Third Circuit Upholds $473 Million Subpart F Deficiency

The Third Circuit Court of Appeals affirmed a deficiency of nearly $473 million against pharmaceutical company Merck & Co. Inc. as successor to Schering-Plough, saying an interest rate swap Schering-Plough engaged in with two foreign subsidiaries was a disguised loan from the subsidiaries.

Subpart F of the IRC (sections 951 through 965) provides that the income of a controlled foreign corporation (CFC) is not taxable income to its U.S. shareholders until such income is invested in U.S. property, which is defined as including any obligation of a U.S. person of which the CFC is pledger or guarantor (section 956). Thus, if a foreign subsidiary loans money from its earnings and profits to its domestic parent, the amount becomes immediately taxable to the parent.

Schering-Plough, a New Jersey corporation, sought to repatriate cash reserves from two Swiss subsidiaries. Investment bank Merrill Lynch proposed that the company fashion an interest rate swap with a Dutch bank and, in exchange for a lump-sum payment from the subsidiaries (partly via an Italian bank), assign its interest in the transaction to the subsidiaries. The 20-year contracts were based on a notional principal amount, with interest payments by the parties designed to offset each other plus compensate the Dutch bank for its involvement. Schering-Plough recognized the lump-sum payments ratably over the life of the swap as allowed (for nonloans) by Notice 89-21. As part of the transaction, the subsidiaries were granted put options to reassign their interests back to Schering-Plough, which were eventually exercised.

In 2004 after an audit, the IRS recharacterized the amounts as loans and assessed deficiencies for tax years 1989, 1991 and 1992 totaling more than $472.8 million. Schering-Plough paid the amounts and sued for a refund in the District Court for the District of New Jersey, arguing the swap-and-assign transactions were sales of future income streams. That court held (Schering-Plough Corp. v. U.S., docket no. 05-2575 (8/28/09)) that the transactions were loans in economic substance and lacked sufficient non-tax motivation. The district court gave particular weight to internal memos, notes and other indicators of the parties’ intent that it said were inconsistent with a bona fide sale. It attached little weight to what Schering-Plough argued were nonloan characteristics of the transactions: that the payment obligations were unsecured and not formally documented as loans, and that they involved the Dutch bank as an intermediary. It also said the swaps lacked subjective business purposes and objective economic effects. The court also found that the put options gave the subsidiaries an unconditional power to recoup the lump sums repatriated. The subsidiaries therefore had a contractual right to enforce repayment upon the options’ exercise, with Schering-Plough’s corresponding obligation to repay.

The Third Circuit found broader grounds for considering the swaps to be loans. It cited Comtel Corp. v. Commissioner (376 F.2d 791, 2nd Cir. (1967)) for the proposition that a transaction can be considered a loan where it is deliberately planned as a practical matter to provide for repayment, even in the absence of any formal legal obligation to repay. Besides the put options, the court noted evidence indicating that if benchmark interest rates on which the payments were based averaged above 2.93% during the swap, the subsidiaries would be repaid. Those rates didn’t go that low when interest rates collapsed toward the end of the first decade of the 21st century, the court said, and had not done so since 1962.

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