Don't Mess with the IRS

The agency is taking companies to court more often, and winning.

July 2008
by Alix Stuart/CFO Magazine

April, always the cruelest month for taxpayers, became more so this year when the Internal Revenue Service racked up yet another victory against a corporate tax shelter. At issue was a decade-old transaction between a U.S.-based financial holding company, BB&T Corp., and a Swedish wood-pulp manufacturer, Sodra Cell.

In 1997, BB&T leased a 22 percent interest in pulp-manufacturing equipment at one of Sodra's mills and immediately subleased it back to Sodra. That brought BB&T a nice deduction. And, the IRS charged, not much else. To the agency, the deal was a prime example of an abusive tax shelter known as lease in, lease out (LILO). Although the transaction predated the 1999 tax code changes that shut down LILOs, the IRS challenged it and won in 2007 — the first time such a shelter had been tested in court.

Then, in April, a federal appeals court sided with the IRS. For BB&T, the verdicts meant an additional $1.2 billion paid in taxes and interest to clear its bill for Sodra and similar transactions.

The BB&T case is just one of several major tax-shelter cases won by the IRS in recent months. The shock waves from those victories are reverberating far and wide. Certainly, any of the hundreds of companies that have engaged in LILO or SILO (sale in, lease out) transactions, banned in 2004, will be reviewing their options. Banking giant Wachovia, for one, announced in April that as a result of the BB&T verdict it would take up to a $1 billion noncash charge to earnings related to SILO transactions. Another bank, KeyCorp, said in June that it would take a charge to earnings and capital of up to $1.2 billion, halve its dividend, and issue shares to raise another $1.5 billion — all because of a SILO strategy involving a German waste-to-energy facility that was struck down by the Northern District of Ohio court.

LILOs and SILOs haven't been the only shelters in the IRS's crosshairs. Last April, in a case involving a so-called intermediary transaction, a Texas federal court judge decided that Enbridge Energy was liable for more than $155 million in past and future taxes, plus penalties. Enbridge had bought stock in a pipeline company in 2001 through what was eventually deemed a sham company, thus gaining tax deductions.

Even companies that aren't harboring any tax shelters on their books may not be safe. Experts say the IRS's treatment of all types of tax disputes is changing as the agency applies the tough tactics it used in shelter cases to more-ordinary transactions. Gerald Kafka, global chair of Latham & Watkins LLP's tax-controversy practice group, calls this "the trickledown effect," which includes more national coordination on issues, a greater involvement of attorneys, and more requests for information from corporate advisers and other third parties. This new approach, coupled with an unprecedented amount of new disclosure required from companies, has made the IRS a fundamentally tougher opponent, both in court and out. "The odds are overwhelmingly in our favor," says Donald Korb, chief counsel for the IRS since 2004.

Making an Example out of You
It wasn't too long ago that the IRS was considered a toothless tiger by big companies with smart tax departments. "There was a long time when the IRS couldn't litigate its way out of a paper bag," claims one attorney, noting that the agency routinely lost transfer-pricing cases in the 1990s. That began to change several years ago when the IRS adopted a new strategy of brinkmanship, pushing more cases to trial to make examples of corporate defendants. In particular, the agency won dozens of cases against companies that engaged in life-insurance and contingent-liability shelters.

To be sure, few tax disputes actually go to trial. According to the IRS, about 85 percent of disputes are settled through alternative means, including the agency's internal appeals process. But experts who advise companies in their dealings with the IRS say it's getting harder to reach agreements in each step of the process leading to litigation.

For his part, Korb says that, in general, the IRS would rather settle than litigate. But to encourage more settlements, the agency is deliberately pushing some companies to trial — refusing to settle for less than 100 percent of taxes owed, plus penalties and interest — in order to make an example of them. The idea is to win a number of cases and thus pressure other companies that made similar transactions to "fold their tents" and pay up, says Korb. "At some point, if the government wins four or five cases, it's going to be hard to have give-and-take," he warns.

Keep It Simple, Taxpayer
On the other hand, some companies would rather fight than settle. Reading International, a cinema-complex owner and operator, recently turned down an IRS settlement offer of $8 million that emerged after a mediation session in 2005 and plans to "aggressively litigate," according to its most recent filings with the Securities and Exchange Commission. The dispute concerns which of Reading's subsidiaries should bear the tax liability for a 1996 stock sale. "While there are always risks in litigation, we believe that a settlement at the level currently offered by the IRS would substantially understate the strength of our position," the company says. The case is now in the discovery phase, in anticipation of a trial in 2010.

Companies that choose to litigate have several options as to where to file their lawsuit. They can file in the U.S. Tax Court, the U.S. Court of Federal Claims, or the federal district court nearest the company's headquarters. The choice of venue hinges on many factors, say lawyers. Cash flow is one: a company can defer paying its taxes if it files in U.S. Tax Court, but it will also face less-favorable odds, as the court's judges are generally tax experts. By contrast, federal district courts require companies to pay taxes up front and then seek a refund, but they have traditionally offered better odds to plaintiffs.

What makes a good case for trial? "The best way to defend any planning transaction is to make it as simple as possible," something easily explainable to a layperson, says Lawrence Gibbs, IRS commissioner from 1986 to 1989 and now a partner at law firm Miller & Chevalier. "Complexity is really the biggest concern," he says, since it automatically makes the IRS suspicious.

That simplicity will come in handy when it's time to round up witnesses, too. Experts say the ideal witness in a tax case is a business executive who can explain why the tax benefits were merely the side effect of an essential business transaction. But the best witnesses are typically "scared to death," because the transactions they are asked to defend are so complicated, says Gibbs. (Tax and finance executives "don't tend to be very credible," notes Gibbs, because they obviously have a vested interest in the tax side.)

Then there is the issue of documentation. Supporting opinion letters that come from the same accounting or law firm that sold a tax shelter will not be very persuasive, says Gibbs. Other documents may contain damning details. In BB&T's case, the court noted that not only had an internal assessment of the deal concluded it was "tax-driven," but that Sodra's tax advisers had also characterized the deal as a purely financial transaction that did not affect its interest in the plant.

Still, some companies settle even when they believe they have a defensible case. "Many companies that are able to litigate are reluctant to do so," comments Gibbs, in large part because they don't want to run the risk of incurring a tax penalty, not to mention negative publicity. Under current policy, tax penalties can accrue automatically depending on the amount in dispute, even if a company has paid its taxes in full and is seeking a refund. As a result, the IRS's take from corporate penalties has nearly tripled, from a net $335 million in 2002 to $939 million in 2007.

This has been excerpted from CFO magazine. Read the full article here.

Alix Stuart is a senior writer at CFO.

© CFO Publishing Corporation 2008. All rights reserved.