’s operations, which instead were managed by the Bank of Nova Scotia (“BNS”), a Canadian chartered bank that operated as Liberty’s administrator. As administrator, BNS managed Liberty’s investments in exchange for a fee. One of BNS’s responsibilities was to arrange for Liberty to enter into Liquidity Asset Purchase Agreements (“LAPAs”) with banks to shift Liberty’s risks to the relevant banks.  Liberty would enter into an LAPA for every package of longer-term investments that it purchased. The LAPA ensured liquidity for Liberty by enabling Liberty to put the relevant investment package to a counterparty at a preset price, regardless of the market value of the investments. Liberty paid a liquidity fee to the counterparty for the assumption of this risk. In addition to being Liberty’s administrator, BNS was also the counterparty on over 95% of Liberty’s LAPAs, including the one at issue in the GSS Holdings case.

In 2006, Liberty entered into a LAPA with BNS. Because BNS was also the administrator of Liberty and primary beneficiary of Liberty's operations, BNS reported Liberty’s activities on BNS’s consolidated balance sheet. In 2007, a Canadian banking regulation (Basel II) took effect with potential adverse consequences to BNS. BNS wanted to avoid these adverse consequences, so BNS decided to deconsolidate from Liberty. To achieve this deconsolidation, Liberty had to shift a sufficient amount of benefit and risk away from BNS. To do so, in April 2007, Liberty entered into the First Loss Reserve Note (“FLN”) with Reconnaissance Investors, LLC (“Reconnaissance”), an unrelated party, and amended its administration agreement with BNS. Pursuant to the terms of the FLN, Reconnaissance loaned money to Liberty in amounts needed to compensate each LAPA counterparty for the losses that it incurred as a result of purchasing distressed assets under the applicable LAPA. Reconnaissance received interest payments in return for the loan proceeds. Under the revised administration agreement, BNS, as administrator, was to withdraw funds from Liberty’s FLN Reserve Account in the amount of the losses at issue and pay them to the LAPA counterparty. This arrangement was designed to shift the risks previously borne by BNS, as LAPA counterparty to 95% of Liberty’s LAPAs, to Reconnaissance.  As a result of terms of the FLN, and the resulting shifting of risks, the First Loss Note was treated as a partnership interest in Liberty for US federal income tax purposes. Thus, Reconnaissance was treated as a partner of Liberty, together with GSS, during the period in which it was a party to the FLN. 

The FLN remained in place with Reconnaissance as creditor until 2011, when BNS adopted the International Financial Reporting Standards (“IFRS”), and this adoption required BNS and Liberty to reconsolidate. As a result, the structure in place with Reconnaissance became unnecessary. Scotiabank (Ireland) Limited (“Scotiabank”), a wholly owned subsidiary of BNS, acquired the FLN on 29 December 2011 to internalize the high interest rates paid to Reconnaissance. When Scotiabank became creditor of the First Loss Note, Scotiabank became a partner in Liberty for US federal income tax purposes and Reconnaissance ceased to be one.  BNS and Liberty also became related parties for tax purposes. 

On 30 December 2011, Liberty exercised an LAPA related to an investment known as “Aardvark IV.” This LAPA, originally put in place in September of 2006, required BNS to purchase the Aardvark IV assets from Liberty at a value equal to Liberty’s basis in the assets.  Exercise of this LAPA resulted in a loss to BNS of $24 million, which triggered a loan by Scotiabank to Liberty’s FLN Reserve Account in the same amount. This amount was then transferred to BNS as counterparty to the LAPA pursuant to the revised administration agreement. The amount claimed on GSS’s return had been reduced by $1.45 million in insurance proceeds that arose from the same event, resulting in the disputed $22.54 million amount noted above. The LAPA and FLN transactions are summarized in the diagrams below.     

Analysis

The IRS put forward two arguments in support of its position to treat the LAPA and FLN as a single, combined transaction: (1) Liberty netted the results of the LAPA and FLN transactions in its tax filings, so GSS should be bound by this characterization under Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967); and (2) under the step transaction doctrine, the LAPA and FLN transactions should be viewed as inextricably linked and stepped together. The court rejected the IRS’s Danielson argument regarding characterization but agreed that the two transactions should be analyzed together under substance over form principles.

Although the court asserted at the outset of the opinion that the transaction should be analyzed under the broad tax concept of “substance over form,” most of the court’s opinion focused on the application of the “end result” test under the step transaction doctrine. The end result test asks if a series of transactions are independent, or if they are actually components of a single transaction that was intended from the outset with the purpose of reaching an ultimate result. GSS asserted that the “end results” test was not applicable because (1) the parties created the FLN for legitimate business reasons and (2) it could not have intended to make the FLN payment because Liberty never intended to invest in declining assets. The court did not appear to question the business reasons for establishing the LAPAs. The court also did not question Liberty’s decision to put the FLN in place and acknowledged the stated business reasons for Scotiabank to acquire the FLN (i.e., to internalize the high interest expense under the agreement with Reconnaissance and because the original purpose of the note no longer existed under new accounting standards). Instead, the court determined that GSS focused on the wrong transaction. The relevant event should not be the creation of the FLN in 2007 but the payment out of it to BNS in 2011. The intended purpose of the FLN was to work in tandem with the LAPA and compensate losses stemming from it. Consequently, the court held that these transactions were inextricably linked and should be considered together, resulting in the characterization of the FLN payment as part of a capital sale.

Given that the “end results” test focuses on the intention of the parties at the outset of the transaction, the court’s focus on events occurring in 2011 seems misplaced. However, it is difficult to deny that, at the time the FLN was executed, payments under this agreement were intended to be made in conjunction with a capital sale. Indeed, the Aardvark IV LAPA was already in place at the time that the original FLN was put into place in 2007, so the parties likely anticipated the possibility that this LAPA might be exercised and might trigger a corresponding payment under the FLN. The question is whether this should be enough to apply the “end results” test when there are business reasons for the structure of the transaction and there does not appear to be any evidence of tax avoidance on the part of the taxpayer. Circuits have been split on this question, but the Federal Circuit in Falconwood Corp. v. U.S., 422 F.3d 1339, 1349 (Fed. Cir. 2005) held that the step transaction doctrine did not apply to step together transactions that the taxpayer performed for independent business purposes. 

The court in GSS Holdings seeks to distinguish the GSS Holdings facts from those in Falconwood but does so unconvincingly in a footnote. It will be interesting to see how the Federal Circuit decides on appeal, as it seems that this decision will hinge largely on how much weight the court gives to business purpose in determining whether the step transaction doctrine applies.