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Merck (Shering Plough) v. U.S.: Will One Taxpayer's Loss Benefit Other Taxpayers Grappling With The Codified Economic Substance Doctrine?

The Third Circuit yesterday issued a harshly worded rebuke to the taxpayer in Merck v. United States, No. 10-2775 (Jun. 20, 2011), affirming the District Court’s decision that the taxpayer’s swap-and-assign transaction was really a disguised loan that gave rise to Subpart F income.  (See TaxProfBlog for a link to the opinion.)

Described briefly, the transactions at issue involved a U.S. company that entered into interest rate swap contracts with a foreign bank.  The company then assigned its right to receive payments under the swaps to foreign subsidiaries in exchange for lump-sum payments.  The lump-sum payments were then to be repaid to the subsidiaries over the term of the swaps through their entitlement to receive payments from the foreign bank on the underlying swaps.

A simplified structure of the transactions is shown below (click on the image for a larger version):

The taxpayer treated the exchange of the swap rights for the lump-sum payments as a sale for federal tax purposes, arguing that the taxation of the transaction should be governed by IRS Notice 89-21, which set forth rules for the timing of income recognition for lump-sum payments made in connection with interest rate swaps.  The District Court, however, held that in substance the transactions amounted to loans by the foreign subsidiaries to the U.S. company because the swap payments received by the subsidiaries essentially repaid the lump-sum advance made by the subsidiaries to the U.S. company at the outset of the transaction.  Consequently, the transaction was treated as an “investment of earnings in United States property” under Code section 956, which gave rise to an inclusion of “subpart F” income on the U.S. company’s tax return.

The District Court’s decision was criticized by practitioners on a number of grounds; however, most troubling was the court’s superfluous examination of the transaction for its “economic substance.”  Though conceding that such an analysis was unnecessary (because the transactions could be recharacterized under the substance-over-form doctrine), the district court nevertheless concluded that the swap-and-assign transactions lacked economic substance.

While the superfluous use of the economic substance doctrine would be troubling in its own right, this sort of loose analysis raises an even more important issue in the world of a codified economic-substance doctrine.  As our readers know, Congress codified the “economic substance” doctrine in 2010, providing for a strict liability penalty against taxpayers where the doctrine is found to be relevant to a transaction and either (i) does not change the taxpayer’s economic position in a meaningful way or (ii) is not motivated by a substantial purpose apart from securing federal tax benefits.  Code section 7701(o).

Taxpayers and their advisors have recognized that determining the “relevance” of the economic substance doctrine will be a key dispute between taxpayers and the government in the coming years.  As I noted in a recent article in Taxes magazine about the codification of the doctrine, the chances of a transaction surviving a challenge on the basis of “economic substance” is not unlike the old chestnut about the “strict scrutiny” standard of review in constitutional law: it is “‘strict’ in theory and fatal in fact.”  Consequently, if the economic substance doctrine is determined to be “relevant” to a particular transaction, there is a significant risk of that transaction being disallowed and, after codification, a strict-liability penalty being imposed.

The text of section 7701(o) suggests, and IRS officials have repeatedly stressed, that the “relevance” of the doctrine will be determined in light of existing case law.   Where a court, such as the District Court in Schering-Plough, examines a transaction for its economic substance, even though no such examination was necessary to reach the court’s holding, is the doctrine to be considered relevant to that transaction (and other substantially similar transactions that may arise in the future)?  A blurring of the line between the economic substance doctrine and other anti-abuse doctrines – such as substance-over-form – increases the risk that the doctrine, and its strict-liability penalty, will be asserted inappropriately against taxpayers in the future.

In the category of silver linings, while the Third Circuit opinion may have been a loss for the taxpayer, it may turn out to be a victory of sorts for taxpayers on the larger question of the relevance of the economic substance doctrine to transactions traditionally analyzed under different doctrines.  In its brief to the appellate court, the government once again argued (as an alternative to its other theories) that the swap-and-assign transactions lacked economic substance.  To the Third Circuit’s credit, however, its only acknowledgement of the economic substance doctrine was to observe, in a footnote, “Because we uphold the District Court’s characterization of the Transactions as loans, we do not reach its alternative conclusion that the Transactions lacked economic substance.”

In other words, where a court can reach a particular conclusion on the basis of another doctrine, the economic substance doctrine is simply not relevant.  This analysis is consistent with the reasoning from my recent article:

[T]he substance-over-form doctrine (and step-transaction doctrine) should be given priority over the economic substance doctrine, because if the transaction can be recharacterized as something that rational actors would do, that is a good indication that the transaction has economic substance. Conversely, the inability to analogize the economics of a challenged transaction to any sort of transactions that taxpayers ordinarily undertake without tax benefits may itself turn out to be a valuable indicator that the transaction lacks economic substance. Prioritizing the doctrines in this way would help avoid some of the confusion that has historically plagued this area of the tax law.

In sum, while the taxpayer and its advisors may have been dealt a blow by the Third Circuit, other taxpayers can rest a bit easier with the knowledge that at least one appellate court has taken a significant step towards reining in the government’s unnecessary use of the economic substance doctrine.  When you have a hammer, everything might look like a nail.  Nevertheless, a good craftsman understands that there is a tool for every job; and the government may find itself at the beginning of a trend where courts do not look kindly on its aggressiveness in asserting the economic substance doctrine where it does not belong.