Economic Substance, Tax Benefits, and Schering-Plough v. U.S.

Economic Substance, Tax Benefits, and Schering-Plough v. U.S.


In Schering-Plough Corporation v. United States, 2009 U.S. Dist. LEXIS 77467, the court's decision for the Government is a clarion call to taxpayers that even in cases when the taxpayer may be technically in compliance with relevant law, transactions -- particularly transfer pricing -- will be scrutinized for economic substance and tax benefits disallowed if a non-tax business purpose is found lacking.
 
Authors Robert Jennings and Elizabeth Sweigart write: Schering-Plough brought a civil suit against the United States in New Jersey District Court seeking a tax refund of approximately $473 million in Federal income taxes for taxable years 1989, 1991 and 1992. In 1991 and 1992, Schering-Plough assigned future income streams -- derived from interest rate swaps with a third party -- to related parties outside of the United States in exchange for lump-sum payments from those affiliates. The taxpayer represented that these "swap-and-assign" transactions were sales as opposed to loans and thus the income tax payment on the net proceeds of the sales could be deferred until later years. Essentially, Schering-Plough could gain access to its offshore cash immediately without a corresponding taxable event in the same year. The IRS concluded that the transactions were in fact intercompany loans and thus subject to tax under Section 956 of the Internal Revenue Code of 1986 (I.R.C.) as the resultant loans were "investments in U.S. property." In rendering its opinion, the court noted the policy rationale underlying the anti-deferral provisions enacted in the Revenue Act of 1962, Pub. L. No. 87-834, 76 Stat. 1006, § 12(a) (1962) (commonly known as "Subpart F").
 
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Lessons for U.S. Multinationals and Their Advisors
  • Lesson 1: Documentation. Contemporaneous documentation is essential... Taliloring a transaction to fit a sentence or two in an IRS notice will not suffice.
  • Lesson 2: Related Party Transactions Subject to Greater Scrutiny. The Government believes that transactions between affiliates offer more opportunities for improper revenue allocation than the same transactions involving third parties...
  • Lesson 3: Do Not Work Backwards. When looking for a tax structuring solution the general tendency is to start with the desired answer (say, achieve deferral) and work backwards. Tax planning decisions should be based on facts and circumstances, not the latest tax guidance "flavor of the month"... Although it may reduce short-term friction between the client and advisor, attempting to shoehorn a given set of facts and circumstances into the selected guidance and to rely on window-dressing to cover a position will put the taxpayer at risk.