Examination Number: 11123191

Tax and Fiscal Policy Examination

Professor John Prebble
Due Date: April 1, 2011
Questions Answered:
Part One: Question 1 – SUBSTANCE OVER FORM
Part 2: Question 3 – SIMPLICITY V. EQUITY: A TAX CONFLICT
Electronic Word Count: 3,311

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Part One: Question 1
SUBSTANCE OVER FORM
Substance, according to Oran’s Dictionary of the Law, is defined as,
“Reality, as opposed to mere appearance.” 1 Conversely, form is defined as,
“the language, arrangement, conduct, procedure, or legal technicalities of a
legal document or legal proceeding.”2 Courts work tirelessly to look past the
legal form of a transaction and to discern its economic or business substance. I
will examine the doctrine of “substance over form” within the framework of
two recent United States court decisions: Canal Corp. v. C.I.R.3 and Schering-
Plough v. U.S.4. After a discussion of the facts in each case, I will examine
each court’s reasoning with respect to its treatment of the substance-over-form
doctrine. I will close with my analysis of the courts’ decisions and their
application of the substance-over-form doctrine.

A. FACTS

I. Canal Corp. v. Commissioner

Canal Corporation (previously known as Chesapeake Corporation

during most of the transactions, infra) is a Virginia corporation operating as a
corrugated paper company. Over time, Canal became involved in a variety of
paper segments including: specialty packaging, tissues, and forest and land
development. Canal’s largest subsidiary was known as Wisconsin Tissue
Mills, Inc. (WISCO). WISCO accounted for almost half of Canal’s sales and
almost all of Canal’s earnings.
Because of the capital intensive nature of the tissue business, Canal
sought to restructure itself in 1997 and looked to divest WISCO in favor of
moving into the specialty packaging business for liquor, pharmaceuticals, and

1
ORAN’S DICTIONARY OF THE LAW 510 (4th ed. 2008).
2
Id. at 217.
3
Canal Corp. v. C.I.R., 135 T.C. No. 9, 2010 WL 3064428 (2010).
4
Schering-Plough v. U.S., 651 F. Supp. 2d. 219 (D. New Jersey)(2009).

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perfumes. Georgia Pacific (GP) was a major participant in the tissue business
and desired to purchase WISCO. Canal resisted an outright sale of WISCO
because it had a low tax basis in the WISCO assets. In order to avoid a
significant tax liability, GP and Canal decided to form a “leveraged
partnership.” Under the new joint venture Georgia-Pacific Tissue LLC (LLC),
WISCO contributed all of their tissue assets to the partnership, approximately
$775 million in value, in exchange for a five-percent interest in LLC. GP also
contributed assets to LLC in exchange for the remaining ninety-five percent
stake. On the same day the transaction closed, LLC then borrowed $755
million dollars and distributed the loan proceeds as a one-time “special
distribution” to Canal. GP guaranteed payment of the bank loan and WISCO
agreed to indemnify GP for any principal payments GP might have to make
under its guaranty. Even though they agreed to indemnify, WISCO’s assets
inside LLC amounted to less than $160 million, or 21% of their potential
indemnity liability. In addition, the Canal used the transaction’s structure to
show a $400 million book gain without a corresponding tax gain.

II. Schering-Plough Corp. v. U.S.

Schering-Plough (SP) was a diversified pharmaceutical company

engaged in the manufacturing and distributing pharmaceutical products from a
consumer division as well as an animal health division. Schering-Plough was
merged with Merck & Company in late 2009 and now operates under the
Merck & Co. brand.
In the instant case, SP entered into two 20-year interest rate swap
transactions (swaps) with a foreign bank. The swaps required the two
counterparties to exchange periodic payments with each other based on a
notional principal amount and two different interest rate indices. SP then
assigned its right to receive the payments under the swap agreements to two of
its Swiss subsidiaries for lump sum payments of $690 million. Relying on
Internal Revenue Service (IRS) Notice 89-21, SP amortized the lump sum

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payments over the life in which future income streams had been assigned (20
years).

B. COURTS’ APPLICATIONS OF AND CONCLUSIONS OF LAW

I. Canal Corporation

The court in Canal was asked to decide whether the LLC transaction
constituted a taxable sale of assets by WISCO to GP. The court began with a
discussion of the applicable Internal Revenue Code (the Code) provisions.
Generally, a partner’s contribution of capital to a partnership in exchange for
an interest in the partnership is not a taxable event. 5 However, these
nonrecognition rules do not apply where the transaction is found to be a
disguised sale of property. 6 A disguised sale may occur when a partner
contributes property to a partnership and soon thereafter (usually within two
years) receives a distribution of money or other consideration.
An exception – relied on by Canal – to this deemed sale rule is a
transaction that involves what is known as debt-financed transfer of
consideration. The regulations allow for nonrecognition of a transaction that
would otherwise be regarded as a disguised sale to the extent that the
distributions are traceable to debt allocated to the distributee partner under
Code § 752 regulations. The regulations under this section require that
recourse debt be allocated to the partner or partners bearing the ultimate
economic risk of repayment without making a determination of whether such
partner(s) actually has the economic ability to meet their obligations unless the
facts and circumstances indicate a plan to circumvent or avoid the obligation.7
The court highlighted two specific facts of the transaction that guided its
determination that neither Canal nor WISCO bore more than a remote chance
of becoming liable on the indemnification agreement.

5
IRC §§ 721, 731.
6
IRC § 707(a)(2)(B).
7
Treas. Reg. § 1.752-2(b)(6).

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 First, the court noted that the only assets held by WISCO after the
transfer were an inter-company note of $151.05 million and a company jet
valued at $6 million. As noted above, this only amounted to 21 percent of the
total amount WISCO could be liable for in the event full indemnification was
required ($755 million). The court also noted that WISCO’s principal asset
(the inter-company note) was cancelable by the Canal board of directors at any
time (most of the executives on the Canal board of directors were also WISCO
executives and directors) and that the indemnification agreement did not
require WISCO to retain the note or any other asset. The court concluded on
this issue that the note served to create merely the appearance, rather than the
reality, of economic risk for a portion of the LLC debt.
Second, the court noted that the indemnification agreement required GP
to exhaust all of its remedies against the LLC’s assets before it could seek
indemnification from WISCO. This would have valued WISCO’s five percent
stake in LLC worthless because all of the LLC assets would have been
exhausted. So, Canal and WISCO could not claim any value for their LLC
interest because of the structure of the indemnification agreement.
The court held that the indemnification agreement should be
disregarded because it only served to create a remote possibility that WISCO
would actually be liable for any payments. Further, the court held that Canal
used the indemnity to create the appearance that WISCO bore an economic
risk when the economic reality showed that GP bore almost all of the risk of
loss in the LLC debt. Consequently, the court concluded that the distribution of
cash to WISCO did not fit within the debt financed transfer exception. The
result is that WISCO is deemed to have sold its business assets to GP in the
year it contributed the assets, not the year it liquidated its LLC interest.

II. Schering-Plough
The court in Schering-Plough painstakingly trudged through the
analysis of substance-over-form and economic substance. My analysis will
deal only with the substance-over-form discussion. The court begins by laying

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out the burden awaiting SP in this case. The court lists three hurdles SP must
overcome to prove the transaction was a sale and not a loan. The three
requirements SP must show are: 1) that the transactions were the economic
equivalent of sales of future income streams; 2) that SP entered into these
transactions with objectives beyond tax avoidance and that its net economic
position was appreciably altered as a result (i.e., these swap-and-assign
transactions were not shams); and 3) the tax shelter that SP alleges that Notice
89-21 provides is consistent with Congressional legislative intent (emphasis
added).
SP argued that the assignment of future income streams in exchange for
the lump sum payments were bona fide sales of an interest in future payments.
The Commissioner countered by arguing that the lump sum payment amounted
to the principal loaned and the streams of future income payments amounted to
the repayment of the lump sum principal with interest.
In its analysis of the substance-over-form doctrine, the court notes that
for a transaction to constitute a true loan there must have been at the time the
funds were transferred, an unconditional obligations to repay the money and an
unconditional obligation on the part of the lender to secure the repayment of
the funds. Because SP and its Swiss subsidiaries were related and did not
bargain at arm’s length, the court gave particular scrutiny to the transaction
because the normal business protections that act to prevent contrived
transactions were not present. Under this analysis, the court concluded, based
on testimony, that executives from both sides of the transaction viewed the
payments in the character of loans. The court even found evidence that some
executives knew to disregard the internal terminology used in the transaction
documents and to regard the swap as a loan.8
The court also notes that the step-transaction doctrine can be used to
reorder the steps used in the swaps to illustrate the de facto loan structure. The
evidence showed that SP management and its treasury department transferred
money from Swiss subsidiaries through an intermediary European bank to the

8
Schering-Plough, 651 F.Supp 2d at 262.

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main corporate treasury – circuitously – and later repaid the money through the
hired intermediary with the only goal being tax avoidance. Since both of the
step-transaction approaches – the end result test and the interdependence test –
show that the steps can be avoided without disturbing the economic reality of
the transaction, the court concluded that the swaps had amounted to a loan.

C. ANALYSIS

There are two basic principles in American jurisprudence that were

illustrated in Gregory v. Helvering.9 A taxpayer may structure a transaction in
such a way that he may reduce or even eliminate the amount of what would
otherwise be his tax liability by means which are permitted by law. To that end
however, the transaction may be examined to determine if the transaction
undertaken and the subsequent tax benefits are the things which the statute
intended. By elevating substance over form, courts work to execute the
Congressional intent of the given legal formality.
The courts in Schering-Plough and Canal Corp. (hereafter, “the courts”)
both recognized that the labels, forms, opinions, and references given to the
particular transactions could not be used to shield the true economic realities of
each transaction. I want to close by examining three points stressed by the
courts which act as illustrate the importance of disregarding form when the
underlying economic substance is not present
The court in Canal made special mention of the disparate treatment
Canal Corp. used between its accounting for financial accounting and its
inconsistent tax treatment. As noted above, Canal reported an immediate book
gain for the transaction but deferred the tax gain under the theory of the debt-
financed transfer. Canal also failed to treat the indemnification obligation as a
liability for book purposes. Canal determined that there was no more than a
remote chance that the indemnity would be triggered. The disparate treatment
of tax and book liabilities plus the inconsistent treatment of the corresponding

9
293 U.S. 456 (1935).

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liability by Canal is strong evidence that the legal form of the transaction does
not match the underlying economic realities. I think the court was correct to
recognize these inconsistencies and understand that Canal was trying to have
its cake (sell its appreciated WISCO assets) and eat it too (not pay tax on the
gain from the sale). This transaction crossed the line between reduction of tax
and evasion of tax.
The second point emphasized by the courts was that each company
used contrived legal formalities to create the appearance of economic
substance where, in reality, none existed. The courts reaffirmed their
commitment to disregard the paper in which these transactions were wrapped
and to open the box to determine what was actually inside. The court in Canal
noted that “this appears to be a concerted plan to drain WISCO of assets and
leave WISCO incapable, as a practical matter, of covering more than a small
fraction of its obligations under the indemnity.”10 Likewise in Schering-Plough,
the court noted that “the risk of [SP] becoming unable to pay was slight, thus
supporting the Swiss subsidiaries’ ultimate expectation of full repayment of the
principal loaned, plus interest.”11
Finally, the courts placed a notable emphasis on notion of bearing risk.
The courts recognized that Congress gives tax deferral benefits to certain
transactions where a company retains the risk of loss in those transactions. The
fact that a company bears the risk of loss in a transaction ensures that the
company will be mindful of the economic realities of a transaction.
Conversely, a company with no risk of loss really does not care whether the
transaction ultimately gains or losses money, because the risk-free company is
economically removed from the transaction. While not articulating a formal
rule, both of the courts in the instant cases identify actual economic risk of loss
as a factor in determining the true substance of a transaction.
Elevating substance over form in business transactions – whether
extremely complex or relatively simple – ensures a fair playing field for

10
Canal, 135 T.C. at 12.
11
Schering-Plough, 651 F.Supp 2d at 260.

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everyone involved. U.S. courts have shows their resolve to disregard form
when necessary to make the tax consequences match the economic realities of
the same transaction.
The court in Schering-Plough sums up this concept rather succinctly:
“Permitting a taxpayer to control the economic destiny of a transaction with
labels would…exalt form over substance, thereby perverting the intention of
the tax code.”

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Part 2: Question 3
SIMPLICITY V. EQUITY: A TAX CONFLICT

Tax analysts have often noted the inherent conflict between simplifying
the tax code while at the same time respecting notions of equity and fairness.12
The paradox can be stated rather simply: equitable taxation can only be
achieved by a complex system. By simplifying the tax code, the focus shifts
more heavily on the view of a taxpayer’s income without being able to take
into account the taxpayer’s situation in life. For example, a simple tax system
would view a single taxpayer with an income of $100,000 in relatively the
same light as a family of five in which both parents work full time, file a joint
tax return, and make $100,000. It is clear that economically speaking, these
two “taxpayers” are in wildly different economic situations. With respect to
tax preferences, the U.S. tax system treats these two taxpayers in a very
different manner.
This over-simplified example shows why some level of complexity
must be employed to achieve the goals Congress has set forth. The tax system
is used to achieve federal goals as well as reflecting certain public policy
matters. The tax system is obviously used to raise revenue for the federal
treasury. It is also used to distribute the tax burden consistent with public
policy consideration. Creating a system that provides more precisely targeted
fairness adds complexity and creates a trade-off between simplicity and
horizontal equity.13 As in the example above, rules that tax different people
different amounts at different income levels also adds complexity to the system.
Public policies that favor saving for college, home ownership, and saving for
retirement – as examples – cause trade-offs between simplicity and growth.14
While there are a multitude of reasons that complexity gets introduced
into our tax system, I will focus on one major reason. I will discuss its place in

12
See, Effects of Tax Simplification Options on Equity, Efficiency, and Simplicity: A
Quantitative Analysis, avaliable at,
http://www.brookings.edu/papers/2003/05useconomics_gale.aspx. (Last visited, April 1, 2011).
13
Id.
14
Id.

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our tax system and as well as its place in furthering non-revenue goals set forth
by our government. The major issue adding to the complexity of the tax system
is that the United States uses the tax system to promote social goals.

A. USING THE TAX SYSTEM TO PROMOTE SOCIAL GOALS

In addition to being the primary revenue generator for the United States,
our federal tax system also bears the additional responsibility of being the
catalyst for many social policies. The tax system promotes home ownership,
spurs charitable giving, drives environmental initiatives, funds individual
health care, and encourages retirement savings. Not only does the tax code
drive a seemingly endless set of initiatives, it does so in a variety of ways. One
way is by providing for a deduction from gross income for certain tax
preferences. With a tax deduction, the size of the tax benefit is determined by
the taxpayer’s marginal tax rate. Another way the tax code encourages (and
rewards) behavior is by giving a tax credit. A credit is a dollar-for-dollar
reduction in the amount of tax owed. Further, tax credits come in two flavors:
refundable or non-refundable. A non-refundable tax credit limits the tax
benefit to a point at which the taxpayer owes no more tax. A refundable credit
– which is more desirable – will repay the taxpayer even if the credit exceeds
the taxpayer’s total income tax liability. So, if you engage in certain activities,
the government will actually pay you. The much ballyhooed Earned Income
Tax credit is one such refundable credit.
Achieving simplicity in the tax code would most certainly require a
drastic reduction in the number of tax deductions and tax credits currently
being offered; however, there is a great force at work that prevents this type of
drastic reform: politics. A simple reality is that tax credits and deductions –
which are nothing more than an alternative form of government spending – are
politically popular. Politicians can put tax preferences into the tax code much
easier than they can pass a spending bill, while still providing a benefit to a
certain segment of their constituents. And the tax preferences can be targeted

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in such a way that they affect the specific segment of the population intended
to get the benefit. Rules that are more complex can be tailored to acts more
precisely, thereby allowing better control of behavior.15 This does not, however,
change the fact that every tax preference inherently makes the tax system more
complex.
Equity plays a part in the social policy aspects mentioned above. Social
goals, such as progressive taxation based upon a taxpayer’s ability to pay, are
achieved partially by adding tax preferences. May tax deductions are reduced
as income is increased, and most are eventually phased out after a taxpayer
reaches a threshold earnings limit. These reductions and phase-outs are
designed with equity in mind but are implemented in a complex fashion. By
using tax credits and tax deductions, the goals of tax equity necessitate a more
complex design.
Kaplow summed up the complexity argument succinctly:
Complexity often is discussed as an evil to
be minimized…in…the income tax. Of
course, less complexity is to be preferred if
the same substantive rules can be applied.
But much complexity… arises because of
the benefits from rules that are more
precisely tailored to particular behavior. To
talk of minimizing complexity in this
context is misguided: the simplest rules
might permit all acts, require equal
reductions of all pollutants regardless of
their toxicity, or require the same speed limit
on all roads.16

If the United States continues to use the tax code as a means of

implementing desired social behavior, then the tax code will continue to be
complex. Complexity and equity are not always a tradeoff. For example,
posting different speed limits on different types of roads adds complexity, but
it does not disturb equity. All drivers are bound by those rules. To carry the

15
Kaplow, Louis, A Model of the Optimal Complexity of Legal Rules, 11 J. L. Econ & Org.
150 (1997).
16
Id.

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analogy forward, each taxpayer is on his or her (or its in the case of a
corporation) own “road” with respect to the tax system. It would be nearly
impossible to find two individuals in the exact same financial situation; and
income is just a small part of a person’s fiscal situation. A single “tax speed
limit”, while easy to enforce, would completely destroy horizontal and vertical
equity. Because every person is in a different position relative to others,
complex rules are needed to achieve equitable treatment of different people in
a similar manner.

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