Sec. 482 and the Sham-Transaction Doctrine

The last few years have seen a surge in the IRS's successful assertion of the sham-transaction doctrine against corporate taxpayers (ACM Partnership, 157 F3d 231 (3rd Cir. 1998), aff'g in relevant part TC Memo 1997-115; Compaq Computer Corp., 113 TC 363 (1999); United Parcel Service of America (UPS), TC Memo 1999-268; Winn-Dixie, 113 TC 254 (1999); and Medieval Attractions N.V., TC Memo 1996-455). In addition, the Service has been successful in using Sec. 482 in the corporate context and in imposing penalties (DHL Corp., TC Memo 1998-461). The clear message of these victories is the willingness of the IRS and the Tax Court to apply Sec. 482 in conjunction with the sham-transaction doctrine, to ignore the form of a taxpayer's transaction and impose not only tax liabilities but also penalties.

Sec. 482 has always been an amalgam of several important tax policies, including tax-avoidance principles, assignment-of-income notions, general deduction theories and clear-reflection-of-income principles; see Foster, 80 TC 34 (1983), aff'd in relevant part 756 F2d 1430 (9th Cir. 1985). The overall purpose of Sec. 482 is to prevent the artificial shifting, milking or distorting of true net incomes of commonly controlled enterprises. It specifically allows the Service to allocate income or deductions between commonly controlled entities, to prevent evasion of taxes or to clearly reflect income. Although the general sham-transaction and assignment-of-income doctrines can achieve the same result, Sec. 482 is designed to enable the IRS to prevent the distortion of income even when a taxpayer has acted in good faith and without a tax-avoidance motive. As can be seen from the recent spate of cases, however, this is most successful when it is supported by the other more general and broad-based doctrines that rely on demonstrating a taxpayer's attempt to avoid taxes.

UPS most clearly demonstrates the choice between a (1) general disallowance of deductions using the economic-substance doctrine and (2) re-allocation of deductions under Sec. 482. The Service determined that amounts UPS collected as excess value charges and paid over to its captive insurance company as premium payments had to be included in its income. The court upheld the IRS's position and imposed substantial penalties, concluding that the taxpayer failed to prove that the structuring of its transaction as the purchase of insurance from its captive was motivated by nontax business reasons or had economic substance. In so holding, the court noted the taxpayer's lack of contemporaneous documentation to support its positions and rejected the testimony of the taxpayer's witnesses who attempted to establish, at trial, the transaction's business purpose.

The UPS court also noted that it was consciously rejecting Sec. 482 in favor of the sham-transaction analysis. In so doing, it cited Foglesong, 621 F2d 865 (7th Cir. 1980), which had held that, if the more precise device of Sec. 482 were available to the Service, it should not use the blunt substance-over-form doctrine, because "there is no need to crack walnuts with a sledgehammer." UPS stated that, because the facts in the instant case were so extreme and "heavily freighted with tax motives," Foglesong and similar cases were distinguishable.

In Medieval Attractions N.V., the Tax Court chose a middle path between substance over form and Sec. 482. The court disallowed deductions claimed for the royalty payments a U.S. corporation made to a related foreign corporation on the grounds that the structure supporting the royalty payments was a sham and that royalty payments were not appropriate under Sec. 482. Thus, the court appeared to use both Sec. 482 and the sham-transaction doctrine to support its rejection of the taxpayer's deductions and its imposition of the negligence penalty.

In those cases in which the IRS has not raised the sham-transaction or substance-over-form doctrine but relied only on a straight Sec. 482 analysis, it has had moderate success; see H Group Holding, Inc., TC Memo 1999-334; Compaq Computer Corp., TC Memo 1999-220; and DHL Corp. In DHL Corp., although the court significantly reduced the Service's Sec. 482 adjustments, it upheld transfer-pricing penalties against the taxpayer. The court specifically commented on the taxpayer's conduct, both in failing to provide timely information to the Service and in originally structuring the transaction to undervalue the trademark transferred by the U.S. company to a foreign entity. Therefore, the court looked, to some extent, at both the substance of the transaction and the taxpayer's conduct. In H Group, the court applied only a Sec. 482 analysis and partially upheld the IRS's adjustments. Finally, in Compaq Computer, the Service relied only on Sec. 482, and the Tax Court entirely rejected its allocations. Interestingly, in an issue involving the same taxpayer, the court was willing to disallow the taxpayer's claimed foreign tax credit on the ground that the transaction generating the credit was a sham and had no economic substance.

Based on these cases, it is clear that when the IRS asserts Sec. 482, coupled with a sham-transaction or substance-over-form attack, it is much more successful in both winning its adjustments and imposing penalties. Stated differently, it appears that the Service has been able to make allocations under Sec. 482 to prevent tax evasion much more successfully than it has been able to make the same allocations to clearly reflect income. Moreover, the recent cases demonstrate that the Tax Court seemingly has abandoned any lingering admonition from Foglesong that the IRS refrain from asserting a broad sham or no-economic-substance analysis if Sec. 482 is available. The issue for the Service (and the silver lining for taxpayers) is whether its Sec. 482 allocation can ever be completely successful if the IRS is unable to show that a transaction lacks economic substance or is a sham. Conversely, a taxpayer that can show a business purpose for a transaction may go a long way in defeating or limiting a Sec. 482 adjustment.

From Cynthia K. Hustad, J.D., LL.M., San Francisco, CA