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 taxpayer's sole motivation for the transactions was the tax benefit of the credits. The court also rejected the taxpayer's argument that the economic substance doctrine should not apply to transactions that Congress intended to encourage, noting that there are no categorical exceptions to the doctrine. Id. In addition, the court noted that while the codified economic substance doctrine in IRC section 7701(o) applies only to income taxes, the common law economic substance doctrine continues to apply to all forms of taxes. Id., n. 5.
Finally, the court relied on the variance doctrine to reject the taxpayer's challenge to the IRS's imposition of penalties. Id. at 7. The variance doctrine arises from section 7422(a), which requires the filing of an administrative refund claim prior to filing a refund suit. Here, the taxpayer asserted that the IRS did not satisfy the procedural requirements of section 6751(b), which requires supervisory approval before the imposition of penalties. Id. But the taxpayer did not raise that issue in its administrative refund claim, and the court therefore concluded that under the variance doctrine, the taxpayer was barred from raising the issue in its complaint. Id. This holding is consistent with prior cases that have come to the same conclusion. See, e.g., Ginsburg v. United States, 17 F.4th 78, 85 (11th Cir. 2021) ("because the supervisory approval argument wasn't exhausted before the Service [in the claim for refund], the district court rightly didn't consider it in Ginsburg's refund lawsuit."); Rische v. United States, 2021 WL 2856598, 7 (W.D. Wash. 2021) (where a taxpayer asserted non-compliance with section 6751(b) for the first time at trial, the court dismissed the claim under the variance doctrine because the issue had not been raised in the taxpayer's administrative refund claim); Colliot v. United States, 2021 WL 2709676, 5-6 (W.D. Tex. 2021) (finding the taxpayer 's attempt to preserve its section 6751(b) claim ineffective because the taxpayer did not specify which of the eight entities at issue were the subject of the section 6751(b) claim). Chemoil provides a useful reminder that taxpayers should include a claim regarding section 6751(b) compliance in any refund claim with penalties at issue, since it is likely that any facts regarding possible mistakes in the IRS's procedures may not be discovered until the case is in litigation, at which point it would be too late to raise the issue for the first time.
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