Merrill Lynch & Co., Inc. v. C.I.R., Docket No. 03-40676-AG.

• Decision Date: 28 September 2004
• Docket Number: Docket No. 03-40676-AG.
• Citation: 386 F.3d 464
• Parties: MERRILL LYNCH & CO., INC., and Subsidiaries, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Second Circuit

386 F.3d 464

MERRILL LYNCH & CO., INC., and Subsidiaries, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

Docket No. 03-40676-AG.

United States Court of Appeals, Second Circuit.

Argued: May 20, 2004.

Decided: September 28, 2004.

Appeal from the United States Tax Court, L. Paige Marvel, J Kenneth W. Gideon, Skadden, Arps, Slate, Meagher & Flom, LLP (Martin D. Ginsburg, of Counsel, on the brief), Washington, DC, for Petitioner.

Bridget M. Rowan, Attorney, Department of Justice (Eileen J. O'Connor, Assistant Attorney General, Richard T. Morrison, Deputy Assistant Attorney General, Richard Farber, Attorney, Department of Justice, on the brief), Washington, DC, for Respondent.

Before: MINER and POOLER, Circuit Judges, and GOLDBERG, Judge.^*

POOLER, Circuit Judge.

Merrill Lynch & Co., Inc. & Subsidiaries ("Merrill Group") appeal from a decision of the United States Tax Court (Marvel, J.), holding that the Commissioner of Internal Revenue (the "Commissioner") correctly assessed deficiencies in Merrill Group's payment of income tax for the tax years 1987 and 1988. Merrill Group contends that a series of transactions that it undertook in order to rid itself of a subsidiary increased its basis in the subsidiary and allowed it to take a large capital loss that was used to reduce capital gains in the 1987 and 1988 tax years.¹ The Commissioner does not share Merrill Group's view of the tax consequences of these transactions.

We affirm the conclusions of the tax court on the issues it reached and remand for the court to consider an interpretation of one section of the Internal Revenue Code ("I.R.C.") that was advanced for the first time on appeal.

BACKGROUND

"The avoidance of taxes is the only intellectual pursuit that carries any reward."

— John Maynard Keynes

A. Merrill Lynch's Transactions

Before any of the transactions at issue in this appeal took place, Merrill Lynch & Co., Inc. ("Merrill") served as a parent corporation to a number of wholly-owned subsidiaries, including Merrill Lynch Capital Resources ("Resources"), Merrill Lynch Realty ("Realty"), Merrill Lynch Asset Management ("Management") and Merrill, Lynch, Pierce, Fenner & Smith, Inc. ("MLPFS"). Although a number of these subsidiaries held subsidiaries of their own, only those held by Resources are relevant to this appeal. Due to the parent-subsidiary relationships that existed among all of these companies, Merrill Group filed a consolidated tax return under the designation "Merrill Lynch & Co., Inc. & Subsidiaries" for each of the tax years at issue in this appeal.

Resources, the subsidiary at the center of this dispute, was a mid-market leasing business created by Merrill to facilitate the expansion of Merrill's brokerage-service business into the mid-market and small business sectors. In early 1987, Merrill's management decided that Resources had served its purpose and that it was time to sell its multi-million dollar leasing portfolio, given that leasing was outside of Merrill's core competency and that the portfolio of leases had begun to generate taxable income. Because Resources held a large number of relatively small leases, Merrill decided that in order to divest itself of Resources' leasing assets it made practical sense to sell its stock in Resources instead of trying to sell each of the leases individually. However, Resources did hold some assets that Merrill wanted to keep, and by February 17, 1987, a draft memorandum identified the assets that Resources would continue to hold at the time it was sold.

On March 13, 1987, Merrill created a project team to handle the Resources divestiture and named Theodore D. Sands chief negotiator. The apparent focus of this team was to maximize Merrill's return on this transaction, taking into account everything from the purchase-price received to the tax benefits it would generate. During the month of March, the team took the first step of organizing the creation of a multi-volume offering memorandum for prospective purchasers (the "March Memorandum").

On March 30, 1987, Resources sold its stock in five of its subsidiaries to Realty for $53,972,607 and the stock in another of its subsidiaries to Management for $160,000,000. On April 3, 1987, Resources sold all of its stock in a final subsidiary to MLPFS for $119,819,690.² As the tax court did, we refer to the subsidiaries Resources sold as the Issuing Corporations and to the three transactions as the Cross-Chain Sales. Upon completing the Cross-Chain Sales, Resources had transferred all of the assets Merrill wished to keep to its sibling subsidiaries. Resources was now ready to be sold.

Meanwhile, by March 4, 1987, Merrill had identified ninety-three potential buyers for Resources and was gauging their interest in the transaction. Neither GATX Leasing Corporation ("GATX") nor BCE Development, Inc. ("BCE"), the companies that eventually purchased Resources, were referred to by name at that time. However, on March 23, 1987, a copy of the March Memorandum was sent to GATX (but not BCE) along with a confidentiality agreement. Nevertheless, no negotiations took place between Merrill and GATX until the confidentiality agreement was executed and returned, which had not yet happened as of April 2, 1987, several days after the first of the Cross-Chain Sales had been conducted and one day before they were to be completed. Eventually, five or six companies, including GATX (with BCE as a partner), were interested enough in Resources to submit bids, which were received on April 21, 1997.

On April 23, 1987, Merrill management presented the potential sale of Resources and its probable tax consequences to the Merrill board. While the definitive buyer had not been established, Merrill's CFO identified GATX/BCE as the likely purchaser, based on the initial bids. This presentation described the Cross-Chain Sales as a step taken in anticipation of the future sale of Resources in order to maximize Merrill's tax benefits. After the board meeting, Merrill conducted another round of bidding and GATX/BCE was left as the only potential purchaser. For an additional two months, Merrill negotiated exclusively with GATX/BCE, during which time due diligence was conducted. Eventually, on June 25, 1987, the parties executed a purchase agreement, whereby GATX/BCE agreed to buy Resources for $57,363,817 (down from their $66 million final bid due to concerns raised by the results of the due diligence).

B. The Tax Treatment of the Transactions

In calculating its 1987 tax liability, Merrill took advantage of the consolidated return regulations that were in place at the time to claim a long-term capital loss from the sale of Resources. Its ability to take this loss was governed by the rule set forth in Woods Investment Co. v. Commissioner, 85 T.C. 274, 1985 WL 15380 (1985), acq. 1986-2 C.B. 1, in which the tax court concluded that basis adjustments in subsidiaries are to be made in accordance with changes in earnings and profits, rather than taxable income or loss. 85 T.C. at 281. The Commissioner did not challenge Merrill's position on this rule. However, Merrill went on to conclude that the Cross-Chain Sales increased its basis in Resources pursuant to Treas. Reg. §§ 1.1502-33(c)(1), 1.1502-32(a), (b)(1)(i). This increase in basis is the crux of the dispute between the parties because it allowed Merrill to increase its tax loss on the sale and use that loss to offset capital gains that were otherwise taxable.

Merrill determined that it could increase its basis in Resources by classifying the Cross-Chain Sales as dividends, based on an interpretation of the interaction between I.R.C. §§ 304, 302, 301 and 318. Dividend treatment for the Cross-Chain Sales is important because it allows the sums received from the purchasing subsidiaries to be treated as earnings, thus triggering an increase in Merrill's basis in Resources. Section 304 provides that sales of stock between companies that are owned by the same individual (or in this case Merrill) are to be treated for tax purposes as a distribution in redemption of the stock of the corporation acquiring the stock. I.R.C. § 304(a). In other words, the way the transaction actually took place is ignored and the transaction is instead viewed as a stock swap between the buying and selling companies, where the stock of the buying company is hypothetically redeemed (to take into account the fact that it was never actually transferred in the first place). Section 301, through an internal reference to I.R.C. § 316, sets forth the default tax rule that distributions of property (including distributions of to-be-redeemed stock) are to be treated as dividends and explains how such dividends are to be accounted for. See I.R.C. §§ 301(c), 316. Section 302 sets forth an exception to this default rule that only applies to certain distributions in redemption of stock. I.R.C. § 302(a). If a distribution in redemption falls within the ambit of any one of four scenarios, the redemption is treated as an exchange and thus does not receive dividend treatment. I.R.C. § 302(b). The scenario that could apply to Merrill Group's transactions is a "complete redemption of all of the stock of the corporation owned by the shareholders," which is essentially a test for whether the selling company has completely terminated its interest in the stock of the company being sold. I.R.C. § 302(b)(3). Resources' sale of the Issuing Corporations might fall under this provision due to the operation of Section 318, which sets forth the constructive ownership of stock provision that applies to this subchapter of the Internal Revenue Code. I.R.C. § 318(a). This rule of constructive ownership operates so that stock owned by one of the subsidiaries of a parent company may also be interpreted as being owned by the other subsidiaries of that same parent company.³ See id. This suggests that when Resources sold the Issuing Corporations it retained an interest in them...