In a closely-watched test case addressing whether taxpayers are entitled to claim capital losses arising from contingent liability transactions, the federal district court in Maryland granted Black & Decker’s motion for summary judgment and entered judgment for the taxpayer. The ruling, which came on October 20th, just a few weeks before the case was set for trial, provided a welcome reminder that the government’s characterization of a transaction as a tax shelter is not the last word on the merits of a transaction. Victory in the Black & Decker case was all the sweeter for corporate taxpayers because it came shortly after the government – emboldened by its much-heralded win in Long Term Capital Holdings – announced tougher settlement guidelines for taxpayers who engaged in listed transactions. The Black & Decker decision also is significant because the district court held that, even if tax avoidance is the sole motivation for a transaction, the transaction must be respected for tax purposes if it has economic substance. Further, the court ruled that economic substance can be determined from the objective facts.

The BDHMI Transaction

At issue in the case were the tax consequences of Black & Decker’s restructuring of its employee and retiree health care liability management. In 1998, Black & Decker decided that it could more aggressively and proactively manage liabilities arising under its health care benefit plans by outsourcing the liabilities to a joint venture company named Black & Decker HealthCare Management, Inc., or “BDHMI.” At the end of 1998, Black & Decker transferred $561 million to BDHMI in exchange for a class of BDHMI stock and BDHMI’s assumption of Black & Decker’s contingent health care liabilities for 1999 through 2007, actuarially estimated and present valued at $560 million. The stock was subsequently sold to an independent, third-party investor for a fair market value of $1 million, resulting in a $560 million capital loss.

Black & Decker filed a $57 million refund claim for the carryover years. The government, in turn, filed a counterclaim seeking $113 million in taxes and an additional $41 million in penalties.

The Government’s Earlier Loss on Its Statutory Argument

The government characterized the BDHMI transaction as a contingent liability tax shelter described in Notice 2001-17. At the end of 2003, the government moved for summary judgment on its principal statutory argument for rejecting contingent liability transactions. The government argued that Black & Decker’s basis in the BDHMI stock should be reduced by the amount of the contingent liabilities assumed by BDHMI, which would have the effect of wiping out the capital loss. Under Code § 358(d)(2), liabilities described in § 357(c)(3) do not result in a basis reduction. Section 357(c)(3) liabilities are liabilities the payment of which “would give rise to a deduction.” The government asserted that the liabilities assumed by BDHMI were not covered by § 357(c)(3) – and thus resulted in a basis reduction – because the statute required that the liabilities be deductible by BDHMI (the transferee) after the § 351 exchange. According to the government, the liabilities continued to be deductible by Black & Decker (the transferor). Black & Decker responded that the statute required only that the liabilities be the sort of liabilities that would have been deductible by the transferor were it not for the exchange. While maintaining that BDHMI is entitled to deduct the health care costs associated with the liabilities it assumed, Black & Decker argued that deductibility by the transferee post-exchange is irrelevant to determining the transferor’s basis under § 358(d)(2). In August 2004, the district court denied the government’s motion on the basis that “the legislative history to § 357(c) lends no support to the United States’ suggested interpretation.”

Black & Decker’s Motion for Summary Judgment

With the court having rejected the government’s chief statutory argument, Black & Decker moved for summary judgment on the basis that the sham transaction doctrine did not apply. The Fourth’s Circuit’s decision in Rice’s Toyota World v. Commissioner, 752 F.2d 89 (4th Cir. 1985), provided the governing precedent. In Rice’s Toyota World, the Fourth Circuit held that a transaction will be treated as a sham if the court finds “that the taxpayer was motivated by no business purpose other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of profit exists.” Id. at 90. Accordingly, under the Fourth Circuit’s two-prong test, a transaction that has either business purpose or economic substance will be respected. The transaction must lack both business purpose and economic substance to be disregarded as a sham.

Although there was ample evidence of Black & Decker’s non-tax business motives for outsourcing its health care liability management to BDHMI, Black & Decker focused on the second prong of the Rice’s Toyota test because the less subjective economic substance test more easily satisfied the summary judgment standard. Solely for purposes of arguing its summary judgment motion, Black & Decker argued that the BDHMI transaction must be respected even if tax avoidance was the sole motivation for the transaction. Relying on Moline Properties v. Comm’r, 319 U.S. 436 (1943); United Parcel Serv. of Am., Inc. v. Comm’r, 254 F.3d 1014 (11th Cir. 2001); and N. Ind. Pub. Serv. Co. v. Comm’r, 115 F.3d 506 (7th Cir. 1997), Black & Decker argued that BDHMI could not be disregarded under a sham theory because it engaged in bona fide and substantial business activities. Where a corporation is restructuring an ongoing business activity, the restructuring may not be disregarded – irrespective of tax avoidance motives – so long as the restructured entity is engaged in meaningful and genuine business activity. Here, BDHMI actively manages health care liabilities arising under Black & Decker’s benefits plans and pays claims for the retirees and employees.

Holding for Black & Decker, Judge Quarles made the following findings: “It is undisputed that BDHMI (1) ‘assumed the responsibility for the management, servicing, and administration of plaintiff’s employee and retiree health plans;’ (2) has considered and proposed numerous healthcare cost containment strategies since its inception in 1998, many of which have been implemented by B&D; and (3) has always maintained salaried employees. Moreover, as a result of the BDHMI transaction, BDHMI became responsible for paying the healthcare claims of B&D employees, and such claims are paid with BDHMI assets.” The court concluded that the BDHMI transaction, therefore, had “very real economic implications.” Further, “[t]he court may not ignore a transaction that has economic substance, even if the motive for the transaction is to avoid taxes. Accordingly , the BDHMI transaction cannot be disregarded as a sham.”

Having held for Black & Decker on the economic substance argument, Judge Quarles entered judgment for Black & Decker, ruling that Black & Decker is entitled to the $57 million refund and dismissing the government’s counterclaims.

The Latest in a Series of Defeats

The government’s loss followed a string of interim defeats in the case, not only on the government’s own motion for summary judgment, but also on a number of important discovery issues. In September 2003, Magistrate Judge Gesner denied the government’s motion to compel production of work product prepared by Black & Decker and Deloitte & Touche, who advised Black & Decker on the transaction. The magistrate ruled that Black & Decker’s intended reliance on opinion letters written by Deloitte & Touche did not waive work product claims on documents underlying or related to the opinion letters. The government also failed in its efforts to withhold production of an unredacted Field Service Advice (“FSA”) memorandum it inadvertently produced. Black & Decker successfully argued that legal analysis had been improperly redacted from the public version of the FSA, in violation of § 6110(i), which requires the IRS to publicly disclose legal analysis contained in FSAs and other Chief Counsel advice. The magistrate also denied the government’s motion for a protective order, in which the government sought to block Black & Decker’s efforts to depose LMSB officials Frank Ng and David Harris.

The Black & Decker case also was notable for the level of discovery Black & Decker was able to obtain from the government on the penalty issue. The Government imposed a 40% gross valuation misstatement penalty despite a revenue ruling and contemporaneous Field Service Advice memoranda supporting Black & Decker’s statutory interpretation and despite Black & Decker’s application for penalty relief under the Announcement 2002-2 voluntary disclosure program. In developing its case for penalty relief under Announcement 2002-2, Black & Decker deposed six IRS officials and obtained evidence that the IRS had engaged in disparate treatment of similarly situated taxpayers in its administration of the Announcement 2002-2 amnesty program. The victory for Black & Decker on the underlying merits of the case eliminated the need for the court to address the government's $41 million penalty claim, which was conditioned on the government prevailing on the merits.

For further information, please contact:

Joel Weiss

Laura Ferguson, lferguson@milchev.com, 202-626-5567

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