A US appeals court held in mid-October that the Internal Revenue Service was right to deny the benefit from a series of complicated offshore maneuvers Colgate-Palmolive undertook in 1989 and 1991 to generate $98 million in tax losses.

The case has attracted enormous attention in the tax community.

The transaction complied technically with US tax rules, but the court refused to honor the results on grounds that it had no credible business purpose. At least one commentator applauded the decision by the lower court last year — also in favor of the government — as a sign that the courts are beginning to hit back at aggressive tax schemes that work technically but defy common sense.

The case is ACM Partnership v. Commissioner. Colgate-Palmolive sold a subsidiary in 1988 at a capital gain of $104.7 million. Merrill Lynch came to it late in the year with an idea for how to generate capital losses to offset the gain. It was late the following year when Colgate-Palmolive implemented the transaction.

Briefly, the company formed an offshore partnership in the Netherlands Antilles with subsidiaries of the Dutch bank ABN-Amro and Merrill Lynch as partners.

The three partners contributed $205 million to the offshore partnership. The partnership used the money the next day to buy short-term floating-rate notes from Citicorp. It sold the notes for roughly the original purchase price later the same month pursuant to terms that Merrill Lynch had negotiated around the time the notes were originally purchased.

The sale generated $140 million in cash for the offshore partnership and a promise from the buyers to pay the rest over time with interest tied to LIBOR. Because of peculiarities in the US tax rules governing installment sales, the offshore partnership claimed a large gain on the sale of the Citicorp notes even though there was no gain in fact. Under the installment sale rules, the partnership was able to allocate its $205 million “basis” in the notes ratably over the four years that the balance of the purchase price was expected to be received from the buyers. This produced a large gain in the year of sale that was expected to be matched by equal losses in later years.

At the time of sale, ABN was an 82.6% partner, so most of the gain was allocated to it. Since ABN was not a US taxpayer, this gain escaped US tax.

By the time the offsetting losses were recorded, Colgate-Palmolive had increased its ownership of the partnership to 99.7%. Thus, the losses were claimed against the US tax base.

The appeals court disallowed almost all the losses. It applied two tests to the transaction. First, it did an objective analysis of the whether the transaction had any effect on Colgate’s financial position or whether it was entirely a tax play. The transaction failed. The court said, “Tax losses such as these, which are purely an artifact of tax accounting methods and which do not correspond to any actual economic losses, do not constitute the type of ‘bona fide’ losses that are deductible under the Internal Revenue Code . . . .”

Next, the court applied a subjective analysis of whether the transaction had any credible business purpose. Colgate argued that one purpose was to reduce the amount of the company’s longterm debt without signalling that fact to the market. The company was a target in 1989 of unwelcome takeover speculation and any move to reduce leverage might give hope to buyers wanting to do a leveraged buyout of the company. The offshore partnership used the $140 million in cash that it received from the sale of the Citicorp notes to buy Colgate debt. The fact that the offshore partnership now holding the Colgate debt was controlled by ABN meant the debt reduction did not have to reported on financial statements as Colgate buying back its own debt. Merrill Lynch originally brought the tax planning idea to Colgate in October 1988. Colgate made it go back and work debt management as another objective into the deal structure. Merrill Lynch returned with the revised proposal in August 1989.

The appeals court was not persuaded. The court said the timing of the debt acquisition strategy made no sense given that Colgate management was expecting interest rates to fall.

Colgate took a real loss of $5.8 million on the installment notes due to declining interest rates. The appeals court allowed this loss to be deducted, but not the rest. The IRS had argued that all losses associated with the transaction should be disallowed.

It was a divided decision. One of three judges dissented. He accused the majority of applying a smell test, and argued the IRS should complain to Congress or fix its own rules rather than rely on the courts.

The case suggests a number of lessons for multinational corporations engaged in foreign tax planning. First, a business purpose is essential, and it must be credible. Second, alarm bells should sound if the transaction has little real economic effect in relation to the large tax consequences claimed. The US government is currently attempting to apply this theory in other areas. For example, in Notice 98-5 earlier this year, the IRS said it would attack transactions that generate large foreign tax credits at the same time little taxable income is reported. Regulations to implement Notice 98-5 are expected shortly.

The case should disabuse any taxpayers who believe the sheer complexity of their transactions will make them impossible for the IRS to sort out. The appeals court opinion takes the better part of a day to read properly. Senator John Breaux (D.-La.), a member of the Senate Finance Committee, once said committee staff should hand out headache tablets at any committee meeting to discuss taxes that runs over two hours.

Another lesson is to exercise care how a transaction is described, not only in internal memoranda, but also by outside participants. Colgate did not want the offshore partnership to report the cost of selling the Citicorp notes as a charge against income for financial purposes. An outside auditor discussed the issue in a memo to his supervisor. The memo described the transaction as “mainly tax driven” and said the problem with reporting the sale charge was the “inclusion might set the IRS on top of the reasons why the partnership was constructed in the first place.” (Auditors’ memos are not protected from disclosure to the IRS.) A note from ABN in Merrill Lynch’s files said the Dutch bank would participate in the transaction only if all the steps were essentially wired and ABN was assured of being bought out at par less than a month after the partnership was formed. Internal computer runs by Colgate showed no interest in the rate of return from the transaction, particularly in relation to the large transaction costs the company would incur to implement it, when deciding whether to proceed. The Colgate board said all the right things in its resolution approving participation in the transaction, but the business purpose claimed was not credible in light of these other documents.

Another appeal is possible to the US Supreme Court. The case is significant enough that this will not be the last word. The IRS has challenged at least 10 other Merrill Lynch customers on their use of the product. One, AlliedSignal, lost in the US tax.

By Keith Martin