Pi in the Sky Update: BTA Decision Applies Sham Transaction Provision
On January 17, 2017, the Ohio Board of Tax Appeals (the “Board”) issued its decision in Pi in the Sky, LLC v. Testa, BTA No. 2015-2005. The Board agreed with the Ohio Tax Commissioner ("Commissioner") that under the specific facts of the case the purchase of an airplane by Pi in the Sky, LLC (“Pi”), a single member LLC, and subsequent lease to its sole member constituted a “sham transaction” for Ohio sales and use tax (“SUT”) purposes and thus did not qualify for the resale exception in R.C. 5739.01(E). Therefore, the Board affirmed the use tax assessment on the purchase of an aircraft by Pi. The case is the first published decision in which the Board addresses the sham transaction doctrine set forth in R.C. 5703.56.
Pi purchased the aircraft outside Ohio. Pi argued the initial purchase of the aircraft qualified for the resale exception because the aircraft was immediately leased to Mitchell’s Salon and Day Spa (“Mitchell’s”). Mitchell’s is the sole member of Pi. The owner and president of Mitchell’s is a licensed pilot and the primary user of the airplane. The Commissioner issued a Final Determination and concluded that the resale exception did not apply because “the facts reveal a scheme to avoid taxation with no legitimate business purpose.”
Pi appealed the Commissioner's Final Determination to the Board. Interestingly, Pi waived its right to hearing before the Board. Thus, the Board's decision was determined based on the evidence from the audit that was included in the statutory transcript. Pi had attempted to submit evidence through seven exhibits attached to its brief. The Board did not consider the exhibits because they were not properly submitted as evidence nor had the parties mutually agreed to include the exhibits in the record.
The Board affirmed the assessment based on the Commissioner's power to disregard a transaction pursuant to R.C. 5703.56, which was enacted in 2003. That statutory provision applies to all Ohio taxes and defines a “sham transaction” as “a transaction or series of transactions without economic substance because there is no business purpose or expectation of profit other than obtaining tax benefits.” The statutory provision authorizes the Commissioner to apply the judicial doctrines of economic reality, substance over form, and step transaction.
In support of its conclusion that the "lease lacked both factual and economic substance,” the Board focused on the lease agreement between Mitchell's and Pi. The Board determined that the fact that the same person signed the lease agreement as president of both the lessee (Mitchell's) and the lessor (Pi) was "most telling" in concluding that the lease agreement was not an arm's-length transaction. The Board also noted that the owner and president of Mitchell's home address was used as the business address for Pi, the loan for the airplane was signed by the owner and president of Mitchell's in her personal capacity, Mitchell’s took all flights taken during the audit period, no advertising was conducted by Pi to attempt to lease the aircraft to third parties. The fact that there was no fixed lease term and that Mitchell’s paid only $80 an hour for leasing the airplane, along with other provisions in the lease agreement, were also referenced by the Board as indicator that the lease “lacked both factual and economic substance.”
After considering all of the facts, the Board concluded "that the purchase of the subject aircraft and ensuing lease transactions between the taxpayer and Mitchell's, its sole member, constitute 'transactions without economic substance because there is no business purpose or expectation of profit other than obtaining tax benefits.'"
The Board also indicated that the only issue before it was the use tax assessment on the purchase of the airplane. Thus, the Board could not consider the taxpayer’s request to reduce the use tax assessment for sales tax paid on the lease payments for the subject aircraft.
The Board also concluded that the Commissioner did not abuse his discretion by not abating penalties. The Board stated that Pi did not present any evidence or testimony supporting an abatement of the penalties. Furthermore, the Board agreed with the imposition of the penalties providing "we are constrained to conclude that taxpayer did not demonstrate good faith or reasonable cause related to its claimed exemption."
The case is interesting because it is the first published decision applying R.C. 5703.56. There are only a handful of decisions applying the judicial doctrines before the enactment of R.C. 5703.56, and most of those were asserted by taxpayers to disregard the form of their own transaction or structure. It is clear from the decision that the Board will permit the Commissioner to use the powers enumerated in R.C. 5703.56, when the Board concludes that the facts support the use of the powers. Additionally, the Board's comments indicating that the taxpayer did not act in good faith may empower the Commissioner to impose the maximum possible penalty in similar situations.
It should be noted that this case was decided on the unique facts of the transaction and the failure of the taxpayer to present evidence to support its assertion that the transaction had a legitimate business purpose. The case underscores the importance of substantiating a legitimate business purpose. The Board dismissed Pi’s assertion that it was incorporated to allow the lease of the airplane to others and to limit liability because Pi only leased the airplane to its owner. Taxpayers and practitioners relying on similar business purposes for a transaction should ensure that the facts support the asserted business purpose and that any legal considerations are properly documented and are available in the event of an audit or litigation.
(Published September 19, 2016)
On October 17, 2016, a hearing will be held at the Ohio Board of Tax Appeals (“Board”) to allow testimony and evidence on whether the sale and subsequent leaseback of an airplane between commonly-owned entities constitutes a “sham transaction” for Ohio sales and use tax (“SUT”) purposes. The Ohio Tax Commissioner (“Commissioner”) issued a Final Determination (“FD”) last summer in which it affirmed a sales tax assessment on the purchase of an aircraft by the taxpayer, Pi in the Sky, LLC (“Pi”). Pi appealed the FD to the Board. The case will likely be the first published decision in which the Board addresses the sham transaction doctrine set forth in R.C. 5703.56.
Pi purchased the aircraft outside Ohio. Pi argues the initial purchase of the aircraft qualified for the resale exemption because the aircraft was immediately leased to a commonly-owned entity, Mitchell’s Salon and Day Spa (“Mitchell’s”). Pi is owned by Mitchell’s. The owner and president of Mitchell’s is a licensed pilot and the primary user of the airplane. In the FD, the Commissioner asserts that the resale exemption does not apply because “the facts reveal a scheme to avoid taxation with no legitimate business purpose.”
The Commissioner affirmed the assessment based on his power to disregard a transaction conferred by R.C. 5703.56, which was enacted in 2003. That statutory provision applies to all Ohio taxes and defines a “sham transaction” as “a transaction or series of transactions without economic substance because there is no business purpose or expectation of profit other than obtaining tax benefits.” The statutory provision authorizes the Commissioner to apply the judicial doctrines of economic reality, substance over form, and step transaction.
In support of his application of the doctrine, the Commissioner references the fact that while Pi asserts the plane was purchased for lease to others, the airplane was never leased to a third party for an arm’s length fee. Instead, the Commissioner notes, the plane was only leased to the owner and president of Mitchell’s, who was also the indirect owner of Pi. There was also no evidence that the airplane was marketed or made available for another party to lease the airplane. The Commissioner references the fact that the official address of the plane was the owner’s residence as further evidence of a sham transaction.
The Commissioner also argues that the lease terms were not arm’s length. The owner signed the sales agreement on behalf of Pi and signed the lease agreement for both parties, which the FD states “demonstrates that no sale has taken place.” “The contention that Pi in the Sky, LLC is leasing to ‘others’ is pure fiction.” The lease did not have a defined term and charged a minimal hourly rental. Additionally, Pi was responsible for all the airplane expenses. According to the Commissioner’s calculations, the rent payments which are based solely on the flight hours by lessee, would be less than one-third of the revenue required to service the loan payments on the plane. Further, the owner was listed as the borrower on the loan. The Commissioner also cited the fact that the plane was not generally used for business but to fly the owner to her lakefront vacation property in Michigan, and there were no other passengers. Finally, there was evidence that advance lease payments were made but the sales tax paid represented only a fraction of those lease payments.
Based on this evidence, the Commissioner concluded that the sale and leaseback had no economic substance and that Pi “sought to obtain the tax benefit associated with the legitimate operation of a dry lease aircraft leasing business (exemption from paying sales tax on the purchase of the aircraft) but failed to operate a legitimate business enterprise.” The assessment imposed the sales tax on the purchase of the plane, including penalties. The FD declines to abate the penalties. It appears that the Commissioner did not reduce the assessed sales tax by the sales tax collected on the lease payments.
The case is interesting for a number of reasons. There is little published Ohio authority on the Commissioner’s ability to disregard a transaction. There are no published decisions interpreting R.C. 5703.56. There are only a handful of decisions applying the judicial doctrines before the enactment of R.C. 5703.56, and most of those involved assertion by taxpayers that the form of their own transaction or structure should be disregarded. The case is also interesting since it involves the Ohio SUT. There are a number of SUT cases where the Commissioner asserted that a transaction between commonly-owned legal entities had to be respected and SUT imposed. That precedent underscores the importance of respecting the separate legal entities through documentation and use of arm’s length pricing and arm’s length practices. While this case is consistent with that precedent, the Commissioner’s arguments, if accepted by the Board, could be used by taxpayers to argue that SUT should not be imposed on transactions between commonly-owned entities.