Schering-Plough Corp., no. 05-2575 (USDC NJ 2007).
No taxpayer likes to get a worse deal with the IRS than a similarly situated taxpayer. This usually happens only in cases that are “close to the line” in terms of the allowability of a tax benefit. Then the outcome may depend on the happenstance of being audited. And that is what the proliferation of self-reporting rules and penalty increases is designed to address.
On the other end of the spectrum, disparate treatment can occur when tax issues are litigated in different forums, when the Tax Court does not agree with district courts, or when the Claims Court or a court of appeals has its own approach to an issue.
In the middle are cases where the IRS chief counsel takes differing positions with different taxpayers. The chief counsel makes every effort to avoid doing this unless it is on purpose by, among other things, making sure that the same people or office look at similar issues. However, the chief counsel sometimes just has to change his mind and in those cases two similarly situated taxpayers can be treated differently on purpose. While the taxpayer may not like it, doing something about it is difficult, as shown by the Schering-Plough decision.
Schering-Plough filed suit in the federal district court in New Jersey to recover almost half-a-billion dollars in taxes paid based on interest rate swaps for 1989-1992. On December 3, 2007, the trial court granted partial summary judgment for the government, thus stopping the taxpayer’s principal ground for refund: disparate treatment by the IRS in an FSA involving an unrelated similarly situated taxpayer in the same industry (i.e., another pharmaceutical company that “repatriated” foreign income).
In 1991 and 1992, taxpayer entered into interest rate swaps with unrelated parties. It sold its income leg of each swap to its Swiss subsidiaries, for prices advised by Merrill Lynch. The sales proceeds totaled $690 million. Beginning four-to-six years after the sales, taxpayer began to accrue the $690M into income over the remaining terms of the swaps. The IRS assessed tax on the basis that the $690M was loans or dividends from the CFCs when received, thus constituting repatriation of foreign earnings of CFCs that were fully taxable upon receipt.
Taxpayer relied upon Notice 89-21. It stated that parties receiving lump sum payments under notional principal contracts must take them into income over the term, and that rule also applied to proceeds of assignments of one leg of the contract; prospective regulations would be issued.
In 1993 Treasury issued Reg. section 1.446-3. It included lump sum taxation of “termination payments,” but exempted amounts received upon assignment of one leg from termination payment treatment. Instead they would be taxed as loans or nonperiodic payments, according to the substance of the transaction. The regulations treated nonperiodic payments essentially the same way as lump sum front end payments: they were to be recognized over the term of the contract in a manner that reflected their economic substance. But a loan from a CFC could cause immediate recognition as a repatriation of CFC income.
If the IRS had treated the sale payments as periodic payments, it would have reached essentially the same result the taxpayer reached. Instead, even though the 1993 regulations did not apply, the IRS asserted that the sale payments were either loans or dividends from the Swiss subsidiaries. This justified immediate recognition in full of repatriation of a CFC’s income.
A competitor had engaged in a similar transaction that the IRS examined and that is discussed in 1997 FSA LEXIS 206. The FSA says that Notice 89-21 was the “law” at the time of the transaction at issue and the agent should not treat the assignment proceeds as a loan. Schering claimed disparate treatment, which is essentially an equal protection or due process claim. Schering did not claim that the IRS had improperly applied the regulation retroactively, even though the court indicated that that was effectively what the IRS did, because the parties appear to have admitted that the IRS recharacterization of the transactions was pursuant to a general form-over-substance approach.
The court rejected the disparate treatment claim on these grounds:
1. Even if there were a right to get the same PLR another taxpayer gets until that one is revoked, that does not apply to FSAs because they are not issued to or at the request of taxpayers.
2. In any event, the fountainhead of disparate treatment law, IBM, 343 F2d 914 (Ct. Cl. 1965), cert den., 382 US 1028 (1966), was distinguishable as an exacerbated case involving two conflicting PLRs, and was effectively overturned by Dickman, 465 US 330 (1984), which the court read for the proposition that “the IRS is not required to apply an erroneous interpretation of the law simply because it previously made an erroneous interpretation with respect to another.”
The FSA appears to have been dated August 29, 1997. Clearly Schering did not rely on the FSA either in setting up or reporting its transactions. Presumably its advisors saw this problem coming and banked heavily on the Notice being literally applied, without regard to “normal” anti-abuse doctrines. Therein lie the seeds of many an assessment.