In a 91-page opinion,1 a federal district court denied a refund claim by Schering- Plough Corp (“Schering”) with respect to two transactions it had entered into almost two decades ago. In 1991 and 1992, Schering, an international pharmaceutical company, entered into two 20-year interest rate swap transactions with Algemene Bank Nederland, N.V. (“ABN”), a Dutch bank. Under the swaps, Schering and ABN agreed to make periodic interest payments based on different interest rate indices with respect to a specified notional amount. To hedge their exposure, both ABN and Schering entered into “mirror swaps” with an investment bank. After entering into the swaps, Schering assigned the majority of its rights to receive payments from ABN with respect to years 6-20 to two of its foreign subsidiaries in exchange for lump-sum payments, totaling approximately $690 million. Relying on an IRS Notice, advice of outside counsel, its financial advisors, and accountants, Schering amortized the lump-sum payments received over the period in which the future income streams had been assigned (i.e., over 15 years), thereby deferring its income tax liability with respect to those payments to that extent.

Economically, Schering had repatriated approximately $690 million from its two foreign subsidiaries to the United States. Had Schering received either a dividend or a loan from its foreign subsidiaries, Schering would have had to include the amount of such dividend or loan in its taxable income when received. The IRS argued that the “swap-and-assign” transactions were in substance loans and that Schering should include the appropriate amount in income in the years it entered into the transactions instead of amortizing its income inclusions over 15 years.

The court agreed with the IRS and concluded that the transactions, in substance, constituted loans by the foreign subsidiaries to Schering. The court compared the transactions, where the amounts of the lump-sum payments were determined by reference to the present value of the future income streams, to home mortgage loans, in which the lender makes an upfront payment in return for periodic principal and interest payments. In applying its substance-over-form analysis, the court (i) looked to Schering’s intent (certain transaction documents of both Schering and ABN referred to loans); (ii) examined the objective indicia of the transaction (the court found that the difference between gross amounts paid to the subsidiaries and the lump sum payments was equivalent to interest; the swap payment legs constituted a repayment schedule; no formal loan documentation was required between the parties; and that because the risk of any Schering default was negligible, no loan collateral was necessary); and (iii) concluded that ABN was merely a conduit (Schering and its subsidiaries had agreed to enter into a transaction prior to involving ABN; ABN’s participation was limited to facilitating the swap transactions; ABN’s risk with respect to the transactions was de minimis; and there was no non-tax business purpose to ABN’s participation).

In addition to its substance-overform analysis, the court provided an encore by also determining that the transactions lacked economic substance. It held that the transactions lacked (i) objective economic substance (Schering’s interest rate risk was manufactured, and it was willing to incur significant costs to enter into the transactions without a profit potential); and (ii) subjective business motivation (arguments regarding financial reporting, cash management and balance sheet motivations were rejected by the court).