A district court in Texas allowed Shell Petroleum to carry back capital losses and receive a nearly $19 million refund. The losses were generated by a restructuring transaction involving an exchange of highbasis property for new subsidiary stock followed by loss-generating dispositions of the stock.
In 1992, Shell Oil was facing serious financial difficulties. Oil prices had dropped significantly, causing serious declines in Shell’s net income and net cash flow at the same time that its debt was increasing.
In reaction, Shell and its affiliated oil companies (the Shell Group) restructured to improve cash flow while preserving assets, especially offshore leases and oil shale rights that were currently nonproducing but that Shell thought could eventually yield profitable oil discoveries. (Shell had learned its lesson decades earlier, when it had abandoned its holdings on the North Slope of Alaska and the region then became home to the biggest oil field in North America.) The Shell Group transferred the properties to a new subsidiary, Shell Frontier Oil & Gas Inc., in a section 351 transaction. In such a transaction, shareholders receive a basis in the stock of the new corporation equal to the basis of the property they transfer to acquire that stock. In this case, the basis of much of the transferred property was far greater than its value. As a result, subsequent disposal of the stock in Shell Frontier created losses exceeding $350 million for tax year 1992. The Shell Group in 2004 carried back the consolidated net capital loss to 1990, which resulted in an overpayment for that tax year of $18.9 million.
The IRS disallowed these losses on various grounds. It claimed that since many of the transferred properties were nonproducing, they had no value and thus should not be considered section 351 property. However, the district court found that even though the properties were nonproducing, they did in fact have value and thus were considered property for section 351 purposes. Noting that the provision does not define “property,” the court said Shell’s interests “fit the classical—indeed, paradigmatic—definition of ‘property’ in that they are identifiable and transferable real property interests.”
The IRS also asserted that the transfer was a sham transaction intended to artificially inflate tax basis. While the Shell Oil tax department was involved in the restructuring plan, it did not discuss any of the plan’s tax benefits with management, so that the restructuring decisions would be based on economic factors. Among other things, this plan enabled the Shell Group to raise cash without jettisoning assets. The court found that the transaction therefore did have economic substance and that it was not tax-motivated and thus not a sham transaction.
Finally, the IRS asserted that it could reallocate the losses to Shell Frontier under section 482, which allows such reallocation between two or more entities owned or controlled by the same interests. The court, however, noted that the reallocation is provided “to prevent evasion of taxes,” which it said was not the case with Shell. Courts have recognized the beneficial effect of tax-deferred exchanges under section 351 in encouraging the formation of new corporations and strengthening existing ones—all the more so, considering that when Shell undertook its transfer, the provision’s allowance of a carryover of basis also enabled tax losses by both the transferee and transferor. Shortly before Shell filed its amended return, however, Congress plugged that loophole with the American Jobs Creation Act of 2004. For section 351 exchanges taking place after Oct. 24, 2004, such transfers of property with builtin losses require a reduction to fair market value of the basis of either the transferred property or the stock received for it.
Shell’s 1990 tax year was open in 2004 because its original return was still under administrative appeal and it had waived the period of assessment. Under section 6511(c)(1) such a waiver also extends the period for filing a claim. The company said in an explanation accompanying its amended return that it had previously executed a Form 870-AD, Offer to Waive Restrictions on Assessment and Collection of Tax Deficiency and to Accept Overassessment, reflecting an agreed overassessment for 1990 of nearly $128 million, not including the $18.9 million that was the subject of the claim.
Shell Petroleum Inc. v. U.S, 102 AFTR2d 2008-5085
By Karen M. Cooley, CPA, MPA, instructor of accounting, and Darlene Pulliam, CPA, Ph.D., McCray Professor of Business and professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.