Schering-Plough Corp. (Merck & Co., Inc.) v. U.S. (CA 3 6/20/2011) 107 AFTR 2d ¶2011-960
The Court of Appeals for the Third Circuit, affirming a district court, has held that a large pharmaceutical company's “swap-and-assign transactions” were loans and not sales of future income streams to its offshore subsidiaries. As loans, they triggered an immediate tax under the subpart F provisions.
Background. Subpart F of the Code mandates taxation of foreign earnings and profits (E&P) upon repatriation to the U.S. Mechanically, Subpart F assesses a tax on any “United States shareholder” (as defined in Code Sec. 951(b) and Code Sec. 951(b)) of a “controlled foreign corporation” (CFC) (as defined in Code Sec. 957 and Code Sec. 958) when the U.S. shareholder invests previously untaxed foreign E&P in “United States property.” An obligation by a United States shareholder acquired by a CFC is deemed to be such an “investment in United States property” under Code Sec. 956(c)(1)(C). When a CFC makes a loan to its domestic parent, the amount of the loan is presently taxable under Subpart F.
Observation: On May 11, 2011, Congressmen Kevin Brady (R-TX), Jim Matheson (D-UT), Robert Dold (R-IL), Jim Cooper (D-TN), Devin Nunes (R-CA) and Jared Polis (D-CO) filed H.R. 1834, the “Freedom to Invest Act of 2011.” It would allow U.S. companies to repatriate earnings from their foreign subsidiaries at a reduced tax rate for a limited period.
Facts. In’91 and’92, Schering-Plough, an international pharmaceutical conglomerate, wishing to repatriate its subsidiaries' foreign earnings back to the U.S., entered into two 20-year interest rate swap transactions with Algemene Bank Nederland, N.V. (ABN), a Dutch investment bank. Under the swaps, the two counterparties agreed to exchange periodic interest payments based on a hypothetical amount (the notional principal) and two different interest rate indices. The swap agreements obligated Schering-Plough and ABN to make periodic payments to each other reflecting the movement of the particular interest rate assigned to their respective sides of the transaction.
Under the swaps, Schering-Plough had the right to assign or otherwise transfer its right to receive interest payments from ABN (the receive legs). It assigned the majority of the receive legs to two of its foreign subsidiaries. In return, the subsidiaries made lump-sum payments to Schering-Plough totaling approximately $690 million. Schering-Plough did not report the lump sums as present income. Instead, it deferred reporting income until later years, relying on Notice 89-21, 1989-1 CB 651. Specifically, because Notice 89-21 required ratable taxation of payments received in exchange for the assignment of future income streams from notional principal contracts, Schering-Plough reported income for the lump sums by amortizing them over the period in which the future income streams had been assigned. Notice 89-21 states that “[n]o inference should be drawn as to the proper treatment of transactions that are not properly characterized as notional principal contracts, for instance, to the extent that such transactions are in substance properly characterized as loans.”
Observation: Notice 89-21 has since been repealed and parties are now required to recognize all such payments as loans under Reg. §1.446-3(g)(4) and Reg. §1.446-3(h)(4)(1).
In 2004, characterizing the transactions as loans, IRS assessed a tax deficiency upon Schering-Plough because it had not reported the lump-sum payments as present income in’91 and’92, the years in which they had been received. Schering-Plough paid the $473 million tax bill, filed for a refund, and ultimately sued in district court after IRS denied the refund.
The district court determined that the economic characteristics of the swap-and-assign transactions did not pass muster as sales under substance-over-form analysis. Rather, the evidence demonstrated that the transactions were, in true economic substance, loans. As loans, the transactions were outside the scope of Notice 89-21 and were taxable under Subpart F as repatriated earnings.
The district court also determined that the transactions lacked economic substance. In addition, it rejected Schering-Plough's argument that it suffered disparate treatment at IRS because IRS didn't go after a similarly-situated taxpayer.
Third Circuit's loan analysis. The Third Circuit said that determining whether a transaction qualifies as a loan requires an analysis of both the objective characteristics of the transaction and the parties' intentions. Under its prior precedent, for disbursements to constitute true loans there must have been, at the time the funds were transferred, an unconditional obligation on the part of the transferee to repay the money, and an unconditional intention on the part of the transferor to secure repayment. In the absence of direct evidence of intent, the nature of the transaction may be inferred from its objective characteristics.
With respect to the parties' intentions, the Third Circuit found no reason to disturb the well-supported finding by the district court that the parties believed that they were crafting a loan, rather than a sale. This was supported by both direct and meaningful indirect evidence.
The more difficult question was whether the transactions had the objective economic attributes of loans. As government experts established, the transactions had certain objective indicia of loans, such as a fixed maturity date, a fixed principal sum, periodic interest payments, and a payment schedule. However, the main dispute was whether the transactions created an unconditional obligation on the part of Schering-Plough to repay the money. In the face of the Code's general insistence on the controlling effect of economic reality rather than form, the Third Circuit refused to apply this test in the literal sense. Rather, the Court held that, in determining whether there was an “obligation” to repay, the test is whether the transferor's intention was to structure the transaction to ensure repayment of funds as a practical matter. Here, the evidence was sufficient to show the parties intended to secure a repayment that was effectively if not explicitly unconditional.
The Third Circuit rejected Schering-Plough's argument that the involvement of ABN meant that the transactions could not have been loans between Schering-Plough and its subsidiaries. The Court said that there is no reason that a loan cannot be arranged among three parties. It also concluded that ABN could be properly considered as a mere conduit for payments between Schering-Plough and its subsidiary.
Accordingly, the Third Circuit held that the district court correctly found that the transactions were in substance loans, not sales. As loans, they were outside the scope of Notice 89-21 and were taxable as repatriated earnings. Because it found the transactions to be loans, the Third Circuit didn't examine the district court's alternative finding that the transactions lacked economic substance.
Failed disparate treatment argument. Schering-Plough also argued that it suffered disparate treatment at the hands of IRS because another taxpayer (Taxpayer One) engaged in a substantially similar transaction and was not assessed a deficiency. When Taxpayer One was being audited in the mid’90s, IRS's National Office issued a Field Service Advice (FSA) to its personnel examining Taxpayer One indicating that transactions of this kind would not be taxable as loans. Schering-Plough asserted that IRS should be bound by its treatment of Taxpayer One's transaction under International Business Machine (IBM) Corp v. U.S., (1965, Ct Cl) 15 AFTR 2d 1526.
In the IBM case, one of IBM's competitors obtained a private letter ruling holding that certain of its products were not subject to a particular excise tax. IBM immediately requested a similar ruling holding that its effectively identical products were not subject to the same tax. After two years, IRS denied the request. At the same time, it informed the competitor that its products would be subject to the tax, but only prospectively. In effect, therefore, only IBM was obliged to pay the excise tax for goods sold during the two years before IRS's denial, though both IBM and its competitor were obliged to pay the excise tax for goods sold after IRS's denial. The Court of Claims ultimately concluded that this was an abuse of discretion.
The Third Circuit noted that the Court of Federal Claims subsequently limited the holding of IBM to its facts and other courts have applied it narrowly.
The Third Circuit said that IBM did not apply to the situation in this case. Taxpayer One did not receive a formal written ruling from IRS holding that its transaction was not taxable, as the competitor did in IBM and which other circuits have required to sustain a claim of disparate treatment. Although IRS did issue an FSA concerning Taxpayer One, FSAs are not binding documents, nor, at the time, were they even public; they are meant as guidance for the team conducting an audit, not as an assurance for the taxpayer being audited. Thus, the Third Circuit rejected the disparate treatment argument.
References: For subpart F income, see FTC 2d/FIN ¶O-2401; United States Tax Reporter ¶9524; TG ¶30429.