Daily Tax Update - July 13, 2006

Today, the Federal Circuit Court of Appeals reversed the Court of Federal Claims decision in Coltec Industries, Inc. v. United States. The court concluded that although Coltec’s claimed capital loss fell within the literal terms of the statute, the transaction that created the high basis in the stock lacked economic substance and, therefore, must be disregarded for tax purposes.

  • In the transaction at issue, Coltec transferred contingent asbestos liabilities to a subsidiary and sold stock in that subsidiary to financial institutions and an independent third party. As result of the stock sale, Coltec claimed a substantial capital loss.
  • The Federal Circuit upheld the Court of Federal Claims’ conclusion that Coltec’s basis in the stock of its subsidiary should not be reduced by the amount of the contingent asbestos liabilities transferred to the subsidiary. Although the Federal Circuit rejected the lower court’s holding that contingent liabilities are not "liabilities" for purposes of reducing basis under section 358(d), it agreed with the lower court’s holding that section 357(c)(3) precluded the liabilities from reducing basis because they "would give rise to a deduction." The court stated that the government’s argument that section 357(c)(3) excludes liabilities only to the extent transferred along with an underlying business was inconsistent with the plain language of the statute.
  • The Federal Circuit also held that section 357(b)(1) was irrelevant in determining whether Coltec’s basis in the subsidiary stock should be reduced, because the exception to basis reduction is invoked if section 357(c)(3) by its terms applies, regardless of whether the anti-abuse provision of section 357(b)(1) would otherwise override the operation of section 357(c)(1).
  • On the issue of economic substance, the Federal Circuit flatly rejected the Court of Federal Claims’ holding that the use of the economic substance doctrine to trump compliance with the Code violates the separation of powers, faulting the court for failing to follow binding precedent of the Supreme Court and its predecessor court, the Court of Claims. The court further rejected the economic substance test adopted by the Fourth Circuit in Black and Decker—that a transaction will be disregarded only if it both lacks economic substance and is motivated solely by tax avoidance—instead adopting a disjunctive approach to disregard a transaction that either lacks economic substance or is motivated solely by tax avoidance.
  • In applying the economic substance test, the Federal Circuit focused solely on the transaction giving Coltec the high stock basis, i.e., the assumption of the liabilities in exchange for the note, and concluded that Coltec had not demonstrated any business purpose for that transaction. The court rejected Coltec’s claim that it would strengthen its position against potential veil-piercing claims, since it only affected relations among Coltec and its own subsidiaries and had no effect on third parties.
  • For additional information, contact Matthew D. Lerner via email, Lisa M. Zarlenga via email or Mark J. Silverman via email.

IRS ISSUES FINAL REGULATIONS ON GROSS PROCEEDS PAYMENTS TO ATTORNEYS: Today, the IRS released final regulations (TD 9270) relating to the reporting of payments of gross proceeds to attorneys. The regulations reflect changes to the law made by the Taxpayer Relief Act of 1997. The final regulations will affect attorneys who receive payments of gross proceeds of behalf of their clients and will affect certain payers that, in the course of their trades or businesses, make payments to these attorneys (for example, defendants in lawsuits and their insurance companies and agents) .

House Majority Leader John Boehner (R-OH) said yesterday that he anticipates that the House would recess on September 29TH in time to campaign for the November 7th elections. However, Boehner said that a lame-duck session would be necessary to complete the work of the 109th Congress. Boehner said a lame-duck session could extend into December. Boehner said, "I’d love to be done by Thanksgiving, but to think that we could finish everything in ten days [before Thanksgiving] I think is a stretch."

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