The trial judge says: "Both arrangements are enormously complicated in their construction and operation." Which brings me to the features of a tax shelter. I address this in my Federal Tax Procedure Book and this is a portion of that discussion (footnotes omitted):
Tax shelters are many and varied. Some are outright fraudulent wrapped in what is disguised as a real deal. The more sophisticated, however, are often without substance but do have some at least tenuous claim to legality. Some of the characteristics that I have observed for tax shelters that the Government might perceive as abusive are that (i) the transaction is outside the mainstream activity of the taxpayer, (ii) the transaction is incredibly complex in its structure and steps so that not many (including specifically IRS auditors) will have the ability, tenacity, time and resources to trace it out to its illogical conclusion (this feature is often included to increase the taxpayer’s odds of winning the audit lottery); (iii) the transaction costs of the arrangement and risks involved, even where large relative to the deal, still have a favorable cost benefit/ratio only because of the tax benefits to be offered by the audit lottery, (iv) the promoters of the adventure make a lot more than even an hourly rate even at the high end for professionals (the so-called value added fee), which in the final analysis is simply a premium for putting the reputations and perhaps their freedom at risk to give a comfort opinion that the deal which will not work if discovered, and (v) the objective indications as to the taxpayer's purpose for entering the transaction are a tax savings motive rather than any type of purposive business or investment motive. More succinctly, a Yale Law Professor has described an abusive tax shelter as “[a] deal done by very smart people that, absent tax considerations, would be very stupid.” Other thoughtful observers vary the theme, e.g. a tax shelter “is a deal done by very smart people who are pretending to be rather stupid themselves for financial gain.”On the merits of the transaction, the court said that the transaction lacked economic substance (more or less the same as calling it bullshit). On the penalties, the Court held that the 20% accuracy related penalty applied but that, since the transaction was rejected on the merits because of lack of economic substance (for being so abusive that is was, colloquially bullshit), Fifth Circuit precedent required it to reject the 40% gross overvaluation penalty. I posted yesterday the current state of the circuit conflict on whether the 40% gross overvaluation penalty can be rejected on that basis, noting that the Fifth Circuit and the Ninth Circuit are outside the growing consensus that the 40% penalty can apply. See Yet Another Bullshit Tax Shelter Bites the Dust (Federal Tax Crimes Blog 2/26/13), here (the quote of footnote 18 of the Third Circuit's opinion).
Here are a few interest excepts from the opinion (in the order presented in the opinion; emphases supplied and most footnotes omitted):
The resolution of this case turns, in large part, on this Court's application of judicial doctrines that have been developed by the courts for more than three-quarters of a century. For the reasons which follow, the Court finds that the Chemtech transactions should be disregarded for tax purposes because: a) the transactions fail both tests under the economic substance doctrine; b) the partnership was a sham and had no legitimate business purpose; and c) even if this Court were to respect the partnership as a separate entity for tax purposes, it would not treat the banks as true equity partners. Finally, the Court finds that a 20% penalty applies for substantial understatement and negligence.
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[Early in the planning] Lawyers from Andrews & Kurth advised Goldman that, under the tax law in force at the time, business purposes other than tax savings were important for the completion of the transaction. In particular, lawyers stressed that the business purpose of off-balance sheet financing ("OBSF") was essential. n2
n1 Deposition of David Ackert, p. 14. This goal was referred to as the "Holy Grail" in reference to its perceived unattainable nature.
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SLIPs was a marketed tax shelter product. This particular type of tax shelter is known as a "lease-strip," meaning that taxable income is "stripped away" from a transaction and is allocated to a non-US taxpayer. Once the taxable income is stripped away, the U.S. taxpayer is left with tax benefits which may be used to reduce or eliminate the income tax that would otherwise be paid by the taxpayer for other business or income.
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[For Chemtech I (the first of the two)] Dow incurred formation costs totaling just over $12.6 million, not including expenses incurred later during the operation of Chemtech and the retiring of the foreign banks.
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In order to fully understand the economics of Chemtech I, an analysis of the flow of money and the resulting tax consequences is required. Conceptually, the money flowed in a circle, akin to the circular flow of patents discussed above, from Dow to Chemtech back to Dow, except the foreign banks were paid a fee equivalent to an interest payment. The tax consequences, on the other hand, do not move in such a way. While Dow claimed royalty expense deductions for the money flowing to Chemtech, it did not take into account the income of the bulk of the money flowing from Chemtech. That is the hallmark of a "lease strip" tax-shelter such as SLIPS: the income from, and deductions related to, circular flows of cash are separated. Tax deductions are given to United States' taxpayers, while taxable income is allocated to tax-exempt entities, i.e. foreign investors.
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The movement of cash begins with Dow, circulates through Chemtech entities, and returns back to Dow. One would expect the tax consequences to follow the cash, so that Dow would receive a deduction for payments made to Chemtech, and report payments received from Chemtech as income. In other words, the transaction would be a "wash" on Dow's tax return. But that's not what happened.
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Like Chemtech I, the cash in Chemtech II generally flowed in a circle, except for the interest-like payment to RBDC (the only non-Dow partner).
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Dow's professed business purpose is a false wall in the maze of the Chemtech transactions. Upon closer inspection, the path does not end at OBSF or credit ratings, but continues to the heart of the case: tax benefits. The evidence in this case leads this Court to find that Dow had no business purpose for entering into the Chemtech transactions other than to obtain tax benefits. Tax law was the basis for the SLIPs transaction from the beginning. Moreover, Dow had no apparent need for the $200 million investment as it was Goldman Sachs who marketed the SLIPs product to Dow in 1992. As much as a year into organizing the transaction with Goldman, Dow had no particular amount in mind for the value of the patents it planned to "monetize," but was throwing around figures between $200 million and $1 billion. The fact that Goldman and Dow had little discussion of taxes appears to be a product of design rather than function, as at least one high-ranking Dow officer reminded himself prior to a meeting that, "We can't talk about the tax impact on [The Dow Chemical Company]. " Finally, in at least one of its calculations of the net present value of the Chemtech transactions, Dow considered risk factors after the transaction had taken place. The only risk to the project after the transaction occurred was that the tax benefits would be disallowed.
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Dow's purpose in entering into the Chemtech transactions was to obtain tax benefits. "Everything other than tax motivation fades under the glare of analysis."
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The Court concludes there was no legitimate business purpose other than tax avoidance behind the Chemtech transactions. Therefore, the transactions fail both the objective and subjective prongs of the economic substance analysis, and are an economic sham.
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It is clear to this Court that, viewing the Chemtech transactions in their totality, the agreements between Dow and the foreign banks did not form true partnerships because they lacked a true "business purpose" as required by Culbertson.
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This all but confirms that the mark-to-market gain was nothing but window dressing, or "a disguise for concealing [the transaction's] real character."In short, Dow Chemical tried to snooker the IRS and failed and then tried to snooker the court and failed. Dow is reportedly considering an appeal. I hope DOJ does appeal the denial of the 40% penalty. I think this case would be an excellent platform to fight the battle again in the Fifth Circuit and then, if necessary, in the Supreme Court. Dow Chemical bears no resemblance in the facts or in equity to the Heasleys.
See also Robert W. Wood, Dow Chemical's $1 Billion Tax Shelter Stinks, Says Court (Forbes 2/27/13), here.
My only comment on Mr. Wood's article is that tax shelter deals such as this are complex creatures designed to give the appearance of a real business deal taking advantage of seemingly arcane tax rules. At the end of the day, if the real deal is ferreted out of the smokescreen of complexity in the documents, these deals do not exploit the tax rules at all but have some basic Achilles heel (or heels). Often there is the critical lie about having a "business purpose" other than tax avoidance. After getting past the deliberate smokescreen the taxpayer and its advisors created to deceive, the Court held "the partnership was a sham and had no legitimate business purpose" and the banks, although nominated partners to mask the elaborate hoax, were not partners. The taxpayer and its advisors knew this was too good to be true -- that this was an illegal raid on the fisc and the citizens of this country, and did it anyway; their only hope was that the the IRS and the courts would be deceived by their shenanigans. In my view, a 20% penalty, even with interest on the tax and the penalty, is not sufficient to adequately address this behavior; indeed, even the 40% penalty is not sufficient.
Finally, afficionados of bullshit tax shelters will recognize King & Spalding as being a major player / enabler in the bullshit tax shelter market (at least until some of their lawyers moved to another firm to make even more money, a move that perhaps resembles Daugerdas' move for the money to Jenkens & Gilchrist). See e.g., Long Term Capital Holdings, Inc. v. United States, 330 F.Supp.2d 122 (D. Conn. 2004), aff’d by unpublished order (2nd Cir. 9/27/05), and David Cay Johnston's deconstruction of the planning rejected in Long Term Capital, here; and TIFD III-E, Inc. v. United States, 666 F.3d 836 (2d Cir. 2012) here, discussed in my prior blog Thoughts on the the Corporate Audit Lottery (Federal Tax Crimes Blog 2/11/12) here. The attorneys in the Chemtech litigation are listed here. Interestingly, if you trace the histories of these attorneys and the cited litigation, at least one appears to have been originally from King & Spalding, the designer of the false Chemtech structure. And, former King & Spalding attorneys represented the taxpayers in Long Term Capital and TIFD. I have no idea whether in Chemtech or the earrlier bogus shelter cases they were defending structures they personally participated in planning, but Judge Aterton had some choice words about one of their then partners (also a former King & Spalding attormey) regarding the various roles played from inception to end (end via litigation). (See Long Term Capital, p. 147 n. 35 and pp. 149-153). I recommend those cases to readers of this blog for some understanding of how cozy the bogus shelter industry is.