Daily Tax Update - February 27, 2013: District Court Holds That 'SLIPS' Transactions Lack Economic Substance

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DISTRICT COURT HOLDS THAT “SLIPS” TRANSACTIONS LACK ECONOMIC SUBSTANCE:  Today, the United States District Court of the Middle District of Louisiana ruled against Dow Chemical Company (“Dow”), who engaged in transactions described by the court as Special Limited Investment Partnerships, or “SLIPs,” transactions. 

In the first iteration of SLIPs (Chemtech I), a U.S. subsidiary of Dow contributed low- or zero‑basis patents to a partnership.  A Dow foreign subsidiary and other foreign investors contributed cash to the partnership.  Dow entered into a licensing agreement with the partnership, who leased the patents back to Dow.  Dow claimed royalty expense deductions for payments made to the partnership.  The partnership allocated 94% of its income to the foreign investors. 

In the second iteration (Chemtech II), another U.S. subsidiary of Dow contributed a chemical plant and all the outstanding stock of a corporation, CPI, to a partnership.  The plant was leased back to Dow.  The partnership made a section 754 election, which, when coupled with the redemption of a Dow subsidiary from the partnership, allowed the partnership to increase the basis of the plant assets by $363 million.  Nearly all of the depreciation deductions arising from the increased basis to the plant were allocated to Dow. 

The court held that both Chemtech I and Chemtech II failed the common law economic substance doctrine.  In the court’s view, objectively, the transactions did not change Dow’s financial position, since no income was generated by forming the partnerships and there was a circular flow of funds between Dow and the partnerships. The court also found that the transactions had no business purpose.  The court noted that there were cheaper and less complex alternatives to SLIPs that could have achieved Dow’s purported business purpose of obtaining off-balance-sheet financing.  In addition, the court held that the partnerships were shams based on the (i) the lack of income-generating activity by the partnerships, (ii) the circular flow of funds, and (iii) the allocation of risk, which insured one partner’s risk at the expense of another partner. 

The court imposed a 20% penalty for negligence and a substantial understatement of tax, but it declined to apply the 40% penalty for a valuation misstatement because the understatement was attributable to a lack of economic substance rather than a valuation discrepancy.

Read the court case here.

LEW WINS SENATE CONFIRMATION:  Tonight, the Senate confirmed Jacob “Jack” Lew to be Treasury Secretary.  Senators voted 71-26 to confirm Lew.

IRS EXPANDS VOLUNTARY WORKER CLASSIFICATION SETTLEMENT PROGRAM:  The IRS has announced the expansion of its Voluntary Classification Settlement Program (VCSP) which gives employers, including tax-exempt organizations, the ability to reclassify workers and obtain relief from past payroll tax liabilities.  The VCSP allows eligible employers who are currently treating workers as independent contractors to resolve worker classification issues by reclassifying workers as employees for future tax periods.  As part of the program, the employer pays a reduced amount of employment tax, is generally not liable for any interest and penalties on the liability, and will not be audited on payroll tax issues related to the workers for prior years. 

  • The expansion of the program allows for employers who are under IRS audit, other than an employment tax audit, to qualify for the program.  In addition, employers accepted into the program will be subject to the usual three-year statute of limitations, rather than a six-year statute of limitations.  The IRS is also temporarily waiving, until June 30, 2013, the eligibility requirement that employers must have filed all required Forms 1099 for the past three years for workers they are seeking to reclassify.

PRESIDENT WILL MEET WITH CONGRESSIONAL LEADERS FRIDAY TO DISCUSS SEQUESTRATION:  President Obama will meet with congressional leaders at the White House on Friday to discuss preventing the automatic spending cuts set to take place on March 1.  White House Press Secretary Jay Carney said, “We remain hopeful that Republicans will understand the need to compromise and that compromise has balance at its essence.”