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.)