Merck & Co. Inc. v. U.S..

• Decision Date: 20 June 2011
• Docket Number: No. 10–2775.,10–2775.
• Citation: 2011 USTC P 50461,652 F.3d 475,107 A.F.T.R.2d 2011
• Court: U.S. Court of Appeals — Third Circuit
• Parties: MERCK & CO., INC., Appellantv.UNITED STATES of America.

652 F.3d 475

107 A.F.T.R.2d 2011-2596

2011-1 USTC P 50,461

MERCK & CO., INC., Appellant

v.UNITED STATES of America.

No. 10–2775.

United States Court of Appeals, Third Circuit.

Argued March 24, 2011.Opinion Filed: June 20, 2011.

Charles W. Hall, William S. Lee, Nancy T. Bowen, Tom C. Godbold, Reagan M. Brown, Fulbright & Jaworski, L.L.P., Houston, TX, Jonathan S. Franklin (argued), Tillman J. Breckenridge, Fulbright & Jaworski, L.L.P., Washington, D.C., Attorneys for Appellant.John A. DiCicco, Gilbert S. Rothenberg, Kenneth L. Greene, Judith A. Hagley (argued), Tax Division, Department of Justice, Washington, D.C., Attorneys for Appellee.Before: FUENTES, SMITH, and GREENBERG, Circuit Judges.

OPINION OF THE COURT

FUENTES, Circuit Judge:

Plaintiff Schering–Plough, Inc.¹ brings this action against the United States for recovery of nearly $500 million in taxes it claims the IRS incorrectly assessed against it. It argues, first, that the funds it received as a result of two transactions were not, as the IRS contends, immediately taxable in full as proceeds of loans from foreign subsidiaries; and, second, that it suffered disparate treatment in comparison with another taxpayer who engaged in similar transactions but was not assessed taxes on the proceeds in the same way. The United States prevailed on both claims in the District Court, and Schering–Plough timely appealed. For the reasons given below, we will affirm the District Court's decision on both claims.²

I.

A. Background

In the early 1990s, Schering–Plough, a New Jersey pharmaceuticals company, was the ultimate owner of two Swiss subsidiaries, Scherico and Limited. These subsidiaries conducted significant manufacturing operations in Ireland, which, at the time, had a favorable corporate income tax. Each of the subsidiaries held significant cash reserves. Scherico had a modest amount of earnings not yet taxed in the United States, whereas Limited had earnings of nearly $1 billion untaxed in the United States.

Schering–Plough wished to make use of those cash reserves to engage in certain business activities, such as a stock repurchase program. However, Subpart F of the Internal Revenue Code, 26 U.S.C. §§ 951–965, which governs the taxation of the income of U.S.-owned foreign subsidiaries, dictates that, while such income is not taxable in the United States when earned, it is subject to taxation if it is ever invested in “United States property.” Such property is defined to include any debt obligation of U.S. companies. In other words, if a foreign subsidiary of a U.S. company lends or distributes money to its parent, the U.S. company is required to recognize that money as income. ³ Thus, Schering–Plough's subsidiaries, Scherico and Limited, could not simply make a loan or pay dividends to Schering–Plough without the proceeds being subject to taxation in full that year.

To avoid immediate taxation under Subpart F of the entire sum it wished to repatriate, Schering–Plough consulted Merrill Lynch, an investment bank that had devised other tax-management strategies for Schering–Plough. Merrill Lynch proposed to Schering–Plough a scheme involving interest rate swaps. Under the scheme, Scherico would provide the funds desired to Schering–Plough. In return, Schering–Plough would transfer to Scherico one of Schering–Plough's accounts receivable. To create the receivable for transfer to Scherico, Schering–Plough negotiated an interest rate swap with an accommodating party—Algemene Bank Nederland (“ABN”), a Dutch financial institution. Schering–Plough then assigned its receivable payment stream resulting from this swap to Scherico.

An interest rate swap is a common and legitimate corporate transaction. ⁴ We draw background information concerning the nature of a swap from the District Court's extensively researched findings. “The counterparties [i.e., Schering–Plough and ABN] agreed to make interest payments to each other based on a notional amount of principal, and [for each] to make payments under a different interest rate for a set term of years. The parties only exchanged the interest payments, not the notional principal [which was used only as the basis of calculating the payments due].... The standardized swap terms permitted ABN and Schering–Plough to offset (net) the two payments, such that the party owing the higher amount paid only the difference.” Schering–Plough Corp. v. United States, 651 F.Supp.2d 219, 229 (D.N.J.2009).

From the point of view of either party, the swap consisted both of a “pay leg” (the responsibility to pay the other according to the first interest rate designated in the contract) and a “receive leg” (the right to receive payments from the other based on the other interest rate designated in the contract). This swap agreement permitted the assignment of the receive leg to a third party. “Significantly, upon any assignment, the parties could no longer net payments; rather, each periodic payment would be due in full to the party owning the right to the particular income stream.... In other words, upon assignment of its receive leg rights, Schering–Plough remained duty-bound to make the entire periodic pay leg distributions to ABN,” regardless of whether ABN fulfilled its “parallel obligation to make the payments to Schering–Plough's third-party designee.” Id. The same applied to ABN; it would have to make its payments to Schering–Plough's assignee regardless of whether Schering–Plough was making payments to it.

At the time Merrill Lynch made its proposal to Schering–Plough, the sale of notional principal contracts such as interest rate swaps was governed by IRS Notice 89–21, which provided that, when a party sells one “leg” of a swap, so that it receives a lump sum in exchange for the right to receive revenues over the remaining life of the swap, that sum should not be recognized as income all at once, but rather should be accounted for over the whole life of the swap. ⁵ Notice 89–21 specifically stated that “[n]o inference should be drawn from this notice as to the proper treatment of transactions that are not properly characterized as notional principal contracts, for instance, to the extent that such transactions are in substance properly characterized as loans.” (emphasis added) This notice has since been repealed, and parties are now required to recognize all such payments as loans. 26 C.F.R. § 1.446–3(g)(4), (h)(4)(i).

In accordance with the scheme designed by Merrill Lynch, Schering–Plough entered into a 20–year interest rate swap (with payments at six-month intervals) with a bank, ABN. This swap agreement included a “credit trigger” which allowed ABN to terminate it if Schering–Plough's credit rating was downgraded for more than 60 days. ABN, meanwhile, entered into a “mirror” swap with Merrill Lynch that was essentially designed to perfectly offset the swap with Schering–Plough, as well as compensating ABN for its involvement. That is, to whatever extent ABN might be the loser in the swap with Schering–Plough, it would be the gainer in the swap with Merrill Lynch.⁶

Schering–Plough then assigned the “receive leg” of the swap to Scherico for a lump sum, as was explicitly permitted under the terms of the initial swap. ⁷ Scherico also received a “put option” which gave it the right to sell the “receive leg” back to Schering–Plough for its current market value at any time.⁸ Most of the funds paid over to Schering–Plough, however, were actually channeled from Limited through Scherico (as Limited held most of the untaxed earnings).⁹ We will refer to the scheme as a whole as the (first) Transaction.

Thus, initially, Schering–Plough and ABN had reciprocal obligations to each other alone, to pay each other at intervals according to the interest rates defined in each swap agreement. In practice, this meant that the party who was the net loser on the swap would pay the net gainer the difference. But by splitting the normally paired “pay leg” and “receive leg” of the swap, the parties created a triangular relationship among Schering–Plough, ABN, and Scherico. Schering–Plough was obligated to pay ABN at intervals based on a particular interest rate (as defined in the original swap). ABN, meanwhile, was obligated to pay Scherico based on another interest rate (because Scherico had been assigned the “receive leg” of the swap from Schering–Plough). Schering–Plough had received a lump sum of money from Scherico in exchange for the “receive leg” of the swap. The parties then repeated this transaction (the second Transaction) the following year, but with another Swiss subsidiary of Schering–Plough, Essex Chemie, A.G., replacing Scherico.

This scheme was intended to allow Schering–Plough to report the lump sum it received as income over the life of the swap under Notice 89–21, rather than all at once, as it would have had to under Subpart F if it simply took a loan or dividends from Scherico. That is, instead of accounting for it immediately as an investment in “United States property,” Schering–Plough accounted for it as a sale of a leg of a swap, which under Notice 89–21 meant—if the transactions were not loans (as Schering–Plough claimed they were not)—that it should be taxed ratably over the life of the Transactions. This was desirable from Schering–Plough's perspective because, as discussed above, a taxpayer generally wishes to delay the recognition of income as long as possible.

Schering–Plough and Scherico did not generate formal loan documentation concerning the transfer of the “receive leg.” However, intercompany loans at Schering–Plough generally lacked such documentation. Also, despite a policy requiring that the Board of Directors pre-approve any investment having a maturity of more than one year, Schering–Plough did not seek approval for the Transactions before executing them, as a Schering–Plough witness conceded that it should have if it regarded them as sales rather than loans.

Schering–Plough then reported each of...