Black & Decker Corp. v. U.S.

• Court: U.S. Court of Appeals — Fourth Circuit
• Writing for the Court: Michael
• Citation: Black & Decker Corp. v. U.S., 436 F.3d 431 (4th Cir. 2006)
• Decision Date: 02 February 2006
• Docket Number: No. 05-1015.,05-1015.
• Parties: The BLACK & DECKER CORPORATION, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.

Page 431

436 F.3d 431

The BLACK & DECKER CORPORATION, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.

No. 05-1015.

United States Court of Appeals, Fourth Circuit.

Argued October 25, 2005.

Decided February 2, 2006.

ARGUED:

Richard Farber, United States Department of Justice, Tax Division, Washington, D.C., for Appellant. Herbert Odell, Miller & Chevalier, Chartered, Bala Cynwyd, Pennsylvania, for Appellee.

ON BRIEF:

Eileen J. O'Connor, Assistant Attorney General, Richard T. Morrison, Deputy Assistant Attorney General, Allen F. Loucks, United States Attorney, Gilbert S. Rothenberg, Bridget M. Rowan, Deborah K. Snyder, Tax Division, United States Department of Justice, Washington, D.C., for Appellant. Philip Karter, Miller & Chevalier, Chartered, Bala Cynwyd, Pennsylvania; Laura G. Ferguson, Miller & Chevalier, Chartered, Washington, D.C.; Harry A. Pogash, Darren G. Pratt, The Black & Decker Corporation, Towson, Maryland; John E. McCann, Jr., Miles & Stockbridge, P.C., Baltimore, Maryland, for Appellee.

Before LUTTIG, WILLIAMS, and MICHAEL, Circuit Judges.

Affirmed in part, reversed in part, and remanded by published opinion. Judge MICHAEL wrote the opinion, in which Judge LUTTIG and Judge WILLIAMS joined.

OPINION

MICHAEL, Circuit Judge.

A corporate taxpayer paid $561 million to a controlled subsidiary in exchange for 10,000 shares of the subsidiary's stock and the subsidiary's assumption of a $560 million contingent liability of the taxpayer. The taxpayer then sold the shares for $1 million, claimed a $560 million capital loss on its federal income tax return, and sought a refund based on that loss. The Internal Revenue Service declined to pay because it concluded that the capital loss stemmed from an illegal tax shelter. After the taxpayer sued, the district court denied the IRS's summary judgment motion and granted the taxpayer's summary judgment motion. The IRS appeals. We conclude that neither the IRS nor the taxpayer is entitled to summary judgment under the controlling tax statutes. Under the sham transaction doctrine, however, the validity of the claimed loss turns on unresolved issues of material fact. Accordingly, we affirm the denial of the IRS's motion, reverse the grant of the taxpayer's motion, and remand for further proceedings.

I.

A.

The Black & Decker Corporation (BDC), its wholly-owned subsidiary Black & Decker Inc. (BDI), and their direct and indirect subsidiaries constitute a major manufacturer of power tools and home improvement products. (The subsidiaries involved are Emhart Industries, Inc., Price Pfister, Inc., and Kwikset Corp., all of which are domestic corporations controlled by BDC. BDC is also owner of Black & Decker Canada, Inc. (the "Canadian subsidiary"), which does not file a tax return in the United States. We will refer to BDC and its domestic direct and indirect subsidiaries as, collectively, "Taxpayer."). Taxpayer provides medical and dental insurance benefits to its current and retired employees, who number in the thousands. The aggregated future health benefits claims constitute a contingent liability because their precise cost is not known in the present. Thus, Taxpayer can estimate but cannot predict with certainty how many of its employees or retirees will be diagnosed with particular illnesses in future years.

In 1998 Taxpayer realized nearly $303 million in capital gains income from the sale of three businesses. Taxpayer sought to offset that income against a large loss to prevent the imposition of a substantial federal income tax obligation. To this end Taxpayer executed a transaction that gave rise to what it intended to be a significant capital loss. The Deloitte & Touche accounting firm had designed the transaction and advised some 30 corporate clients, including Taxpayer, on its implementation as a tax strategy. The transaction involved a subsidiary called Black & Decker Healthcare Management Inc. (BDHMI). Taxpayer owned all of BDHMI's common stock. BDHMI's preferred shareholders included an affiliate of William M. Mercer, Inc. (Taxpayer's benefits consultant and a subsidiary of Marsh & McLennan Companies, Inc.) and Taxpayer's Canadian subsidiary. The participation of outside investors permitted BDHMI to file a federal income tax return separate from Taxpayer's.

The transaction consisted of two phases. Phase One was an exchange on November 25, 1998, between Taxpayer and its Canadian subsidiary on the one hand and BDHMI on the other. Taxpayer and the Canadian subsidiary paid BDHMI approximately $561 million in cash with funds Taxpayer had borrowed from its banks for 30 days. In return BDHMI (1) gave Taxpayer and the Canadian subsidiary 10,000 shares of BDHMI's series C preferred stock and (2) assumed liability for the future health benefits claims against Taxpayer and the Canadian subsidiary from 1999 to 2007, which had an estimated net present value of $560 million. According to the exchange agreement the companies executed, BDHMI's assumption of liability "[did] not constitute either a legal defeasance of the Benefits Liabilities by [Taxpayer] or a novation and consequently, [Taxpayer] ... continue[d] to be primarily liable for the payment and performance of the Benefits Liabilities." J.A. 217. Thus, Taxpayer remained liable on the underlying obligations transferred to BDHMI.

The companies executed Phase Two on December 29, 1998. Taxpayer and the Canadian subsidiary sold the 10,000 BDHMI shares at a price of $1 million to an unrelated third-party trust benefitting a former BDC executive. Also that day, BDHMI promised to lend BDI approximately $564 million, most of which was to be repaid in monthly installments according to the terms of three lending agreements. BDI's installment payments on the loans were "designed to provide [BDHMI] with sufficient funds to pay" the benefits liabilities as they came due. J.A. 127. Although BDHMI continued to hold the benefits liabilities, Taxpayer reported all of the income from the businesses and employees that gave rise to those liabilities.

As one of BDHMI's outside investors put it, "The rationale behind the establishment of the subsidiary [BDHMI] is that a loss equal to the reserve for the liabilities can be recognized upfront for tax purposes and the [special purpose vehicle, BDHMI] may be able to deduct the amount of the claims a second time as they are actually incurred." J.A. 3235. Formally, the investors in BDHMI stood to earn a positive return on their investment in the event that Taxpayer's actual health care liabilities fell short of the expected cost of those liabilities, so that Taxpayer's repayment on the loan would exceed BDHMI's payments on the medical claims, creating net income for BDHMI. But as a practical matter Taxpayer expected BDHMI to generate net operating losses because the health expenses were likely to consistently exceed BDHMI's interest income from the loan to Taxpayer. Or, in the words of Taxpayer's in-house accountants, "BDHMI will generate net operating losses since the interest income on the note receivable is not likely to exceed annual claims paid which are recognized for tax purposes when paid." J.A. 148.

B.

In its 1998 tax return Taxpayer characterized Phase One as the purchase of the BDHMI shares for $561 million and Phase Two as the sale of those shares for $1 million, generating a $560 million capital loss. Taxpayer claimed that its basis in the BDHMI stock was equal to the cash payment without reduction by the benefits liabilities BDHMI assumed in Phase One. The large capital loss offset the capital gains from Taxpayer's divestitures earlier in the year. Further, the large loss had both retrospective and prospective tax-reducing effects under the Internal Revenue Code of 1986, as amended, 26 U.S.C. ("IRC"), allowing Taxpayer to file for refunds on its returns for the 1995 through 2000 tax years. The refunds sought totaled approximately $57 million.

Because the IRS did not pay the refunds for more than six months, Taxpayer commenced a civil action in the U.S. District Court for the District of Maryland. 26 U.S.C. §§ 7422; 6532(a)(1). The IRS filed a counterclaim for tax, interest, and penalties of approximately $215 million. The IRS construed the tax laws as requiring Taxpayer to state its basis in the shares sold as $1 million, not $560 million. Taxpayer took the opposite view. Moving for summary judgment, the IRS argued that under IRC § 357(c)(3)(A) Taxpayer, the transferor, had to reduce its stock basis by the amount of the contingent liability assumed by BDHMI, the transferee. The district court denied the motion. Taxpayer then moved for summary judgment, arguing that the transfer of the benefits liabilities was not a sham transaction that could be disregarded for tax purposes. The district court granted the motion, Black & Decker Corp. v. United States, 340 F.Supp.2d 621 (D.Md.2004). The district court stated that because BDHMI was constituted for a valid business purpose, BDHMI and all of its transactions were "objectively reasonable" and thus could not be disregarded for tax purposes. Id. at 623-24. This appeal by the IRS followed.

II.

The IRS first contends that it was entitled to summary judgment because, on the undisputed facts, the statutes governing the transaction required the basis reduction. Preliminarily, we note that if Taxpayer were to engage in the contingent liability transfer today, it would be required to reduce its basis by the amount of the transferred liabilities under IRC § 358(h), which Congress enacted as part of the Community Renewal Tax Relief Act of 2000. P.L. 106-554, § 1(a)(7), 114 Stat. 2763 (2000). That statute does not control here because it does not apply retroactively. In addition, in 2001 the IRS issued Notice 2001-17 on contingent liability tax shelters, which put corporations on notice that the IRS would challenge transactions of the type at issue here. These legal and enforcement policy developments...