Company Seeks Summary Judgment in Fuel Mixture Tax Credit Case

CHEMOIL CORP.,
Plaintiff,
v.
UNITED STATES OF AMERICA,
Defendant.

UNITED STATES DISTRICT COURT
SOUTHERN DISTRICT OF NEW YORK

ORAL ARGUMENT REQUESTED

PLAINTIFF CHEMOIL CORP.'S MEMORANDUM OF LAW IN SUPPORT OF CROSS-MOTION FOR PARTIAL SUMMARY JUDGMENT

Sarah E. Paul
Attorney-in-Charge
Eversheds Sutherland (US) LLP
1114 Avenue of the Americas
New York, NY 10036
Tel: 212-389-5000
Fax: 212-389-5099
SarahPaul@eversheds-sutherland.com

Amish M. Shah
District of Columbia Bar No. 468530, pro hac vice
Daniel G. Strickland
District of Columbia Bar No. 1531288, pro hac vice
Eversheds Sutherland (US) LLP
700 Sixth Street, NW, Suite 700
Washington, DC 20001
Tel: 202-383-0100
Fax: 202-637-3593
AmishShah@eversheds-sutherland.com
DanielStrickland@eversheds-sutherland.com
— Of Counsel —

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TABLE OF CONTENTS

TABLE OF AUTHORITIES

BACKGROUND AND ARGUMENT

CONCLUSION

TABLE OF AUTHORITIES

Cases

Altria Grp., Inc. v. United States, 694 F. Supp. 2d 259 (S.D.N.Y. 2010)

Am. Int'l Grp., Inc. v. London Am. Int'l Corp., 664 F.2d 348 (2d Cir. 1981)

Anderson v. Liberty Lobby, Inc., 477 U.S. 242 (1986)

Atl. Cleaners & Dyers, Inc. v. United States, 286 U.S. 427 (1932)

Benenson v. Comm'r, 910 F.3d 690 (2d Cir. 2018)

Celotex Corp. v. Catrett, 477 U.S. 317 (1986)

Chai v. Comm'r, 851 F.3d 190 (2d Cir. 2017)

Clay v. Comm'r, 152 T.C. 223 (2019)

Comm'r v. Lester, 366 U.S. 299 (1961)

Corley v. United States, 556 U.S. 303 (2009)

Cross Refined Coal v. Comm'r, No. 19502-17 (T.C. Aug. 29, 2019)

Dawson v. Cnty. of Westchester, 373 F.3d 265 (2d Cir. 2004)

Dow Chem. Co. v. United States, 435 F.3d 594 (6th Cir. 2006)

Frank Lyon Co. v. United States, 435 U.S. 561 (1978)

Gilman v. Comm'r, 933 F.2d 143 (2d Cir. 1991)

Historic Boardwalk Hall, L.L.C. v. Comm'r, 694 F.3d 425 (3d Cir. 2012)

Kirchman v. Comm'r, 862 F.2d 1486 (11th Cir. 1989)

Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122 (D. Conn. 2004)

Patterson v. Cnty. of Oneida, 375 F.3d 206 (2d Cir. 2004)

Rice's Toyota World v. Comm'r, 752 F.2d 89 (4th Cir. 1985)

Sacks v. Comm'r, 69 F.3d 982 (9th Cir. 1995)

Sec. Ins. Co. v. Old Dominion Freight Line, Inc., 391 F.3d 77 (2d Cir. 2004)

Sorenson v. Secretary of Treasury, 475 U.S. 851 (1986)

United States v. Coplan, 703 F.3d 46 (2d Cir. 2012)

Statutes

26 U.S.C. § 40

26 U.S.C. § 40(b)(1)(B)

26 U.S.C. § 40(b)(2)(A)

26 U.S.C. § 40(b)(6)(D)

26 U.S.C. § 42

26 U.S.C. § 45

26 U.S.C. § 45D

26 U.S.C. § 45Q

26 U.S.C. § 45Q(a)(3)

26 U.S.C. § 45Q(a)(4)

26 U.S.C. § 45Q(b)

26 U.S.C. § 47

26 U.S.C. § 48

26 U.S.C. § 4081

26 U.S.C. § 6426

26 U.S.C. § 6426(b)

26 U.S.C. § 6426(b)(3)

26 U.S.C. § 6426(b)(3)(A)

26 U.S.C. § 6426(c)(3)

26 U.S.C. § 6426(d)(1)

26 U.S.C. § 6426(e)

26 U.S.C. § 6426(e)(2)

26 U.S.C. § 6427

26 U.S.C. § 6427(e)

26 U.S.C. § 6675

26 U.S.C. § 6751

26 U.S.C. § 6751(b)

26 U.S.C. § 6861

26 U.S.C. § 7701(a)

26 U.S.C. § 7701(a)(12)(B)

26 U.S.C. § 7701(a)(16)

26 U.S.C. § 7701(a)(28)

26 U.S.C. § 7701(a)(36)

26 U.S.C. § 7701(a)(43)

26 U.S.C. § 7701(a)(44)

26 U.S.C. § 7701(a)(49)(C)

26 U.S.C. § 7701(b)(1)

26 U.S.C. § 7701(c)

26 U.S.C. § 7701(d)

26 U.S.C. § 7701(f)

26 U.S.C. § 7701(g)

26 U.S.C. § 7701(o)

26 U.S.C. § 7701(o)(1)

26 U.S.C. § 7701(o)(5)(C)

Health Care and Education Reconciliation Act of 2010 Pub. L. No. 111-152, 124 Stat. 1029 (Mar. 30, 2010)

Legislative History

IRS Restructuring: Hearings on H.R. 2676 Before the S. Comm. on Finance, 105th Cong. (1998), available at https://www.congress.gov/105/chrg/CHRG-105shrg47361/CHRG-105shrg47361.pdf

S. Rep. No. 105-174 (1998), available at https://www.congress.gov/105/crpt/srpt174/CRPT-105srpt174.pdf

Staff of J. Comm. on Tax'n, JCS-1-81, General Explanation of the Crude Oil Windfall Profit Tax Act of 1980 (Comm. Print 1980), available at https://www.jct.gov/publications/1981/jcs-1-81/

Staff of J. Comm. on Tax'n, JCX-18-10, Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010” (Comm. Print 2010), available at https://www.jct.gov/publications/2010/jcx-18-10/

Rules

Fed. R. Civ. P. 56

Fed. R. Civ. P. 56(c)

Other Authorities

I.R.S. Notice 2006-92, 2006-2 C.B. 774, available at https://www.irs.gov/pub/irs-drop/n-06-92.pdf

Molly Sherlock, Cong. Rsch. Serv., IF10479, The Energy Credit or Energy Investment Tax Credit (ITC) (2021), available at https://crsreports.congress.gov/product/pdf/IF/IF10479/6

Molly Sherlock et al., Cong. Rsch. Serv., R46451, Energy Tax Provisions Expiring in 2020, 2021, 2022, and 2023 (“Tax Extenders”) (2020), available at https://www.everycrsreport.com/files/2020-07-14_R46451_3414d85ad68fbb367b79e8451a1a0897469c1c0e.pdf

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Pursuant to Federal Rule of Civil Procedure 56, Plaintiff, Chemoil Corp. (“Chemoil” or “Plaintiff”), by its attorney, Sarah E. Paul, respectfully submits this memorandum of law in support of its cross-motion for partial summary judgment in Chemoil Corp. v. United States, 19 Civ. 6314.

BACKGROUND AND ARGUMENT

The primary issue in this case is whether Chemoil satisfied each of the statutory requirements for entitlement to the alcohol fuel mixture credit under section 6426.¹ (Complaint, Count One.) For the taxable period at issue in this case, section 6426 provided an incentive to taxpayers to blend ethanol into the gasoline supply and sell the resulting mixture, referred to as an alcohol fuel mixture, to any person “for use as a fuel”. The incentive was based on the gallons of ethanol (or other alcohol) used in the mixture. The incentive was available under section 6426 as an excise tax credit, which was allowed as an offset against the excise tax imposed by section 4081 upon taxable fuels. To the extent not claimed under section 6426 because the credit amount exceeded a taxpayer's section 4081 tax liability amount, the excise tax credit was available as a cash payment under section 6427. At issue in this case are Chemoil's alcohol fuel mixture credit payments claimed under section 6427 for the 4th quarter of 2011.

The secondary issue is whether Chemoil is liable for a penalty under section 6675. (Complaint, Count Two.) The IRS assessed a section 6675 excessive claims penalty against Chemoil for certain fuel credits claimed for the fourth quarter of 2011. However, section 6675 only allows a penalty to be assessed if a claim is made for an “excessive amount,” and no penalty may be imposed if the taxpayer acted with reasonable cause. Further, section 6751 prohibits the penalty from being assessed unless the penalty is timely approved in writing by the immediate supervisor of the individual at the IRS who makes the initial determination to assert the penalty.

Because there are numerous factual questions in this case that are better suited for the jury, Chemoil brings only three distinct questions on its motion for partial summary judgment. Each of these three questions raise no genuine dispute as to any material fact.

First, Chemoil asks the Court to find that as a matter of law, either (i) the economic substance doctrine is not relevant in this case or (ii) if the doctrine is relevant, then excise tax benefits can be considered in determining whether the transactions at issue had economic substance.

Second, Chemoil asks the Court to find that (i) Chemoil's alcohol fuel mixtures could have been used as a fuel without further processing; and (ii) the “sold . . . for use as a fuel” requirement of section 6426(b)(3) is satisfied.

Third, Chemoil asks the Court to find that the IRS failed to satisfy the section 6751(b) requirement that the penalty be properly approved because the asserted section 6675 penalty was not timely approved in writing by the appropriate IRS supervisor.

These questions are ripe for the Court's resolution.

A. Summary Judgment Standard

A motion for summary judgment must be granted if the pleadings, discovery materials before the court, and any affidavits show that there is no genuine issue as to any material fact and it is clear that the moving party is entitled to judgment as a matter of law. Fed. R. Civ. P. 56(c); Celotex Corp. v. Catrett, 477 U.S. 317, 322 (1986).

A dispute regarding a material fact is genuine if there is sufficient evidence that a reasonable jury could return a verdict for the nonmoving party. See Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248 (1986). The burden is on the moving party to demonstrate the absence of any material factual issue genuinely in dispute. Am. Int'l Grp., Inc. v. London Am. Int'l Corp., 664 F.2d 348, 351 (2d Cir. 1981).

In turn, to defeat a motion for summary judgment, the non-moving party must raise a genuine issue of material fact. If the nonmoving party submits evidence, which is “merely colorable,” legally sufficient opposition to the motion for summary judgment is not met. Anderson, 477 U.S. at 249. The mere existence of a scintilla of evidence in support of the nonmoving party's position is insufficient; there must be evidence on which the jury could reasonably find for the non-moving party. See Dawson v. Cnty. of Westchester, 373 F.3d 265, 272 (2d Cir. 2004).

On summary judgment, the court resolves all ambiguities and draws all permissible factual inferences in favor of the nonmoving party. See Patterson v. Cnty. of Oneida, 375 F.3d 206, 218 (2d Cir. 2004). If there is any evidence in the record from which a reasonable inference could be drawn in favor of the opposing party on the issue on which summary judgment is sought, summary judgment is improper. See Sec. Ins. Co. of Hartford v. Old Dominion Freight Line Inc., 391 F.3d 77, 83 (2d Cir. 2004).

As noted above and discussed in more detail below, Chemoil is entitled to summary judgment respect to each of the three distinct questions outlined above.

B. The Economic Substance Doctrine Is Not Relevant.

Chemoil asks this Court to find as a matter of law that the economic substance doctrine is not relevant in this case. Alternatively, Chemoil asks this Court to find as a matter of law that alcohol fuel mixture excise tax benefits may be considered in determining whether a transaction has economic substance. Because there are no material facts in dispute with respect to these pure legal questions, summary judgment is appropriate.

1. Congress codified the economic substance doctrine in section 7701(o) to provide consistency and uniformity in the application of the doctrine across the circuits.

Congress codified the economic substance doctrine in section 7701(o) when it enacted the Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, section 1409, 124 Stat. 1029, 1067 (Mar. 30, 2010). But the doctrine's common law history predates the codification by more than thirty years, often tracing its roots to the Supreme Court's holding in Frank Lyon Co. v. United States, 435 U.S. 561 (1978).

Courts historically applied the common law economic substance doctrine using a two pronged test — (1) whether the taxpayer had a non-tax business purpose or objective for entering into the disputed transaction (the subjective prong); and (2) whether the transaction had economic substance beyond the anticipated tax benefits (the objective prong). The two prongs enabled “courts to question the validity of a transaction and deny taxpayers benefits to which they are technically entitled under the Code if the transaction at issue lacks economic substance.” Benenson v. Comm'r, 910 F.3d 690, 699 n.8 (2d Cir. 2018) (quoting Bank of N.Y. Mellon Corp. v. Comm'r, 801 F.3d 104, 113 (2d Cir. 2015)).

Over time, the appellate circuits began to diverge in their application of the two prongs. Some circuits applied them disjunctively, requiring only one to be satisfied to show economic substance. See, e.g., Rice's Toyota World, Inc. v. Comm'r, 752 F.2d 89 (4th Cir. 1985) at 91–92. Other circuits applied them conjunctively, requiring both to be satisfied to show economic substance. See, e.g., Dow Chem. Co. v. United States, 435 F.3d 594, 599 (6th Cir. 2006). And a third group of circuits, including the Second Circuit, collapsed the prongs into a single, comprehensive inquiry. See, e.g., Altria Grp., Inc. v. United States, 694 F. Supp. 2d 259, 271 (S.D.N.Y. 2010), aff'd, 658 F.3d 276 (2d Cir. 2011) (instructing the jury that in the Second Circuit, “the economic substance test was flexible” and that while it could find economic substance based on satisfying a single prong, it was nonetheless required to “consider both the 'business purpose' and 'economic effects' inquiries before reaching a conclusion as to the economic substance of a transaction.”); Sacks v. Comm'r, 69 F.3d 982, 988 (9th Cir. 1995), rev'g 64 T.C.M. (CCH) 1003 (1992); Kirchman v. Comm'r, 862 F.2d 1486, 1492 (11th Cir. 1989), aff'g Glass v. Comm'r, 87 T.C. 1087 (1986).

This divergence necessitated congressional action. Accordingly, in 2010, Congress provided certainty to taxpayers when it codified the economic substance doctrine as a conjunctive test in section 7701(o). This codified doctrine was made effective for “transactions entered into after the date of enactment [of section 7701(o)]”, which was March 30, 2010. Pub. L. No. 111-152, section 1409(e)(1), 124 Stat. 1029, 1070. Accordingly, as a matter of law, the codified economic substance doctrine — rather than the common law doctrine — applies to post-March 30, 2010, transactions. Cf. United States v. Coplan, 703 F.3d 46, 92 n.41 (2d Cir. 2012) (noting that “[i]n 2010, Congress finally codified the economic substance doctrine at 26 U.S.C. § 7701(o)” and that “[t]he codified version applies prospectively to transactions entered into after March 30, 2010” before applying the common law doctrine because the transaction at issue was entered into before March 30, 2010); Historic Boardwalk Hall, L.L.C. v. Comm'r, 694 F.3d 425, 431 n.7 (3d Cir. 2012) (noting that “[s]ection 7701(o) applies to all transactions entered into after March 30, 2010” and applying the common law doctrine rather than the statutory doctrine to transactions entered into before that date).

There is no dispute that the transactions at issue in this case were entered into by Chemoil after March 30, 2010. (Exhibit 1 at p. 11-12 (identifying Chemoil's contracts); Exhibit 2 (containing Chemoil's identified contracts).) Accordingly, the codified economic substance doctrine in section 7701(o) applies to the transactions at issue.

2. The economic substance doctrine is not relevant to transactions involving alcohol fuel mixture excise tax incentives.

Although section 7701(o) effectively superseded the common law economic substance doctrine with respect to how the doctrine is applied, Congress was careful to explain that “[t]he determination of whether the economic substance doctrine is relevant to a transaction is made in the same manner as if the provision had never been enacted.” Section 7701(o)(5)(C) (emphasis added). Stated otherwise, Congress wanted to provide a consistent test while also making sure that the codified doctrine “d[id] not change present law standards in determining when to utilize an economic substance analysis.” Staff of J. Comm. on Tax'n, JCX-18-10, Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010” 152 (Comm. Print 2010) (emphasis added). That consistent test recognizes that the doctrine is not relevant to all transactions. Thus, before applying the economic substance doctrine, this Court should first determine whether, as a matter of law, the doctrine is relevant to transactions involving alcohol fuel mixture excise tax incentives. It is not.

The Joint Committee on Taxation published a report on the statutory enactment, explaining that “[i]f the realization of the tax benefits is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate, it is not intended that such benefits be disallowed.” Id. at n.344. The same footnote further provides that “it is not intended” that certain tax credits be disallowed in a transaction “pursuant to which, in form and substance, a taxpayer makes the type of investment or undertakes the type of activity that the credit was intended to encourage.” Id. The footnote then provides a few examples for illustration: section 42 (low income housing credit), section 45 (renewable energy and refined coal production tax credit), section 45D (new markets tax credit), section 47 (rehabilitation credit), and section 48 (renewable energy credit). These tax incentives share a common trait. Congress created each specifically to incentivize the respective activities that would not be undertaken in the absence of the tax incentive.

Congress understands that taxpayers are not going to undertake certain activities absent tax incentives to make them economically beneficial. This understanding is well illustrated by the changes made in 2018 to the section 45Q carbon capture and sequestration credit. That tax credit is available for capturing carbon dioxide and then, inter alia, disposing of it deep underground. When Congress created this credit, it was well aware that there is no economic incentive for deep underground storage of captured carbon dioxide other than the section 45Q tax credit. In fact, Congress actually provided a greater amount of tax credit for deep underground storage, as compared to the amount of tax credit that it provided for other carbon dioxide storage activities that do have economic incentives in addition to the section 45Q tax credit. See sections 45Q(a)(3), (a)(4), and (b).

The section 6426(b) alcohol fuel mixture credit is no different from the credits discussed above. Congress enacted a tax credit for blending alcohol fuels with gasoline as part of the Windfall Profits Tax Act of 1980 in order to create an economic incentive for taxpayers to add an alternative fuel — i.e., ethanol or other alcohol fuels — into the nation's gasoline supply.² At the time of enactment of the Windfall Profit Tax Act, a reduced rate of excise tax was available for blends of gasoline and an alcohol fuel, commonly referred to as gasohol, containing at least 10% alcohol. Because of the way that the reduced-rate benefit was available for gasoline blended with alcohol at a minimum concentration of 10% alcohol, taxpayers had no economic incentive to use anything other than exactly 10% alcohol. Stated otherwise, using less than 10% alcohol provided no tax benefit; using more than 10% provided no additional tax benefit; so taxpayers typically produced gasohol at exactly 10%.

Congress concluded that gasohol with concentrations of alcohol other than exactly 10% similarly met its goal of encouraging the production and use of alcohol fuels. Thus, Congress, in the Windfall Profit Tax Act, enacted the alcohol fuel mixture credit, which provided a tax credit based on the number of gallons of alcohol fuel that were blended with gasoline, no matter the concentration. Staff of J. Comm. on Tax'n, JCS-1-81, General Explanation of the Crude Oil Windfall Profit Tax Act of 1980 at 85–92 (Comm. Print 1980).

The alcohol fuel mixture credit is just one example of Congress' efforts to use tax incentives to encourage taxpayer investment in alternative energy; many others have been considered, proposed, debated, and enacted. See, e.g., CRS, The Energy Credit or Energy Investment Tax Credit (ITC) (April 23, 2021) (When considering the Tax Reform Act of 1986 (P.L. 99-514), “Congress believed it desirable to maintain tax credits for renewable energy to continue stimulating technological development and the use of renewable energy sources.”); CRS Report No. R46451 at 5 (July 14, 2020) (“Tax credits for second generation biofuels are motivated by a desire to reduce dependence on petroleum imports (i.e., enhance national energy security), address environmental concerns, and maintain farm incomes.”).

As noted above, section 7701(o) does not apply to all transactions, but rather only to a transaction for which the “economic substance doctrine is relevant.” Section 7701(o)(1). Transactions that Congress specifically sought to incentivize with a tax benefit are not transactions for which the “economic substance doctrine is relevant.” Id. Because taxpayers who are blending ethanol into the nation's gasoline supply and selling those alcohol fuel mixtures for use as a fuel are engaging in exactly the activity that Congress sought to incentivize with this credit, the economic substance doctrine is inapplicable to this case as a matter of law. See, e.g., Altria Grp., Inc., 694 F. Supp. at 284 (“[T]he economic substance doctrine simply has no application if it is clear that a claimed deduction is within the intent of a provision of the Code.”); Sacks, 69 F.3d at 991 (“Absence of pre-tax profitability does not show 'whether the transaction had economic substance beyond the creation of tax benefits,' where Congress has purposely used tax incentives to change investors' conduct.” (citation omitted)).

3. Even if the economic substance doctrine were relevant to alcohol fuel mixture credits, the benefits from those excise tax credits may be considered in the doctrine's application.

Title 26 of the U.S. Code, the Internal Revenue Code, provides for various types of federal taxes, including income taxes under Subtitle A, estate and gift taxes under Subtitle B, employment taxes under Subtitle C, certain excise taxes under Subtitle D, and alcohol, tobacco and certain other excise taxes under Subtitle E. Subtitle F addresses “Procedure and Administration” with respect to those various types of taxes and includes section 7701(o), which provides:

(1) Application of doctrine. In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if —

(emphasis added). Congress expanded the exclusions in paragraph (3):

(3) State and local tax benefits. For purposes of paragraph (1), any State or local income tax effect which is related to a Federal income tax effect shall be treated in the same manner as a Federal income tax effect.

(emphasis added). The phrase “Federal income tax” refers to taxes imposed under Subtitle A of the Internal Revenue Code. The alcohol fuel excise tax mixture credits at issue here are not “Federal income tax” effects; rather, they are part of Subtitle D, “other excise taxes”. Accordingly, assuming, arguendo, that this Court finds that the economic substance doctrine is relevant to the transactions at issue in this case, the benefits from these credits may still be considered in determining whether the transactions at issue had economic substance, because the alcohol fuel mixture credits do not have any “Federal income tax” effect. Indeed, the United States does not suggest that any Federal income tax effect exists here.

Where the language of a statute is plain and unambiguous, courts give effect to each word of the statute as written, such that no word is rendered superfluous, void, or insignificant. Corley v. United States, 556 U.S. 303, 314 (2009). Notably absent from the excluded tax effects in section 7701(o) is any reference to other Federal tax effects. As relevant to this case, section 4081 imposes a Federal excise tax on motor fuels; section 6426(b) provides an excise tax credit for alcohol fuel mixtures that is allowed against the excise tax liability imposed by section 4081; and section 6427(e) provides a direct payment of an amount equal to any alcohol fuel mixture excise tax credits to which a taxpayer is entitled under section 6426(b) that exceed that taxpayer's section 4081 excise tax liability. Each of section 4081, 6426, and section 6427 is within Subtitle D (other excise taxes) of the Internal Revenue Code, not Subtitle A (income taxes).

It would be illogical to expand the term “income tax” that Congress used in section 7701(o) to include other types of taxes. Indeed, where Congress intends to reference all Federal tax provisions, it uses the phrase “this title” to reference the entirety of Title 26. See, e.g., section 7701(a), (b)(1), (c), (d), (f). And where Congress intends to reference specific portions of Title 26, it uses other phrases.³

Based on the words used by Congress, in analyzing either prong of the economic substance doctrine, only income tax effects are excluded from consideration. Accordingly, as a matter of law, other tax effects, such as Federal excise tax effects, may be taken into account.

4. Case law supports the inclusion of excise tax effects in an economic substance analysis.

Historically, the Second Circuit employed a “flexible” economic substance analysis where both prongs were factors to consider in the overall inquiry into a transaction's practical economic effects. See Gilman v. Comm'r, 933 F.2d 143, 148 (2d Cir. 1991); Altria Grp., Inc., 694 F. Supp. 2d at 282; Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122, 171 (D. Conn. 2004), aff'd, 150 F. App'x 40 (2d Cir. 2005) (summary order). Thus, “a finding of either a lack of a business purpose other than tax avoidance or an absence of economic substance beyond the creation of tax benefits can be but is not necessarily sufficient to conclude the transaction a sham.” Long Term Capital Holdings, 330 F. Supp. 2d at 171. None of these cases, however, addressed excise tax effects, and none concluded that excise tax benefits could not be considered in determining whether a transaction had economic substance.

Moreover, case law outside of the Second Circuit clarifies that tax incentives created by Congress, such as excise tax credits, are not excluded from an economic substance analysis where the taxpayer is engaging in the behavior Congress is attempting to encourage. Some representative examples of that case law include the following:

Sacks v. Commissioner

In Sacks, the IRS disallowed tax credits claimed by an investor in a solar water heating business. 69 F.3d 982, 990 (9th Cir. 1995). The Tax Court upheld the determination, finding that the taxpayer's investment was a sham transaction because the taxpayer was “unlikely to make money from his solar water heaters, but for the tax benefits.” Id. But the Court of Appeals for the Ninth Circuit reversed the Tax Court, finding that a “tax advantage such as Congress awarded for alternative energy investments is intended to induce investments which otherwise would not have been made.” Id. at 992 (“If the government treats tax-advantaged transactions as shams unless they make economic sense on a pre-tax basis, then it takes away with the executive hand what it gives with the legislative.”).

The Ninth Circuit concluded that the “[a]bsence of pre-tax profitability does not show 'whether the transaction had economic substance beyond the creation of tax benefits,' where Congress has purposely used tax incentives to change investors' conduct.” Id. at 991 (citation omitted). Stated otherwise, when Congress creates a tax credit for participating in a particular activity that would be uneconomical without the credit, the economic substance of the activity should be evaluated to include the credit. Id. The court explained that in creating the tax credit at issue, Congress “purposely skewed the neutrality of the tax system . . . because [it] sought to induce people to invest in solar energy.” Id. “[Using] the reason Congress created the tax benefits as a ground for denying them,” as the IRS proposed to do, would “violate[ ] the principle that statutes ought to be construed in light of their purpose.” Id. at 992.

The Sacks transaction's lack of pre-tax profitability was not evidence of abuse by the taxpayer — rather, it was evidence that the transaction was consistent with Congress' purpose of “induc[ing] investments which otherwise would not have been made.” Id. “If the Commissioner were permitted to deny tax benefits when the investments would not have been made but for the tax advantages, then only those investments would be made which would have been made without the Congressional decision to favor them.” Id.

Cross Refined Coal, LLC v. Commissioner

The United States Tax Court in held similarly in a bench opinion that pre-tax profit is an inappropriate indicia of the validity of an investment in clean coal. Cross Refined Coal v. Comm'r, No. 19502-17 (T.C. Aug. 29, 2019) (bench opinion)⁴, on appeal No. 20-1015 (D.C. Cir. Argued Apr. 12, 2021). Instead, the court found it appropriate to “look to the post-tax profits” given the nature and purpose of section 45. Id. at 45.

The refined coal tax credit under section 45 incentivized taxpayers to pre-treat coal in a manner that would result in substantially reduced emissions of certain harmful substances. The credit was added by Congress “for the purpose of incentivizing the refined coal activity; it did so because the market, unassisted by credits, was not producing refined coal on the scale that Congress thought beneficial. Congress manifestly decided that, if refined coal was to be produced in sufficient quantity, money beyond that which the market would offer would need to be added to the mix.” Id. at 53. The Tax Court acknowledged that although the IRS was correct that pre-tax losses were generated on “the sale of every ton of coal refined,” the government's position “deliberately disregards the obvious economic reality of the situation”. Id. at 43. “Without the credits, the refined coal activity was a losing proposition; but that fact cannot mean that the activity, undertaken by someone who gains by claiming the credits, lacks economic substance; rather, that fact is the reason for the credits.” Id. at 54.

The facts presented by Cross Refined Coal showed that “the partners deliberately and conscientiously pursued the economic goal that Congress incentivized them to seek — that is, an after-tax (and after-tax-credit) profit.” Id. at 45. Accordingly, the incentive offered by after-tax profits was the very purpose of the credit: as Congress understood, and as the facts demonstrated, “[w]ithout the credits, the operation would have always necessarily been a losing proposition.” Id. at 27. Accordingly, the credits were “a necessary predicate for the entire arrangement.” Id. at 43–44. The court acknowledged that “[t]here are indeed abusive situations in which the tax law will disregard transactions that lack substance apart from tax manipulations, but this is not such a circumstance.” Id. at 44.

In sum, there is no basis in the law for excluding alcohol fuel mixture credits from the analysis of whether a transaction has economic substance. In the event that the Court finds the economic substance doctrine relevant to this case, Chemoil asks this Court to find that the benefits from the alcohol fuel mixture excise tax credits may be considered in determining whether the transactions at issue had economic substance.

C. Chemoil Satisfied The “Sold For Use As A Fuel” Requirement Of Section 6426(b)(3)(A).

Among the statutory requirements for taxpayers to qualify for entitlement to alcohol fuel mixture credits is the requirement that the mixture be sold by the taxpayer producing such mixture to any person for use as a fuel. Section 6426(b)(3)(A). The relevant IRS guidance provides that (1) a mixture is used as a fuel when it is “consumed in the production of energy” and (2) that a taxpayer sells a mixture for use as a fuel if they have “reason to believe” that the mixture will be used as a fuel — i.e., consumed in the production of energy. I.R.S. Notice 2006-92, 2006-2 C.B. 774 (“Notice 2006-92”). Here, there is no dispute of material fact regarding Chemoil's fuel mixture content or its reason to believe that the fuel mixtures, which consisted of ethanol and gasoline, would be consumed in the production of energy. Accordingly, this Court should find that the alcohol fuel mixtures at issue in this case were sold “for use as a fuel”.

1. Chemoil's mixtures could be used as a fuel.

First, there is no genuine dispute of material fact that Chemoil's mixtures were capable of being used as a fuel. In fact, the United States' proffered expert witness on the subject, Michael Leister, agrees that this is the typical use for such mixtures.

In this case, the fuel mixtures at issue are blends of ethanol and gasoline in slightly varying quantities. (Exhibit 1 at pp. 11-13 (examining fuel blend specifications); Exhibit 3 (containing fuel blend testing records); Exhibit 4 (containing terminal tank reports showing blended fuel volumes).) Mr. Leister analyzed seven of Chemoil's fuel mixture transactions at issue in this litigation and concluded that all seven had sufficient ethanol to meet the American Society for Testing and Materials (ASTM) D4806 specification, which is the Specification for Denatured Fuel Ethanol for Blending with Gasolines for Use as Automotive Spark-Ignition Engine Fuel. (See Exhibit 1 at pp. 8, 11–13; Exhibit 5 at pp. 54–55; Exhibit 3.) As Mr. Leister's report and deposition make clear, mixtures of ethanol and gasoline that meet this specification, such as the mixtures at issue here, are plainly mixtures that can be used as a fuel and, indeed, that is their typical use.

Mr. Leister explained in his report that fuel ethanol is categorized and named based on water content — hydrous and anhydrous. (Exhibit 1 at p. 2.) He categorized Chemoil's fuel mixtures as anhydrous. (Id. at p. 5.) But to understand how and why anhydrous ethanol can meet the “use as a fuel” requirement, it is helpful to first walk through the use of hydrous ethanol as a fuel.

Hydrous Ethanol

Hydrous ethanol is a form of ethanol containing approximately 5% water content, which is often referred to as E100 or “hydrous ethanol fuel.”⁵ (Id. at p. 2.) Moreover, Mr. Leister asserted that “[i]n the 1970s, compelled by the second oil crisis, E100 hydrous ethanol was made available for use as an automotive fuel in Brazil.” (Id. at p. 4.) Mr. Leister thus agrees that E100, hydrous ethanol fuel can be used as a fuel, a proposition with which published technical papers and government agencies concur. See, e.g., The Use of E100 to Fuel a Used 4-Stroke Motorcycle, American Journal of Applied Sciences 9 (5): 647-653 (2012) (addressing the use of hydrous ethanol in a motorcycle engine); U.S. Energy Information Administration, Biofuels explained: Ethanol, available at https://www.eia.gov/energyexplained/biofuels/ethanol.php (“Most of the cars in Brazil can run on pure ethanol or on a blend of gasoline and ethanol.”).

Anhydrous Ethanol

Mr. Leister further stated in his report that “absolute” or “anhydrous” ethanol refers to ethanol with a low water content. (Exhibit 1 at p. 2.) He noted that anhydrous ethanol is used as a fuel alcohol — “that is, alcohol intended to be used as a fuel or a component of a fuel, and (in the United States) produced to meet the ASTM D4806 specification.” (Id.) While he asserted that anhydrous alcohol, by itself, “is generally not usable as a fuel without further processing or mixing,” he conceded that “[a]nhydrous ethanol is used as a fuel after it is blended with gasoline.” (Id. at pp. 2–3.) He characterized the mixtures produced by Chemoil as E99 anhydrous ethanol and stated that E99 refers to “anhydrous fuel ethanol containing a minimum of 98.0% ethanol and up to 2 percent of a denaturant [e.g., gasoline].” (Id. at pp. 2, 5.)

At his deposition, Mr. Leister further conceded that “[t]he typical use for anhydrous fuel ethanol with a denaturant is as a blend with gasoline.” (Exhibit 5 at p. 100.) He also agreed this type of ethanol is typically used “[a]s a fuel with gasoline.” (Id.) Moreover, he stated that ethanol blended with gasoline is generally not used for any purpose other than as a fuel and noted that it is an “expensive” operation to remove gasoline from ethanol once ethanol has gasoline in it. (Id. at pp. 85, 100–01.) Finally, Mr. Leister agreed that anhydrous fuel ethanol can be consumed in an internal combustion engine to power a vehicle. (Id. at p. 101.)

Accordingly, there is no genuine dispute that the ethanol-gasoline mixtures produced by Chemoil could be used as a fuel. In fact, as the United States' own proffered expert conceded, that is the typical use for mixtures such as these.

2. Chemoil had “reason to believe” its mixtures would be used as a fuel and, thus, the “for use as a fuel” requirement is satisfied.

Second, there is no genuine dispute that Chemoil had “reason to believe” its mixtures would be used as a fuel. Under section 6426(b), alcohol fuel mixtures produced by a taxpayer seeking the credit must be either “used as a fuel” by the taxpayer, or sold to a third party for “use as a fuel.” See section 6426(b)(3). While Title 26 of the U.S. Code includes the phrase “use as a fuel” multiple times in section 40 and 6426, Congress did not define that phrase. See sections 40(b)(1)(B) (alcohol mixture), (b)(2)(A) (neat alcohol), (b)(6)(D) (second generation biofuel); 6426(b)(3) (alcohol fuel mixtures), (c)(3) (biodiesel mixtures), (d)(1) (neat alternative fuel), and (e)(2) (alternative fuel mixtures).

It is a “normal rule of statutory construction,” Sorenson v. Secretary of Treasury, 475 U.S. 851, 860 (1986), that “identical words used in different parts of the same act are intended to have the same meaning,” Atl. Cleaners & Dyers, Inc. v. United States, 286 U.S. 427, 433 (1932). Further, “the Code must be given 'as great an internal symmetry and consistency as its words permit.'” Comm'r v. Lester, 366 U.S. 299, 304 (1961). Therefore, Notice 2006-92, which provides a clear definition of this phrase in the context of section 6426(e), applies equally to section 6426(b).

In Notice 2006-92, the IRS stated that a mixture is used as a fuel “when it is consumed in the production of energy.” Id. at 3. In addition to this simple and straightforward definition, the IRS notice provides an example: “a mixture is used as a fuel when it is consumed in an internal combustion engine to power a vehicle or in a furnace to produce heat.” Id. The Notice further explains that taxpayers are not required to have complete knowledge of what does or will happen to the fuel mixtures after they are sold. That is not surprising given that fuel mixtures may be sold numerous times and may be comingled with fuel products from other sources, making tracking of fuel mixture molecules often impossible. Instead, mixture producers are treated as selling their mixture “for use as a fuel” if the producer “has reason to believe” that the mixture will be “used as a fuel” — i.e., consumed in the production of energy — “either by the person buying the mixture from the producer or by any later buyer of the mixture.” Id. The Notice does not mandate that the mixture not require further processing under the laws of any jurisdiction or for any other reason.

Considering this guidance, it cannot reasonably be disputed that Chemoil had a “reason to believe” that its mixtures would be used as a fuel, i.e., consumed in the production of energy. As discussed above, Mr. Leister agreed that anhydrous fuel ethanol, such as that produced by Chemoil, can be consumed in an internal combustion engine to power a vehicle. (Exhibit 5 at p. 101.) Further, he conceded that the typical use for anhydrous fuel ethanol with a denaturant is as a blend with gasoline, and that this type of ethanol is typically used as a fuel with gasoline. (Id. at p. 100.)

Mr. Leister did not dispute the guidance set forth in Notice 2006-92, nor did he take the position that Chemoil does not meet the standards described in that guidance. Rather, Mr. Leister simply contended that, to the extent Chemoil's mixtures were exported to Brazil, they “could not have been used as a fuel in Brazil without the addition of more gasoline or further processing to convert [them] to hydrous ethanol.” (Exhibit 1 at p. 5.) This contention was based on his underlying assumption that “the only fuels present in Brazilian service stations during the time period around the seven Chemoil Transactions were a blend of anhydrous ethanol with gasoline fuel (E18 to E25), and E100 hydrous ethanol fuel (containing about 95% ethanol and 5% water).” (Id.) Chemoil reserves the right to challenge, as a factual matter at trial, Mr. Leister's underlying assumption about the fuels that were present in Brazil at this time. But even assuming, arguendo, that Mr. Leister's assumption is correct, Chemoil still meets the “for use as a fuel” requirement. As Mr. Leister conceded, the anhydrous ethanol sold in the Chemoil transactions could have been blended with additional gasoline to create E18 to E25 gasoline usable as a fuel in Brazil. (Exhibit 5 at p. 93.) Likewise, the anhydrous ethanol sold in the Chemoil transactions could have been converted to hydrous ethanol, through further chemical processing, and sold and used as E100 fuel in Brazil. (Exhibit 1 at p. 5.)

Under either scenario, and as consistently testified by Chemoil's traders, Chemoil clearly had a “reason to believe” that its mixtures would be consumed in the production of energy, even if they were sold and ultimately used in Brazil, given the typical use for mixtures of this type. (See, e.g., Exhibit 6 at pp. 41–44, 59; Exhibit 7 at 52–53; Exhibit 8 at 48–49, 51–52. Cf Exhibit 9 at 19 (describing understanding of Chemoil's counterparty that E99 would be used as a fuel in vehicles).)

Therefore, summary judgment on the “for use as a fuel” element should be granted in favor of Chemoil.

D. The Internal Revenue Service Failed To Comply With Section 6751(b) Regarding The Section 6675 Penalty.

Section 6751 imposes both a notice and a supervisory approval requirement on a number of tax penalties, including a penalty for excessive claims with respect to the use of certain fuels under section 6675, which is the penalty at issue in this case. Congress added these requirements as part of the Taxpayer Bill of Rights in 1998 in order to protect taxpayers from the IRS using penalties as a “bargaining chip.” S. Rep. No. 105-174, at 65 (1998). Stated differently, the statute was designed and enacted to prevent IRS agents from threatening unjustified penalties to encourage taxpayers to settle tax disputes. IRS Restructuring: Hearings on H.R. 2676 Before the S. Comm. on Finance, 105th Cong. 92 (1998) (statement of Stefan F. Tucker, Chair-Elect, Section of Taxation, American Bar Association) (“[T]he IRS will often say, if you don't settle, we are going to assert the penalties.”).

The undisputed material facts in this case show that the IRS failed to satisfy the supervisory approval requirement of section 6751(b). Proper supervisory approval is a necessary prerequisite to the legal assessment of penalties; without it, the statute unequivocally prohibits the IRS from assessing a penalty. In pertinent part, the supervisory approval requirement of section 6751(b) is as follows:

No penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.

“Because § 6751(b)(1) provides that '[n]o penalty . . . shall be assessed' (emphasis added) unless the written-approval requirement is satisfied, it would be inappropriate to impose a penalty where § 6751(b)(1) was not satisfied.” Chai v. Comm'r, 851 F.3d 190, 222 (2d Cir. 2017).

In this case, it is undisputed that the IRS Agent who made the “initial determination” of the penalty assessment was Alan Anderson. (Exhibit 10 (response to Interrogatory number 5).) It is also undisputed that at the time Mr. Anderson made the initial determination, his immediate supervisor was Tom Deis. (Exhibit 10 (response to Interrogatory number 10).) In short, the IRS Agent was required under section 6751(b) to obtain written approval of his immediate supervisor before asserting a penalty against Chemoil. The United States identified a limited number of documents related to Mr. Deis's written approval. None of those documents support that such prior written approval was obtained.

As addressed below, there is no reasonable dispute that Mr. Deis failed to timely approve in writing the section 6675 penalty that Mr. Anderson initially determined to assess against Chemoil. Accordingly, the penalty under section 6675 was illegally assessed, and the amount taken by the IRS must be refunded to Chemoil.

In many circumstances, the IRS uses a standard form for obtaining supervisory approval of asserted penalties. This form, the E500 Penalty Check Sheet (“E500”), contains a list of eleven potential penalties. (Exhibit 12.) In the top portion of the E500, the examining agent can check one of the eleven boxes to communicate to his or her immediate supervisor that the agent believes a particular penalty is warranted. (Id.) At the bottom is a space for the immediate supervisor to either approve or disapprove of the penalty and space for the supervisor to provide a signature and date. (Id.) Mr. Anderson filled out a form E500 for Chemoil's case. (Exhibit 11 at pp. 136–38.) At the bottom of that form, the “Approved” box is checked; “TD” is typed, followed by Mr. Deis's original signature; and the typed date of “8/18/2014” is below. (Exhibit 12.)

There is no reasonable dispute that Mr. Deis failed to sign that form until after the penalty was formally communicated to Chemoil. The formal communication of the penalty was made on August 19, 2014, when Mr. Anderson sent to Chemoil a Notice of Proposed Adjustment (“NOPA”). (Exhibit 14.) See, e.g., Clay v. Comm'r, 152 T.C. 223, 249 (2019) (holding that the “initial determination” was made no later than the date of the NOPA). For the reasons discussed below, despite the E500 including a date of August 18, 2014, Mr. Deis could not have given his written supervisory approval of the section 6675 penalty initially determined by Mr. Anderson prior to August 19, 2014. Accordingly, there is no genuine issue to be tried, and Chemoil is entitled to summary judgment with respect to the failure of the IRS to obtain timely penalty approval.

During the course of the IRS examination, Mr. Anderson and Mr. Deis worked in different offices: Mr. Anderson in Portland Oregon, and Mr. Deis in Salt Lake City, Utah. (Exhibit 11 at p. 140; Exhibit 17 at p. 90.) Towards the end of the examination process, Mr. Anderson prepared the E500. (Exhibit 11 at pp. 136–38.) Mr. Anderson was unaware of the statutory requirement that he obtain written approval from Mr. Deis prior to sending the NOPA to Chemoil (i.e., Mr. Anderson was unaware of a reason to request rush written approval from Mr. Deis or withhold issuance of the NOPA until he received that written approval). (Exhibit 11 at pp. 136, 143–44.) The E500 included a typed date of August 18, 2014 — one day prior to the issuance of the NOPA. (Exhibit 12.) But the undisputed evidence in this case shows that Mr. Deis could not have signed, and did not sign, the form on that date.

Mr. Anderson sent the E500 to Mr. Deis for his written approval in two ways: first, as part of the digital penalty case file; second, in hard copy when he mailed the physical file to Mr. Deis. (Exhibit 16 (entries dated 09/18/2014 and 09/25/2014).) Mr. Anderson and Mr. Deis each completed an activity record for the exam case file and the penalty case file. (Exhibit 15; Exhibit 16; Exhibit 18; Exhibit 19.) Mr. Anderson's activity record for the penalty case file shows that he did not create the digital penalty case file on the IRS system until September 18, 2014. (Exhibit 16 (entry dated 09/18/2014); see also Exhibit 17 at 91–92.) Further, Mr. Anderson's activity record for the penalty case file shows that Mr. Anderson did not mail the hard copy of the case file to Mr. Deis until September 25, 2014. (Exhibit 16 (entry dated 09/25/2014).) Mr. Deis's activity record for the penalty case file also confirms that he did not receive the hard copy of the case file until September 30, 2014. (Exhibit 19 (entry dated 10/21/2014).) There are no other records showing the transmittal of the penalty approval form from Mr. Anderson to Mr. Deis for written approval. Accordingly, despite the date on the E500, the undisputed facts show that Mr. Deis did not receive the penalty approval form until after the penalty assertion was first formally communicated to Chemoil on August 19, 2014. He therefore could not have signed the form prior to that date.

The copies of the E500 produced by the government, along with Mr. Deis's deposition testimony, are further confirmation of this conclusion. During his deposition, Mr. Deis testified that he would have been the one to date and type his initials onto the E500. (Exhibit 17 at pp. 84–85, 88.) He also explained that when a document was important enough to warrant his signature, he either used his official electronic signature or printed, signed, and scanned the document back into the digital case file. (Id. at pp. 76–77.) The only versions of the E500 are unsigned, fillable pdf files, one unsigned hardcopy, and one hardcopy with Mr. Deis's original signature. (Exhibit 20; Exhibit 21; Exhibit 13; Exhibit 12. See also Declaration at 4–6.) There is no E500 bearing Mr. Deis's official electronic signature. (Exhibit 12; Exhibit 13; Exhibit 20; Exhibit 21.) Thus, there are two possibilities for how and when the form was signed by Mr. Deis.

The first possibility is that Mr. Deis printed the digital E500 and signed it. As noted above, Mr. Anderson uploaded the digital E500 after Mr. Deis approved the creation of the digital file on September 18, 2014. The metadata on the native pdfs produced by the United States in this case indicate that the information was “last modified” on September 20, 2014, and September 22, 2014, respectively. (Exhibit 20; Exhibit 21.) Because the digital penalty case file was not created until September 18, 2014, Mr. Deis could not have typed the date and his initials, printed the unsigned pdf, and signed it before August 19, 2014, when Mr. Anderson sent the NOPA to Chemoil. (Compare Exhibit 16 (entry dated 09/18/2014) with Exhibit 14 (dated August 19, 2014).)

The second possibility is that Mr. Deis signed a copy of the E500 that Mr. Anderson included in the physical file. As noted above, Mr. Anderson mailed the hard copy of the penalty case file to Mr. Deis on September 25, 2014, and Mr. Deis did not receive it until September 30, 2014. (Exhibit 16 (entry dated 09/25/2014); Exhibit 19 (entry dated 10/21/2014).) Sometime later, Mr. Deis could have pulled the printed (but unsigned) draft out of the folder, signed it, and returned it. (Compare Exhibit 19 (entry dated 10/21/2014), and Exhibit 17 at p. 95 with Exhibit 14 (dated August 19, 2014).) But, again, this could not have happened prior to August 19, 2014.

Accordingly, under either possibility, Mr. Deis could not have timely signed the penalty approval form. Therefore, Chemoil is entitled to summary judgment with respect to the asserted section 6675 penalty.

CONCLUSION

For the foregoing reasons, Chemoil respectfully requests that the Court grant this cross-motion for partial summary judgment and (1) find as a matter of law that either the economic substance doctrine is not relevant in this case or if relevant, that excise tax benefits may be considered in determining whether the transactions have economic substance; (2) find that Chemoil satisfied the “sold . . . for use as a fuel” requirement of section 6426(b)(3); and (3) find that the IRS failed to satisfy the statutory requirements of section 6751(b) for approving the section 6675 penalty at issue in this case.

Dated: July 8, 2022

Respectfully submitted,

Sarah E. Paul
Attorney-in-Charge
Eversheds Sutherland (US) LLP
1114 Avenue of the Americas
New York, NY 10036
Tel: 212-389-5000
Fax: 212-389-5099
SarahPaul@eversheds-sutherland.com

Of counsel:

Amish M. Shah
District of Columbia Bar No. 468530, pro hac vice
Daniel G. Strickland
District of Columbia Bar No. 1531288, pro hac vice
Eversheds Sutherland (US) LLP
700 Sixth Street, NW, Suite 700
Washington, DC 20001
Tel: 202-383-0100
Fax: 202-637-3593
AmishShah@eversheds-sutherland.com
DanielStrickland@eversheds-sutherland.com

Attorneys for Chemoil Corp.