Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.
Thursday, October 24, 2013
When A Tax Shelter Blows Up
image losing a tax case with the IRS and owing a billion dollars?
this? We are talking about Dow Chemical Company (“Dow”). They lost in the
District Court for the Middle District of Louisiana. I suppose they have no
choice but to appeal. It is a billion dollars, after all.
them in this mess?
A couple of
tax shelters, one marketed by Goldman Sachs and both implemented by the law
firm of King & Spalding. The IRS sued for tax years 1993 to 2003.
about the first of the shelters – called a SLIP – which lasted from 1993 to
1997. Dow was not the only one that tried to SLIP the IRS. Merck and
International Paper tried also.
for “Special Limited Investment Partnership.” Its claim to fame was taking low-basis assets
and turning them into tax deductions.How would you do this? Well you could contribute them to a partnership,
but that low basis would carryover. You would get no increased tax deduction by
putting it a partnership.
What if you
put low-basis assets into a partnership and then leased them back?Wait, the partnership would then have taxable
income. Who would own the partnership? If you owned it, then the whole effort
would be circular.
What if there
are other partners? Problem: you do not want other partners.
What if you limit
the other partners to a fixed return? It would be the same as paying interest
to a bank, right? In partnership taxation we call this a priority or preference
of that income would be coming back to you. How can we solve this puzzle?
the income distribution from the cash distribution. We bring in partners who
will accept 6 or 7 percent priority, and we allocate virtually all the income
would someone agree to this?
If someone doesn’t
pay U.S. tax, that’s why. Someone like a foreign bank.
You offer a
foreign bank the deal, now referred to as a “structured financial transaction.”
This means that it is complicated, and you will be paying top dollar for
investment, legal and accounting advice. You explain to the bank that it would:
a significant premium over a corporate bond
on less credit risk than a corporate bond
any U.S. tax
Dow and Goldman Sachs rounded up five foreign banks willing to contribute $200
million. Dow set up a maze of subsidiaries, into which it dumped 73 patents. The
interesting fact about these patents is that Dow had amortized them virtually
to zero, Dow still used them in current operations and retained enough of the
processes to make it unlikely anyone would want to buy the patents, though. The patents appraised at $867 million.
One of those
Dow subs contributed the patents into a partnership called Chemtech I, taking
back an 81 percent ownership.
Dow paid Chemtech
I around $143 million for use of the patents.
Chemtech I paid
the foreign banks 7 percent as their priority return. Since the banks had
invested $200 million, this was a cool $14 million in their pockets. Chemtech I
paid a couple of other things, took the remaining cash and put in a subsidiary.
That subsidiary loaned the money back to Dow. How much cash did it loan back,
you ask? About $136 million. For one year.
On its tax
return Chemtech I reported approximately $122 million in income. It allocated
$115 million of that to the banks. Only $28 million in income went back to Dow
What we have
just talked about is known in tax lingo as a “strip.”
And there is
the SLIP. All Dow did was move money around. It paid the foreign banks $14
million in interest but called it a priority, thereby dragging over $115
million of income with it. As the banks did not pay U.S. tax, they did not
care. Dow however did.
there was a change in U.S. tax law, and Dow had to switch to another tax strategy.
Dow wanted to cash out the banks and start something else.
wanted their share of the market value of those patents on the way out. Seems fair,
as they were “partners” and all. Dow said “no way”. The partnership agreement
stipulated how the patents were to be valued and how to calculate the banks’
share. Dow paid the banks approximately $8 million. The banks complained, but
to no avail. Dow controlled the calculation of value.
banks were out of the way, Dow created a second tax shelter using a
fully-depreciated chemical plant in Louisiana. This strategy did not require banks,
but it did employ a very clever maneuver to pump-up the basis of the plant,
thereby creating depreciation deductions that Dow could use to offset real
income from other sources.
was a formidable tax issue that Dow resolved by ripping up a piece of paper and
replacing it with another.
OBSERVATION: And there you see the IRS’ frustration: Dow is
not dealing with independent parties. In Chemtech I, it was dealing with banks
acting as banks. Dow called them partners, but it may as well have called them
peanut –butter sandwiches for the difference it made. In the second deal
(called Chemtech II), Dow did not even leave the ranch. It replaced a deal
between its subsidiaries with another deal between its subsidiaries. Really? No wonder the IRS was hot around the ears.
So the IRS
gets into Dow’s tax returns. In 2005 it issued a Notice of Final Partnership
Administrative Adjustment for tax years 1993 and 1994. Dow responds that the
IRS did not give the notice to the properly designated person – the Tax Matters
Partner – and the notice was therefore invalid.
OBSERVATION: The tax matters partner rule is to protect both
the partnership and the IRS. It means something when you have big partnerships
with hundreds if not thousands of partners. Dow however was setting up
partnerships like they were jellybeans. I find it cheeky – to be polite – that Dow’s
defense was “you sent the mail to the wrong cubicle.”
goes back and forth like a tennis match. In the end, a court has to decide. The
IRS had scooped up additional years – through 2003 – by the time this was
the IRS attack the shelters?
There are a
couple of ways. The first is the “economic substance” doctrine. Think of it as
the tax equivalent of “where’s the beef?” The court looks at the transactions
and determines if there is any reality to what supposedly is going on. There
are three prongs to this test:
(1)Does the transaction have economic
substance compelled by business or regulatory realties;
(2)Does the transaction have
tax-independent considerations; and
(3)Is the transaction not designed in toto with
tax avoidance intent?
The Court looks at the SLIPS and observes the
(1)The SLIPs did not change Dow’s
financial position in any way. Chemtech I could not have licensed those patents
to a third party if it wanted to, as it did not own all the rights. This means
that Chemtech I could not produce independent revenue. That is a problem.
(2)The cash flow was circular. The
little bit that left (to the banks) was the equivalent of interest. Big
(3)Dow argued that it was preserving its
credit rating and borrowing power, but it could not prove any increase in its credit
rating or borrowing power. Dow also stumbled explaining why it structured the
transaction this way rather than another way – like having domestic banks in
way the IRS attacked was by arguing the partnership was a sham. This argument
is slightly different from “economic substance,” as that argument looks at transactions.
The sham partnership argument looks at the partnership itself and asks: is this
a real partnership?
notes the following:
banks got a priority of 7%.
only room left for the banks to profit was if the patents went up in value. The
banks were only allocated 1% of that number, and Dow controlled how to
calculate the number.
the banks complained about their lousy 1%, a Dow executive called them
It was clear the Court was not impressed with this executive’s comment.
was virtually impossible for the banks to lose money.
one risk to the banks – IRS challenge – was indemnified by Dow.
observed that true partners have the risk of loss and the hope of gain. The
banks had virtually no risk of loss and sharply limited room for gain. There
may have been a banking relationship, but there was no more a partnership here
than in a Kardashian marriage.
said the shelters were bogus and Dow owed the tax.
And a 20
percent penalty to boot.
MY TAKE:Those who
know me, or who follow this blog, know that I generally side with the taxpayer.
After all, it is the taxpayer who sets an alarm clock, takes on a mortgage or builds
a website that actually works, whereas the government is little more than weight
in the trunk.
Still, at least pretend that there is some business reason
for all the tax fireworks that are going off.
This court opinion is 74 pages long. While I am somewhat
impressed with the tax wizardry that Dow brought to bear, I must admit that I
am reading tax planning for its own sake. That may groove someone like me, but
that is not enough to pass muster. There has to be a business purpose for
moving all the pieces around the board, otherwise the IRS can challenge your