In your face Doug – #1

I am starting a new segment at Cranky and Taxing – In your face Doug! – Where I showcase recent tax cases in which the taxpayer prevails against the commissioner.

Who is Doug? Douglas H. Shulman is the 47th Commissioner of Internal Revenue Service. The segment title in no way reflects any personal feelings towards Mr. Shulman, who is a very snappy dresser and who I am confident is a prince among men. I have not a slanderous thought in my insignificant brain for our esteemed Commissioner, long may he watch benignly over our tax world. His status as a grand gentleman, did not prevent his opponents serving him on a platter in today’s proceeding, courtesy of some well-organized accountants and tax advisors.

For the inaugural – In your face Doug, I present – NA GENERAL PARTNERSHIP & SUBSIDIARIES, IBERDROLA RENEWABLES HOLDINGS, INC. & SUBSIDIARIES (SUCCESSOR IN INTEREST TO NA GENERAL PARTNERSHIP & SUBSIDIARIES), Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent (Respondent would be Douglas H. Shulman, 47th Commissioner of Internal Revenue Service – FYI)

In my opinion this case was not a slam dunk win for the petitioner, the hero of the day was their expert witness and the proactive thinking of Pricewaterhousecoopers.

The contention under investigation was the classification of monies transferred between two related entities, NA General Partnership & Subsidiaries and its parent company ScottishPower PLC (ScottishPower), was debt or equity.

To quote the memo –

The sole question is whether an advance made by ScottishPower to NAGP in connection with NAGP’s acquisition of PacifiCorp & Subsidiaries (PacifiCorp) was a loan or a capital contribution for Federal tax purposes, and thus whether petitioner is entitled to interest expense deductions under sections 162(a)3 and 163. We hold the advance was a loan, and the payments on the loan notes are deductible as interest.

Most big tax cases fall prey to the substance over form doctrine, which evaluates economic substance for legitimacy if it is found illegitimate (or without substance) then it can overrule the formal execution of a transaction, no matter how perfect the form.

We have to give to Doug most of the time as there are multiple examples of tax advisors totally blowing it big time on substance. For example, take the judgment made earlier this year in HEWLETT-PACKARD COMPANY AND CONSOLIDATED SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent. HP pretty much got its behind kicked when an investment in a foreign company was determined to lack economic substance and entered into merely for the tax benefits.

I believe that an understanding of this crucial precept separates the true experts from the wannabe losers. – Oh yea, I went there.

Per the court on the case under discussion –

A transaction’s substance, not its form, controls its effect for tax purposes. See Hardman v. United States, 827 F.2d 1409, 1411 (9th Cir. 1987). Nevertheless, tax consequences are a significant consideration in many commercial transactions, and planning a legitimate transaction to take advantage of tax benefits does not invalidate the transaction.

OH yea, did you see what they did there – I think you did indeed.

NAGP had its financial house in order, they were not caught unprepared – as they had substantiated their claims that the transactions construed a bona fide debt obligation and could demonstrate the economic validity of their strategy. The petitioner’s expert witness, Israel Shaked , was suitably awe-inspiring in his testimony that anticipated cash flow was sufficient for NAGP to timely service and retire the intercompany debt as it became due, or they could have refinanced that bad boy related party liability. Kudos to you Mr. Shaked well-played sir.

While respondent’s expert, Robert Mudge, concluded there would have been a cash shortfall, although had not even considered the proceeds from the sale of the Australian operations in his financial analysis, which was undeniably a factor in the financial assessments that led to the transaction under examination– which he had to concede – Burn! Mr. Mudge assumes that NAGP would have used the sale proceeds to issue ScottishPower a dividend rather than repaying the intercompany obligations. Like really? And just how do you know that? – Mind reading? Tarot cards? – As if… The court saw right through that and went drew the conclusion that was supported by the record. I only wish I could have watched the proceedings in person, as it was most likely a battle royale of tax arguments.

I cannot even give a sympathetic justification for his less than convincing position, on the lack of wherewithal to pay the debt. Hopefully Mudge will fight a more advantageous challenge career wise next time.

I do not want to spoil all the thrill and enjoyment of determining the nature of debt instruments when challenged as disguised equity contributions, for all two of my loyal readers. I hope you find it as much of a thrill ride as I did the first time I read it. There is so much to this case, the numerous factors to be considered, the argument for each…

…oh be still my heart.

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