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Tuesday, January 21, 2003


Does Merrill Lynch have a person on staff whose sole job is to think up names for their new subsidiaries? Or do they just have a long computer generated list of thousands, and just pick the next one off the top when the need arises?

As quick as I can make it: In each year of 1986 and 1987, Merrill Lynch sold wholly-owned subsidiaries in the leasing business to outside companies. In each case, there were assets in the subsidiaries that ML wanted to keep. All of these assets were, naturally, held in the form of wholly-owned subsidiaries of the companies being sold. So, before selling the leasing companies, the assets were sold to, naturally, sibling corporations (other wholly-owned subsidiaries of ML). The parties agreed that section 304 applies to these "cross-chain" sales and that section 304 treats these sales as redemptions. IRS argued the sales were redemptions in complete termination of the shareholder's interests under section 302(b)(3) and that therefore the sales should be taxed as distributions in exchange for stock under section 302(a). ML argued otherwise, claiming that the sales should be treated as distributions of property under section 301. IRS's arguments were barely hinted at and mostly ignored. IRS said the step transaction doctrine should apply and apparently tried to claim that this doctrine could apply simply by looking at the results: ML's entire interest in the leasing companies was terminated. ML's arguments were explained and refuted in great detail, presumably in anticipation of the inevitable appeal. They argued that the step transaction doctrine only applied if there was a firm and fixed plan for terminating their ownership in the companies, and that there was not a binding agreement to sell the leasing companies at the time of the cross-chain sales. The contingent nature of the arrangement precluded any plan from being "firm and fixed".

Tax Court held for IRS. They agreed with ML that the results alone do not activate the step transaction doctrine, and that there must be a firm and fixed plan to apply it. But Tax Court said that the determination of whether or not there was such a plan is a fact based analysis consisting of several factors, and that the existence of a binding agreement is only one factor to consider, and not a necessary one. The facts in this case clearly showed the existence of a firm and fixed plan to sell the leasing companies. Tax Court reviewed previous case holdings on this issue at great length, and examined the facts in this case in great detail. Anyone wanting to learn how the step transaction doctrine applies to section 302(b)(3) is well advised to read this case.

What Tax Court failed to mention in the opinion is the policy rationale for their holding. The step transaction doctrine exists to allow the IRS to tax the substance of a transaction without letting the taxpayer determine the taxation based on how they structure the form of the transaction. If binding agreements were necessary to apply the step transaction doctrine, then taxpayers could thwart the step transaction doctrine by structuring when they signed such agreements. Thus they could chronologically cut many steps out of the step transaction doctrine regardless of how important they are to the substance of the transaction.

If this seems pretty basic, it is. ML knew they would lose. They knew it back in 1986 and 1987 when they set up "tax reserves" to cover the amounts owed whenever the government is finally able to make them pay. This case raises interesting questions about such tax reserves. First, are they a good idea for a company to set up? You want to be able to take risky positions that you are entitled to take, and you should also be protected from the uncertainties of the tax law. Yet in this case, the existence of the tax reserve was used as evidence of the existence of a "firm and fixed" plan. So trying to protect yourself from the uncertainties of the tax law can be used as evidence of a sort of "guilty conscience" in cases where the taxpayer's intent is important. Second, should companies be allowed to create these tax reserves? Yes, I know I just made ML look like a victim for having the tax reserve used against them. But the most likely reason ML is making the public spend all of this time and money to collect taxes due based on a position that any first-year tax student can tell them is wrong is that this giant financial services company thinks it can make more money from their investments from the tax reserve then they will eventually owe in interest, penalties, costs, and legal fees. ML is screwing the public with the time value of money in case that has taken 13 years so far and will undoubtedly be appealed until SCOTUS denies certiori.

In fact, everything about this case is a nightmare example of business being conducted for tax advantages rather than any underlying business rationale. The reason ML wanted to sell the leasing companies to begin with is that the assets being leased had "turned around" for tax purposes and were no longer generating tax loses. The leasing companies were then marketed and sold to other companies with huge NOLs, thus allowing ML to charge a premium of profit that essentially allowed them to split the expected tax advantage to the buyer.

All of this from a company that makes its millions selling financial advice that, under efficient market theory, is self-defeating. Is the public getting *ANY* benefit from authorizing the existence of ML's corporate charter? Excuse me, charters?

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