In October, the Maryland U.S. District Court handed corporate taxpayers a victory when Judge William Quarles ruled against the Internal Revenue Service in a case involving a Black & Decker Corp. (B&D) tax shelter. In essence, the court ruled that a tax shelter can be valid if it has “economic substance” even when the company’s sole motivation for entering the transaction is tax avoidance.
The decision seemed to stun everyone except the B&D lawyers who had argued for it. That’s because it shot down one of the IRS’s favorite arguments: Transactions solely motivated by tax avoidance lack economic substance and therefore must be discounted on the basis that they’re shams.
The case marked the first of three straight tax-shelter-related losses for the IRS in cases decided this fall. Two of the cases, against B&D and Coltec Industries Inc., involved contingent-liability shelter arrangements.
On the surface, the B&D deal looked like a typical transaction involving the tax-free transfer of assets to a newly formed subsidiary. In 1998, B&D formed Black & Decker Healthcare Management (BDHM) and transferred $561 million in cash and $560 million dollar in contingent employee health-care claims to the subsidiary.
In exchange, B&D received newly issued BDHM stock, which it sold to an independent third party for $1 million. B&D reported a loss of $560 million on the stock sale, which was recorded on its 1998 tax returns. It used the loss to offset $670 million in gains it recorded that same year from the sale of three businesses.
In December 2001, B&D claimed a $57 million tax refund linked to what the company assumed were overpayments for 1999 through 2000. But the IRS never paid the refund, and B&D sued the service in June 2004. The IRS countersued for $113 million in taxes and $41 million in penalties, arguing that B&D’s tax basis should have been reduced by $560 million, the amount of the assumed contingent liabilities.
The precise details of the B&D transaction might affect only those companies with old contingent liabilities that have been challenged by the IRS. In 1999, the year after B&D used the tax strategy, Congress in effect shut down the shelter by expanding the tax code’s Section 358(h) basis-reduction rule. The action essentially barred a parent company and its subsidiary from taking a tax deduction for the same contingent liabilities.
But the court’s “novel views” with regard to the issue of economic substance as a gauge of a valid tax shelter will have “huge implications” for corporations in the future, noted Robert Willens, a tax specialist with Lehman Brothers Inc.
Historically, courts have used a two-pronged test based on the 1985 Rice’s Toyota v. Commissioner decision to determine whether such transactions are shams. One part of the test requires that arrangements have a non-tax-related business purpose; the other requires that they have economic substance. Courts have defined “economic substance” as a material economic effect on the parties involved in the transaction. (In Maryland’s fourth U.S. district, where the case was decided, the definition hinges on the “reasonable possibility of profit,” according to the judge’s decision.)
Many jurisdictions have held that a transaction has to clear both test hurdles to get a tax break. Quarles and other judges, however, have opined that passing either prong of the test is enough to sanction the transaction as valid for tax purposes, rather than deeming it a sham.
“It might not be right in light of past cases, but [the Maryland U.S. District] court read Rice’s Toyota to mean that a transaction had to fail both prongs of the test” to be considered a sham, according to Christopher Rizek, a tax attorney with Caplin and Drysdale.
In effect, the “disjunctive” interpretation by Quarles sets a legal precedent favoring taxpayers who create subsidiaries with no other business purpose than to shelter gains, as long as there are net savings to the parent, Rizek added. He and other experts expect the IRS to beat the January deadline for filing an appeal. IRS officials declined to comment on the case.
Besides questioning the two-pronged approach, the judge’s ruling appeared to lower the threshold for determining when economic substance exists, asserted attorney Philip Karter of Miller and Chevalier, the law firm that represented B&D.
Quarles, in his opinion memorandum, said that the B&D transaction — the formation of the BDHM subsidiary — “had very real economic implications.” The judge wrote that BDHM assumed responsibility for managing rapidly rising health-care costs of B&D’s employees and retirees, and used its assets to pay health-care claim liabilities as they came due.
The decision, however, isn’t likely to be the last word on the issue. “Stay tuned, the IRS isn’t done with the fight yet,” said Louis Marett, a tax attorney with Testa, Hurwitz, and Thibeault. Marett reckoned that the B&D case will be at the center of a debate between literalist tax-shelter designers, who promote the letter of the tax code, and the IRS and other proponents of the spirit of the law. What’s more, experts say, Congress will likely act to codify the definition of “economic substance,” especially if the IRS leans on the lawmakers.
In addition, Marett asserted, tax courts will continue to follow the spirit of the law and demand a more robust business-purpose explanation in shelter cases. “In 70 years of decisions, the tax courts have always applied a ‘spiritual’ overlay,” he said.
That might be true in the U.S. Tax Court. But the B&D suit, because it was a tax-refund case, had to be brought before a district court. The maneuver, experts say, was a smart legal ploy: Instead of arguing for the validity of the shelter in tax court, the company’s lawyers chose to sue for the refund.
B&D was “in a refund posture that permitted us to sue in the district court, which we thought might be a more receptive forum,” Karter explained.
“The chances are good that Black & Decker would not have won this case in tax court,” posited Willens. He noted that district courts seem less dogmatic about tax decisions and tend to concentrate on the relatively subjective business-purpose argument rather than on the more objective matter of economic substance.
There’s no questions the B&D decision was a setback for the IRS, but the service doesn’t seem to be staying on the mat. Last week, the IRS released new ethics standards (Treasury Department Circular 230) for lawyers, accountants, and other tax advisors that issue “opinion letters” to support shelters set up only to avoid taxes.
It will be interesting to see how tax practitioners receive the new standards in light of the Maryland District Court decision. The ruling, after all, seemed to encourage taxpayers to continue to regard hefty tax advantages as a key element in planning their business affairs.
Marie Leone’s “Courts and Torts” column appears monthly. Contact her at MarieLeone@cfo.com.