Benjamin Alarie & Christopher Yan (Blue J Legal), Economic Substance Doctrine: Still Giving Perrigo Heartburn?, 172 Tax Notes Fed. 599 (July 26, 2021):
Tax practitioners frequently struggle when providing advice on some cases in areas of tax law that have limited statutory guidance and a sizable body of case law. The reason is that the case law is often internally inconsistent; the courts can generate obfuscating noise. Sometimes the signal in the accumulated case law is relatively faint. For those studying hundreds of cases, the noisiness of a complex web of interacting considerations makes it difficult to assess the importance of any given factor in a case. Fortunately, advances in computing power and machine learning offer an opportunity to amplify the signal and diminish the noise to better understand the law.
In last month’s inaugural installment of Blue J Predicts, we examined whether an appeal of a Tax Court decision to the D.C. Circuit would be dismissed on the issue of whether a partnership exists [An Unprofitable Pretax Venture Can Still Be a Partnership, 171 Tax Notes Fed. 1951 (June 17, 2021)] This month’s installment evaluates the strength of the commissioner’s economic substance arguments in the pending Perrigo case, which was heard before the U.S. District Court for the Western District of Michigan in a nine-day bench trial that concluded on June 7 [Perrigo Co. v. United States, No. 1:17-cv-00737 (W.D. Mich. 2021)]. Post-trial submissions have not yet been filed by the parties, and proposed findings of fact and conclusions of law were unavailable at the time of writing.
Although there are multiple issues at play in Perrigo, here we focus primarily on the economic substance arguments advanced by the government and the taxpayer.
In addition to defending its transactions as having economic substance, the taxpayer takes the position that the application of the economic substance and sham doctrines is improper in the circumstances, and the court should focus solely on remedying any alleged deficiencies through section 482 transfer pricing mechanisms designed to deal with disputes of this nature. Although it remains to be seen whether the court will bypass what would otherwise be a significant issue in cases like this one, any discussion of the issue by the court will necessitate some commentary on the nature of the transactions and whether they meet some de minimis threshold to overcome the government’s sham doctrine and economic substance attacks.
Unlike an appeal decision, parties before a court of first instance do not have the benefit of presumed findings of fact or conclusions of law. Instead, parties must contend with the uncertainties regarding sufficiency of evidence and vastly different characterizations of material facts. This makes understanding the legal significance of each factor more important and allows tax practitioners to focus their arguments on characterizations likely to matter most to courts.
Based on only the information available leading up to trial and without regard to the sufficiency of evidence, Blue J’s algorithm predicts with 68 percent confidence that a court will find that the transactions in question will survive an economic substance challenge. This prediction does not, however, speak to the extent to which the taxpayer’s income may be subject to recharacterization under section 482 transfer pricing rules. The economic substance issue could go either way, especially since the merits of the case turn on disputed material findings of fact and conclusions of law that are unavailable.