The economic substance doctrine: sorting through the Federal Circuit's "we know it when we see it" ruling in Coltec.

• Author: Silverman, Mark J.

It is perhaps unfortunate, but the most recognizable line from a Supreme Court opinion may be Potter Stewart's "I know it when I see it" lament about the difficulty of defining obscenity in Jacobellis v. United States. (1) Justice Stewart's declaration was made in a short concurrence to a 1964 opinion overturning the conviction of Nico Jacobellis for showing the film "Les Amants" in his movie theater. The context of Justice Stewart's statement is usually omitted when it is cited:

I have reached the conclusion, which I think is confirmed at least by negative implication in the Court's decisions since Roth and Alberts, that under the First and Fourteenth Amendments criminal laws in this area are constitutionally limited to hardcore pornography. I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that. (Emphasis added.) Justice Stewart's declaration can be read as an honest admission of the limits of reason to discriminate between the acceptable and the offensive or it can be read as evasive and evidence of an unwillingness (or inability) to pursue consistency by formulating an objective standard.

One might raise a similar question about the Federal Circuit's recent decision in Coltec Industries, Inc. v. United States. (2) In Coltec, the Federal Circuit found that the taxpayer's capital loss on the sale of stock in a subsidiary was technically correct under the Internal Revenue Code, but that the loss should be disallowed because the transaction lacked "economic substance." The Federal Circuit's opinion offers an ambiguous and potentially expansive view of the economic substance doctrine. The opinion is difficult to decipher, and it is impossible to determine exactly what standard the Federal Circuit adopted and applied. In addition, the Federal Circuit applied its ambiguous standard of the economic substance doctrine to a single step of the transaction. The combination of the Federal Circuit's narrow focus on a single step of a transaction and its expansive view of the economic substance doctrine has the potential to distend the authority of the IRS to void the tax consequences that would otherwise flow from legitimate transactions. Although the court clearly found the transaction at issue offensive, the opinion shows a striking disregard for the possible implications of the decision.

A review of the history of U.S. obscenity law is helpful to understanding the implications the Federal Circuit's decision in Coltec. The Supreme Court first declared obscenity to be speech that was not protected by the First Amendment in Roth v. United States (3) in 1957. The general standard for obscenity set forth in Justice Brennan's majority opinion was material whose "dominant theme taken as a whole appeals to the prurient interest" to the "average person, applying contemporary community standards." This case triggered a wave of obscenity cases, culminating in Miller v. California (4) in 1973. In 1966, the Court refined Roth's obscenity test in Memoirs v. Massachusetts, (5) stating that for material to be beyond the pale of the First Amendment, "it must be established that (a) the dominant theme of the material taken as a whole appeals to a prurient interest in sex; (b) the material is patently offensive because it affronts contemporary community standards relating to the description or representation of sexual matters; and (c) the material is utterly without redeeming social value." Justice Stewart's famous "I know it when I see it" concurrence in Jacobellis occurred two years earlier. Finally, in 1973 Miller established a three-prong test that must be satisfied for a work to be obscene and therefore unprotected speech: (i) the average person, applying contemporary community standards must find that the work, taken as a whole, appeals to the prurient interest; (ii) the work depicts or describes, in a patently offensive way, sexual conduct or excretory functions specifically defined by applicable state law; and (iii) the work, taken as a whole, lacks serious literary, artistic, political, or scientific value.

There are striking parallels between the courts' struggle to articulate and apply standards against pornography and the judiciary's recent crusade against what appears to be a new form of obscenity--tax shelters. Recent cases demonstrate that the line between legitimate tax planning and "obscene" tax shelters is proving as equally difficult to draw as the line between art and unprotected pornography. Substitute "tax avoidance purpose" for "appeals to the prurient interest" and "economic reality" for "serious literary, artistic, political, or scientific value," and you essentially have the tenets of the economic substance test. As the Federal Circuit's opinion in Coltec demonstrates, the judiciary's effort to stanch tax shelters is quickly becoming as tortuous as past efforts to police obscenity.

The Transaction in Coltec

History of Contingent Liability Transactions Coltec was one of a series of cases in which the government challenged transactions involving the transfer of contingent liabilities and assets to a subsidiary followed by the sale of the subsidiary's stock. The contingent liabilities reduced the value of the stock of the subsidiary, but did not reduce the taxpayer's basis in the subsidiary's stock. Therefore the taxpayer realized a capital loss on the stock sale. (6)

On January 18, 2001, the Internal Revenue Service "listed" the contingent liability transaction in Notice 2001-17, 2001-9 I.R.B. 1, and announced that it will disallow losses generated by contingent liability transactions. Rev. Proc. 2002-67, 2002-43 I.R.B. 733, announced a settlement initiative giving taxpayers who engaged in transactions substantially similar to those described in Notice 2001-17 an opportunity to resolve their tax issues. The settlement initiative offered eligible taxpayers two methods to resolve their issues involving Contingent Liability Transactions--a fixed concession procedure and a fast-track dispute resolution procedure. These settlement proposals were relatively taxpayer-friendly compared with other IRS settlement initiatives. (7)

Section 358(h), which was added to the Code by the Community Renewal Tax Relief Act of 2000, provides that if the application of section 358 results in a stock basis that is higher than the fair market value, then basis shall be reduced by the liabilities, but not lower than the fair market value unless either of two exceptions applies: (i) the trade or business with which the liability is associated is transferred to the person assuming the liability as part of the exchange; or (ii) substantially all of the assets with which the liability is associated are transferred to the person assuming the liability as part of the exchange. The enactment of section 358(h) presumably eliminated the tax benefits of contingent liability transactions, though (as discussed below) certain questions remain. The transactions at issue in Coltec and other similar cases were entered into before the enactment of section 358(h).

Several taxpayers litigated and challenged the disallowance of the capital losses generated from a contingent liability transaction. One such transaction was addressed by the U.S. District Court of Maryland and the Fourth Circuit in Black & Decker v. United States. (8) Although the district court ruled in favor of the taxpayer, the Fourth Circuit reversed the decision and remanded the case for a determination whether the contingent liability transaction at issue had economic substance. (9)

History of Transaction in Coltec

In 1996, Coltec sold one of its businesses and recognized a capital gain of approximately $240.9 million. In prior years, one of Coltec's subsidiaries (Garlock, Inc.) had manufactured or distributed asbestos products and in 1996 was facing numerous lawsuits and potential liabilities. As a result of a recommendation from Arthur Andersen LLP, Coltec entered into a contingent liability transaction that involved the following steps: (i) Coltec renamed a dormant subsidiary Garrison Litigation Management Group, Ltd. (Garrison); (ii) Coltec caused Garrison to issue 99,800 shares of common stock and 1,300,000 shares of Class A stock to Coltec in exchange for $13,998,000 cash; (iii) Garlock transferred all the outstanding stock in one of its subsidiaries, Anchor Packing Company (Anchor), certain other property, and a $375 million note from one of its other subsidiaries (Stemco, Inc.) to Garrison, in exchange for 100,000 shares of common stock of Garrison (approximately a six-percent interest) and an agreement by Garrison to assume the liabilities incurred in connection with asbestos claims against Garlock. In addition, Garlock agreed to advance up to $200 million to Garrison to cover Garrison's capital needs. Finally, Garlock sold all of its 100,000 shares of Garrison stock to two banks for $500,000.

This transaction resulted in a $378.7 million capital loss to Garlock because the basis of the 100,000 shares was not reduced by the amount of the contingent liabilities resulting from the asbestos claims. Therefore Garlock's basis in the 100,000 shares was approximately $379.2 million (the $375 million note plus $4.2 million in other property).

The Federal Circuit's Opinion

The U.S. Court of Appeals for the Federal Circuit affirmed the Court of Federal Claims' opinion that the resulting capital loss was consistent with the technical operation of sections 351, 357, and 358 of the Internal Revenue Code. The court rejected the government's arguments that the basis should be reduced because (i) the liabilities would not give rise to a deduction under section 357(c)(3) or (ii) the principal purpose behind the assumption of liabilities was to avoid taxes under...