How To Lose $610 Million In Basis

 

Let’s talk today about partnership taxation.

The driving concept is relatively straightforward: have tax step out of the way and let partners arrange their own deal.

Q. You are willing to forego future (potential) profits for a larger guaranteed paycheck today?

A. Fine.

Q. You do not want to be responsible for any partnership losses?

A. We can work with that.

The problem, of course, is that some people will always try to game the system, so Congress and the IRS have been busy for decades trying to close the most egregious loopholes. The passive activity rules, for example, represented Congress responding to the Thurston Howell III tax shelters.

The taxation of a vanilla partnership is usually straightforward. Introduce complexity – especially intentional complexity – and the taxation can challenge even the most trained professional.

Let’s look at a recent case, one involving German companies and a U.S. parent. Do not worry: we will not discuss international tax provisions.

Let’s call the first German company “Dorothy.”

Dorothy owned a (German) subsidiary called “Blanche.”

There was a U.S. company called “Sophia” that ultimately owned both Dorothy and Blanche. Sophia is relatively quiet in this story.

In March 2001 Dorothy issued Blanche a $610 million promissory note guaranteed by Sophia.

Blanche contributed the note to a spanking new partnership - let’s call it “Rose” - in exchange for a limited partnership interest.

There are a couple of Code sections at play.

Code § 722 - Basis of contributing partner’s interest

The basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under section 721(b) to the contributing partner at such time.

There is (usually) no gain or loss when a partner contributes property – including cash – to a partnership in exchange for an interest in the partnership. In fact, the only thing that (usually) happens is that the partner’s basis in the property (including cash) carries over to his/her basis in the partnership interest itself.

What about the partnership – does anything happen to the partnership?

26 U.S. Code § 723 - Basis of property contributed to partnership

The basis of property contributed to a partnership by a partner shall be the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under section 721(b) to the contributing partner at such time.

The partnership (again – usually) just steps into the basis of the contributing partner.

But why Dorothy and all the weird maneuvering?

Remember that note which Dorothy issued to Blanche which was contributed to Rose? It will be paid off in 2009. With accumulated interest, the total would be over $1 billion.

Looks to me like we are moving money. And taxes, likely.

In April 2002, Blanche filed an entity classification election with the IRS to be disregarded as a entity separate from Dorothy.

The election was retroactive. Let’s check: retroactive to a few days BEFORE Dorothy issued the $610 million promissory note to Blanche.

You may have heard of entity classification elections by another name: check-the-box. Much of this area has to do with the popularity of limited liability companies. Left alone and depending on ownership, an LLC might be taxable as a partnership, a corporation, a proprietorship, whatever. The IRS tried to bring order to this, hence the check-the-box rules. If the LLC wants to be taxed as a corporation, it makes an entity election. This is, in fact, a common technique for LLCs that intend to be taxed as S corporations, as it has to be (recognized as) a corporation before it can be taxed as an S corporation.

Blanche went the other way. Blanche decided it wanted to be disregarded from Dorothy, meaning that it would be regarded as a division, department or branch of Dorothy. The IRS would “disregard” Blanche as a separate entity.

But one has to be careful. One wants to review tax-significant transactions, especially when check-the-box is retroactive. There is a Thanos finger snap element here.

Let’s go back to the basis that is powering Code sections 722 and 723. More specifically, let’s look at the section for basis itself:

Sec. 1012 Basis of property - cost

(a) In general. The basis of property shall be the cost of such property, except as otherwise provided in this subchapter and subchapters C (relating to corporate distributions and adjustments), K (relating to partners and partnerships), and P (relating to capital gains and losses).

Typical tax: the description of one word leads to another. Basis shall be the cost, padawan.

So, what is “cost”?

Black’s Law Dictionary (4th ed. 1957) tells us “that which is actually paid for goods.”

What did Dorothy start this story with?

A note to Blanche.

Can a note represent “cost”?

You betcha, if I owe it to someone who can and intends to collect from me. Think about the note on a car purchase, for example.

Dorothy “actually paid for goods” before the Thanos snap. Blanche was a separate company and could enforce collection.

What happened after the Thanos snap?

There is no Blanche, at least not as a separate company.

Dorothy in effect owed itself.

Here is the Court:

… CSC Germany paid no amount, in money or property, to create the Note. Nor did CSC Germany “engage to pay or give” anything to someone else in exchange for that third person’s help in making the Note. The Note’s adjusted basis in CSC Germany’s hands was therefore zero, as we have held in multiple similar cases.”

Dorothy cannot create “cost” by issuing a note to itself. To phrase it differently, I cannot make myself a millionaire by issuing a million-dollar promissory note to myself.

Without cost, Dorothy does not have “basis” in the note.

Which means that Blanche does not have “basis” in Rose, since Blanche’s basis is just a roll-forward of Dorothy’s basis.

So, what happens when Dorothy pays Rose $1 billion in 2009?

I expect:

              Proceeds                         $1 billion

              Basis                                  zero (-0-)

              Gain                                  $1 billion

Blanche thought it had a $610 million asset on its books.

It did.

Blanche thought it had basis of $610 million in that asset.

It did … until the finger snap.

Our case today was Continental Grand Limited Partnership v Commissioner, 166 T.C. No. 3 (March 2, 2026).

Pfizer Wants To Decrease Its Taxes By Moving To Britain

I am reading the following headline at Bloomberg Businessweek: “Pfizer’s $99 Billion Bid for AstraZeneca Is a Tax Shelter.”

No, it is not. This is a tax shelter the same way I am Floyd Mayweather Jr.’s next opponent.

It is sign of a problem, though.

Pfizer is based in New York City. AstraZeneca is based in London. Pfizer has proposed the deal, but AstraZeneca has not yet accepted. The deal may fall yet fall through. There are any number of reasons why a drug company would buy another drug company, but this one would move one of the largest U.S. multinationals to London. The term for this is “inversion.”

Mind you: the Pfizer executives are not moving. They will remain in New York, and Pfizer research facilities will remain in Connecticut. Pfizer will however go from being a U.S.-based multinational to a U.K.-based one. How? There will be a new parent company, and that parent will be based in London. Voila!

Inversions are more complicated than they used to be. In 2004 Congress passed IRC Section 7874, which denies tax benefits to an inversion unless certain thresholds are met. For example,

·       If the former shareholders of the former U.S. parent own 80% or more of the foreign corporation after the inversion, then the inverted company will continue to be considered – and taxed – as a U.S. company.

You can quickly assume that new – and non-U.S. shareholders – will own more than 20% of the new Pfizer parent.

What if you own Pfizer stock? In addition to owning less than 80% of the new parent, code Section 367 is going to tax you when Pfizer inverts. This is considered an “outbound” transaction, and there is a “toll” tax on the outbound. What does that tell you? It tells you that there has to be cash in the deal, otherwise you are voting against it. There has to be at least enough cash for the U.S. shareholders to pay the toll.

Let’s say the deal happens. Then what?

I cannot speak about the drug pipeline and clinical trials and so forth. I can speak about the tax part of the deal, however.

As a U.S. multinational, Pfizer has to pay taxes on its worldwide income. This means that that it pays U.S. taxes on profits earned in Kansas City, as well as in Bonn, Cairo, Mumbai and Sydney. To the extent that a competitor in Germany, Egypt, India or Australia has lower tax rates, Pfizer is at an immediate disadvantage. In the short term, Pfizer would be less profitable than its overseas competitor. In the long term, Pfizer would move overseas. Congress realized this and allowed tax breaks on these overseas profits. Pfizer doesn’t have to pay taxes until it brings the profits back to the United States, for example. Clever tax planners learned quickly how to bend, pull and stretch that requirement, so Congress passed additional rules saying that certain types of income (referred to as “Subpart F” income) would be immediately taxed, irrespective of whether the income was ever returned to the United States. The planners responded to that, and the IRS to them, and we now have an almost incomprehensible area of tax Code.

Take a moment, though, and consider what Congress did. If you made your bones overseas, you could delay paying taxes until you brought the money back to the U.S. Then you would have to pay tax – but at a higher rate than your competitor in Germany, Egypt, India or Australia. You delayed the pain, but you did not avert it. In the end, your competitor is still better off than you, as he/she got to keep more of his/her profit.

What do you do? Well, one thing you cannot do is ever return the profit to the United States. You will expand your overseas location, establish new markets, perhaps buy another – and foreign – company. What you will not do is ship the money home.

How much money has Pfizer stashed overseas? I have read different amounts, but $70 billion seems to be a common estimate.

When Pfizer inverts, it may be able to repatriate that money to the U.S. without paying the inbound toll. That is a lot of money to free up. I could use it.

The U.S. also has one of the highest – in truth, maybe the highest – corporate tax rate in the world. The U.K. taxes corporate profits at 20%, compared to the U.S. 35%. The U.K. also taxes profits on U.K. patents at 10%, an even lower rate. This is a pharmaceutical company, folks. They have more patents than Reese’s has pieces. And the U.K. taxes only the profits generated in the U.K., which is a 180 degree turn from Washington’s insistence that it can tax profits of an American company anywhere on the planet.

Now, Pfizer does not get to avoid U.S. taxes altogether. It will still pay U.S. tax on profits from its U.S. sales and activities. The difference is that it will not pay U.S. taxes on sales and activities occurring outside the United States.

Since 2012 approximately 15 large U.S. companies have moved or announced plans to move offshore. Granted, there are numerous reasons why, but a significant – and common – reason has to be the benighted policy of U.S. multinational taxation. What has the White House proposed to stem the tide? Increase the ownership threshold from 20% to 50% before the company will be deemed based outside the U.S.

Brilliant.  To think that Washington at one time pulled off the Manhattan Project, Hoover Dam and landing a man on the moon. How far the apple has fallen.

The issue of corporate inversion has been swept up as part of the larger discussion on tax reform. That discussion is all but dead, unfortunately, although perhaps it may resurrect after the Congressional elections. The Camp tax proposal wants to move the U.S. to a territorial tax system rather than the existing worldwide system, which is an acknowledgement of the problem and a very good first step. It will not stop Pfizer, but we may able to stop the next company to follow.