Whither corporate tax shelters?

• Author: Lipton, Richard M.
• Position: Tax shelter litigation

Within the last several months, two important decisions were issued by the courts concerning so-called corporate tax shelters. In the first decision, ASA Investerings Partnership v. Commissioner, T.C. Memo. 1998-305 (Aug. 20, 1998), the Tax Court found a new way to attack a corporate tax shelter that was marketed by an investment bank. By disregarding the partnership created for the transaction, the Tax Court disallowed the claimed tax benefits to Allied Signal, the large U.S. corporation that had invested in the tax shelter. In the second decision, ACM v. Commissioner, 151 F. 3d 231 (3d Cir. Oct. 13, 1998), a divided panel of the Court of Appeals for me Third Circuit affirmed the Tax Court's decision in ACM v. Commissioner, T.C. Memo. 1997-115 (Mar. 5,1997).(1) The appeals court, however, did not accept the Tax Court's reasoning, and the well-reasoned dissent suggests that further controversy is likely.

This article analyzes Investerings and ACM.(2) After setting forth the facts and holdings in these decisions, the article analyzes the strengths and weaknesses of these opinions and then considers the effect of these cases on tax planning as well as the burgeoning market for corporate tax shelters. Although each of these decisions has analytical problems, the facts support the courts' conclusions. More important, these decisions confirm how hard it is for a corporation to attempt to reduce its tax liability using a corporate tax shelter obtained from a promoter such as an investment bank. These decisions should not, however, limit the ability of corporations to structure transactions to minimize their tax liability.

Investerings

This case arose from the audit of a partnership, ASA Investerings Partnership (ASA). Although ASA was a partnership, the "real" taxpayer in the case was AlliedSignal, Inc., a large Delaware corporation that produces aerospace and automotive products. In January 1990, AlliedSignal decided to sell it interest in Union Texas Petroleum Holdings, Inc. (UTP), an oil, gas, and petrochemical company. AlliedSignal expected to sell UTP before February 1991 and realize a capital gain of approximately $450 million in this transaction.

The Merrill Lynch Proposal. One of the members of the board of directors of AlliedSignal was also on the board of Merrill, Lynch & Co. He knew that Merrill Lynch had developed a tax proposal that could create capital losses to shelter AlliedSignal's anticipated capital gain. He also was associated with another corporation that had utilized this strategy. At his urging, AlliedSignal decided to explore this strategy.

In February 1990, representatives of Merrill Lynch described the plan to AlliedSignal. The proposal, according to Merrill Lynch's representatives, included the following steps:

1. A partnership created by Merrill Lynch is formed between AlliedSignal and a foreign partner not subject to U.S. taxation. 2. The partnership is capitalized with cash contributions, primarily from the foreign partner, who will be the majority partner after the initial contributions. 3. The partnership purchases high-grade, floating rate private placement notes (PPNs), which include put options permitting the notes to be sold to the issuer at par. 4. The partnership sells the PPNs for consideration consisting of 80-percent cash and 20-percent indexed installment LIBOR notes. 5. The partnership reports the sale of the PPNs using the installment method under section 453 of the Internal Revenue Code. The gain is allocated according to each partner's partnership interest (i.e., the foreign partner recognizes most of the gain). 6. The partnership purchases high-grade financial instruments. Income on such instruments is allocated among the partners. 7. AlliedSignal buys a portion of the foreign partner's interest and becomes the majority partner. 8. The partnership distributes the LIBOR notes to AlliedSignal and cash to the foreign partner. AlliedSignal sells the LIBOR notes and recognizes a tax loss. 9. The partnership liquidates. Merrill Lynch explained that the PPN sale could be reported pursuant to the installment sale rules. Under these rules, a small fraction of the PPNs' basis would be used to calculate the gain on the sale and the remaining basis would be allocated to the LIBOR notes. Thus, the PPN sale would create a large capital gain and the LIBOR note sale would create a large capital loss. The tax-exempt foreign partner would be allocated most of the capital gain, and AlliedSignal would realize the capital loss.

   Merrill Lynch further explained that the proposal was a package deal. Merrill Lynch would serve as the partnership's financial adviser and, for a $7 million fee, recruit the foreign partner and arrange for the issuance and sale of the PPNs and the LIBOR notes. To ensure a market for such issuance and sale, Merrill Lynch would structure and enter into the requisite swap transactions. Merrill Lynch would also serve as the partnership's financial intermediary, earning additional fees. The foreign partner would charge AlliedSignal the greater of $2.85 million or 75 basis points on funds advanced to the partnership. As a result, AlliedSignal would incur total expenses for the entire transaction between $11.3 and $12.6 million.

   Board Approval. In March 1990, the Treasurer and Vice President of Taxes of AlliedSignal presented the proposed plan to the company's Chairman and CEO, with the recommendation that the plan be approved because of its tax advantages. The proposal was submitted to the executive committee of the board of directors in mid-April 1990, which reviewed the plan and the proposed steps; the executive committee approved the proposal and an initial contribution of $110 million. Two weeks later, after a brief presentation of the proposal's potential tax benefits, the entire board of directors of AlliedSignal approved the venture.

   ABN. When the board of directors of AlliedSignal approved the Merrill Lynch proposal, it did not know the identity of the partners in the partnership. Indeed, AlliedSignal only knew that its partner would be an AA- or AAA-rated international bank that would participate in the venture at AlliedSignal's direction.

   Although AlliedSignal was not told, Merrill Lynch had selected Algemene Bank Netherlands N.V. (ABN) to serve as the foreign partner. ABN had participated in several similar transactions designed by Merrill Lynch. Furthermore, ABN and AlliedSignal already had a banking relationship, which ABN hoped to strengthen through this transaction.

   From ABN's perspective, the transaction was treated as a loan. ABN followed its standard procedures for processing loans in excess of $25 million, including approval through the North American credit committee, the foreign credit committee, and bank headquarters.

   The transaction required ABN to form two corporations to which it would lend $990 million, which these corporations would then contribute to a partnership. The internal ABN documents to obtain approval for these loans emphasized the anticipated repayment schedule under which the ABN-related foreign partners would be taken out of the partnership. These documents also noted that the transaction was undertaken because AlliedSignal had a capital gain tax liability and this transaction would cure that liability.

   From an economic perspective, ABN viewed the transaction as yielding a profit of 75 basis points through interest and fees, resulting in net income of $5.5 million to ABN. ABN knew that the partnership's income would not be sufficient to generate this level of income, so that the balance would be made up by direct payments from AlliedSignal.

   Even with this projected income, ABN was concerned about the possibility of a loss on the sale of the PPNs, which would be held by the partnership for a limited period of time. ABN's loan officer assured ABN management that any such loss would be added to the value of the LIBOR notes and ultimately be borne by AlliedSignal. This aspect of the transaction could not be put into writing, but ABN management was assured that unless any such loss was paid for by AlliedSignal, ABN would prevent the distribution of the LIBOR notes to AlliedSignal, thereby eliminating the tax benefits of the deal.

   Formation of ASA. On April 17, 1990, representatives of AlliedSignal and ABN met for the first time in Bermuda. At this meeting, the parties negotiated the "Bermuda Agreement," which focused on the formation of ASA as well as ABN's expected return and the venture's transaction costs.

   Pursuant to the Bermuda Agreement, AlliedSignal agreed to pay all of the partnership's expenses and a return to ABN equal to its cost of money (approximately LIBOR) plus 75 basis points. These payments to ABN would be made through a combination of income allocations from ASA as well as the direct payment of fees and other amounts to ABN by AlliedSignal, with the direct payments equalling the difference between partnership allocations and the required return. ABN and AlliedSignal also agreed that ABN would receive partial repayment of the amount advanced in August 1990 and March 1991, with the balance being repaid by May 1992.

   On April 18, 1990, AlliedSignal formed AlliedSignal Investment Corp. (ASIC), a wholly owned subsidiary, to serve as one of the partners in ASA. On the same day, two foundations controlled by ABN Trust, an ABN affiliate in Curacao, formed Barber Corp. N.V. (Barber) and Dominguito Corp. N.V. (Dominguito) to serve as partners in ASA. Barber and Dominguito were each capitalized with $6,000; the corporations then entered into loan agreements that allowed Berber and Dominguito to borrow money from ABN, with the loans being secured by Barber's and Dominguito's interests in ASA. In addition, each foundation granted ABN an irrevocable option to acquire, at par value (i.e., for $3,000), the shares of the respective corporation that each foundation owned.

   On April 19, 1990, AlliedSignal, ASIC, Barber, and...