Introduction

During the last two weeks of October, 2004, two US Federal courts in separate, but highly similar cases, ruled in favor of Taxpayers’ tax-advantaged transactions, and against the Internal Revenue Service (variously referred to as “IRS” or “Government”).

In Black & Decker Corp. v. United States, 94 AFTR 2d 2004-XXXX, (N.D. Md. Oct. 20, 2004), and Coltec Industries, Inc. v. United States, 94 AFTR 2d 2004-XXXX, (Crt. Fed. Clms. October 29, 2004), the US Federal District Court (for the Northern District of Maryland), and the US Court of Federal Claims, respectively, both ruled that as a matter of law, the Taxpayers complied with the requirements of the applicable provisions of the Internal Revenue Code (“IRC”) with relation to an assumption of contingent liabilities.  Accordingly, the respective courts ruled that the Taxpayers were due refunds of $US 57 million dollars, and $US 83 million dollars, respectively.

The Transactions and Issue in a Nut-Shell

Background: The IRC provides for a mechanism to incorporate a new entity with appreciated property without recognizing a gain (or loss), despite the fact that a disposition occurs when the shareholder contributes the property to its controlled corporation.  Accordingly, as long as immediately after contribution of property to a corporation, such person or persons have “control” of the corporation, the contribution of property to the corporation should be a tax-deferred transaction (See IRC Section 351(a)).  By virtue of classification as a tax deferred transaction, the cost basis of the shares received by the contributor of the contributed property should be equal to the contributor’s basis in the contributed property (See IRC Section 358(a)(1)).

An interesting question arises when the property contributed to the controlled corporation is encumbered with liabilities; what is the contributor’s basis in the shares of the controlled corporation upon contribution of encumbered property?  The answer to this question is mandated by the IRC wherein it is provided that the amount of liabilities assumed by the controlled corporation will be a negative adjustment (i.e., grinds down) the contributor’s basis in its shares of the controlled corporation (See IRC Section 358(d)(1)).

A Quick Numerical Example: Mr. A contributes a car to controlled Corporation in exchange for shares.  Mr. A’s basis in the car is $10, and the car is encumbered with liabilities of $9.  Upon contribution, Corporation assumes $9 of liabilities attached to the car.  Mr. A’s basis in controlled Corporation’s shares is $1 (or basis of $10 adjusted for $9 of liabilities assumed, i.e., $10 less $9, resulting in basis of $1).

What is the Key Issue in the Black & Decker and Coltec cases?

In the above cited cases, the Taxpayers, in the context of an IRC Section 351 transaction (i.e., a tax deferred incorporation, or contribution of property to controlled corporation in exchange for shares), contributed property with Contingent liabilities.  The salient issue then becomes whether: a) the Contingent liabilities are treated as regular liabilities (i.e., grind down the basis of controlled corporation’s shares), or b) is it the case that the Contingent liabilities do not enter the calculus of the contributor’s basis in the controlled corporation’s shares (i.e., contributor’s basis is unaffected by controlled corporation’s assumption of Contingent liabilities).

An Example:  Mr. A’s twin brother contributes a car to controlled Corporation in exchange for shares.  The twin brother’s basis in the car is $10, and the car is encumbered with Contingent liabilities of $9.  Upon contribution, Corporation assumes $9 of Contingent liabilities attached to the car.  If Contingent liabilities are counted as regular liabilities, then twin brother’s basis in controlled Corporation’s shares is $1 (i.e., same as his brother [Mr. A] in above example, or basis of $10 adjusted for $9 of liabilities assumed, i.e., $10 less $9, resulting in basis of $1).  However, if the Contingent liabilities do not enter the calculus of basis, then the basis of Mr. A’s twin brother in the shares of the controlled corporation is $10 (i.e., basis in car of $10 without negative adjustment for Contingent liabilities).

The respective courts in the Black & Decker and Coltec cases ruled in accordance with choice “b” above, in that the controlled corporation’s assumption of Contingent liabilities did not affect the contributor’s basis in the controlled corporation’s shares.  This was primarily due to IRC Section 357(c)(3)(A), wherein it is provided that liabilities assumed by the controlled corporation in the context of a tax-deferred incorporation (i.e., IRC Section 351 transaction), which will later give rise to a deduction by the controlled corporation, are explicitly excluded from negatively adjusting the contributor’s basis (i.e., such liabilities do not affect the contributor’s basis in the shares of the controlled corporation).

Thus, the base-line statutory issue decided in the above-cited cases was whether Contingent liabilities fit within the purview of the excluded IRC Section 357(c)(3)(A) liabilities (i.e., liabilities that will later give rise to a deduction by the controlled corporation).

Aside from the base-line statutory issue, the Government also strongly interposed the argument that the Taxpayers were not eligible to invoke the IRC Section 357(c)(3)(A) excluded liability statutory benefit, as the Government contended that the Taxpayers engaged in the subject transactions merely to obtain the resultant tax benefits devoid of the requisite independent non-tax benefits.

However, the Government lost in its efforts to have the Taxpayers’ transactions ignored or set aside as a sham, otherwise known as the “economic substance” doctrine.  Incidentally, the “economic substance” doctrine manifests itself into different case law doctrines known as the “business purpose” doctrine, the “substance over form” doctrine, and the “sham transaction” doctrine.  All these doctrines generally point to the same underlying administrative power of the IRS to ignore a transaction, for US federal tax purposes, where it is successfully argued that the taxpayer engaged in a transaction or set of transactions as a mere device for the ensuing tax benefits, as opposed to normal and customary business or corporate purposes.

The factual common denominator between the Black & Decker and Coltec cases may best be explained through the following hypothetical set of facts.  Incidentally, the amounts used in the hypothetical example are not materially distant from the facts of both cases.

Each respective Taxpayer identified Contingent liabilities in its business or line of business.  In the course of a series of corporate transactions, the Taxpayers transferred approximately $US 350 million dollars to a controlled corporation and professionally valuated contingent liabilities of $US 349 million.  Each respective Taxpayer asserted the position that its basis in the controlled corporation shares was $US 350 million dollars (i.e., the amount of actual cash funds without offset for the Contingent liabilities assumed).  Subsequently, each respective Taxpayer sold its shares in its controlled corporation for approximately $US 1 million dollars, thus, realizing and recognizing a capital loss of $US 349 million dollars.  Each Taxpayer utilized the capital loss to offset other capital gains (from the sale of other lines of business), and thus made a claim for refund.  In each case, the Government was ordered to issue each Taxpayer its rightful refund.

Ramifications of Decision of the Black & Decker and Coltec Cases to Taxpayers

One may argue that in an environment of tax shelter regulations, listed transactions, IRS attacks on abusive tax-shelters, and other crackdowns on what some practitioners may assert to be traditional tax planning, these cases are a welcome change to the judicial and legal current.

However, the above-cited cases do not create new principles or engender new judicial concepts in that, such cases invoke and utilize well-settled principles of tax law, as opposed to newly created ones.  There are many cases (too many to cite) that stand for the following propositions:

a) The tax laws are highly technical statutes, and thus, as long as the taxpayer abides by and fits within the four corners of a clear and unambiguous Statute, the tax effect of the literal words of the statute will govern, irrespective of the taxpayer’s motive.

b) The words of the Statute will be given their plain and ordinary meaning.

c) It is not for the judiciary to divine the Legislature’s intent, but rather give effect to the Legislature’s intent by interpreting the tax laws as written.

On the other side, there are a plethora of cases that have recognized the power of the IRS to set aside transactions that it believes to be (or are successfully proven to be) a “sham”.

The questions become: What should tax practitioners do with the Black & Decker and Coltec cases? Should these cases be thrown into the bi-polar world of the vast judicial history of sham transaction cases and forgotten, or should these cases have a special place in the world of US federal tax judicial precedent?

In other words, what is so special about these cases?

J&R maintains that the Black & Decker and Coltec cases add new glosses to judicial interpretation of the US federal tax law, and thus, should be segregated and monitored for potentially deeper ramifications as a platform for a shift in judicial thinking of the “economic substance” doctrine (with its related permutations, i.e., the “business purpose” doctrine, the “substance over form” doctrine, and the “sham transaction” doctrine).

Many sham transaction cases reach their conclusions through a judicial evaluation of the following variables:

a) Chronology of consideration of non-tax purpose(s) to the transactions (i.e., what was the business purpose and when did it arise relative to the identification of the tax benefits that would ensue from the transactions?)  Many cases hold that the tax benefits must be an after-thought, i.e., the non-tax benefits, chronologically, must come first in the taxpayer’s consideration and evaluation of whether to commence the transaction.

b) Universe of events that are taken into account when considering or applying the sham transaction doctrine (i.e., when does the court’s factual inquiry begin and end relative to the circumstances considered in the application of the “sham transaction” doctrine?)  Many cases hold that every single fact from the beginning to the end of a series of transactions is considered when applying the “sham transaction” doctrine(s).

The Black & Decker and Coltec cases appear to maintain the following, which J&R suggests may be a turning point in jurisprudence relative to the “sham transaction” doctrine, and thus, may act as a fertile venue for tax planning:

1) The tax benefits of a transaction or series of transactions may be considered at the inception of Company management’s consideration of a transaction or a series of transactions.  The tax benefits do not have to necessarily be a “by-product” of the transaction’s corporate or business purposes, but rather may be considered alongside and coincident with such purposes; and

2) The respective courts did not necessarily look at the series of transactions from beginning to end, but rather looked at each prong of the series as a matter unto itself.

In conclusion, these developments are meaningful.  While the “sham transaction” doctrine case law and its progeny are difficult to calibrate, and in some cases, predict, there appears to be a shift in the judiciary’s thinking and evaluation of these matters.  Thus, these cases, as long as they are not successfully appealed or overturned, may provide some comfort to practitioners that they may practice their trade, i.e., to come as close to the “line” as legally permissible without breaching the “line”.  J&R will monitor, and keep you informed of, these developments.