H.R. 2345, the Abusive Tax Shelter Shutdown and Taxpayer Accountability Act of 2007 and economic substance

Last week there was an interesting article on Tax Notes Today as to a pending bill pertaining to Economic substance. But just as quickly, i.e. in a blink of an eye, it was removed. However, this did not stop the story from having a life of its own as I and a few tax litigators debated was it really going to pass. That debate is sill ongoing.

But for those who have not seen the pending language, William Caudill from Fulbright & Jaworski’s Houston office, was kind enough to forward me the legislation that is pending before Congress as to Economic Substance. As they say here its:

H.R. 2345

To amend the Internal Revenue Code of 1986 to curb tax abuses by disallowing tax benefits claimed to arise from transactions without substantial economic substance, and for other purposes.

IN THE HOUSE OF REPRESENTATIVES

MAY 16, 2007

A BILL

To amend the Internal Revenue Code of 1986 to curb tax abuses by disallowing tax benefits claimed to arise from transactions without substantial economic substance, and for other purposes.  Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,


SECTION 1. SHORT TITLE; ETC.
(a) SHORT TITLE. -- This Act may be cited as the "Abusive Tax Shelter Shutdown and Taxpayer Account ability Act of 2007".
(b) AMENDMENT OF 1986 CODE. -- Except as other wise expressly provided, whenever in this Act an amendment or repeal is expressed in terms of an amendment to, or repeal of, a section or other provision, the reference shall be considered to be made to a section or other provision of the Internal Revenue Code of 1986.
(c) TABLE OF CONTENTS. -- The table of contents for this Act is as follows:
Sec. 1. Short title; etc.
Sec. 2. Findings and purpose.

TITLE I -- PROVISIONS DESIGNED TO CURTAIL TAX SHELTERS

Sec. 101. Clarification of economic substance doctrine.

Sec. 102. Modification of penalty for failing to disclose reportable transaction.

Sec. 103. Penalty for understatements attributable to transactions lacking economic substance, etc.

Sec. 104. Required disclosure by material advisors not subject to claim of confidentiality.

Sec. 105. Understatement of taxpayer's liability by income tax return preparer.

Sec. 106. Frivolous tax submissions.

Sec. 107. Denial of deduction for interest on underpayments attributable to nondisclosed
reportable and noneconomic substance transactions.

TITLE II -- OTHER PROVISIONS

Sec. 201. Expanded authority to disallow tax benefits under section 269.

Sec. 202. Modifications of certain rules relating to controlled foreign corporations.

Sec. 203. Basis for determining loss always reduced by nontaxed portion of dividends.

SEC. 2. FINDINGS AND PURPOSE.
(a) FINDINGS. -- The Congress hereby finds that:
(1) Many corporate tax shelter transactions are complicated ways of accomplishing nothing aside from claimed tax benefits, and the legal opinions justifying those transactions take an inappropriately narrow and restrictive view of well-developed court doctrines under which --
(A) the taxation of a transaction is determined in accordance with its substance and not merely its form,
(B) transactions which have no significant effect on the taxpayer's economic or beneficial interests except for tax benefits are treated as sham transactions and disregarded,
(C) transactions involving multiple steps are collapsed when those steps have no substantial economic meaning and are merely designed to create tax benefits,
(D) transactions with no business purpose are not given effect, and
(E) in the absence of a specific congressional authorization, it is presumed that Congress did not intend a transaction to result in a negative tax where the taxpayer's economic position or rate of return is better after tax than before tax.
(2) Permitting aggressive and abusive tax shelters not only results in large revenue losses but also undermines voluntary compliance with the Internal Revenue Code of 1986.
(b) PURPOSE. -- The purpose of this Act is to eliminate abusive tax shelters by denying tax attributes claimed to arise from transactions that do not meet a heightened economic substance requirement and by repealing the provision that permits legal opinions to be used to avoid penalties on tax underpayments resulting from transactions without significant economic substance or business purpose.

TITLE I -- PROVISIONS DESIGNED TO CURTAIL TAX SHELTERS

SEC. 101. CLARIFICATION OF ECONOMIC SUBSTANCE DOCTRINE.
(a) IN GENERAL. -- Section 7701 is amended by redesignating subsection (p) as subsection (q) and by inserting after subsection (o) the following new subsection:
"(p) CLARIFICATION OF ECONOMIC SUBSTANCE DOCTRINE; ETC. --
"(1) GENERAL RULES. --
"(A) IN GENERAL. -- In applying the economic substance doctrine, the determination of whether a transaction has economic substance shall be made as provided in this paragraph.
"(B) DEFINITION OF ECONOMIC SUBSTANCE. -- For purposes of subparagraph (A) --
"(i) IN GENERAL. -- A transaction has economic substance only if --
"(I) the transaction changes in a meaningful way (apart from Federal tax effects and, if there are any Federal tax effects, also apart from any foreign, State, or local tax effects) the taxpayer's economic position, and
"(II) the taxpayer has a substantial nontax purpose for entering into such transaction and the transaction is a reasonable means of accomplishing such purpose.
"(ii) SPECIAL RULE WHERE TAXPAYER RELIES ON PROFIT POTENTIAL. -- A transaction shall not be treated as having economic substance by reason of having a potential for profit unless --
"(I) the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected, and
"(II) the reasonably expected pre-tax profit from the transaction exceeds a risk-free rate of return.
"(C) TREATMENT OF FEES AND FOREIGN TAXES. -- Fees and other transaction expenses and foreign taxes shall be taken into account as expenses in determining pre-tax profit under subparagraph (B)(ii).
"(2) SPECIAL RULES FOR TRANSACTIONS WITH TAX-INDIFFERENT PARTIES. --
"(A) SPECIAL RULES FOR FINANCING TRANSACTIONS. -- The form of a transaction which is in substance the borrowing of money or the acquisition of financial capital directly or indirectly from a tax-indifferent party shall not be respected if the present value of the deductions to be claimed with respect to the transaction is substantially in excess of the present value of the anticipated economic returns of the person lending the money or providing the financial capital. A public offering shall be treated as a borrowing, or an acquisition of financial capital, from a tax-indifferent party if it is reasonably expected that at least 50 percent of the offering will be placed with tax-indifferent parties.
"(B) ARTIFICIAL INCOME SHIFTING AND BASIS ADJUSTMENTS. -- The form of a transaction with a tax-indifferent party shall not be respected if --
"(i) it results in an allocation of in come or gain to the tax- indifferent party in excess of such party's economic income or gain, or
"(ii) it results in a basis adjustment or shifting of basis on account of over stating the income or gain of the tax-indifferent party.
"(3) DEFINITIONS AND SPECIAL RULES. -- For purposes of this subsection --
"(A) ECONOMIC SUBSTANCE DOCTRINE. -- The term `economic substance doctrine' means the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.
"(B) TAX-INDIFFERENT PARTY. -- The term `tax-indifferent party' means any person or entity not subject to tax imposed by subtitle A. A person shall be treated as a tax-indifferent party with respect to a transaction if the items taken into account with respect to the transaction have no substantial impact on such person's liability under subtitle A.
"(C) SUBSTANTIAL NONTAX PURPOSE. -- In applying subclause (II) of paragraph (1)(B)(i), a purpose of achieving a financial accounting benefit shall not be taken into account in determining whether a transaction has a substantial nontax purpose if the origin of such financial accounting benefit is a reduction of income tax.
"(D) EXCEPTION FOR PERSONAL TRANSACTIONS OF INDIVIDUALS. -- In the case of an individual, this subsection shall apply only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income.
"(E) TREATMENT OF LESSORS. -- In applying subclause (I) of paragraph (1)(B)(ii) to the lessor of tangible property subject to a lease, the expected net tax benefits shall not include the benefits of depreciation, or any tax credit, with respect to the leased property and subclause (II) of paragraph (1)(B)(ii) shall be disregarded in determining whether any of such benefits are allowable.
"(4) OTHER COMMON LAW DOCTRINES NOT AFFECTED. -- Except as specifically provided in this subsection, the provisions of this subsection shall not be construed as altering or supplanting any other rule of law, and the requirements of this subsection shall be construed as being in addition to any such other rule of law.
"(5) REGULATIONS. -- The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this subsection. Such regulations may include exemptions from the application of this subsection.".
(b) EFFECTIVE DATE. -- The amendments made by this section shall apply to transactions entered into after the date of the enactment of this Act.

SEC. 102. MODIFICATION OF PENALTY FOR FAILING TO DISCLOSE REPORTABLE TRANSACTION.
(a) INCREASE IN PENALTY FOR LARGE ENTITIES AND HIGH NET WORTH INDIVIDUALS. --
(1) IN GENERAL. -- Subsection (b) of section 6707A is amended to read as follows:
"(b) AMOUNT OF PENALTY. --
"(1) IN GENERAL. -- Except as provided in paragraph (2), the amount of the penalty under subsection (a) shall be --
"(A) $10,000 in the case of a natural person who is not a high net worth individual,
"(B) $100,000 in the case of a large entity or a high net worth individual, and
"(C) $50,000 in any other case.
"(2) LISTED TRANSACTION. -- The amount of the penalty under subsection (a) with respect to a listed transaction shall be --
"(A) $100,000 in the case of a natural person who is not a high net worth individual, and
"(B) $200,000 in any other case.".
(2) LARGE ENTITIES AND HIGH NET WORTH INDIVIDUALS DEFINED. -- Subsection (c) of section 6707A is amended by adding at the end the following new paragraphs:
"(3) LARGE ENTITY. -- The term `large entity' means, with respect to any taxable year, a person (other than a natural person) with gross receipts in excess of $10,000,000 for the taxable year in which the reportable transaction occurs or the preceding taxable year. Rules similar to the rules of paragraph (2) and subparagraphs (B), (C), and (D) of paragraph (3) of section 448(c) shall apply for purposes of this subparagraph.
"(4) HIGH NET WORTH INDIVIDUAL. -- The term `high net worth individual' means, with respect to a reportable transaction, a natural person whose net worth exceeds $2,000,000 immediately before the transaction.".
(b) RESTRICTION OF AUTHORITY TO RESCIND PENALTY. -- Paragraph (1) of section 6707A(d) is amended by striking "and" at the end of subparagraph (A), by redesignating subparagraph (B) as subparagraph (E), and by inserting after subparagraph (A) the following new subparagraphs:
"(B) the person on whom the penalty is imposed has a history of complying with the requirements of this title, "(C) it is shown that the violation is due to an unintentional mistake of fact,
"(D) imposing the penalty would be against equity and good conscience, and".
(c) EFFECTIVE DATE. -- The amendments made by this section shall apply to returns and statements the due date for which is after the date of the enactment of this Act.

SEC. 103. PENALTY FOR UNDERSTATEMENTS ATTRIBUTABLE TO TRANSACTIONS LACKING ECONOMIC SUBSTANCE, ETC.
(a) IN GENERAL. -- Subchapter A of chapter 68 is amended by inserting after section 6662A the following new section:

"SEC. 6662B. PENALTY FOR UNDERSTATEMENTS ATTRIBUTABLE TO TRANSACTIONS LACKING ECONOMIC SUBSTANCE, ETC.
"(a) IMPOSITION OF PENALTY. -- If a taxpayer has an noneconomic substance transaction understatement for any taxable year, there shall be added to the tax an amount equal to 40 percent of the amount of such understatement.
"(b) REDUCTION OF PENALTY FOR DISCLOSED TRANSACTIONS. -- Subsection (a) shall be applied by substituting `20 percent' for `40 percent' with respect to the portion of any noneconomic substance transaction understatement with respect to which the relevant facts affecting the tax treatment of the item are adequately disclosed in the return or a statement attached to the return.
"(c) NONECONOMIC SUBSTANCE TRANSACTION UNDERSTATEMENT. -- For purposes of this section --
"(1) IN GENERAL. -- The term `noneconomic substance transaction understatement' means any amount which would be an understatement under section 6662A(b)(1) if section 6662A were applied by taking into account items attributable to non- economic substance transactions rather than items to which section 6662A would apply without regard to this paragraph.
"(2) NONECONOMIC SUBSTANCE TRANSACTION. -- The term `noneconomic substance transaction' means any transaction if --
"(A) there is a lack of economic substance (within the meaning of section 7701(p)(1)) for the transaction giving rise to the claimed tax benefit or the transaction was not respected under section 7701(p)(2), or
"(B) the transaction fails to meet the requirements of any similar rule of law.
"(d) RULES APPLICABLE TO COMPROMISE OF PENALTY. --
"(1) IN GENERAL. -- If the 1st letter of proposed deficiency which allows the taxpayer an opportunity for administrative review in the Internal Revenue Service Office of Appeals has been sent with respect to a penalty to which this section applies, only the Commissioner of Internal Revenue may compromise all or any portion of such penalty.
"(2) APPLICABLE RULES. -- The rules of paragraphs (3), (4), and (5) of section 6707A(d) shall apply for purposes of paragraph (1).
"(e) COORDINATION WITH OTHER PENALTIES. -- Except as otherwise provided in this part, the penalty imposed by this section shall be in addition to any other penalty imposed by this title.
"(f) CROSS REFERENCES. -- "(1) For coordination of penalty with understatements under section 6662 and other special rules, see section 6662A(e).
"(2) For reporting of penalty imposed under this section to the Securities and Exchange Commission, see section 6707A(e).".
(b) COORDINATION WITH OTHER UNDERSTATEMENTS AND PENALTIES. --
(1) Subparagraph (A) of section 6662(d)(2) is amended by inserting "and without regard to items with respect to which a penalty is imposed by section 6662B" before the period at the end.
(2) Subsection (e) of section 6662A is amended --
(A) in paragraph (1), by inserting "and noneconomic substance transaction understatements" after "reportable transaction understatements" each place it appears,
(B) in paragraph (2)(A) and (3), by inserting "and noneconomic substance transaction understatement" after "reportable transaction understatement",
(C) in paragraph (2)(B), by inserting "6662B or" before "6663",
(D) in paragraph (2)(C)(i), by inserting "or section 6662B" before the period at the end, and
(E) in paragraph (2)(C)(ii), by inserting "and section 6662B" after "This section", and
(F) by adding at the end the following new paragraph:
"(4) NONECONOMIC SUBSTANCE TRANSACTION UNDERSTATEMENT. -- For purposes of this subsection, the term `noneconomic substance transaction understatement' has the meaning given such term by section 6662B(c).".
(c) CLERICAL AMENDMENT. -- The table of sections for part II of subchapter A of chapter 68 is amended by inserting after the item relating to section 6662A the following new item:
"Sec. 6662B. Penalty for understatements attributable to transactions lacking economic substance, etc.".
(d) EFFECTIVE DATE. -- The amendments made by this section shall apply to transactions entered into after the date of the enactment of this Act. Sections 6662(d)(2)(A) and 6662A(e) of the Internal Revenue Code of 1986 shall apply to such transactions to the extent such sections relate to such amendments.

SEC. 104. REQUIRED DISCLOSURE BY MATERIAL ADVISORS NOT SUBJECT TO CLAIM OF CONFIDENTIALITY.
(a) IN GENERAL. -- Paragraph (1) of section 6112(b) is amended by adding at the end the following new flush sentence: "For purposes of this section, the identity of any person on such list shall not be privileged.".
(b) EFFECTIVE DATE. -- The amendment made by this section shall take effect as if included in the amendments made by section 142 of the Deficit Reduction Act of 1984.

SEC. 105. UNDERSTATEMENT OF TAXPAYER'S LIABILITY BY INCOME TAX RETURN PREPARER.
(a) STANDARDS CONFORMED TO TAXPAYER STANDARDS. -- Section 6694(a) (relating to understatements due to unrealistic positions) is amended --
(1) by striking "realistic possibility of being sustained on its merits" in paragraph (1) and inserting "reasonable belief that the tax treatment in such position was more likely than not the proper treatment",
(2) by striking "or was frivolous" in paragraph (3) and inserting "or there was no reasonable basis for the tax treatment of such position", and
(3) by striking "Unrealistic" in the heading and inserting "Improper".
(b) AMOUNT OF PENALTY. -- Section 6694 is amended --
(1) by striking "$250" in subsection (a) and inserting "$1,000", and
(2) by striking "$1,000" in subsection (b) and inserting "$5,000".
(c) EFFECTIVE DATE. -- The amendments made by this section shall apply to documents prepared after the date of the enactment of this Act.

SEC. 106. FRIVOLOUS TAX SUBMISSIONS.
(a) CIVIL PENALTIES. -- Section 6702 is amended to read as follows:

"SEC. 6702. FRIVOLOUS TAX SUBMISSIONS.
"(a) CIVIL PENALTY FOR FRIVOLOUS TAX RETURNS. -- A person shall pay a penalty of $5,000 if --
"(1) such person files what purports to be a return of a tax imposed by this title but which --
"(A) does not contain information on which the substantial correctness of the self-assessment may be judged, or
"(B) contains information that on its face indicates that the self-assessment is substantially incorrect; and
"(2) the conduct referred to in paragraph (1) --
"(A) is based on a position which the Secretary has identified as frivolous under sub section (c), or
"(B) reflects a desire to delay or impede the administration of Federal tax laws.
"(b) CIVIL PENALTY FOR SPECIFIED FRIVOLOUS SUBMISSIONS. --
"(1) IMPOSITION OF PENALTY. -- Except as provided in paragraph (3), any person who submits a specified frivolous submission shall pay a penalty of $5,000.
"(2) SPECIFIED FRIVOLOUS SUBMISSION. -- For purposes of this section --
"(A) SPECIFIED FRIVOLOUS SUBMISSION. -- The term `specified frivolous submission' means a specified submission if any portion of such submission --
"(i) is based on a position which the Secretary has identified as frivolous under subsection (c), or
"(ii) reflects a desire to delay or impede the administration of Federal tax laws.
"(B) SPECIFIED SUBMISSION. -- The term `specified submission' means --
"(i) a request for a hearing under --
"(I) section 6320 (relating to no tice and opportunity for hearing upon filing of notice of lien), or
"(II) section 6330 (relating to notice and opportunity for hearing before levy), and
"(ii) an application under --
"(I) section 6159 (relating to agreements for payment of tax liability in installments),
"(II) section 7122 (relating to compromises), or
"(III) section 7811 (relating to taxpayer assistance orders).
"(3) OPPORTUNITY TO WITHDRAW SUBMISSION. -- If the Secretary provides a person with no tice that a submission is a specified frivolous sub mission and such person withdraws such submission within 30 days after such notice, the penalty imposed under paragraph (1) shall not apply with respect to such submission.
"(c) LISTING OF FRIVOLOUS POSITIONS. -- The Secretary shall prescribe (and periodically revise) a list of positions which the Secretary has identified as being frivolous for purposes of this subsection. The Secretary shall not include in such list any position that the Secretary determines meets the requirement of section 6662(d)(2)(B)(ii)(II).
"(d) REDUCTION OF PENALTY. -- The Secretary may reduce the amount of any penalty imposed under this section if the Secretary determines that such reduction would promote compliance with and administration of the Federal tax laws.
"(e) PENALTIES IN ADDITION TO OTHER PENALTIES. -- The penalties imposed by this section shall be in addition to any other penalty provided by law.".
(b) TREATMENT OF FRIVOLOUS REQUESTS FOR HEARINGS BEFORE LEVY. --
(1) FRIVOLOUS REQUESTS DISREGARDED. -- Section 6330 (relating to notice and opportunity for hearing before levy) is amended by adding at the end the following new subsection:
"(g) FRIVOLOUS REQUESTS FOR HEARING, ETC. --
Notwithstanding any other provision of this section, if the Secretary determines that any portion of a request for a hearing under this section or section 6320 meets the requirement of clause (i) or (ii) of section 6702(b)(2)(A), then the Secretary may treat such portion as if it were never submitted and such portion shall not be subject to any further administrative or judicial review.".
(2) PRECLUSION FROM RAISING FRIVOLOUS ISSUES AT HEARING. -- Section 6330(c)(4) is amended --
(A) by striking "(A)" and inserting "(A)(i)";
(B) by striking "(B)" and inserting "(ii)";
(C) by striking the period at the end of the first sentence and inserting "; or"; and
(D) by inserting after subparagraph (A)(ii) (as so redesignated) the following:
"(B) the issue meets the requirement of clause (i) or (ii) of section 6702(b)(2)(A).".
(3) STATEMENT OF GROUNDS. -- Section 6330(b)(1) is amended by striking "under subsection (a)(3)(B)" and inserting "in writing under subsection (a)(3)(B) and states the grounds for the requested hearing".
(c) TREATMENT OF FRIVOLOUS REQUESTS FOR HEARINGS UPON FILING OF NOTICE OF LIEN. -- Section 6320 is amended --
(1) in subsection (b)(1), by striking "under subsection (a)(3)(B)" and inserting "in writing under subsection (a)(3)(B) and states the grounds for the requested hearing", and
(2) in subsection (c), by striking "and (e)" and inserting "(e), and (g)".
(d) TREATMENT OF FRIVOLOUS APPLICATIONS FOR OFFERS-IN-COMPROMISE AND INSTALLMENT AGREEMENTS. -- Section 7122 is amended by adding at the end the following new subsection:
"(f) FRIVOLOUS SUBMISSIONS, ETC. -- Notwith-standing any other provision of this section, if the Secretary determines that any portion of an application for an offer-in-compromise or installment agreement submitted under this section or section 6159 meets the requirement of clause (i) or (ii) of section 6702(b)(2)(A), hen the Secretary may treat such portion as if it were never submitted and such portion shall not be subject to any further administrative or judicial review.".
(e) CLERICAL AMENDMENT. -- The table of sections for part I of subchapter B of chapter 68 is amended by striking the item relating to section 6702 and inserting the following new item:
"Sec. 6702. Frivolous tax submissions.".
(f) EFFECTIVE DATE. -- The amendments made by this section shall apply to submissions made and issues raised after the date on which the Secretary first prescribes a list under section 6702(c) of the Internal Revenue Code of 1986, as amended by subsection (a).

SEC. 107. DENIAL OF DEDUCTION FOR INTEREST ON UNDERPAYMENTS ATTRIBUTABLE TO NONDISCLOSED REPORTABLE AND NONECONOMIC SUBSTANCE TRANSACTIONS.
(a) IN GENERAL. -- Subsection (m) of section 163 is amended to read as follows:
"(m) INTEREST ON UNPAID TAXES ATTRIBUTABLE TO NONDISCLOSED REPORTABLE TRANSACTIONS AND NONECONOMIC SUBSTANCE TRANSACTIONS. -- No deduction shall be allowed under this chapter for any interest paid or accrued under section 6601 on any underpayment of tax which is attributable to --
"(1) the portion of any reportable transaction understatement (as defined in section 6662A(b)) with respect to which the requirement of section 6664(d)(2)(A) is not met, or
"(2) any noneconomic substance transaction understatement (as defined in section 6662B(c))."
(b) EFFECTIVE DATE. -- The amendments made by this section shall apply to transactions after the date of the enactment of this Act in taxable years ending after such date.

TITLE II -- OTHER PROVISIONS

SEC. 201. EXPANDED AUTHORITY TO DISALLOW TAX BENEFITS UNDER SECTION 269.
(a) IN GENERAL. -- Subsection (a) of section 269 (relating to acquisitions made to evade or avoid income tax) is amended to read as follows:
"(a) IN GENERAL. --
If -- "(1)(A) any person acquires stock in a corporation, or
"(B) any corporation acquires, directly or indirectly, property of another corporation and the basis of such property, in the hands of the acquiring corporation, is determined by reference to the basis in the hands of the transferor corporation, and
"(2) the principal purpose for which such acquisition was made is evasion or avoidance of Federal income tax by securing the benefit of a deduction, credit, or other allowance,
then the Secretary may disallow such deduction, credit, or other allowance.".
(b) EFFECTIVE DATE. -- The amendment made by this section shall apply to stock and property acquired after the date of the enactment of this Act.

SEC. 202. MODIFICATIONS OF CERTAIN RULES RELATING TO CONTROLLED FOREIGN CORPORATIONS.
(a) LIMITATION ON EXCEPTION FROM PFIC RULES FOR UNITED STATES SHAREHOLDERS OF CONTROLLED FOREIGN CORPORATIONS. -- Paragraph (2) of section 1297(e) (relating to passive investment company) is amended by adding at the end the following flush sentence:
"Such term shall not include any period if there is only a remote likelihood of an inclusion in gross income under section 951(a)(1)(A)(i) of subpart F income of such corporation for such period.".
(b) DETERMINATION OF PRO RATA SHARE OF SUBPART F INCOME. -- Subsection (a) of section 951 (relating to amounts included in gross income of United States shareholders) is amended by adding at the end the following new paragraph:
"(4) SPECIAL RULES FOR DETERMINING PRO RATA SHARE OF SUBPART F INCOME. -- The pro rata share under paragraph (2) shall be determined by disregarding --
"(A) any rights lacking substantial economic effect, and
"(B) stock owned by a shareholder who is a tax-indifferent party (as defined in section 7701(m)(3)) if the amount which would (but for this paragraph) be allocated to such shareholder does not reflect such shareholder's economic share of the earnings and profits of the corporation.".
(c) EFFECTIVE DATE. -- The amendments made by this section shall apply to taxable years on controlled foreign corporation beginning after the date of the enactment of this Act and to taxable years of United States shareholder in which or with which such taxable years of controlled foreign corporations end.
SEC. 203. BASIS FOR DETERMINING LOSS ALWAYS REDUCED BY NONTAXED PORTION OF DIVIDENDS.
(a) IN GENERAL. -- Section 1059 (relating to corporate shareholder's basis in stock reduced by nontaxed portion of extraordinary dividends) is amended by redesignating subsection (g) as subsection (h) and by inserting after subsection (f) the following new subsection: "
(g) BASIS FOR DETERMINING LOSS ALWAYS REDUCED BY NONTAXED PORTION OF DIVIDENDS. -- The basis of stock in a corporation (for purposes of determining loss) shall be reduced by the nontaxed portion of any dividend received with respect to such stock if this section does not otherwise apply to such dividend.".
(b) EFFECTIVE DATE. -- The amendment made by this section shall apply to dividends received after the date of the enactment of this Act.

EC Term of Years Trust v. United States, - U.S. - (2007) Statutory Analysis wins!

The Supreme Court held that as to third party wrongful levy actions there is a specific statute § 7426(a)(1) that governs this area. Therefore, the limitations period for a tax refund action under 28 U.S.C. § 1346(a)(1) does not apply. The outcome is not a surprise but the analysis in the decision, albeit short and simple, again raises questions as to the strategy being employed by the Government in its battles as to tax shelters.

The facts in this case are as follows: After two individuals established a Trust, the IRS assessed federal tax liabilities against them for what the Government claimed were unwarranted income tax deductions in an earlier taxable year. The Government assumed that the individuals had transferred assets to the Trust to evade taxes, and so filed a tax lien against the Trust. The Trust denied any obligation, but for the sake of preventing disruptive collection efforts by the IRS, it deposited funds in a bank account, which the IRS levied upon.

Almost a year after that, the Trust brought a civil action under § 7426(a)(1) claiming wrongful levies, but the District Court dismissed it because the com-plaint was filed after the 9-month limitations period had expired. See § 6532(c)(1). The court also noted that tax-refund claims under 28 U.S.C. § 1346(a)(1) were not open to the plaintiff trusts because § 7426 "'affords the exclusive remedy for an innocent third party whose property is confiscated by the IRS to satisfy another person's tax liability.'" At first the Trust sought review by the Court of Appeals for the Fifth Circuit, but then voluntarily dismissed its appeal. After unsuccessfully pursuing a tax refund at the administrative level, the Trust filed a second action - a refund under § 1346(a)(1). The District Court remained of the view that a claim for a wrongful levy under § 7426(a)(1) had been the sole remedy possible and dismissed. The Court of Appeals for the Fifth Circuit affirmed.

The Supreme Court agreed with the Fifth Circuit. The Supreme Court stated:

 In a variety of contexts the Court has held that a precisely drawn, detailed statute pre-empts more general remedies.” Brown v. GSA, 425 U.S. 820, 834 (1976). . . Resisting the force of the better-fitted statute requires a good countervailing reason, and none appears here. Congress specifically tailored § 7426(a)(1) to third party claims of wrongful levy, and if third parties could avail them-selves of the general tax refund jurisdiction of § 1346(a)(1), they could effortlessly evade the levy statute's 9-month limitations period thought essential to the Government's tax collection.


Interestingly Brown reads as follows:

In a variety of contexts the Court has held that a precisely drawn, detailed statute pre-empts more general remedies. In Preiser v. Rodriguez, supra, for example, state prisoners whose good-time credits had been canceled for disciplinary reasons brought suit under the Civil Rights Act of 1871, as amended, 42 U.S.C. s 1983, in conjunction with a habeas corpus action. Although acknowledging that the civil rights statute was, by its terms, literally applicable, we held that challenges to the fact or duration of imprisonment appropriately lie only under habeas corpus, the “more specific act.” Permitting such challenges to be brought under the general, civil rights statute, where exhaustion is not required, would undermine the “strong policy requiring exhaustion of state remedies” when prisoners challenge the length of their confinement. 411 U.S., at 488-490. The Court has reached similar results in cases in which injured federal employees have claimed the right to proceed under facially applicable tort recovery statutes. E. g., United States v. Demko, 385 U.S. 149 (1966) (18 U.S.C. s 4126; Federal Tort Claims Act); Patterson v. United States, 359 U.S. 495 (1959) (Federal Employees' Compensation Act; Suits in Admiralty Act); Johansen v. United States, 343 U.S. 427 (1952) (Federal Employees' Compensation Act; Public Vessels Act). We have consistently held that a narrowly tailored employee compensation scheme pre-empts the more general tort recovery statutes. See also Fourco Glass Co. v. Transmirra Products Corp., 353 U.S. 222 (1957); Stonite Products Co. v. Melvin Lloyd Co., 315 U.S. 561 (1942) (in patent cases, venue is governed exclusively by statute dealing specifically with patent cases; general venue statute held inapplicable).

Thus, Supreme Court is clear if the statute is clear, then there is no need to use a general remedy. The question then becomes can someone explain to me what is going on in the tax shelter wars, i.e. is a general remedy superseding the governing statutes? Personally, I do believe so but the more the IRS becomes solely reliant on the economic substance doctrine rather than the code then this potential problem can come to fruition.

In its battles with the Tax Shelters, the IRS has relied on the judicial doctrine of economic substance. Said economic substance does not have one definition but has, at my count, four different variations to its flavor. Thus, depending on which Circuit you live in and/or were you filed the proceeding – you may have a chance to win the underlying case and the penalties while in other circuits/venues “it ain’t happening captain.” Maybe this is the dilemma that the Judge in Jade Trading is confronting and why she continues to asks the parties to file briefs when a new tax shelter opinion case comes out.

The bottom line is that I have heard government officials’ side step this issue and rationalize that there is no need for economic substance to be defined in the code. They can rationalize it all they want but the bottom line is that it suits the Government’s needs not to have standard because they are winning these cases. But this come at a price – the expense of treating similarly treated in a consistent manner. Personally, that is too a high price to win this battle. Remember government who is supposed to wear the white hats.

Don’t misunderstand my point to be of advocating these shelters because that is not my point. My point is very simple, and I do recognize it is also complex; a taxpayer should be entitled to rely on the plain meaning of a statute and be held to the language and the intent contained in the statute. How that is achieved while balancing a fair and equitable tax system is the open question which we have not been able to answer since the beginning of time.

But mark my words, which every tax litigator knows, there will come a time when the pendulum swings back to rigid construction. Is EC Term of Years Trust, the case that swings the pendulum – who knows? But with Jade Trading still out there and numerous son-of-boss cases being set for trial in the Tax Court before Judge Halpern and Judge Laro, we will get our answer shortly.

Call it the Government just being obstinate or worse call it for what it is - just plain dumb idea - Klamath Strategic Investment Fund, LLC v. United States, --- F.Supp.2d ----, 2007 TNT 66-9 (E.D.Tex.. 2007). (Part II).

Well the Government asked the Court to reconsider its opinion. Let’s just say for the Government that said motion was not a wise choice but for taxpayers in the Fifth (and maybe the Eleventh) they say “Thank You”!!!

Not only did the Court not reconsider its opinion but it further elaborated as to why the plaintiff’s were entitled to deduct operational and interest expenses. Bottom line – It looks like the taxpayers did a lot better than they would have if they had agreed to the settlement initiative offered by the IRS.

The Court in two paragraphs dismissed the Government’s motion to reconsider and focused on the Government’s argument as to disallowing the operational expenses claimed by the plaintiffs.

The government had two arguments -- 1) No deduction can be taken for expenses related to a sham transaction, and 2) Presidio, as the managing partner, did not have the requisite profit motive. As to the first argument the Government stated that expenses incurred in connection with a transaction that lacks economic substance are not deductible and that the fees associated with a loan can only be deducted if the underlying debt is determined to be genuine. The plaintiffs disagreed and the Court agreed with the plaintiffs.

The Court looked at the cases cited by the Government and politely accused the government of misrepresenting what the cases actually held. The Court found that the cases cited by the Government were not as broad as the Government contended but limited to disallow only the losses generated as part of the sham transactions. The Court found that in contrast “The operating expenses were real economic losses and were never going to be recovered as a part of the loan transactions that lacked economic substance. When the taxpayers executed these loan transactions, they expected to repay them in full and the taxpayers planned to use those loan proceeds for the purpose of making a profit.”


“Furthermore, a court "may not ignore transactions that have economic substance even if the motive for the transaction is to avoid taxes.". "Even where a transaction is not intended to serve business purposes, it may give rise to a deduction to the extent that it has objective economic substance apart from tax benefits." The plaintiffs in this case incurred actual economic losses which are separable from the tax benefits of the premium loan transactions. Some of these economic losses involve the fees paid to Presidio as part of the investment plan, the losses from the foreign currency transactions, and the interest expenses from the loan. Although these losses relate to the premium loan transactions, they were real and are separable from the tax benefits associated with those loans.”  (citations Omitted).

Now that analysis really hurts. In the shelters I have seen this language from the Court will come into play – it’s called cash out of pocket and the Court determined that  cash out of pocket losses can be deducted. This Court’s position clearly goes against the IRS’s announcements of no cash out pocket for those that did not partake in the IRS's settlement initiatives.

As to the second argument the government argued that it is the partnership's primary motive, rather than the individual partners' profit motives, that governs the deductibility of expenses. The Plaintiffs argued that it was the individual taxpayers that paid and claimed the expenses.

The Court agreed with the Plaintiffs. The Court found that the plaintiffs had entered into these transactions for the purposes of making a profit. So even though the partnership arguably did not have a profit motive, the Court applied an aggregate not an entity theory and allowed the expenses to be claimed by the individual taxpayers. Call this a major ouch!

There was no analysis conducted by the Court - No Tefra, No aggregate/entity. If I were the Government I would leave this case alone and not appeal but it is the Government and this is a major loss.


So when the Government trumpets its victory in Jade Trading (I know I am jumping the gun) just remember what Lee Corso says – “Not so fast my friend” because in Klamath you got hammered!! The taxpayer for all practical purposes won – No penalties and deductibility of cash out of pocket.

Celebration time at the IRS!

Did you hear that champagne cork pop from Washington, D.C.? I think we all did as this past week the Supreme Court denied certiorari in Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). The obvious question becomes - Now What?

Well first the obvious – The opinion as to Jade Trading should be coming out shortly and it should be in the favor of the government. This is not a difficult conclusion to make after all the Court of Claims is bound by the Federal Circuit and the parties had agreed to postpone the Court’s ruling until Coltec’s appeal. It appears that the Court just wanted to see the appeal run its course. Thus, for all those pending cases in the Court of Claims the outcome is pretty well settled and the only remaining question will be one of penalties.

The interesting question is what will the IRS do with it new toy? Well with the Son of Boss cases pending in the United States Tax Court, we can and should expect the IRS to seek to have the Coltec standard applied in these cases. That is, the worst kept secret is that the IRS was disappointed with the result in Salina v. Commissioner, T.C. Memo 2000-352. Yes, the the IRS did win its section 752 argument but Judge Jacob’s refused to accept the Coltec argument as submitted by the IRS. Rather, Judge Jacobs looked at the entire transaction for purposes of applying the economic substance doctrine. As stated in the opinion:

"Contrary to respondent's position, we decline to analyze the economic substance of the disputed transaction by focusing solely on events occurring during the period December 28 through 31, 1992. Segregating FPL's investment in Salina into two parts, as respondent suggests, would violate the principle that the economic substance of a transaction turns on a review of the entire transaction. See Kirchman v. Commissioner, supra at 1493-1494; Winn-Dixie Stores, Inc. v. Commissioner, supra at 280. Although we agree with respondent that Goldman Sachs structured FPL's purchase of the Salina partnership interest to provide FPL with a perceived tax benefit, this factor, standing alone, is insufficient to render the transaction a sham in substance. "

With Coltec out there, one should expect the IRS to try again and persuade the United States Tax Court to reconsider its position. Personally, I hope the entire Court visits the economic substance doctrine.  Even though I question various aspects of the Tax Court’s opinion in Estate of Bongard v. Commissioner, 124 T.C. 95 (2005), Bongard gave tax litigators and planners an opportunity to examine/reexamine the merits of family limited partnerships. I believe most tax litigators/tax planners would likewise want to hear the full court's views on economic substance.  Stated bluntly, the Court is a national forum and there is too much intellectual and judicial talent to have it spent on due process hearing cases and I want to hear, for better or for worse, what the full Court has to say on this important judical doctrine.

But if I were the IRS I would be very careful as to which cases I would seek to apply the Coltec standard. After all not all tax deferral mechanisms are tax shelters. For example, the IRS might be emboldened to bring out the Coltec standard in a LILO case. Yes, I am familiar with the case in North Carolina but that LILO case was the exception not the general rule. Most LILO cases involve legitimate factual issues. The IRS’s pointing to interest earning financial instruments while interest deductions are being claimed may not be sufficient - After all can we say UPS.

In United Parcel Service of America v. Commissioner, 254 F. 3d 1014 (11th Cir. 2001), the Eleventh Circuit in an eight page opinion disposed of the one hundred plus page opinion of the Tax Court. In the Eleventh Circuit’s opinion at page 1019, the Court stated:

“A “business purpose” does not mean a reason for a transaction that is free of tax considerations. Rather, a transaction has a “business purpose,” when we are talking about a going concern like UPS, as long as it figures in a bona fide, profit-seeking business. See ACM P'ship v. Comm'r, 157 F.3d 231, 251 (3d Cir.1998). This concept of “business purpose” is a necessary corollary to the venerable axiom that tax-planning is permissible. See Gregory v. Helvering, 293 U.S. 465, 469, 55 S.Ct. 266, 267, 79 L.Ed. 596 (1935) (“The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.”).”

Thus, I would humbly submit that not even the Coltec standard could withstand the UPS standard if the facts involved an aggressive but legitimate LILO. As they say we shall see.

Ramblings: So what was argued in Klamath Strategic Investment Fund, LLC v. United States, --- F.Supp.2d ----, 2007 WL 283790 (E.D.Tex.. 2007)?

I will “blame” the severe weather conditions in the Northeast for the lack of cases reported this week. But thanks to Tax Notes Today, tax practitioners were able to see what the Government argued in Klamath and taxpayer’s response.

Before I get to those arguments, if you like this kind of transparency then take notice that the United States Tax Court is accepting comments as to the amendments to its proposed rules. Under the proposed rules, only if you live in the Washington DC area will you have access to its electronic filings. Otherwise, you will still have to contact the Docket room and obtain a hard copy.

Simply stated, I don’t like it. Two points, the IRS gets full access as should all private practitioners not just those private practitioners that live in the DC area and can go by the Court house and review the case of interest. Second, the United States Tax Court must strive to be fully transparent. See Estate of Kanter v. Commissioner, T.C. Memo. 2007-21 and it looks like they have not learned that lesson. I mean wouldn’t you just love to see what exactly the Special Trial Judge’s report actually said, compare it to the IRS’s brief and then compare to the opinion. I bet, without seeing that STJ report, the IRS’s brief equals the final opinion. Oh well, just a guess but I digress. To Klamath, I go.

As stated in the blog of two weeks ago, the Government’s “victory” was to ask the Court to accept its argument raised in Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1356-57 (Fed.Cir.2006), i.e. the transaction to be analyzed is the particular transaction that gives rise to the tax benefit. In its brief the Government argued:

"When applying the economic substance doctrine, courts have taken pains to emphasize that the transaction to be analyzed is the particular transaction that gave rise to the tax benefit, and not collateral transactions which do not produce tax benefits. Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1356-57 (Fed. Cir. 2006); Nicole Rose Corp. v. Comm'r., 320 F.3d 282, 283-84 (2d Cir. 2002); ACM P'ship v. Comm'r., 157 F.3d 231, 260 (3d Cir. 1998); Long-Term Capital Holdings v. United States, 330 F. Supp 2d 122, 171 (D. Conn. 2004).

For example, in the recent Coltec decision, the Federal Circuit explained that the taxpayer had missed the point when it attempted to prove that the creation of a subsidiary, and the transfer of certain management activities of its business to that subsidiary, had a business purpose (454 F.3d at 1358): "Here . . . we must focus on the transaction that gave the taxpayer a high basis in the stock and thus gave rise to the alleged benefit upon sale. That transaction is Garrison's assumption of Garlock's asbestos liabilities in exchange for the $375 million note. . . . It is this exchange that provided Garlock with the high basis in the Garrison stock, this exchange whose tax consequence is in dispute, and therefore it is this exchange on which we must focus."

The Government then focused solely on the transaction that gave rise to the tax benefit - the premium loan and argued that the leg had no economic substance. Question: Is the line becoming a little blurry as to the economic substance doctrine and the step-transaction doctrine? Most private practitioners recognize that there is a distinction between the two doctrines even thought the doctrines are kissing cousins. Yet, it appears that the two doctrines are morphing into one.

After all if one compares Klamath, Coltec with True v. United States, 190 F.3d 1165, 1177 (10th Cir.1999) what do we get? [ As stated in True at 1177:  “To ratify a step transaction that exalts form over substance merely because the taxpayer can either (1) articulate some business purpose allegedly motivating the indirect nature of the transaction or (2) point to an economic effect resulting from the series of steps, would frequently defeat the purpose of the substance over form principle.”]. I would respectfully submit that the judicial doctrines are being morphed together and we are moving farther away from a clearly defined test and are being left with a glorified smell test. Thus, it will be interesting to see what the United States Supreme Court does with Coltec. For if Coltec is reversed then it appears that the Government’s one pony ride on the back of Cotlec will cause Klamath to be overturned assuming it is appealed.

Klamath was also note worthy as to the taxpayer’s victory as to the penalties. Surprisingly the Government’s brief gave little argument as to the 40% penalty – no case law analysis, no argument other than a “one paragraph argument “which submitted that the 40% penalty was applicable. Then the Government attacked the reasonable cause defense based on the following arguments:

  • “In the first place, plaintiffs' due diligence was a sham itself. They failed to even inquire as to the profit performance of the 75 prior BLIPS deals in 1999 and 2000 (prior to their transactions); not one of which made a profit.” Needles to say, it is apparent that the Government is really insisting on the use of pattern evidence as to the penalty phase of the case. 
  • “Furthermore, their claim that they only belatedly learned of BLIPS' enormous tax benefits defies common sense.” The old common sense argument. This is usually an argument of last resort when the testimony is not to one’s liking or the trial attorney forgot to have his/her expert testify as to a point – such emphasizing after tax rate of return vs. economic rate of return.
  • “Plaintiffs' argue that they are not tax lawyers and relied upon professional advisors for tax advice. Here, the authors of these legal opinions had a conflict of interest. Lemons had discussed the design of the BLIPS tax shelter with Presidio before it was ever sold to Nix and Patterson, and both Holland & Hart and Olson Lemons had both represented Presidio and its principals on numerous corporate and tax matters concerning BLIPS in general -- including the question of whether or not to register BLIPS as a tax shelter.” Looks like the Government did bring out the 500lb monster (the attorneys work with the promoters argument) and lost big time. The fact is the code is complex and the law firms that were engaged in these transactions were highly reputable firms. What is a taxpayer to do? It appears that the Government is arguing that the taxpayer should disagree with a prestigious tax firm when they tell the taxpayer – “Yes, even though it looks to be good to be true, this really does comply with the tax code.”
  • “Moreover, these so-called legal opinions were worthless since their ultimate conclusion as to the allowance of the BLIPS tax benefits was based on the accuracy and correctness of information allegedly provided by the plaintiffs themselves.” The Government trotted out Long Term Capital and it came right back at them. End result - it left the Government feeling like Darius III at the Battle at Issus.

Not surprisingly, the taxpayers in Klamath argued that penalties were not warranted based on the following:

  • The Government had admitted that the transactions "complied with the literal provisions of the Internal Revenue Code.” As such there was substantial authority for the positions taken on the returns. 
  • The 40% penalty did not apply due to Weiner v. United States, 389 F.3d 152 (5th Cir. 2004); Heasley v. Comm'r, 902 F.2d 380, 383 (5th Cir. 1990).
  • Taxpayers relied on and in good faith on the advice of several qualified tax professionals.The taxpayers also obtained detailed opinions from prominent tax counsel. 
  • As to the theory that there was no due diligence as to the facts, the taxpayers submitted that the lawyers prepared the statement of facts from the underlying transactional documents and that they had Presidio review the fact statement to confirm its accuracy. In addition, the lawyers sent the opinions under cover letters that instructed the taxpayers to review the fact statements for accuracy and, had the taxpayers been silent, they would have taken that as an affirmative representation that the facts were accurate. The lawyers testified that it was common for a practitioner to prepare fact statements for opinions since the practitioner knows what representations are important to the issues at hand -- and to then have the taxpayers review and approve those representations. This argument was accepted by the Court when it stated “ That Holland & Hart and Olson Lemons (the attorneys) had access to all relevant transactional documents which were reviewed by Presidio for accuracy.” This is the part of the opinion that hurts the Government more than any other part of the opinion. Reason:  It puts Long Term Capital on its head.

In conclusion: With Long Term Capital, the Government had the perfect storm (Noble Prize winner who knew a little bit about economics, an oral tax opinion, etc.) but in these other shelters both sides have litigation risks. Once the Government understands that  the concept of hazards of litigation does apply to these cases then more cases will be settled in terms that are more likely than not favorable to the Government. What is that saying about pigs? Well government keep trying cases in circuits that are not favorable and you will end up just like that poor old hog.

Klamath, Estate of Kanter, and IRS's Announces Civil/Criminal Enforcement in Foreign Transactions

Two opinions were announced this week - Klamath Strategic Investment Fund, LLC v. United States, --- F.Supp.2d ----, 2007 WL 283790, (E.D.Tex.. 2007); Estate of Kanter v. Commissioner, T.C. Memo. 2007-21. These two opinions were highly anticipated as they afforded the respective Courts an opportunity to interpret new judicial doctrines/rules and answer questions concerning the trial judge’s role in evaluating and determining witness credibility.

In addition, in three separate publications, the IRS’s criminal and civil intentions as to foreign transactions were broadcast.

The inherent facts and issues of Klamath are set forth in: Dawson, COLTEC: A New Standard for Economic Substance, Business Entities (WG&L) (Nov./Dec. 2006). As stated in the article, there were three issues worth following: 1) Whether the Court would refine its application of the economic substance test in light of Coltec? As stated in the article they might and the Court did. 2) In light of the 5th Circuit’s ruling in Todd v. I.R.S., 862 F.2d 540 (5th Cir.1988), would the Court impose a 40% penalty for gross valuation misstatement? As stated in the article the Court would not and it did not as a matter of law. 3) Would the Court impose a 20% negligence penalty? No opinion offered was in the article as it was viewed as a question of fact. Based on the Court’s determination concerning the credibility of the witnesses no penalty was asserted.

Issue #1. The Court in citing to Compaq Computer Corp. v. Comm'r, 277 F .3d 778, 781-82 (5th Cir.2001) noted that the Compaq “declined, however, to consider whether a court must invalidate a transaction that fails only one of the prongs of the test.” Noting this declination, the Court decided that indeed only one of the prongs must be found to fail the economic substance test and the appropriate prong to test is the event that creates the tax loss, i.e. did that event have independent business purpose other than the creation of a tax loss. The Court stated:

“When applying the economic substance doctrine, courts emphasize that the transaction to be analyzed is the particular transaction that gives rise to the tax benefit, and not collateral transactions which do not produce tax benefits. Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1356-57 (Fed.Cir.2006).”

The Court then focused on the loan agreements and arrangements at issue and determined that the financial institutions and Presido never intended to implement the seven year plan. To the contrary, if necessary the financial institutions and Presido would have compelled the taxpayers to exit the strategy at the end of Stage I through financial pressure. In addition, Presidio’s fee arrangement as set forth in its Congressional testimony was predicated on the tax loss generated by the investment plan. Thus, taxpayer’s intent concerning the legitimate business reasons for the transaction was all for naught as Presidio and the financial institutions did not the “investment plan” in the same light.

From the Government’s perspective this could not be better news. The Court in the 5th Circuit applies Coltec and as stated in the blog of January 21, 2007 the Government’s use of pattern evidence was justified. That is, the Court stated that it can and should focus on the intent of all the parties of the transactions and not just the intent of the taxpayers. Thus, if the intent of one of the parties, i.e. a facilitator, and/or stage is dubious in terms of economic profit then the transaction will fail regardless of the taxpayer’s and the plan’s overall economic profit.

But as the saying goes the Government won the battle but lost the war. Taxpayer’s and their representatives have realized that as to the majority of these transactions it will be difficult to demonstrate that the investments have economic substance. (I still maintain that certain LILO’s may have economic substance even though RJT Investments ruling is to the contrary. See Blog dated January 14, 2007). Thus, the primary concern of many practitioners and taxpayers was/is the penalty(ies) issue.

As to the office of Chief Counsel, we have been hearing from them that the maximum amount of penalties would be sought and obtained. The IRS in various cases had done very well in obtaining the maximum amount of penalties it had sought. See Long Term Capital Holdings, Ltd. v. United States, 330 F.Supp.2d 122, 205 (D.Conn.2004); Santa Monica Pictures v. Commissioner, T.C. Memo. 2005-104. However none of the cases had been in the forum the IRS has sustained it’s more notable losses – the 5th Circuit. Well in this case the IRS not only failed to obtain the 40% penalty the IRS got zeroed out.

Issue #2 The IRS’s loss as to the 40% penalty was not surprising as it was based on a matter of law. Todd v. I.R.S., 862 F.2d 540 (5th Cir.1988); Heasley v. Commissioner, 902 F.2d 380, 383 (5th Cir.1990); Weiner v. U.S., 389 F.3d 152, 161-62 (5th Cir.2004). It is obvious that the IRS wanted to test the Court and see if they could get it to reconsider Todd as the Court in Santa Monica had done. One factor the IRS failed to consider was the forum it was in. In Santa Monica the forum was the Tax Court here it was a Federal District Court. [It should be noted that Santa Monica is currently on Appeal to the 9th Circuit]. Thus, the IRS losing on the 40% issue was not surprising.

Issue #3: However, the fact that no penalties were imposed is from the taxpayer’s perspective the victory that they have long sought. The reason is premised on how the Court arrived at its conclusion. The Court arrived at its conclusion by looking at the taxpayer’s particular facts and circumstance. The Court decision in Klamath as to the penalties focused on the primary role of the fact-finder – his assessment as to credibility of the primary witnesses. The Court found the taxpayer and their testimony to be credible. He found that they were not looking solely at the tax advantages of the transaction. To the contrary, the taxpayers had a continuous and ongoing relationship with their accountants and had asked their accountants to identify a firm that specialized in foreign currency trading.

The Court found the taxpayers to be credible when they testified that when they met with the representatives from Presido they had no discussions of tax issues surrounding the investments. Instead, the meeting was entirely devoted to the business opportunity being presented to the taxpayers. Rather, the Court found that from the time the taxpayers began considering foreign currency investments until the time they decided to invest with Presidio, their primary motives had been to make a profit. The Court found as credible their testimony that the reason for exiting the investment was due to other financial investments.

As to the tax advice received, the Court found the taxpayer’s evidence to be highly credible. The taxpayers sought the oral advice of a prominent tax lawyer who gave the transaction his blessing. (Compare with Long Term Capital). The fact that the taxpayers received a tax opinion from the law firm that represented Presidio was not troubling to the Court as the opinion was detailed, came from qualified attorneys, the taxpayer’s needed advice as to the transaction, and the taxpayers had determined for themselves that there was no conflict of interest with the opinion.

Needless to say, that part of the opinion is and will be a major blow to the IRS’s future endeavors in this area. For the Klamath Court has demonstrated a common sense resolution to the government’s argument of reliance of the “promoter’s agent” argument. The area is/was complex therefore why shouldn’t the taxpayer be entitled to rely on the opinions of reputable law firms? If the government says no, then the government needs to demonstrate that the taxpayers knew or should have known that the law firms in question were acting in a duplicitous manner. See Klamath’s opinion as to “Substantial Understatement of Income Tax”; “Disregard of Rule and Regulations” (“Contrary to the government's approach with respect to many of the other BLIPS investors, the IRS did not even bother to interview the taxpayers before it asserted the penalties. The court finds that no penalty should apply for disregard of rules or regulations.”) and “Reasonable Cause and Good Faith”.

Thus the government’s use of pattern evidence will be of limited value in the key issue in these cases – the imposition of penalties. If the question is of credibility of the witnesses, then the facts of the particular case will be of the up most relevance. Thus, the fact-finder, i.e. the particular judge’s, assessment of the witness and the evidence cannot be absconded by others. This brings me to the Estate of Kanter.

In Estate of Kanter, the key issue was the credibility of the witnesses. Tax Court Rule 183 states/stated and the Supreme Court noted that: “[d]ue regard ••• to the circumstance that the [s]pecial [t]rial [j]udge had the opportunity to evaluate the credibility of the witnesses,” must “presum[e] to be correct” fact findings contained in the report. . .” Ballard v. Commissioner, 544 U.S. 40, 45            (2005). Because of this failure to follow its own rules, the Tax Court’s decision in Kanter was overruled.

Tax Court 183 was subsequently amended and T.C. Rule 183(d) makes specific reference to the language cited by the Supreme Court. Curiously or rather enlightening,  the Kanter opinion does not highlight this language but rather highlights T.C. Rule 183(c) even though the Supreme Court and the 11th Circuit specifically brought to the attention of the United States Tax Court the above stated language of T.C. Rule 183(d).

Being that the case was one of first impression it is worth noting that the case was rendered as a T.C. Memo. opinion and not as a fully reviewed T.C. opinion. The Kanter opinion is over 450 pages long and is an attempt by the Court to explain to the 11th Circuit and the Supreme Court why the Tax Court’s original decision was correct and why the Special Trial Judge’s findings as to the witnesses and other key evidence should be given no weight at all.

The Tax Court interprets Tax Court Rule 183(c) as not providing a bar to new proposed findings of fact and leaves the matter within the discretion of the reviewing Judge. This is a rather broad read of T.C. Rule 183(c) as this interpretation gave the IRS and the Court the ability to make new findings of fact contrary to the findings of the Special Trial Judges report and contrary to the original findings proposed by the IRS awhich were objected to by petitioner’s counsel when the original trial and briefs were submitted. Simply stated we are not talking about Monday quarterbacking we are talking about Friday quarterbacking. 

Tthe Court’s docket sheet reflects a “no objection to the Special Trial Report” being filed by the Petitioners and Respondent filing an “objection to the Special Trial Report” rumored to be over a 1,000 pages long and certainly containing numerous proposed alternative findings of facts. One clear observation can be made as to Respondent’s alternative findings of fact - Petitioner was never afforded an opportunity to object to these alternative findings. Rather, according to the Court this is simply within the Court’s jurisprudence. Such an analysis by the Court’s is alarming and disturbing. This Court’s bedrock foundation is found in fairness amongst the parties and to the Court. Such fairness is found in the it’s discovery rules specifically the Branerton process, its rules as to expert testimony, and last but not least the Court rules concerning the briefing process under Tax Court 151.

Under Tax Court Rule 151, a party is afforded an opportunity to file objections to an opponent’s proposed finding of fact if said opponent has filed a brief in the case. Such position allows a party an opportunity to state for the record his/her/its objections to Respondent’s requested findings, i.e. it assures due process and does not allow Respondent or any other party an advantage in the brief processing. For this opinion to ignore such a premise/result and create a conflict as to its own rules is rather disturbing to all practitioners, i.e. is due process being ensured by this  ruling? 

Under its interpretation of new 183(c), the Court was given ample opportunity to ignore the STJ’s report and agree with Respondent and ignore the original findings as to the credibility of the witnesses. As the Court stated: “Thus, the Court does not feel constrained from correcting manifestly unreasonable findings of fact or making additional findings of fact, so long as any additional facts find direct support in the case record.”

In the ensuing opinion the Court reviewed Respondent’s requested additional findings of fact and for the majority of these new findings accepted them and rejected the STJ’s report as follows:

  • The Special Trial Judge misunderstood Respondent’s legal positions in the case. See for example the following findings made in the opinion:

o “The STJ report also incorrectly stated: "respondent's claim of fraud is not based, per se, on the payments by The Five to Kanter or any of the other entities to which such payments were directed.”
o “In addition, the statement in the STJ report limiting respondent's theory of fraud to the failure of Kanter, Ballard, and Lisle to report as income amounts "dropped down" to them in the form of loans is inaccurate and incomplete.”

  • Kanter’s testimony as well as other witnesses was in the eyes of Judge Haines unconvincing and advocacy in nature. See for example the following findings made in the opinion:

o “Errors in the STJ Report108- The STJ report was based on two fundamental misconceptions regarding respondent's position which resulted in (1) compelling evidence largely being ignored, (2) credibility determinations regarding The Five that were not relevant to a determination whether a kickback scheme existed among Kanter, Ballard, and Lisle, and (3) credibility determinations regarding Kanter, Ballard, and Lisle that were manifestly unreasonable. A detailed examination of the substantial record in these cases, along with a review of the parties' posttrial briefs, demonstrates that the ultimate holding recommended in the STJ report, i.e., that Kanter, Ballard, and Lisle did not participate in a kickback scheme, is directly contradicted by the overwhelming objective evidence in these cases and thus is manifestly unreasonable.”

In the next one hundred pages plus, the opinion details  the errors alleged to have been made by the sitting judge as to the credibility of the witnesses. Suffice it to say, that the opinion of this Judge is at odds with the opinion of the sitting judge. Suffice it to say that the observations of the Judge were made after Respondent had an opportunity to restate the record. Suffice it to say that the observations of the Judge were made over a number of years after the trial occurred and the witnesses are now deceased. Suffice it to say that it appears the instructions of the Supreme Court and the Eleventh Circuit appear to be ignored. Suffice it to say that we are looking at another Succession of McCord v. Commissioner, 461 F.3d 614 (5th Circuit 2006) or worse Dixon v. Commissioner, 316 F.3d 1041 (9th Cir. 2003) were now the Eleventh Circuit may be step in and by highly critical of the United States Tax Court..

Being that the Tax Court is an honorable institution and being that the opinion was not fully reviewed, I am forward enough to ask this honorable institution to vacate this decision on its own and determine whether Tax Court 183 was properly interpreted and applied in this proceeding.

Finally, in three different publications, (Tax Notes Today, the Wall Street Journal and BNA Daily Reports) the IRS announced that it intends to will include high-wealth individuals and tax practitioners in addition to business taxpayers under its new focus on coordinated international enforcement. See BNA Daily Tax Report for January 29, 2007. The BNA daily report stated that the “IRS will have some 500 of its 4,000 special agents trained in advanced international tax issues as part of the new strategy. Those agents will be segmented in "issue management teams" involving a number of technical issues, including foreign tax credits, hybrid arbitrage, and transfer pricing.” Call my blog of January  28th  a lucky guess.

What is in the Pipeline?

Being that I worked in the IRS’s Office of Chief Counsel for 13 years, the question tends to be asked: What are the issues that the IRS is looking at? My response is usually a shrug because I really do not know how the IRS determines what issues are the “hot issues.” But what I can relay to you is the advice that a very senior and experienced Special Trial Attorney once gave me: “If you want to know the issues that are on the radar screen read the journal.” This blog is not intended as a plug but since that time I have read the daily Tax Notes Reports, the BNA daily reports and the Wall Street Journal. Curiously, his advice has been rather accurate.

These trade journals in the last six moths have revealed that the usual cast of characters, Family Limited Partnerships (See January 6, 2007 Year in Review) and Tax Shelters (See Below), are alive and well. But, because of their success in these ventures, it appears that the IRS’s Office of Chief Counsel appears eager to venture back into the contentious area of section 482 and possibly into a new one Private Foundations.

For example, Tax Notes Today on November 15, 2006 issued a story on IRS Chief Counsel Donald Korb discussing recent internal tax guidance. Per the article, Mr. Korb states “that Chief Counsel is focused on “protecting the integrity of U.S. tax law in a global economy” by ‘keeping an eye on highly engineered and abusive transactions.”.” See Nadal, Korb Discusses International Tax Developments, Praises IRS’s Success, 2006 TNT 220-3. Now fast forward to this past week and another headline concerning the section 482 litigation that the IRS has undertaken. See Nutt, Another Transfer Pricing Dispute in the Litigation Pipeline, 2007 TNT 15-13. It appears due to the IRS recent well publicized settlement  in GlaxoSmithKline, the Office of Chief Counsel had gotten rid of the bad taste of  Xilinx v.  Commissioner, 125 T.C. 37 (2005);  Eli Lilly v. Commissioner, 856 F.2d 855 (7th Cir. 1988) revg. 84 T.C. 996; Bausch & Lomb v.Commissioner, 92 T.C. 525 (1989); Sundstrand v. Commissioner, 96 T.C. 226 (1991); Seagate Technology v. Commissioner, 102 T.C. 149 (1994). Throw in their victories in the tax shelter wars and you can feel the IRS’s confidence permeating through the air. So now the Office of Chief Counsel is seeking section 482 adjustments from Symantec Corp. See Docket No. 12075-06.

Word to the Wise to my fellow tax practitioners - Become familiar with the 482 regulations especially the new regulations issued under 482 during the summer of 2006. See T.D. 9278. See also Nutt, No Saftey in the Harbor: New Transfer Pricing Services Regs., 2006 TNT 167-4. The reason is simple Section 482 does not apply just to large multi-national corporations. It can and will be applied to mid-size corporations or any corporation that ventures into this area. Stated otherwise, the IRS is issuing these regulations for a reason and its litigators are once again becoming conversant in these complex regulations. Thus, expect 482 issues to once again surface. Therefore, it will be time again for lawyers and the accounting firms to work together in addressing the 482 issues and resolving the issue at the exam level and if need be visa vi litigation.

Observation: A successful strategy that I saw during my time with the Office of Chief Counsel was implemented by Baker& McKenzie. The strategy was to turn over a summary report, the economist report, and the underlying source documents that were compliant with the regulations under 6662, while retaining the entire legal analysis. See United States v. Bell, 1994 WL 665295 (N.D.Cal.1994). As to the attorney’s underlying analysis, the strategy was to preserve the work product doctrine and attorney client privilege. See United States v. Roxworthy, 457 F.3d 590 (6th Cir. 2006). Whether this strategy is successful in today’s environment of 26 C.F.R. § 1.6662-6, the tax shelter regulations/wars remains to be seen. See FIN 48 and Textron (Blog dated January 21, 2007).

Another topic that I have been seeing with regularity being discussed in the Wall Street Journal and the tax journals is in regard to non-profits/charitable organizations. A recent article in Tax Notes – VanDenburgh, Harmelink, Nichols, Various Motivations Behind Family Charitable Foundations, 114 Tax Notes 205 (Jan. 15, 2007) - provides an excellent overview of the positive/negatives of family charitable foundations. The article points out as well the abuses of the same and reminds the readers that the IRS has listed certain charitable organizations as “notorious tax scams”. The result was certain changes in the Pension Protection Act of 2006. Therefore, expect the IRS to monitor this area. The only question is who from the IRS will be monitoring the situation – i.e. check how the IRS is organized and you will certain divisions are limited in numbers. Last time I looked the Brahma Bulls of Chief Counsel’s office, the Special Trial Attorneys, were in the Large Business Division and they are rather busy with the shelter wars. The question for Chief Counsel’s office is - who is going to be the enforcer/hammer?

Then here is FIN 48. A blog is not the proper forum to discuss the issues surrounding this area but I would submit the following -both the attorneys and the accountants must work together on these matters. The IRS will be looking at the disclosures emanating from FIN 48 as part of their document request. Word to the wise – Become familiar better yet - know and understand FIN 48. If I were back in the Office of Chief Counsel, I would ask every revenue agent I was working with to issue an IDR as to every issue identified under FIN 48 in the first package of IDR’s.

Finally, there is the old and reliable economic substance doctrine. The government filed its objection to Coltec’s Writ for Certiorari. See 2007 TNT 16-16. No surprise as the Government acknowledges a new test and that there are various formulations to the economic substance test. The Government states that the Supreme Court should not grant Coltec’s Writ as no matter what standard was applied Coltec would lose. Query: Then why the need for the new standard, if not for the reason that the Federal Circuit did not believe that the other standards of its sister circuits were insufficient.

It will be interesting to see whether the Supreme Court accepts this case. For purposes of consistency to fellow taxpayers I hope the Supreme Court does. Otherwise, those living in the Fifth, and to an extent the Eleventh Circuit, will have a certain advantage as to the economic substance doctrine that are not found in the other circuits. See Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001) and United Parcel Service of America v. Commissioner, 254 F. 3d 1014 (11th Cir. 2001).

Lease-In/Lease-Out ("LILO") -BB&T Corporation v. United States

During my days working with the Office of Chief Counsel, I was fortunate to be involved in tax shelter litigation. In one of those meetings in Washington, D.C. a former deputy chief counsel uttered the phrase “not all LILO’s are bad”. Reason - LILO’s are factually intense. Surprise! A LILO case was decided through a motion for summary judgment – BB&T Corporation v. United States, 2007 TNT 4-19 (M.D. N.C. 2007).

BB&T, a financial service company, participated in a LILO transaction ("Transaction") with Sodra Cell AB ("Sodra"), a Swedish company, a world-wide manufacturer of wood pulp. The Transaction at issue involved the lease and sublease of the pulp manufacturing equipment (the "Equipment") at one of Sodra's pulp-manufacturing facilities.

During my days working with the Office of Chief Counsel, I was fortunate to be involved in tax shelter litigation. In one of those meetings in Washington, D.C. a former deputy chief counsel uttered the phrase “not all LILO’s are bad”. Reason - LILO’s are factually intense. Surprise! A LILO case was decided through a motion for summary judgment – BB&T Corporation v. United States, 2007 TNT 4-19 (M.D. N.C. 2007).

BB&T, a financial service company, participated in a LILO transaction ("Transaction") with Sodra Cell AB ("Sodra"), a Swedish company, a world-wide manufacturer of wood pulp. The Transaction at issue involved the lease and sublease of the pulp manufacturing equipment (the "Equipment") at one of Sodra's pulp-manufacturing facilities.

On June 30, 1997, Sodra and BB&T, through a trust, entered into the Transaction by executing a series of agreements. The Transaction consisted of a "Head Lease" in which BB&T acquired an undivided interest in the Equipment for a period of 36 years ending June 30, 2033 and an immediate shorter term sublease (the "Lease") of the undivided interest in the Equipment back to Sodra for a term of 15.5 years.

The Head Lease required BB&T to pay rent to Sodra in two installments. The first installment (the "initial Head Lease Payment"), approximately $86.2 million, was due on the closing date and was allocated to the first five years of the Head Lease term. The second installment (the "Deferred Head Lease Payment") of approximately $557.8 million was due in 2038, five years after the expiration of the Head Lease term, and was allocated to the last 31.5 years of the Head Lease term.

At Closing:

  • BB&T paid the Initial Head Lease Payment with $18,228,895 of its own funds plus $68,008,236 from a non-recourse loan from Hollandsche Bank-Unie N.V. ("HBU"). HBU was a wholly owned subsidiary of ABNAMBRO Bank N.V. ("ABN").
  • On June 30, 1997, ABN, on behalf of HBU, transferred $68,008,236 (the funds representing the HBU loan) into BB&T's Trust (the "Trust") account at ABN.  BB&T transferred $18,228,895 into the Trust account at ABN. Thus, at closing a total of $86,237,131 was deposited into the Trust account at ABN either by BB&T or on BB&T's behalf.
  • Sodra was required to pay $68,008,236 to ABN as "Debt PUA Issuer" under the Debt Payment Undertaking Agreement ("Debt PUA"). Under the Debt PUA, BN was obligated to make certain payments to BB&T on Sodra's behalf.
  • Sodra was required to pay $12,000,193 to Fleet National Bank ("Fleet") as the "Equity PUA Issuer" under the Equity Payment Undertaking Agreement ("Equity PUA"). Under the Equity PUA, Fleet was required to use the $12,000,193 to purchase certain government securities.

Sodra's Debt PUA and Equity PUA payments were made at closing as follows: (1) the Trust, on Sodra's behalf, made the $68,008,236 payment that Sodra was required to make to ABN as Debt PUA Issuer using proceeds of BB&T's first installment payment and (2), the Trust, on Sodra's behalf, made the $12,000,193 payment Sodra was required to make to the Equity PUA Issuer also using proceeds of BB&T's first installment payment. In sum, $86,237,131 was deposited into the Trust account at ABN either by BB&T or on BB&T's behalf. Of the total deposited by BB&T, $80,008,429 was paid on Sodra's behalf to the Equity PUA the Debt PUA, leaving a balance of $6,228,702, which the Trust transferred to Sodra's account at ABN. BB&T has described this $6 million payment as Sodra's "incentive for doing the deal."

Pursuant to the Lease, Sodra was required to make annual rent payments to BB&T. Sodra's rent payments were equal to BB&T's scheduled loan payments to HBU, in both amount and timing, through January 1, 2012. In addition, BB&T's scheduled debt payments to HBU on the HBU loan, and Sodra's annual rent payments to BB&T, were equal to the scheduled payments required by the Debt PUA, which obligated ABN to pay Sodra's rent during the Head Lease term directly to HBU, until January 1, 2012. The interest rate on the funds that Sodra paid to the Debt PUA Issuer was equal to the interest rate on the HBU loan. Thus, the Debt PUA payments from ABN to its subsidiary HBU satisfied both Sodra's rental obligations to BB&T under the sublease and BB&T's obligations to HBU under the loan agreement. Finally, the Debt PUA obligated ABN to make a final payment of $11,542,500 in 2013, either to or for the benefit of Sodra, depending on which of the options at the end of the Lease are exercised by the parties.

Net effect: Sodra received a $6 million dollar payment and continued to use the property the same before/after the transaction; ABN received $6,228,702 for its participation and Fleet was holding on to $12,000,193 which has been invested in government securities for someone’s benefit; and BB&T received the rental/lease and interest deductions, while having to report rental income.

HOLDING:

The Court stated that the parties agreed that the applicable doctrine was substance over form and cited to Frank Lyon Co. v. United States, 435 U.S. 561, 572 - 73 (1978). The Court then found that if BB&T wanted the rental deductions the facts had to establish that it had an interest in the property. Citing and analyzing the facts in Alstores Realty Corp. v. Comm'r, 46 T.C. 363, 371 (1966), the Court found that Sodra's use and possession of the Equipment was unaltered by the Transaction (but for BB&T's annual right of inspection). In particular, Sodra used, maintained, and serviced the Equipment as it did before the Transaction and even made significant investments in and improvements to the Equipment. In addition, Sodra was entitled to all of the profits generated from the use of the Equipment during the term of the Lease. Moreover, although the form of the transaction required Sodra to make rent payments to BB&T, those payments were in fact made by the Debt PUA, were funded in full by BB&T's Initial Head Lease Payment, and did not require Sodra to invest any of its own funds. Thus, the Court found that only a future interest in the property was conveyed to BB&T.

BB&T asserted that it bore an unlimited risk of loss in the vent certain options were not exercised. The Court found the Transaction was structured so that there was no risk to BB&T's initial (and only) cash outlay. Of the $18,228,895 million that BB&T initially transferred into the Trust account at ABN, $12,000,193 was paid to the Equity PUA to purchase certain government securities. The remainder of BB&T's equity investment, $6,228,702, was transferred to Sodra's account at ABN as Sodra's "incentive for doing the deal." In the event Sodra exercised the purchase option, the funds in the Equity PUA would be returned to BB&T through the payment of the purchase price. In the event Sodra did not exercise the purchase option and BB&T enforced the Sublease Renewal provision, the funds in the Equity PUA would be returned to BB&T through the Sublease Renewal rents. Moreover, BB&T's own internal documents noted that Sodra's Letter of Credit requirement added to BB&T's security that its initial investment, and anticipated after- tax yield, would be protected from the loss at all times.

The Court finally held that when the intermediate payment steps were disregarded, which must be done in order to consider the substance of the loan transaction and not the form selected by the parties, it became clear that the loan transaction was only a circular transfer of funds in which the HBU loan was paid from the proceeds of the loan itself. There was no money lent to BB&T in a substantive sense, and the HBU loan did not reflect genuine indebtedness.  The Court stated:

"For interest to accrue there must be an underlying indebtedness requiring an "unconditional and legally enforceable obligation for the payment of money." Autenreith v. Comm'r, 115 F.2d 856, 858 (3d Cir.1940), aff'g 41 B.T.A. 319 (1940). In this case, although the loan documents -- the form selected by the parties -- may provide that BB&T had a legal obligation to repay the loan, the transaction in fact -- the substance -- did not actually require BB&T to pay any money to HBU. Through the circular nature of the transaction, BB&T's purported principal and interest payments were actually paid from the proceeds of the loan itself. In fact, after the closing in June 1997, BB&T was not required to provide any additional funds over the life of the loan. As such, BB&T's purported interest payments could not be what Congress intended to allow as an income tax deduction. "

Year in Review - Tax shelters and the economic substance doctrine

The Court of Appeals overturned various lower court opinions and the Federal Circuit created yet another legal standard as to the economic substance. In Black & Decker Corp. v. United States, 436 F.3d 431 (4th Cir. 2006), which involved a transfer of stock in exchange, in part, for contingent liabilities, the Fourth Circuit remanded the case back to the lower court for consideration of the economic doctrine test under Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91 (4th Cir. 1985). In TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006), overturned the lower court decision based on “the totality-of-the-circumstances”. The 2d circuit cited as authority Commissioner v. Culbertson, 337 U.S. 733, 742 (1949), which is an assignment of income case. But by far the most important case was Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). In Coltec Industries, the Federal Circuit Court created a new standard for economic substance.

The Court of Appeals overturned various lower court opinions and the Federal Circuit created yet another legal standard as to the economic substance. In Black & Decker Corp. v. United States, 436 F.3d 431 (4th Cir. 2006), which involved a transfer of stock in exchange, in part, for contingent liabilities, the Fourth Circuit remanded the case back to the lower court for consideration of the economic doctrine test under Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91 (4th Cir. 1985). In TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006), overturned the lower court decision based on “the totality-of-the-circumstances”. The 2d circuit cited as authority Commissioner v. Culbertson, 337 U.S. 733, 742 (1949), which is an assignment of income case. But by far the most important case was Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). In Coltec Industries, the Federal Circuit Court created a new standard for economic substance. The standard consists of the following:

  1. A transfer of assets will be disregard if it lacks a business purpose other than reduce taxes. A lack of economic substance is sufficient to disqualify the transaction without proof that the taxpayer’s sole motive is tax avoidance. 
  2. The taxpayer bears the burden of proving that the transaction has economic substance. 
  3. The economic substance of the transaction must be viewed objectively rather than subjectively. 
  4. The transaction to be analyzed for economic substance is the transaction that gives rise to the alleged tax benefit not the legitimate transactions at the end of the line.  
      1. Arrangements with subsidiaries, i.e. related parties, that do not affect the economic interest of independent third parties deserve particularly close scrutiny.

For a thorough analysis of Coltec, see Dawson, COLTEC: A New Standard for Economic Substance, Business Entities (WG&L) (Nov./Dec. 2006)

On November 8, 2006, Coltec filed a Writ of Certiorari citing to the fact that there is a split amongst the Circuits as to proper applicable standard for the economic substance test and that the Coltec test is in conflict with those judicial standards.

Whether the Supreme Court accepts the case for review will be worth following, after all Congress has continuously been considering whether to adopt a uniform definition for economic substance and has postponed making a decision. The Supreme Court may view the definition of economic substance as a matter for Congress and therefore not accept the case.