Schering-Plough Corp. v. U.S., Civ. Action No. 05-2575 (KSH).

• Decision Date: 28 August 2009
• Docket Number: Civ. Action No. 05-2575 (KSH).
• Citation: 651 F.Supp.2d 219
• Parties: SCHERING-PLOUGH CORPORATION, Plaintiff, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — District of New Jersey

651 F.Supp.2d 219

SCHERING-PLOUGH CORPORATION, Plaintiff, v. UNITED STATES of America, Defendant.

Civ. Action No. 05-2575 (KSH).

United States District Court, D. New Jersey.

August 28, 2009.

COPYRIGHT MATERIAL OMITTED

William J. O'Shaughnessy, Richard Hernandez, McCarter & English, LLP, Newark, NJ, Charles W. Hall, William S. Lee, Nancy T. Bowen, Tom C. Godbold, Reagan M. Brown, Edward J. Patterson III, Robert C. Morris, Fulbright & Jaworski, L.L.P., Houston, TX, for Plaintiff.

David Martin Katinsky, Lindsey W. Cooper, Lisa Lynn Bellamy, Dara B. Oliphant, Richard G. Jacobus, U.S. Department of Justice, Washington, DC, for Defendant.

OPINION

KATHARINE S. HAYDEN, District Judge.

I. INTRODUCTION

In this taxpayer refund action, the Court examines a domestic corporation's assignment of future income streams-derived from interest rate swaps with a third party-to its offshore subsidiaries, in exchange for lump-sum payments from the subsidiaries. In so doing, the Court must decide whether the structured transactions were in essence a loan from, or a sale to, the subsidiaries. Should it find the former, the Court must uphold as valid the tax levied by the government. Should it conclude the latter, plaintiff Schering-Plough Corporation ("Schering-Plough") is entitled to a $473 million refund, plus interest.

Before discussing the facts of the case more closely, the Court briefly describes the critical loan/sale distinction underlying the dispute, the operation of the relevant taxation policy, and the transactions at issue. Generally, the earnings of a domestic corporation's foreign subsidiaries are not taxed until the money is distributed to the parent corporation via a dividend. See I.R.C. § 451(a).¹ Under the international taxation scheme in effect at all relevant times here, however, an intercompany loan from an offshore subsidiary to its domestic parent is immediately taxable. This is a departure from the traditional rule that a loan is not income. See James v. United States, 366 U.S. 213, 219, 81 S.Ct. 1052, 6 L.Ed.2d 246 (1961) (accepted definition of gross income "excludes loans"). Instead, Congress has enacted its policy judgment, discussed more fully below, that when a foreign subsidiary invests in the corporate debt of its domestic parent, the use of the loaned funds is no different than a dividend to the parent shareholder, and should be taxed accordingly. This regime, known as Subpart F of the tax code, is intended to prevent United States corporations from sheltering their subsidiaries' income in so-called "tax-haven" countries, while simultaneously putting the money to domestic use.

Conversely, the sale of future income rights under an interest rate swap transaction triggers a different principle of taxation. The federal tax code mandates that when a taxpayer's method of accounting does not clearly reflect the income the taxpayer actually generates, the method of computing taxable income-as prescribed by the Commissioner of the Internal Revenue Service ("IRS")²—should nonetheless be reflective of such income. See I.R.C. § 446(b); United States v. Hughes Props., Inc., 476 U.S. 593, 603, 106 S.Ct. 2092, 90 L.Ed.2d 569 (1986). The Commissioner determined in Notice 89-21, a revenue notice published on February 7, 1989, that money received from the sale of rights to future income streams under an interest rate swap transaction did not clearly reflect income if it was reported in the year received. Instead, the notice stated that income is more accurately reflected when it is reported as having been received over the lifetime of the swap contract.³

Turning to the transactions at issue: in 1991 and 1992, Schering-Plough, an international pharmaceutical conglomerate, wishing to repatriate its subsidiaries' foreign earnings back to the United States, entered into two 20-year interest rate swap transactions with Algemene Bank Nederland, N.V. ("ABN"), a Dutch investment bank. Under the swaps, the two counterparties agreed to exchange periodic interest payments based on a hypothetical amount (the "notional principal") and two different interest rate indices. The swap agreements obligated Schering-Plough and ABN to make periodic payments to each other reflecting the movement of the particular interest rate assigned to their respective sides of the transaction.

Under the swaps, Schering-Plough had the right to assign or otherwise transfer its right to receive interest payments from ABN (the "receive legs"). It did, in fact, assign the majority of the receive legs to two of its foreign subsidiaries. In return, the subsidiaries made lump-sum payments to Schering-Plough totaling approximately $690 million. Schering-Plough did not report the lump sums as present income. Instead, it deferred reporting income until later years, relying on Notice 89-21. Specifically, because Notice 89-21 required ratable taxation of payments received in exchange for the assignment of future income streams from notional principal contracts, Schering-Plough reported income for the lump sums by amortizing them over the period in which the future income streams had been assigned.⁴

Notice 89-21 also states 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." So if the Schering-Plough transactions are deemed loans (as the government eventually deemed them to be), the amortization provision does not apply and the entire lumpsum payments are immediately taxable.

In 2004, characterizing the transactions as loans, the Commissioner assessed a tax deficiency upon Schering-Plough because it had not reported the lump-sum payments as present income in 1991 and 1992, the years in which they had been received. Schering-Plough paid the $473 million tax bill and thereafter filed this action seeking a refund.

The Court's decision requires an examination of the transactions for their "economic reality"-that is, regardless of how a given transaction was characterized by the taxpayer, is it in reality a loan or is it in reality a sale? Put another way, the Court scrutinizes for substance over form. The Court then tests the "economic substance" of the transaction: Does it have sufficient economic substance despite the existence of tax avoidance objectives, or is it a "sham transaction"? Finally, the Court must assess whether the transactions, anchored as they were in Notice 89-21, duly comported with the relevant taxation scheme implemented by Congress.

For Schering-Plough to prevail, the Court must find the following: (1) that the transactions were the economic equivalent of sales of future income streams (that is, they were not loans dressed up as sales); (2) that Schering-Plough entered into them with objectives beyond tax avoidance and that its net economic position was appreciably altered as a result (that is, that the transactions were not shams); and (3) that the tax shelter that Schering-Plough alleges Notice 89-21 provides is consistent with Congress's legislative intent. Should Schering-Plough falter on any of these grounds, the Court must render judgment for the government.

Because the Court conducted a bench trial during which the parties took full opportunity to present their respective positions, there is plenty of evidence, factual and opinion, to examine in making the ultimate decision. Throughout this opinion the Court will be citing the testimony of: (a) fact witnesses-the people who made the decisions and signed the documents-to determine what they did and why they did it; and (b) the opinions of experts called by the parties-both their reports and their testimony-for guidance about the best reasoned, least strained interpretations of the facts. Pursuant to Rule 52(a) of the Federal Rules of Civil Procedure, the Court has organized this opinion around a full discussion of the facts surrounding the transactions, based on the evidence adduced at trial. Following its factual findings, the Court examines the transactions' economic reality, economic substance, and, finally, their assimilation with applicable tax laws.

II. JURISDICTION

The Court has jurisdiction concurrent with the United States Court of Federal Claims to hear all actions against the United States seeking the "recovery of any internal-revenue tax alleged to have been erroneously or illegally assessed or collected . . . ." 28 U.S.C. § 1346(a); I.R.C. § 7422. Venue is proper in this District pursuant to 28 U.S.C. § 1402(a)(2) because Schering-Plough's principal place of business is located in New Jersey.

III. STANDARD OF REVIEW

A tax assessed by the IRS is presumed to be correct; a taxpayer challenging the assessment shoulders the burden of proving that the assessment is legally erroneous.⁵ Welch v. Helvering, 290 U.S 111, 115, 54 S.Ct. 8, 78 L.Ed. 212 (1933); Francisco v. United States, 267 F.3d 303, 319 (3d Cir.2001); Sullivan v. United States, 618 F.2d 1001, 1009 (3d Cir.1980); Psaty v. United States, 442 F.2d 1154, 1159 (3d Cir.1971). The Court's review of the IRS determination is de novo. Lewis v. Reynolds, 284 U.S. 281, 283, 52 S.Ct. 145, 76 L.Ed. 293 (1932).

IV. FACTS

Schering-Plough seeks a tax refund of $472,870,042.69 in paid federal income taxes for taxable years 1989, 1991, and 1992. The taxes were assessed and collected by the IRS as a result of the two interest rate swap-and-assign transactions that Schering-Plough entered into with its foreign subsidiaries and ABN in 1991 and 1992. Before turning to the specifics of the transactions, the Court describes the applicable taxation scheme, Schering-Plough's corporate structure, and the financial condition in which it found itself in the late 1980s.

A. Subpart F Taxation

The independent taxing identity of corporations and the worldwide taxation of income before President John F. Kennedy...