Tax Shelters

Reversal of Fortunes
Marie LeoneDecember 1, 2001

The Internal Revenue Service’s crackdown on abusive tax shelters lost some momentum in October when a federal judge reversed a 1996 IRS determination and refunded more than $500 million, including five years’ worth of interest, to Madison, N.J.- based American Home Products Corp.

The decision, by District Court Judge Paul L. Friedman, in Washington, D.C., held that the tax shelter, originally designed by Merrill Lynch more than 10 years ago and used by AHP in 1990, was legal. He also ruled that the IRS “erred” when it determined that the pharmaceutical company owed the government $226 million in back taxes. Interestingly, earlier this year the IRS chalked up three court victories–over Allied Signal Inc., Colgate-Palmolive Co., and Brunswick Corp.–that labeled the Merrill-designed shelter illegal. If the IRS appeals this most recent decision (notice of appeal is due this month), the case will move to the D.C. Circuit Court, the same venue that handed the IRS its win over Allied Signal.

The shelter in question, which uses a partnership to maximize tax losses on securities transactions, was used by all four companies. But the AHP case has some distinguishing characteristics, says Peter Norton, a New York tax attorney with Baker & McKenzie. Perhaps most significant, he says, is that AHP was able to document that the partnership was set up in a manner consistent with the company’s standard business practices. That, says Norton, was enough to convince the court that the partnership was not formed solely for tax purposes, something the other three companies were never able to do.

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According to the court documents, Judge Friedman also suggested that the IRS attorney’s performance was less than stellar, noting that the agency’s star witness–a disgruntled ex-Merrill employee–was discredited during the proceedings.

Norton muses that if the IRS does not seek an appeal, it may be because the Bush Administration contends that tax-shelter abuse is in decline, and that new regulations, such as the registration process, are quelling the misconduct. — Marie Leone