Tax Controversy Alert
For corporate taxpayers, the pre-election “October surprise” was three court decisions, issued within a few weeks of each other, all holding for the taxpayer despite the government’s allegations that the transactions at issue were tax avoidance vehicles. Black & Decker Corp. v. United States, 2004 U.S. Dist. LEXIS 21201 (D. Md. Oct. 22, 2004); Coltec Indus. Inc. v. United States, 2004 U.S. Claims LEXIS 286 (Fed. Cl. Oct. 29, 2004); TIFD III-E Inc. (“Castle Harbour”) v. United States, 2004 U.S. Dist. LEXIS 22119 (D. Conn. Nov. 1, 2004). In Black & Decker and Castle Harbour, two district courts found that the transactions had sufficient economic substance. In Coltec, the Court of Federal Claims rejected the economic substance doctrine as a violation of the separation of powers. Together, these cases indicate that, where the taxpayer is engaged in a restructuring of an ongoing business activity and has structured its transaction in a manner that complies with the technical requirements of the Code, at least some courts are reluctant to use substance-over-form principles to disregard the transaction even if tax avoidance played a significant role. Both the Coltec and Castle Harbour courts directed the IRS to look to Congress rather than to the courts for relief.
Black & Decker: A Taxpayer Can Prevail Under Fourth’s Circuit Two-Prong Sham Test Even If Tax Avoidance Is Sole Motive
Because the Black & Decker decision was the subject of Miller & Chevalier’s November 1, 2004, Tax Controversy Alert, we will review only the highlights here. Black & Decker was the first decision to address whether capital losses arising from contingent liability transactions, listed by the IRS in Notice 2001-17, could be sustained. In late 2003, the government moved for summary judgment on its principal statutory argument. The government argued that Black & Decker’s basis in the stock of its health care liability management subsidiary should be reduced by the amount of the liabilities assumed by the subsidiary, which would have the effect of eliminating any capital loss on Black & Decker’s subsequent sale of the stock.
After the government’s motion was denied in August 2004, Black & Decker moved for summary judgment, asserting that the sham transaction doctrine did not apply because the transaction had economic substance. In the Fourth Circuit, to which an appeal of the Black & Decker decision would lie, the sham transaction doctrine does not apply if the taxpayer can show either that it had a non-tax business purpose for the transaction or that the transaction has economic substance. See Rice’s Toyota World v. Commissioner, 752 F.2d 89 (4th Cir. 1985). Solely for purposes of the summary judgment motion, Black & Decker conceded for the sake of argument that the sole motive for the transaction was tax avoidance. Relying on Moline Properties v. Comm’r, 319 U.S. 436 (1943); United Parcel Serv. of Am., Inc. v. Comm’r, 254 F.3d 1014 (11th Cir. 2001); and N. Ind. Pub. Serv. Co. v. Comm’r, 115 F.3d 506 (7th Cir. 1997), Black & Decker argued that the transaction could not be disregarded under a sham theory because the health care liability management subsidiary created in the transaction engaged in bona fide and substantial business activities.
The court had no difficulty finding that the transaction had “very real economic implications” and cited the following factors in support of its finding: the health care liability management subsidiary assumed the responsibility for the management, servicing, and administration of Black & Decker’s employee and retiree health plans; considered and proposed numerous health care cost containment strategies since its inception, many of which were implemented by Black & Decker; and always maintained salaried employees. Lastly, the court noted that, as a result of the transaction, the subsidiary became responsible for paying the health care claims of Black & Decker employees with its own assets.
In ruling for Black & Decker, the court held that a “corporation and its transactions are objectively reasonable, despite any tax-avoidance motive, so long as the corporation engages in bona fide, economically-based business transactions.” Accordingly, the court concluded that it “may not ignore a transaction that has economic substance, even if the motive for the transaction is to avoid taxes.”
Coltec: A Strict Constructionist Approach to the Internal Revenue Code
Judge Braden set the tone for her decision by beginning with the following taxpayer-friendly quote from Atlantic Coast Line v. Phillips, 332 U.S. 168, 172-73 (1947): “As to the astuteness of taxpayers in ordering their affairs so as to minimize taxes we have said that ‘the very meaning of a line in the law is that you intentionally may go as close to it as you can if you do not pass it.’ This is because [there is no] ‘public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions.'" Judge Braden then followed with the pithy observation: “And, that is what happened here.”
Overview of the Transaction
Like Black & Decker, Coltec claimed a capital loss arising from the sale of stock in a subsidiary set up to manage contingent liabilities. While Black & Decker involved the company’s efforts to manage rapidly escalating employee and retiree health care benefits costs, Coltec was struggling with asbestos liabilities of two companies owned by Garlock, Inc., which Coltec acquired in 1976. In September 1996, Coltec created Garrison Litigation Management Group. In a § 351 exchange, Garlock transferred a $375 million note, stock, rights to future asbestos insurance recoveries, and the assets and records of the Asbestos Litigation Department in exchange for stock in Garrison and Garrison’s assumption of Garlock’s asbestos liability. Garlock later sold the high basis, low value Garrison stock to third parties at a loss. The government argued that the transaction was designed to generate a capital loss that could be used to offset Coltec’s $283 million gain on the sale of one of its subsidiaries earlier that year.
The Government’s Technical Arguments
Before turning to the economic substance doctrine, the court first rejected the government’s statutory arguments. The government asserted that Garrison’s assumption of Garlock’s asbestos liabilities reduced Garlock’s basis in the Garrison stock because (1) the liabilities are “other property” under § 358(a); (2) the liabilities do not qualify for the § 358(d)(2) exception; or (3) § 357(b) applies.
The court found none of these arguments persuasive. Under the general rule of § 358(d)(1), if the transferee in a § 351 exchange assumes the transferor’s liabilities, the assumption is treated as money received by the transferor on the exchange and, under § 358(a), results in a corresponding reduction in the transferor’s basis in the transferee stock. The court first concluded that asbestos liabilities are not “liabilities” for purposes of § 358(d)(1) and, therefore, are not treated as money received by the taxpayer on the exchange. Citing Black & Decker, Judge Braden then held that, even if the contingent asbestos liabilities are “liabilities” for purposes of § 358(d)(1), they will not be treated as liabilities under § 358(d)(2). Under that provision, liabilities that would have given rise to a deduction by the transferor were it not for the § 351 exchange do not result in a reduction in basis. Judge Braden also quickly dispatched the government’s argument that the contingent asbestos liabilities are “other property” for purposes of § 358(a), noting that a liability is not an asset and therefore is not property.
Although not essential to the court’s holding, the court also rejected the government’s § 357(b) argument, finding both that the principal purpose for entering into the transaction was not solely to avoid federal income tax and that the assumption of the liabilities had a bona fide business purpose. By creating a separate asbestos liability management subsidiary, Coltec furthered its goal of protecting itself and Garlock from liability under a piercing-the-corporate veil or successor liability theory. The court also noted that the separate Garrison structure became an important factor in Coltec’s ability to sell the company to B.F. Goodrich in 1999. Based on these business purpose findings, Judge Braden found it unnecessary to address Coltec’s argument that, even if § 357(b) applied, it would have no relevance to the calculation of Garlock’s basis in the Garrison stock. Taxpayers have argued (with significant support from FSA 1999-05008) that § 357(b) only causes realized gain to be recognized under § 351 and has no impact on basis calculations under § 358.
A Vindication of the Merits of Contingent Liability Transaction
The district court in Black & Decker rejected the government’s chief statutory argument against contingent liability transactions, namely that § 358(d)(2) does not apply. In Coltec, the Court of Federal Claims also sided with taxpayers on the § 358(d)(2) issue and rejected additional arguments the government has raised against these transactions. Both decisions signal that contingent liability cases are winnable and that taxpayers who engaged in them at the very least should not be subject to penalties.
The Court’s Rejection of the Economic Substance Doctrine
Although the Coltec decision will be of particular interest to taxpayers with contingent liability transactions, it also will be of great interest to taxpayers expecting an economic substance challenge to their transaction. The decision represents a significant repudiation of the substance-over- form doctrine, at least “where the language of the Code is clear.” According to the court, where the Code is clear, “the ‘substance rather than form’ doctrine is irrelevant.”
Observing that the economic substance doctrine is “dizzyingly complex,” Judge Braden explained that the “public must be able to rely on clear and understandable rules established by Congress to ascertain their federal tax obligations.” Judge Braden further cautioned: “If federal tax laws are applied in an unpredictable and arbitrary manner, albeit by federal judges for the ‘right’ reasons in the ‘right case,’ public confidence in the Code and tax enforcement system surely will be further eroded.”
Judge Braden also emphasized that Congress has debated and rejected several proposals to codify the economic substance doctrine. After citing Justice Scalia on the dangers of judge-made law, Judge Braden then held that “where a taxpayer has satisfied all statutory requirements established by Congress, as Coltec did in this case, the use of the ‘economic substance’ doctrine to trump ‘mere compliance with the Code’ would violate separation of powers.”
The Coltec decision, with its endorsement of formalism and concern for taxpayer certainty and predictability, is potentially a watershed event for taxpayers, particularly if it is upheld on appeal.
Castle Harbour: The Long-Term Capital Holdings Court Rules for the Taxpayer
Castle Harbour was decided by the federal district court in Connecticut, the same court that ruled for the Government in Long-Term Capital Holdings, in part on economic substance grounds. See Long Term Capital Holdings v. United States, 330 F. Supp.2d 122 (D. Conn. 2004). In Castle Harbour, the taxpayer fared dramatically better.
Overview of the Transaction
General Electric Capital Corp. (“GECC”) was in the airplane leasing business. GECC created a limited liability company (Castle Harbor), which was owned by three GECC subs. Through the subs, GECC contributed to Castle Harbor 63 airplanes, rents due on the airplanes, and additional cash. The GECC subs then sold $50 million of their interest in Castle Harbor to two Dutch banks. The Dutch banks also contributed an additional $67.5 million, bringing their total investment to $117.5 million. Castle Harbor was a self-liquidating partnership. Over eight years, the Dutch banks’ ownership interest was to be almost entirely bought out with the income of the partnership, giving the banks a 9% return on their investment.
Under the operating agreement for Castle Harbor, 98% of the operating income was allocated to the Dutch banks. For financial reporting purposes, operating income was reduced by expenses, including asset depreciation. For tax purposes, all of the airplanes already had been fully depreciated. The court described the tax consequences of the transaction as follows: Accordingly the taxable income allocated to the Dutch Banks was greater than their book allocation by the amount of book depreciation for that year. The Dutch Banks, however, did not pay United States income taxes. Thus, by allocating 98% of the income from fully tax-depreciated aircraft to the Dutch Banks, GECC avoided an enormous tax burden, while shifting very little book income. Put another way, by allocating income less depreciation to tax-neutral parties, GECC was able to ‘re-depreciate’ the assets for tax purposes.”
The Court’s Economic Substance Analysis
In challenging the transaction, the government presented three arguments. First, the government contended that the transaction should be disregarded under the sham transaction doctrine. Second, the government asserted that the Dutch Banks were, for tax purposes, lenders to Castle Harbor, not partners. Therefore, the banks could not be allocated any partnership income. Third, the government claimed that, even if Castle Harbour were a partnership for tax purposes, Castle Harbour allocated its income in a manner that violated the “overall tax effect” rule of Code § 704(b). The court rejected the government’s technical arguments, as well as its efforts to sham the transaction with the economic substance doctrine.
Turning to the Second Circuit case law on the sham transaction test, the court noted that the cases were not “perfectly explicit” regarding whether the court should require the taxpayer to meet both the subjective business purpose test and the objective “economic effect” test, only one of them, or a “flexible standard that considers both factors but makes neither dispositive.” The court was able to avoid resolving this issue by concluding that the “transaction had both a non-tax economic effect and a non-tax business motivation, satisfying both tests and requiring that it be given effect under any reading of the law.”
Analyzing the non-tax economic effect of the transaction, the court rejected the government’s assertion that the Dutch banks’ investment lacked economic reality because they were guaranteed a certain return on their investment. In a passage that will no doubt be frequently quoted by taxpayer, the court stated that “a lack of risk is not enough to make a transaction economically meaningless. . . . Participating in upside potential, even with some guarantee against loss, is economically substantial. In short, entirely open-ended risk is not the only economically real risk.”
With regard to the taxpayer’s business purpose for the transaction, the court found that GECC’s need to raise capital and, more importantly, to demonstrate to investors that it could raise capital on a fleet of aging aircraft were important non-tax motivations.
Distinguishing Boca Investerings Partnership v. United States, 314 F.3d 625, 632 (D.C. Cir. 2003), and ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (D.C. Cir. 2000), in which the D.C. Circuit found an absence of a non-tax business purpose for the formation of the partnerships in question, the Castle Harbour court concluded, that, here, not only did the partnership undertake a legitimate business but there also was economic substance and business purpose to the formation of the partnership. In contrast to the partners in the D.C. Circuit cases, the Dutch banks in Castle Harbour had an economic stake in the partnership and there was a valid business reason to form a separate entity to engage in the underlying transaction. The Dutch banks’ return on their investment was directly tied to the partnership’s performance in the aircraft leasing business. Although the Dutch banks were protected against loss, the banks participated in the upside. The better the leasing business did, the greater their return on their investment. Addressing GECC’s reason for forming the partnership, the court observed that “given that GECC wanted to raise money against its aircraft, and given that it could not borrow against them, it is difficult to see what else it could have done other than create a separate entity and seek investments in that entity.”
In its conclusion, the court remarked that the government is “understandably concerned that the Castle Harbour transaction deprived the public fisc of some $62 million in tax revenue,” especially because it “appears likely that one of GECC’s principal motivations in entering into this transaction . . . was to avoid that substantial tax burden.” Although the transaction “sheltered a great deal of income from taxes,” the court emphasized that the transaction was “legally permissible” and was an “economically real transaction, undertaken, at least in part, for a non-tax business purpose.” Given these circumstances, the court bluntly directed the IRS to “address its concerns to those who write the tax laws.”
In each of the three cases, the taxpayers were confronted with a widely-recognized and easily-grasped threat to their bottom line. Black & Decker was faced with double-digit increases in health care benefits costs; Coltec was trying to protect itself from incurring staggering asbestos liability under a piercing-the-corporate veil theory; and GE Capital Corp. was responding to a substantial downturn in the airplane leasing business. In each case, the taxpayer created a separate entity to restructure its management of these risks and liabilities. Given this fact pattern and assuming the taxpayer has satisfied the relevant statutory requirements, these decisions demonstrate that at least some courts are reluctant to invoke the economic substance doctrine to deprive the taxpayer of the benefits the Code provides. Under this approach, the taxpayer is free to go right up to the “line in the law;” leaving to Congress, rather than the courts, responsibility for redrawing that line, as needed.
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