Thursday, July 13, 2006

In 1996, Coltec, an industrial concern, reported a capital loss of approximately $380 million on its consolidated tax return. It generated the loss through a transaction structured by Arthur Andersen, creating a special-purpose entity and then selling it high-basis stock for a relatively low price. The IRS disallowed the loss and assessed additional taxes, ruling that the transaction lacked any economic substance. Coltec paid the assessment and filed a refund action for roughly $83 million in the U.S. Court of Federal Claims, which awarded Coltec a full refund.

The U.S. appealed to the Federal Circuit, which concluded that although Coltec’s claimed capital loss fell within the literal terms of acceptable deduction the IRS Code, the transaction that created the high basis in the stock lacked “economic substance” and therefore must be disregarded for tax purposes.

The decision centers on whether a court’s use of the economic substance doctrine violates the separation of powers clause. The trial court had said that because the transaction complied with the IRS Code, “the use of the ‘economic substance’ doctrine to trump ‘mere compliance with the code’ would violate the . . . the U.S. Constitution,” effectively allowing judges to legislate from the bench. But the appeals court called the doctrine “merely a judicial tool for effectuating the underlying Congressional purpose that, despite literal compliance with the statute, tax benefits not be afforded based on transactions lacking in economic substance.”