The Fifth Circuit Court of Appeals upheld a decision of the U.S. District Court for the Southern District of Texas that recharacterized a corporation’s acquisition of assets as an acquisition of stock with a subsequent liquidation of the acquired corporation. The appellate court agreed with the IRS and the district court that, under the substance-over-form doctrine, an intermediary’s role in the transaction should be ignored, since the intermediary was a mere conduit in the acquisition.
Under the substance-over-form doctrine, the IRS may assess taxes by recharacterizing a transaction based on its substance. The doctrine can be applied by using the conduit theory, the step transaction doctrine or the economic substance doctrine. Under the conduit theory, an entity may be ignored if it acts solely as a conduit in the transaction. The step transaction doctrine allows the steps of an integrated transaction to be viewed as parts of an overall transaction if one or more of those steps individually have no substance. Under the economic substance doctrine, a transaction may be ignored if it serves no valid business purpose and is used to obtain tax benefits not foreseen by a reasonable application of the Tax Code. These doctrines can overlap, and many times more than one of them could be used to recharacterize a transaction based on its substance (see, for example, Schering-Plough Corp. v. U.S., docket no. 05-2575, D. N.J., 8/28/09).
In 1999, Midcoast Energy LP, a natural gas pipeline company, was interested in acquiring assets of the Bishop Group, another natural gas pipeline company. Based on tax considerations, the sole owner of Bishop Group, Dennis Langley, preferred to sell his stock rather than the corporation’s assets, while Midcoast preferred to purchase the assets. For Langley, although a stock sale followed by liquidation of assets would have required him to pay tax on any gain in his shares, the liquidation of Bishop into Midcoast would be tax-free. For Midcoast, however, the assets would retain their lower, carryover basis. In a direct asset sale, on the other hand, in addition to Langley having to pay tax on his stock gain, Bishop would have to pay tax on its gain, but Midcoast would get a more favorable cost basis in the purchased assets. After a period of unsuccessful negotiations, Midcoast used Fortrend International LLC, an investment bank, to set up what is known as a “midco” transaction. Fortrend created an entity called K-Pipe, which in 1999 purchased the Bishop stock from Langley. One day later, K-Pipe sold the assets of Bishop to Midcoast and thereafter conducted no substantive business activities.
After the transaction was completed but before Midcoast filed its 2001 tax return containing a loss related to the transaction, the IRS in Notice 2001-16 made such “intermediary transaction tax shelters” listed transactions. (It provided additional guidance concerning them in Notice 2008-20.) In 2001, Midcoast was purchased by Enbridge Energy Co. Midcoast considered the midco transaction not substantially similar to those described in Notice 2001-16, but as its successor in interest, Enbridge decided in 2003 to disclose it. A resulting IRS audit recharacterized the transaction as a stock purchase. Midcoast was assessed deficiencies totaling $3,849,808 for tax years 2000 and 2001, plus the 20% penalty for a substantial underpayment of tax. Midcoast paid the tax and penalties, then filed suit in district court seeking a refund.
The district court agreed with the IRS that K-Pipe’s role in the transaction should be ignored. It found five factors indicating K-Pipe was a mere conduit in the transaction: (1) K-Pipe helped facilitate a formal buy/sell agreement between Langley and Midcoast; (2) K-Pipe was not an independent actor, since there was no evidence of its participation in any of the negotiations; (3) K-Pipe assumed no risk in the transaction because Midcoast agreed to guarantee its obligations; (4) K-Pipe was formed by Fortrend, which was brought into the transaction at the request of Midcoast’s tax adviser; and (5) K-Pipe conducted no substantive business activity after the transaction, and thus its only role was to let Midcoast increase its tax basis of the acquired assets.
The court also found the 20% negligence penalty applied, since Midcoast understated its tax liability by more than 10% and could not show it either had substantial authority to support its position or had adequately disclosed the facts related to the transaction.
Midcoast appealed the decision to the Fifth Circuit Court of Appeals, where Midcoast advanced three business reasons for K-Pipe to have been involved in the transaction. All were rejected by the court. Midcoast claimed K-Pipe wanted to earn a profit; however, the court said that did not answer the question of why any entity would pay K-Pipe for its involvement. Midcoast also stated K-Pipe’s involvement made the acquisition economically viable; however, the court could not find any business purpose for its involvement other than the tax savings. In addition, Midcoast stated this particular form of the transaction shielded it from any of the Bishop Group’s actual or potential liabilities; however, according to the court, it could have accomplished that goal by buying the assets directly from Bishop. The court also upheld the lower court’s application of the 20% penalty.
Enbridge Energy Co. v. U.S. , docket no. 08-20261 (5th Cir., 11/10/09, aff’g, 553 F. Supp. 2d 716, S.D. Texas)
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.