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US: I.R.S. Wins Its Appeal Over Abusive Tax Shelter

by Lynnley BrowningThe New York Times
July 13th, 2006

A federal appeals court handed a victory to the Internal Revenue Service yesterday in its war on questionable tax shelters, ruling that a shelter bought in 1996 by a former subsidiary of the Goodrich Corporation was abusive.

The case involving the Goodrich subsidiary, Coltec Industries, has been closely watched by tax lawyers and lobbyists as they argue over what constitutes an abusive shelter.

In the ruling, three judges on the United States Court of Appeals for the Federal Circuit overturned a lower court’s ruling in 2004, which said that Coltec was entitled to a $83 million refund from the I.R.S. stemming from its use of the shelter. That original ruling dealt a blow to I.R.S. efforts against abusive shelters.

Tax shelters like the one that Coltec bought through Arthur Andersen, were available in the last decade through large accounting firms. The shelter, known as a continent liability shelter, is intended to generate losses and was barred by the I.R.S. in 2001.

Tax lawyers regard yesterday’s ruling as significant because it addresses a disputed area known as the economic substance doctrine.

Under the doctrine, which is not a formal part of the tax code, the I.R.S. considers invalid any shelter that follows the letter of the tax code, but violates its spirit by existing only to engineer tax losses.

In the ruling, the judges wrote that “the law does not permit the taxpayer to reap tax benefits from a transaction that lacks economic reality” and that “a lack of economic substance is sufficient to disqualify the transaction without proof that the taxpayer’s sole motive is tax avoidance.”

Coltec, a maker of aerospace and industrial products that was bought by Goodrich in 2003, bought the shelter to protect itself from $375 million in asbestos-related liabilities. In 1996, through a series of transactions, Coltec shifted a $375 million promissory note to a subsidiary to insulate itself from the asbestos liabilities.

The subsidiary then sold $500,000 in stock — most of its entire capitalization — to investors.

On its federal income tax return for 1996, Coltec then claimed a loss of more than $375 million, arguing that the subsidiary’s worth included the asbestos liabilities. The loss more than offset Coltec’s taxable gains for the year.

The I.R.S. disallowed the loss, and assessed Coltec a tax bill of nearly $83 million. In 2000, Coltec sued for a refund in the United States Court of Federal Claims in Washington, where in 2004, Judge Susan G. Braden upheld Coltec’s position and denied the I.R.S.’s position. The I.R.S. appealed the decision.

Eileen J. O’Connor, an assistant attorney general, said in a statement yesterday that the latest ruling “confirms that illusionary losses purportedly created by the so-called ‘contingent liability’ tax shelter are not deductible against actual taxable income.”

The ruling is similar to one that the I.R.S. won involving Black & Decker.

The economic substance doctrine has been a source of fierce debate among judges, lawyers and tax officials, with some of them arguing that it must be codified to prevent abusive tax shelters and others saying that it is hopelessly murky and unconstitutional.

But a tax lawyer, E. Ray Beeman, said yesterday that the ruling might encourage lawmakers not to make the economic substance doctrine a formal part of the tax code in favor of letting the courts decide which shelters had substance.

 





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