By reversing a district court’s grant of summary judgment that originally favored the taxpayer (see “Tax Matters,” JofA, March 05, page 88), the Fourth Circuit Court of Appeals opened the door for further interpretation of the “sham transaction” rule as it relates to contingent liability transactions. The case, involving Black & Decker (B&D), was remanded last year to the district court for further analysis to determine if the transaction in question served a legitimate business purpose or was a sham. Should the court rule that this was a sham transaction, it would give the IRS firmer footing in aggressively litigating transactions it considers tax shelters. The case is one of several appellate rulings during 2006 that breathed new life into IRS positions on contested transactions, including Coltec (“Tax Matters,” JofA, Jan. 07, page 67), which, like B&D, concerned the economic substance doctrine as applied to contingent liabilities.
Black & Decker created a separate corporation, Black & Decker Healthcare Management Inc. (BDHMI), to manage its health care claims. In doing so, B&D transferred $561 million, along with $560 million in contingent health care claims, to BDHMI in exchange for its stock. B&D then sold this stock to an independent third party for $1 million. B&D claimed a $560 million capital loss, the amount of the assets originally transferred to BDHMI less the $1 million proceeds from the stock sale. The IRS disallowed the loss under the sham transaction rule.
As discussed in the district court ruling, to be considered a sham, a transaction must meet two criteria: First, it serves no business purpose other than to provide tax benefits to the taxpayer (the subjective test), and second, it offers no reasonable possibility of a profit and thus lacks economic substance (the objective test). In granting summary judgment, the district court found that while the transaction was indeed tax-motivated—a point conceded by B&D—it nonetheless had economic substance because BDHMI provided a legitimate economic service to every participant in the B&D benefit program. The IRS appealed.
In remanding, the Fourth Circuit ruled that the district court had applied the objective test at the wrong level. The district court had evaluated whether BDHMI itself engaged in legitimate, economically based business activities. Instead, it should have applied the objective test to the transaction that carried the tax implications—the transfer of assets to BDHMI in exchange for its stock and then the sale of that stock at a loss, the Fourth Circuit said.
Black & Decker Corp. v. U.S. (CA 4 2/2/2006), 97 AFTR 2d 2006-841.
Prepared by Karen M. Cooley, CPA, instructor of accounting, and Darlene Pulliam, CPA, Ph.D., professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.