Merrill Lynch lost another round in the US courts within the past month in its effort to defend a complicated financial product that it sold to prominent US corporations to help the companies generate capital losses.

The decision is important for the project finance community because it shows the fragility of financial products that have little purpose other than generating tax results when tested in the US courts.

AlliedSignal was planning in 1990 to sell a subsidiary at a large capital gain.

An individual who sat on both the AlliedSignal and Merrill Lynch boards brought a new financial product that Merrill Lynch had developed to AlliedSignal’s attention. The transaction involved a series of complicated offshore maneuvers at the end of which AlliedSignal would be able to claim a capital loss.

Briefly, the company set up an offshore partnership in April 1990. It had a 9% interest. Most of the remaining 91% of the partnership was owned by two Dutch Antilles subsidiaries of a foundation that was controlled by Dutch bank ABN-AMRO. The partners made capital contributions in their owner-ship percentages. ABN loaned the two Dutch Antilles companies the money they required to cover their capital contributions. The partnership then used $850 million of the capital to buy 5-year notes, called PPNs, from two Japanese banks. Less than a month later in May 1990, the partnership sold the PPNs for approximately $850 million to two other banks. The sales price was received partly in cash ($681 million) and partly in the form of notes with a market value of a little under $170 million payable over five years. The amount of each quarterly payment under the notes was uncertain because it varied with LIBOR. The partnership’s tax year ended on May 31 shortly after the sale.

The partnership reported the disposition of the PPNs as an installment sale. It used the rules where the sales proceeds include “contingent debt” to report a large gain in its tax year when the sale occurred and to set up a largely matching loss in later years. The gain was allocated largely to the Dutch Antilles entities. They were not US taxpayers.

Three months later in August, AlliedSignal increased its interest in the partnership to 58%. The partnership distributed its assets to the partners in the August ownership ratio. The Dutch Antilles entities took cash. AlliedSignal got the LIBOR notes with the built-in capital losses. AlliedSignal then sold the LIBOR notes and claimed net capital losses of $538 million.

The transactions cost AlliedSignal $11.3 to $12.6 million in transaction fees.

The US Tax Court cut through the transaction to conclude there was never any real partnership between AlliedSignal and the two Dutch Antilles companies.

The court ignored the existence of the two Dutch Antilles companies on grounds that they were thinly capitalized and “mere conduits” for participation by ABN. It said the relationship between ABN and AlliedSignal was one of lender-borrower rather than a partnership. The companies had divergent business goals. AlliedSignal entered into the venture for the sole purpose of generating capital losses. It ignored the transaction costs, profit potential and other fundamental business considerations. The AlliedSignal board focused only on the potential tax benefits when it approved the plan. Meanwhile, ABN entered into the venture for the sole purpose of receiving a debt return. This return was independent of the investment results of the venture. ABN had no profit potential beyond its specified return. The court said, quoting former US Supreme Court Justice Felix Frankfurter, if an arrangement does not put all parties “in the same business boat, then they cannot get into the same boat merely to seek . . . [tax] benefits.”

Without a partnership, the tax results from the transaction collapsed.

The case is interesting for a number of reasons. First, it is an unusual case when courts ignore the separate existence of subsidiaries. Second, the fact that the court was unwilling to find a partnership may shed light on what parties should be careful to do when the shoe is on the other foot. US companies making outbound investments sometimes try to go in the opposite direction of claiming that a relationship is a joint venture, or partnership for US tax purposes, even though the contracts governing the relationship bear other names.

Third, the case serves as a reminder: It was unhelpful to have the AlliedSignal board focusing only on tax benefits from the transaction. Fourth, it was equally unhelpful that ABN treated the transaction as a loan internally. The transaction went through normal credit committee procedures at ABN. An internal ABN memo described the transaction as, “AlliedSignal Inc. has a capital gain tax liability and this will cure their liability.” No matter how careful the tax advisers may be for a company, there is no way to control what is said about the transaction by other participants. Such materials will come out in discovery.

This is the second loss for Merrill Lynch on its product. The US Tax Court ruled against Colgate-Palmolive on different grounds in a similar case last year called ACM Partnership. That case has attracted a lot of attention in the tax bar and is being appealed. The taxpayer hired the former top tax official in the Bush administration to handle the appeal. The IRS has challenged at least nine other Merrill Lynch customers on their use of the product.

Keith Martin