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Friday, May 25, 2007

IRS Wins Another Tax Shelter Case

The IRS won another tax shelter case yesterday:  H.J. Heinz & Co. v. United States, No. 03-2847T (Ct. Fed. Cl. 5/24/07).  The court denied Heinz's claimed $42.6 million tax refund on economic substance grounds.  The opinion is noteworthy in at least two respects: (1) the court's description of the role of basis in the income tax (an issue much discussed in the context of the Murphy case), and (2) the court's pithy conclusion:

[1]  All tax students are familiar with the concept of “basis,” which, in the income tax law, is the touchstone for measuring income and loss. Generally speaking, it is basis that prevents the double taxation of income reflected in a property’s cost, by allowing that cost to be recovered, tax-free, upon the asset’s disposition. And it is basis, again, that measures the loss realized if the seller recovers less than its investment in property. Sometimes, the process for determining basis is straight-forward, with the amount readily traceable, for example, to specific costs incurred by the taxpayer with respect to the asset being sold. Other times, however, the origins of basis are more obscure, particularly, when the tax law attributes costs previously incurred by a taxpayer to the sold asset. Those attribution rules are fairly complicated, providing opportunities both for bona fide tax planning and undue manipulation of the tax system. Sometimes it falls to a court to discern which of these has occurred. ...

[2]  A Heinz promotion from the late 1950s and early 1960s touted its tomato ketchup by stating – “It’s Red Magic Time!” But no amount of magic, red or otherwise, can hide the meat of the transactions in question, the connective tissues and gristle of which have been revealed by the multi-tined substance-over-form doctrine. Sans sa sauce, it becomes plain that plaintiffs’ transaction simply was not “the thing which the statute intended.” Gregory, 293 U.S. at 469.

For a description of the precise tax issue in the case, see below the fold.

This tax refund case is before the court following a three-day trial in Washington, D.C. Plaintiffs seek a refund of $42,586,967. At issue is whether H.J. Heinz Credit Company (HCC), a subsidiary of the H.J. Heinz Company (Heinz), may deduct a capital loss of $124,134,189 on a sale of 175,000 shares of Heinz stock in May 1995. In 1994, HCC purchased 3,500,000 shares of Heinz stock, 3,325,000 shares of which were transferred to Heinz in January of 1995 in exchange for a convertible note issued by Heinz. Heinz asserts that this was a redemption which should be taxed as a dividend, and that HCC’s basis in the redeemed stock should be added to its basis in the 175,000 shares it retained. HCC sold the latter stock in May of 1995 and, in plaintiff’s view, recognized a capital loss arising from the increase in basis that occurred upon the earlier redemption. That loss, plaintiffs argue, should then be carried back to reduce their taxes in their 1994, 1993 and 1992 taxable years.

Not so, defendant argues, asserting that Heinz did not, in fact, effectuate a redemption of stock from HCC. In this regard, it asseverates that a redemption did not occur because HCC’s ownership of the 3,325,000 shares of Heinz stock was transitory and should be disregarded. It further claims that no redemption occurred because Heinz had no business purpose for interposing a subsidiary between itself and the shareholders from whom HCC purchased stock, save to engineer an artificial tax loss. And, finally, it contends that while Heinz structured the second purchase as an exchange for property under section 317(b) of the Internal Revenue Code of 1986,2 the steps of the transaction should be collapsed under the so-called “step transaction doctrine,” with Heinz again viewed as having repurchased its stock directly from the outside investors. As such, defendant contends, the basis in the 3,325,000 shares allegedly “redeemed” by Heinz should not be added to the 175,000 shares that HCC retained, with the effect that no capital loss was produced upon the sale of the latter shares.

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Comments

My god, how do people get away with writing opinions like this? The court may very well have reached the legally correct result, but the reasoning was atrocious. Perhaps the taxpayer will draw an appellate panel (different from the Coltec one) which will produce an opinion that isn't complete nonsense.

Congress really needs to codify the doctrine.

Posted by: andy | May 25, 2007 11:52:17 AM