IES Industries v. United States

• Decision Date: 10 January 2001
• Docket Number: CROSS-APPELLEE,00-1535,CROSS-APPELLANT,Nos. 00-1221,s. 00-1221
• Citation: 253 F.3d 350
• Parties: (8th Cir. 2001) IES INDUSTRIES, INC., AND SUBSIDIARIES, PLAINTIFF, ALLIANT ENERGY CORPORATION, SUCCESSOR IN INTEREST TO IES INDUSTRIES, INC., AND SUBSIDIARIES, APPELLANT/, v. UNITED STATES OF AMERICA, APPELLEE/ Submitted:
• Court: U.S. Court of Appeals — Eighth Circuit

Page 350

253 F.3d 350 (8th Cir. 2001)

IES INDUSTRIES, INC., AND SUBSIDIARIES, PLAINTIFF, ALLIANT ENERGY CORPORATION, SUCCESSOR IN INTEREST TO IES INDUSTRIES, INC., AND SUBSIDIARIES, APPELLANT/CROSS-APPELLEE, v. UNITED STATES OF AMERICA, APPELLEE/CROSS-APPELLANT.

Nos. 00-1221, 00-1535

UNITED STATES COURT OF APPEALS FOR THE EIGHTH CIRCUIT

Submitted: January 10, 2001

Filed: June 14, 2001

Appeal from the United States District Court for the Northern District of Iowa.

Before Richard S. Arnold and Bowman, Circuit Judges, and Kyle, ¹ District Judge.

Bowman, Circuit Judge

IES Industries, Inc., ² appeals from the order of the District Court granting the United States summary judgment on IES's claim for tax refunds to which IES contends it is entitled as a result of securities trades that the court held to be sham transactions. The United States cross appeals, challenging the District Court's decision granting summary judgment to IES on its second claim for a tax refund, that IES is entitled to deduct fifteen years' worth of environmental cleanup cost assessments in the tax year in which the amount of the liability was determined. We affirm in part and reverse in part.

I. IES's Appeal

We review de novo a district court's decision to grant summary judgment, and will affirm if the record shows no genuine issues of material fact and the moving party is entitled to judgment as a matter of law. Land v. Washington County, Minn., 243 F.3d 1093, 1095 (8th Cir. 2001). The material facts are undisputed; the question of law before us is "[t]he general characterization of a transaction for tax purposes." Frank Lyon Co. v. United States, 435 U.S. 561, 581 n.16 (1978). Before we discuss the legal question, we first set out in some detail the facts leading to IES's claim for a tax refund, drawing heavily on the parties' very helpful stipulation of facts.

The transactions at issue involved American Depository Receipts, or ADRs. ADRs are publicly traded securities, or receipts, fully negotiable in U.S. dollars, that represent shares of a foreign corporation held in trust by a U.S. bank. The owner of an ADR is entitled to all dividends and capital gains associated with the ADR, with those moneys taxable in the home country of the foreign corporation.

Before a dividend is paid on an ADR, the corporation issuing the stock will declare the amount to be paid, the record date, and the payment date. The owner of the ADR as of the close of business on the record date will be paid the dividend. The payment date for the dividend ordinarily is several weeks or more after the record date. When a dividend is paid, tax is withheld, usually by the foreign corporation, before the funds are transferred to the United States. In this case, the ADR dividends were paid by corporations in the United Kingdom, the Netherlands, and Norway. Under the terms of tax treaties between those countries and the United States, the withholding rate on ADR dividends paid to U.S. citizens is 15%. Thus the record owner of the ADR would receive 85% of the dividend in cash, but the gross income--100% of the dividend--would be fully taxable in the United States. In these circumstances, the record owner is entitled to a 15% foreign tax credit, a dollar-for-dollar credit against U.S. taxes owed.

In 1991, Twenty-First Securities Corporation, a securities broker in New York, proposed ADR trading opportunities to IES, an electric utility company in Iowa. After some initial investigation, IES decided to sign on. The trades worked as follows.

Twenty-First was responsible for identifying and locating ADRs whose companies had announced dividends. IES purchased ADRs with a settlement date, or effective trade date, before the record date for the dividend, so that IES was the owner on the record date and therefore entitled to be paid the dividend. IES then promptly sold the ADRs, with a settlement date after the record date. The purchase and sale generally took place within hours of each other, and sometimes in Amsterdam when the U.S. and European markets were closed.

The sellers of the ADRs were tax-exempt entities, such as pension funds. But such entities were exempt only from U.S. taxes; they still were required to pay the 15% foreign tax on any ADR dividends collected. Because they owed no U.S. tax, they could not benefit from the foreign tax credit. Before the dividend record date, the tax-exempt holders of the ADRs loaned them to a counterparty selected by Twenty-First. The counterparty then sold the ADRs short (that is, sold borrowed property) to IES, which then became the actual owner of the ADRs with full right, title, and interest in the ADRs. The counterparty bought back the ADRs after the dividend accrued to IES.

The purchase price of the securities was equal to market price plus 85% of the ADRs' expected gross dividends, that is, the same amount the ADR lender would have received after foreign tax was withheld had it been the record owner entitled to payment of the dividends. In addition, the lender received a deposit of cash (or equivalent) collateral, generally 102% of the market value of the ADRs on loan. The lender would have that collateral available to invest during the term of the loan of the ADRs, thus earning a profit on its loan. IES paid commissions to Twenty-First on the purchases and sales; Twenty-First in turn paid the counterparty a fee, generally $1000 per trade day. IES sold the ADRs back to the lenders at market price.

So, IES purchased ADRs with dividend rights attached, or cum-dividend, for more than it sold them ex-dividend, thus incurring capital losses. IES sought to carry back the losses to offset capital gains received when it sold stock in tax years 1989 and 1990, and thus to receive a refund of capital gains taxes paid in those years. (Capital losses could not be used to offset "ordinary" income, but they could be carried back three years or carried forward five years to offset capital gains.)

While generating capital losses on each ADR purchase/sale combination, IES nevertheless made a profit because it was entitled to the dividends, which actually exceeded the capital losses. IES retained the dividends, which were ordinary income to the company, paid the 15% foreign tax, and therefore claimed a 15% foreign tax credit in the United States. IES claimed deductions for the commissions it paid Twenty-First. Further, IES purchased the ADRs on margin and incurred interest expense that it also claimed as a deduction. After 1992, IES did not engage in any additional ADR trades. By then, it had offset all of its 1989 and 1990 capital gains with the capital losses incurred as a result of the ADR trades.

Thus, for its 1991 and 1992 taxes, IES:

1. Reported gross dividend income on the ADR dividends of nearly $90.8 million 2. Claimed a foreign tax credit on the ADR dividends for the amount of foreign tax withheld and paid to foreign governments, over $13.5 million.

3. Recognized capital losses from the ADR purchases and sales and sought to carry back more than $82.7 million to offset capital gains earned in 1989 and 1990. An additional $56,643 in capital losses offset capital gains earned in 1992.

4."[I]ncluded the commissions it paid to purchase ADRs in its basis, and deducted the commissions paid to sell ADRs from the amount realized." Brief of Appellant IES at 17.

5. Deducted over $3.1 million in interest expense incurred in purchasing the ADRs on margin.

The Internal Revenue Service (IRS) audited IES's tax returns for 1991 and 1992 and disallowed the claimed capital losses and the concomitant 1989 and 1990 capital loss carrybacks. The IRS further disallowed the ADR-related foreign tax credit and eliminated the reported dividend income. Deductions for interest expenses, commissions, and one-half of the foreign income tax paid on the ADR transactions were allowed. ³

IES sought a refund of over $26 million, plus interest. The government rejected the claim and IES filed suit in the District Court. The court granted the government's motion for summary judgment, concluding that the transactions "were shaped solely by tax avoidance considerations, had no other practical economic effect, and are properly disregarded for tax purposes." Order of Sept. 22, 1999, at 3. IES appeals and we reverse.

The District Court viewed "[t]he question presented" as "whether these transactions are a sham and therefore to be disregarded for tax purposes." Id. at 3. In determining whether a transaction is a sham for tax purposes, the Eighth Circuit has applied a two-part test set forth in Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91-92 (4th Cir. 1985), which the Fourth Circuit ostensibly found in the Supreme Court's opinion in Frank Lyon Co. See Shriver v. Comm'r , 899 F.2d 724, 725-26 (8th Cir. 1990). Applying that test, a transaction will be characterized as a sham if "it is not motivated by any economic purpose outside of tax considerations" (the business purpose test), and if it "is without economic substance because no real potential for profit exists" (the economic substance test). Id. at 725, 725-26. The Shriver Court analyzed the transaction at issue in that case under both parts of the test, but then said in dictum, "[W]e do not read Frank Lyon to say anything that mandates a two-part analysis." Id. at 727. The Court suggested that a failure to demonstrate either economic substance or business purpose--both not required--would result in the conclusion that the transaction in question was a sham for tax purposes. As in Shriver, we do not decide whether the Rice's Toyota World test requires a two-part analysis because we conclude that the ADR trades here had both economic substance and business purpose.

The District Court dealt with the sham transaction issue summarily and did not apply, or even mention, the Rice's Toyota World test iterated in Shriver. After a cursory review of the facts and the law, the court simply concluded that...