Economic Substance Doctrine Applies To Fuel Credits And Variance Doctrine Prohibits Challenge To Penalty Assessment

• Published date: 06 November 2023
• Subject Matter: Corporate/Commercial Law, Tax, Compliance, Corporate and Company Law, Income Tax
• Law Firm: Miller & Chevalier Chartered
• Author: Maria O'Toole Jones and Andrew Beaghley

In Chemoil Corp. v. United States, the court applied the economic substance doctrine to conclude that the taxpayer was not entitled to the alcohol fuel mixture credit under section 6426(b). 2023 WL 6257928 (S.D.N.Y. 2023). The court also held that the taxpayer could not challenge whether the IRS complied with the procedural requirements of IRC section 6751(b) for the imposition of a penalty, because the argument was raised for the first time in the taxpayer's complaint and was therefore barred under the variance doctrine. Id.

The Chemoil case involved seven transactions for which the company was seeking the excise tax credit. In some of the first transactions, the taxpayer purchased ethanol from a third party, then, after adding a small amount of gasoline to the ethanol, sold the mixture back to the same counterparty for $0.40 per gallon less than the original purchase price. Id. at 2. The sales price for the mixture, when combined with the $0.45 per gallon excise tax credit, would net the taxpayer $0.05 per gallon on the transactions. Id. In the remaining transactions, the taxpayer agreed to sell the fuel at a below-market price. Id. at 3. In all the transactions, the sales would have resulted in a net loss for the taxpayer without the excise tax credit. Id. at 5. The IRS disallowed the excise tax credits for the seven transactions. The IRS also imposed an excessive claims penalty on one of the transactions, in which the taxpayer had attempted to change the terms of the contract so that title to the fuel would be transferred on December 31, 2011, the last day to claim the credit, rather than upon delivery in accordance with the original terms of the agreement. Id. at 6.

The court relied on the economic substance doctrine to disallow the claimed credits. The court explained that the economic substance doctrine requires a two-part test: (1) whether the transaction had an objective pre-tax profit motive and an overall economic effect; and (2) whether the taxpayer's sole motivation for entering the transaction was to realize a tax benefit. Id. at 5. On the first part, the court acknowledged that it was possible for a legitimate transaction to "conceivably lack economic profit," but in this case found that the pre-tax loss failed the test because the addition of a very small amount of gasoline to the ethanol had no legitimate purpose other than qualifying for the tax credit. Id. (citations omitted). On the second part of the test, the court found that the...