The opinion of the court was delivered by: Katharine S. Hayden, U.S.D.J.
In this taxpayer refund action, the Court examines a domestic corporation's assignment of future income streams-derived from interest rate swaps with a third party-to its offshore subsidiaries, in exchange for lump-sum payments from the subsidiaries. In so doing, the Court must decide whether the structured transactions were in essence a loan from, or a sale to, the subsidiaries. Should it find the former, the Court must uphold as valid the tax levied by the government. Should it conclude the latter, plaintiff Schering-Plough Corporation (―Schering-Plough‖) is entitled to a $473 million refund, plus interest.
Before discussing the facts of the case more closely, the Court briefly describes the critical loan/sale distinction underlying the dispute, the operation of the relevant taxation policy, and the transactions at issue. Generally, the earnings of a domestic corporation's foreign subsidiaries are not taxed until the money is distributed to the parent corporation via a dividend.
See I.R.C. § 451(a).*fn1 Under the international taxation scheme in effect at all relevant times here, however, an intercompany loan from an offshore subsidiary to its domestic parent is immediately taxable. This is a departure from the traditional rule that a loan is not income. See James v. United States, 366 U.S. 213, 219 (1961) (accepted definition of gross income ―excludes loans‖). Instead, Congress has enacted its policy judgment, discussed more fully below, that when a foreign subsidiary invests in the corporate debt of its domestic parent, the use of the loaned funds is no different than a dividend to the parent shareholder, and should be taxed accordingly. This regime, known as Subpart F of the tax code, is intended to prevent United States corporations from sheltering their subsidiaries' income in so-called ―tax-haven‖ countries, while simultaneously putting the money to domestic use.
Conversely, the sale of future income rights under an interest rate swap transaction triggers a different principle of taxation. The federal tax code mandates that when a taxpayer's method of accounting does not clearly reflect the income the taxpayer actually generates, the method of computing taxable income-as prescribed by the Commissioner of the Internal Revenue Service (―IRS‖)*fn2 -should nonetheless be reflective of such income. SeeI.R.C. § 446(b); United States v. Hughes Props., Inc., 476 U.S. 593, 603 (1986). The Commissioner determined in Notice 89-21, a revenue notice published on February 7, 1989, that money received from the sale of rights to future income streams under an interest rate swap transaction did not clearly reflect income if it was reported in the year received. Instead, the notice stated that income is more accurately reflected when it is reported as having been received over the lifetime of the swap contract.*fn3
Turning to the transactions at issue: in 1991 and 1992, Schering-Plough, an international pharmaceutical conglomerate, wishing to repatriate its subsidiaries' foreign earnings back to the United States, entered into two 20-year interest rate swap transactions with Algemene Bank Nederland, N.V. (―ABN‖), a Dutch investment bank. Under the swaps, the two counterparties agreed to exchange periodic interest payments based on a hypothetical amount (the ―notional principal‖) and two different interest rate indices. The swap agreements obligated ScheringPlough and ABN to make periodic payments to each other reflecting the movement of the particular interest rate assigned to their respective sides of the transaction.
Under the swaps, Schering-Plough had the right to assign or otherwise transfer its right to receive interest payments from ABN (the ―receive legs‖). It did, in fact, assign the majority of the receive legs to two of its foreign subsidiaries. In return, the subsidiaries made lump-sum payments to Schering-Plough totaling approximately $690 million. Schering-Plough did not report the lump sums as present income. Instead, it deferred reporting income until later years, relying on Notice 89-21. Specifically, because Notice 89-21 required ratable taxation of payments received in exchange for the assignment of future income streams from notional principal contracts, Schering-Plough reported income for the lump sums by amortizing them over the period in which the future income streams had been assigned.*fn4
Notice 89-21 also states that ―[n]o inference should be drawn from this notice as to the proper treatment of transactions that are not properly characterized as notional principal contracts, for instance, to the extent that such transactions are in substance properly characterized as loans.‖ So if the Schering-Plough transactions are deemed loans (as the government eventually deemed them to be), the amortization provision does not apply and the entire lump-sum payments are immediately taxable.
In 2004, characterizing the transactions as loans, the Commissioner assessed a tax deficiency upon Schering-Plough because it had not reported the lump-sum payments as present income in 1991 and 1992, the years in which they had been received. Schering-Plough paid the $473 million tax bill and thereafter filed this action seeking a refund.
The Court's decision requires an examination of the transactions for their ―economic reality‖-that is, regardless of how a given transaction was characterized by the taxpayer, is it in reality a loan or is it in reality a sale? Put another way, the Court scrutinizes for substance over form. The Court then tests the ―economic substance‖ of the transaction: Does it have sufficient economic substance despite the existence of tax avoidance objectives, or is it a ―sham transaction‖? Finally, the Court must assess whether the transactions, anchored as they were in Notice 89-21, duly comported with the relevant taxation scheme implemented by Congress.
For Schering-Plough to prevail, the Court must find the following: (1) that the transactions were the economic equivalent of sales of future income streams (that is, they were not loans dressed up as sales); (2) that Schering-Plough entered into them with objectives beyond tax avoidance and that its net economic position was appreciably altered as a result (that is, that the transactions were not shams); and (3) that the tax shelter that Schering-Plough alleges Notice 89-21 provides is consistent with Congress's legislative intent. Should Schering-Plough falter on any of these grounds, the Court must render judgment for the government.
Because the Court conducted a bench trial during which the parties took full opportunity to present their respective positions, there is plenty of evidence, factual and opinion, to examine in making the ultimate decision. Throughout this opinion the Court will be citing the testimony of: (a) fact witnesses-the people who made the decisions and signed the documents-to determine what they did and why they did it; and (b) the opinions of experts called by the parties-both their reports and their testimony-for guidance about the best reasoned, least strained interpretations of the facts. Pursuant to Rule 52(a) of the Federal Rules of Civil Procedure, the Court has organized this opinion around a full discussion of the facts surrounding the transactions, based on the evidence adduced at trial. Following its factual findings, the Court examines the transactions' economic reality, economic substance, and, finally, their assimilation with applicable tax laws.
The Court has jurisdiction concurrent with the United States Court of Federal Claims to hear all actions against the United States seeking the ―recovery of any internal-revenue tax alleged to have been erroneously or illegally assessed or collected . . . .‖ 28 U.S.C. § 1346(a); I.R.C. § 7422. Venue is proper in this District pursuant to 28 U.S.C. § 1402(a)(2) because Schering-Plough's principal place of business is located in New Jersey.
A tax assessed by the IRS is presumed to be correct; a taxpayer challenging the assessment shoulders the burden of proving that the assessment is legally erroneous.*fn5 Welch v. Helvering, 290 U.S. 111, 115 (1933); Francisco v. United States, 267 F.3d 303, 319 (3d Cir. 2001); Sullivan v. United States, 618 F.2d 1001, 1009 (3d Cir. 1980); Psaty v. United States, 442 F.2d 1154, 1159 (3d Cir. 1971). The Court's review of the IRS determination is de novo. Lewis v. Reynolds, 284 U.S. 281, 283 (1932).
Schering-Plough seeks a tax refund of $472,870,042.69 in paid federal income taxes for taxable years 1989, 1991, and 1992. The taxes were assessed and collected by the IRS as a result of the two interest rate swap-and-assign transactions that Schering-Plough entered into with its foreign subsidiaries and ABN in 1991 and 1992. Before turning to the specifics of the transactions, the Court describes the applicable taxation scheme, Schering-Plough's corporate structure, and the financial condition in which it found itself in the late 1980s.
The independent taxing identity of corporations and the worldwide taxation of income before President John F. Kennedy assumed office led to creative tax planning structures that enabled corporations to shelter revenue in subsidiaries headquartered outside the United States. Office of Tax Policy, Dep't of the Treasury, The Deferral of Income Earned Through U.S. Controlled Foreign Corporations: A Policy Study, at x, 1-5 (2000), available at www.ustreas.gov/offices/tax-policy/library/subpartf.pdf (last visited Aug. 28, 2009). In response, Congress passed the Revenue Act of 1962, Pub. L. No. 87-834, 76 Stat. 1006, § 12(a) (1962), which was designed to prevent United States corporations from stockpiling their foreign subsidiaries' earnings and profits (―E&P‖) offshore in an effort to avoid domestic income tax. The objective was to end ―‗artificial arrangements' between related corporations that ‗exploit the multiplicity of foreign tax systems and international agreements in order to reduce sharply or eliminate completely their tax liabilities both at home and abroad.'‖ Id. at 13 (quoting Message from the President of the United States Relative to our Federal Tax System, H.R. Doc. No. 140, 87th Cong., 1st Sess. 6 (1961)).
The legislation-Subpart F of the Internal Revenue Code-mandates taxation of foreign E&P upon repatriation to the United States. Mechanically, Subpart F assesses a tax on any ―United States shareholder‖ (as defined in I.R.C. §§ 951(b) & 958(b)) of a ―controlled foreign corporation‖ (―CFC‖) (as defined in I.R.C. §§ 957 & 958) when the United States shareholder invests previously untaxed foreign E&P in ―United States property.‖ An obligation by a United States shareholder acquired by a CFC is deemed to be such an ―investment in United States property‖ under I.R.C. § 956(c)(1)(C). When a CFC makes a loan to its domestic parent, the amount of the loan is presently taxable under Subpart F. (Joint Trial Stipulation (―JTS‖) 12, ¶¶ 100-01); see also Ludwig v. Comm'r, 68 T.C. 979, 983-84 (1977) (―[I]f a controlled foreign corporation makes a loan to its shareholder, a United States person, the obligation to repay the loan is United States property and the shareholder thereby realizes income under section 951.‖).
B. Schering-Plough's Corporate Structure
During the tax years in question, Schering-Plough was a New Jersey corporation, which, through its wholly-owned subsidiary Schering Corporation (a New Jersey corporation), owned all of the voting stock of Schering-Plough International, Inc. (―International‖) (a Delaware corporation). International owned a majority of the voting stock of Schering-Plough Ltd. (―Limited‖), which, in turn, owned a majority share in Scherico, Ltd. (―Scherico‖). Finally, Scherico was the majority owner of Essex Chemie, A.G. (―Essex Chemie‖). Limited, Scherico, and Essex Chemie are Swiss corporations (collectively, the ―Swiss subsidiaries‖). (JTS 11, ¶¶ 73-85.) Due to a favorable Irish corporate income tax on manufacturers at the time, Limited, like many other pharmaceutical companies, conducted significant manufacturing operations in Ireland. (JTS 11-12, ¶¶ 80, 81, 88; Nichols Dep. 90:10-23; Ex. 2000.)
Given the above, Schering-Plough (through its domestic subsidiaries) was a United States shareholder within the meaning of I.R.C. §§ 951(b) and 958(b). (JTS 12, ¶¶ 95-96.) Moreover, there is no dispute that the Swiss subsidiaries were CFCs within the meaning of I.R.C. §§ 957 and 958. (JTS 12, ¶ 94.) The taxation format implemented by Subpart F therefore applied in all relevant respects during the tax years at issue. The sole question is whether the particular transactions at issue were subject to immediate taxation as investments in United States property (i.e., loans) under the Subpart F regime.
At trial, Schering-Plough presented testimony from some of its senior management working at the company during the relevant time periods, including Schering-Plough's Chief Executive Officer Robert Luciano, and finance executive Dan Nichols, who headed the company's tax department. These senior managers testified about Schering-Plough's hierarchy and general objectives during the late 1980s and early 1990s. Also testifying was Jay Ludwig, who served in Schering-Plough's treasury department and worked on the team that designed the swap-and-assign transactions.
During the late 1980s, Schering-Plough's Swiss subsidiaries (particularly Limited) generated and held substantial amounts of untaxed E&P from their operations in Ireland. (JTS 11, ¶¶ 88-89; 1/16/08 Nichols Test. 74:25-75:9.) By the end of 1990, Limited had accumulated $391.5 million of this ―Irish cash,‖ of which only $41 million was previously taxed income (―PTI‖). Under the tax code, investments in United States property are not taxed to the extent that the funds used have already been subjected to Subpart F taxation. See I.R.C. § 959(a), (c)). By 1991, the earnings figure had grown to $498 million, of which only $16 million was PTI; and by 1992 it had ballooned to $829.7 million, of which only $29.6 million was PTI. (Exs. 33, 2068.)
Schering-Plough housed its Irish cash generated by Scherico and Limited in a ―cash investment pool‖ located within Essex Chemie on the theory that it was administratively and economically more efficient to manage the E&P under one entity. (JTS 13, ¶ 103; 1/17/08 Ludwig Test. 70:25-71:11; Ex. 75.) Ludwig testified that when Schering-Plough engineered inter-subsidiary loans and advances, it used intercompany payables and receivables. But he never saw accompanying formalities such as loan documentation, promissory notes, or other documents containing any covenants, warranties, or default events. Nor did he ever see a transferee post security or collateral for an advance. (1/17/08 Ludwig Test. 69:25-73:2.)
Schering-Plough wanted to use the mostly untaxed, offshore Irish cash in the United States for multiple purposes, including R&D programs, normal operating expenses, and particularly a $1 billion stock repurchase program. Stock repurchase programs, which reduce the number of shares outstanding, were common among Schering-Plough's competitors in the late 1980s and early 1990s for several reasons, not least of which was that they created value for shareholders by increasing earnings per share, which usually results in a higher stock price.
Stock repurchase programs also help protect companies from hostile takeovers. (1/15/08 Luciano Test. 56:16-57:12; 1/15/08 Wyszomierski Test 115:14-22; 1/16/08 Nichols Test. 24:3-25:11.) Schering-Plough's stock repurchase program, which it had announced in September 1990, required leveraged financing (i.e., loans). (1/15/08 Wyszomierski Test. 128:4-18; Ex. 211 at 3, 11, 14; 1/16/08 Nichols Test. 21:16-24:9.)
Luciano and Nichols testified that Schering-Plough was eager to not incur debt where cash was otherwise accessible to fund domestic operations, including its stock repurchase programs. (1/15/08 Luciano Test. 65:1-67:2; 1/16/08 Nichols Test. 23:25-24; 27:24-28:7.) Schering-Plough continually attempted to maintain a debt-to-capital ratio comparable to those of competitor pharmaceutical companies. (1/15/08 Wyszomierski Test. 128:23-129:20; 1/17/08 Ludwig Test. 10:18-11:8; 1/29/08 Moore Test. 12:3-22.) Pharmaceutical companies typically had low debt-to-capital ratios, and, in order to keep its favorable credit rating, Schering-Plough needed to keep its debt ratio below 50 percent. (1/15/08 Luciano Test. 65:1-67:2.) Despite its efforts, by the end of 1990, Schering-Plough's debt-to-capital ratio was higher than any of its main competitors. (1/17/08 Ludwig Test. 10:18-11:8.)
Because Schering-Plough found increasing debt and a ―ballooning‖*fn6 balance sheet undesirable, it consulted with ABN in the late-1980s about how it could decrease the cash and debt on its balance sheet. (1/15/08 Wyszomierski Test. 127:19-129:5; 1/18/08 Ludwig Test. 31:23-33:8; 1/17/08 Ludwig 76:11-77:25.) According to Ludwig, Schering-Plough engaged ABN in the late 1980s under a consulting agreement to provide advisory services on how Schering-Plough could reduce the ballooning of its balance sheet. (1/17/08 Ludwig Test. 76:11-77:25.)
Schering-Plough also consulted with Merrill Lynch, its long-time investment banker and principal financial advisor. (1/18/08 Ludwig Test. 8:3-9; 31:23-33:8; 1/16/08 Nichols Test. 19:13-20:19; 1/15/08 Wyszomierski Test. 115:23-116:17.) Luciano testified that a principal responsibility Schering-Plough placed on Merrill Lynch was to design tax-beneficial investment vehicles. (1/15/08 Luciano Test. 69:24-71:8.) In the past, Merrill Lynch had developed a tax vehicle for Schering-Plough and others known as a contingent installment note sale. Under this product, Schering-Plough invested in a partnership known as the Kralendijk Partnership in which ABN had participated as a counterparty. The Kralendijk Partnership generated capital losses that offset certain capital gains Schering-Plough had received through a sale of one of its divisions. (1/16/08 Nichols Test. 100:1-12, 128:16-25, 129:1-14; 1/17/08 Ludwig Test. 78:19-79:9).*fn7 It is against this backdrop that Schering-Plough again sought counsel from Merrill Lynch on how to repatriate its offshore cash without incurring the bite of Subpart F.
In addressing Schering-Plough's need for cash and ballooning balance sheet, Luciano enlisted Schering-Plough executive Nichols to help find a tax-efficient domestic funding solution. (1/16/08 Nichols Test. 19:4-12.) Nichols considered, but ultimately rejected, the options of direct loans and so-called ―back-to-back‖ loans. (1/16/08 Nichols Test. 26:2-28:7; 2/25/08 Foster Test. 158:20-159:16; JTS 13, ¶¶ 108-110.) In a ―back-to-back‖ loan, a foreign subsidiary with excess cash makes a deposit at a foreign branch of a bank, from which the domestic parent company would subsequently borrow money. (JTS 13, ¶ 109.) Despite the fact that back-to-back loan arrangements would have had no federal income tax consequences, Schering-Plough did not pursue this mode of domestic funding because it considered the financial accounting treatment inferior to other alternatives. (JTS 13-14, ¶ 110.) According to Ludwig, the company rejected intercompany lending from subsidiary to parent, as well as a dividend issuance from the Swiss subsidiaries to their parent shareholder because these proposals would have been presently taxable to the extent the offshore cash had not been previously taxed. (1/17/08 Ludwig Test. 128:11-24.) See I.R.C. §§ 316, 956, 959,
Merrill Lynch proposed to Nichols and other Schering-Plough executives within Schering-Plough's treasury, accounting, legal, and tax departments another alternative, this time an interest rate swap-and-assign transaction that would enable Schering-Plough to obtain cash to finance its domestic operations, would not balloon Schering-Plough's balance sheet, and would be tax efficient. (1/16/08 Nichols Test. 28:8-32:13; 1/17/08 Ludwig Test. 15:13-25; Exs. 2, 22.) The transactions, Merrill Lynch explained, would be governed by IRS Notice 89-21.
Notice 89-21, entitled ―Deferred Recognition of Income from Lump-Sum Payments in Connection with Notional Principal Contracts,‖ was published in the Internal Revenue Bulletin on February 7, 1989. Notice 89-21 ―provide[d] guidance with respect to the federal income tax treatment of lump-sum payments received in connection with interest rate and currency swap contracts.‖ (Ex. 224, p. 651.) Notice 89-21 functioned as the prevailing guidance for tax reporting of receipt of a lump-sum payment in connection with an interest rate swap where swap counterparties were obligated to make swap payments in future taxable years. (Ex. 224 at 651; Treas. Regs. § 1.446-3(g)(4), and (j).) The notice states in pertinent part:
Under . . . the Internal Revenue Code, if a taxpayer's method of accounting does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income. . . . In the case of a payment received during one taxable year with respect to a notional principal contract where such payment relates to the obligation to make a payment or payments in other taxable years under the contract, a method of accounting that properly recognizes such payment over the life of the contract clearly reflects income. Moreover, including the entire amount of such payment in income when it is received or deferring the entire amount of such payment to the termination of the contract does not clearly reflect income and is an impermissible method of accounting. . . . In the case of lump-sum payments made or received with respect to notional principal contracts entered into, or assignments made, prior to the effective date of the regulations (including contracts entered into prior to the publication of this notice), a method of accounting used by a taxpayer is a method that clearly reflects income only if the payments are taken into account over the life of the contract using a reasonable method of amortization. . . . No inference should be drawn from this notice as to the proper treatment of transactions that are not properly characterized as notional principal contracts, for instance, to the extent that such transactions are in substance properly characterized as loans. This notice serves as an ―administrative pronouncement‖ as that term is described in section 1.6661-3(b)(3) of the Income Tax Regulations and may be relied upon to the same extent as a revenue ruling or revenue procedure.
IRS Notice 89-21, 1989-1 C.B. 651, 1989 IRB LEXIS 91 (emphasis added).
Relying on Notice 89-21, Skadden, Arps, Slate, Meagher & Flom (―Skadden Arps‖), Schering-Plough's outside counsel, and Deloitte & Touche (―Deloitte‖), Schering-Plough's independent auditor, reviewed the swap structure, after which Deloitte opined that ―there is no need to accrue U.S. income taxes on the proceeds of the sale‖ of the swap receive legs to Scherico and Limited. (1/16/08 Nichols Test. 29:25-30:13; 32:14-33:17; 34:6-10; 38:23-39:11; 39:25-40:6; 102:12-104:6; Ex. 21.) Schering-Plough and Merrill Lynch executed a standard-form engagement letter memorializing Schering-Plough's business objectives and outlining Merrill Lynch's supporting role. (Ex. 1424; 1/17/08 Ludwig Test. 17:6-18; 2/1/08 Pepe Test. 12:5-15:7.) A report prepared for Schering-Plough's Finance and Audit Committee confirmed that the swap-and-assign transactions ―effectively repatriated $728 million while deferring U.S. tax.‖ (Exs. 216, 34.) Deloitte concurred, stating that the transactions ―were used as a means of repatriating money from Europe without having it taxed as a dividend.‖ (Ex. 15.)
Luciano answered affirmatively when asked at trial whether ―Mr. Das [of Merrill Lynch] represented to [him] that the sole purpose of this swap and sale transaction was to give ScheringPlough access to its foreign cash, without paying taxes, correct?‖ (1/15/08 Luciano Test. 76:4-17.) Luciano also responded ―yes‖ without qualification when asked if ―the STRIPS transactions were opportunities allowing the repatriation of additional funds from non-U.S. forces to accelerate future remittances by several years.‖ (1/15/08 Luciano Test. 78:19-23.) Luciano also agreed that the ―only problem with accessing cash‖ earned by the foreign subsidiaries was paying the tax upon repatriation. (1/15/08 Luciano Test. 75:10-13.) Jack Wyszomierski, who was a vice president and treasurer at Schering-Plough at the time the transactions at issue were executed, testified that at the time, Schering-Plough had been suffering from a ballooning balance sheet due to the cash-flush Swiss subsidiaries and Schering-Plough's domestic borrowing. (1/15/08 Wyszomierski Test. 124:4-18.)
D. The 1991 and 1992 Swap-and-Assign Transactions
1. 1991 Swap-and-Assign Transaction
Consistent with its plan detailed above, in 1991, Schering-Plough entered into an interest rate swap with ABN on January 2, 1991. (JTS 4, ¶ 9; Compl. ¶ 16.) The counterparties agreed to make interest payments to each other based on a notional amount of principal, and to make payments under a different interest rate for a set term of years. (Compl. ¶ 5.) The parties only exchanged the interest payments, not the notional principal. (Id.) Schering-Plough's 1991 transaction with ABN (―1991 swap‖) called for each party to make payments every six months from January 2, 1991 until December 15, 2010, based on a principal amount of $650 million. (JTS 5, ¶ 11; Compl. ¶ 16.) The agreement called for Schering-Plough to pay ABN interest based upon the London Interbank Offered Rate (―LIBOR‖), while ABN would pay Schering-Plough interest based on the federal funds rate.*fn8 (JTS 5, ¶ 13; Compl. ¶ 16.) The standardized swap terms permitted ABN and Schering-Plough to offset (―net‖) the two payments, such that the party owing the higher amount paid only the difference. (JTS 5, ¶ 15.) Because the swaps were entered into at market, the present value of Schering-Plough's receive leg at inception approximated the present value of its pay leg. (1/24/08 Taylor Test. 21:13-20; 1/30/08 Parsons Test. 53:21-54:3.)
Under the 1991 swap, Schering-Plough was permitted to assign its right to receive payments from ABN to a designated assignee, which included the Swiss subsidiaries. (JTS 5, 18.) Significantly, upon any assignment, the parties could no longer net payments; rather, each periodic payment would be due in full to the party owning the right to the particular income stream. (JTS 5, ¶ 19.) Thus, Schering-Plough's obligations to ABN remained unchanged, irrespective of any re-routing of incoming payments to Schering-Plough's offshore subsidiaries. In other words, upon assignment of its receive leg rights, Schering-Plough remained duty-bound to make the entire periodic pay leg distributions to ABN, notwithstanding ABN's parallel obligation to make the payments to Schering-Plough's third-party designee. Another provision in the 1991 swap permitted ABN to terminate the swap upon default by Schering-Plough. One of the events triggering default-the so-called ―60-day credit trigger‖-permitted ABN to terminate upon the following occurrence:
If [Schering-Plough's] credit rating by Standard & Poor's Corporation shall fall below AA- and its credit rating by Moody's Investors Service shall fall below Aa3 and within 60 days of the later of such credit ratings so to fall [Schering-Plough] shall not have reinstated one of such credit ratings . . . . (JTS 6, ¶ 20.)
Upon entering into the $650 million notional principal interest rate swap with ScheringPlough, ABN entered into a ―mirror swap‖ with Merrill Lynch with the same notional principal of $650 million. (1/24/08 Taylor Test. 35:24-37:11.) Under the mirror swap, ABN obligated itself to make the same LIBOR-based payments that it was to receive under its swap with Schering-Plough. In exchange, it received from Merrill Lynch the same federal funds rate payments that it was obligated to make to Schering-Plough, plus a premium of ten basis points for serving as intermediary to the swap-and-assign transaction.*fn9 (1/24/08 Taylor Test. 37:2-5.) The purpose of this mirror swap was to eliminate the market (i.e., interest rate) risk ABN faced under its swap with Schering-Plough. At the same time, however, ABN faced (at least nominally) credit risk exposure were Schering-Plough to default on its swap obligations. (1/24/08 Taylor Test. 37:18-24.)
On February 6, 1991, Schering-Plough assigned its right to receive income streams on $60 million of the notional principal to Banco di Roma, a third-party bank. The purpose of this assignment was to establish an arms-length pricing arrangement for the assignments to the Swiss subsidiaries that followed. (1/17/08 Ludwig Test. 81:21-83:5; 1/18/08 Ludwig Test. 33:21- 34:19; Exs. 662-667.) Banco di Roma paid Schering-Plough $26.4 million for the assignment on February 8, 1991; it funded the lump-sum payment with a $27 million zero coupon time deposit provided by ABN. (Exs. 667, 2038.)
In contrast with the assignments to the Swiss subsidiaries, ABN and Banco di Roma agreed that ABN would have an option to call (i.e., terminate) its payment obligation, and Banco di Roma would have the corresponding ability to sell the same income streams back to ABN. As part of the agreement, ABN agreed to compensate Banco di Roma 15 basis points (.015%) per year until the option was exercised. The option was, in fact, exercised in full by March 1993. (Ex. 2038; 1/23/08 Den Baas Test. 62:7-63:2.) Unlike the Swiss subsidiaries, Banco di Roma did not receive the plenary option to sell the assigned receive legs back to Schering-Plough. (1/17/08 Ludwig Test. 88:14-20.) See infra.
After entering into the benchmark assignment with Banco di Roma, Schering-Plough assigned its right to receive payments under the 1991 swap to Scherico for years 6-20, which would commence on December 15, 1995, and consist of payments for $460 million of the notional principal relating to the 1991 swap (―1991 Scherico Assignment‖). (JTS 6, ¶ 21.) Using the benchmark price established by the Banco di Roma assignment, Scherico paid Schering-Plough $202.4 million for the assignment of the receive leg under the 1991 swap. (JTS 6, ¶¶ 22-23.) ABN assented to the assignment by way of a Letter of Consent to ScheringPlough. (JTS 6, ¶ 28.) ABN also confirmed that it would make the assigned payments to Scherico ―independently of, and without reference to, the performance by . . . [Schering-Plough] of . . . [Schering-Plough's] obligations in respect of the [1991 swap].‖ (JTS 6, ¶ 27.) At the same time, Scherico and Schering-Plough entered into a ―Put Option Agreement‖ that would permit Scherico to assign back to Schering-Plough the receive leg of the 1991 swap that Scherico had purchased, and would thereby compel Schering-Plough to pay the fair market value of the remaining receive leg income streams on the date the put option was exercised. (JTS 6-7, ¶¶ 29-30.)
Also on February 6, 1991, Schering-Plough assigned Limited the right to receive payments from the 1991 swap as to $100 million of the notional principal amount, for which Limited paid Schering-Plough $44 million (again using the Banco di Roma benchmark price) on February 8, 1991 (―1991 Limited Assignment‖). (JTS 7, ¶¶ 32-34.) As with Scherico's assignment, ABN also consented to the assignment to Limited, and a put option was granted to Limited to re-assign the receive pay leg back to Schering-Plough. (JTS 7, ¶¶ 32-34.) The Court will refer to the 1991 Scherico Assignment and the 1991 Limited Assignment collectively as the ―1991 assignments.‖
Schering-Plough paid Merrill Lynch a fee of $2.2 million for its services in connection with the 1991 swap and subsequent assignments to Scherico and Limited. (JTS 8, ¶ 44.) It accounted for those fees by capitalizing them over the intended 20-year length of the swaps, analogizing to Statement of Financial Accounting Standards (―SFAS‖) No. 91: Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases. (JTS 118; Exs. 52, 501, 2058.)
Schering-Plough reported the assignments as sales for federal income tax purposes and applied an amortization method set forth in Notice 89-21. (JTS 8, ¶ 45; 1/16/08 Nichols Test. 38:23-39:7; Ex. 31.) Schering-Plough did not report as income in 1991 the consideration received from the offshore subsidiaries for the assignment of payment streams. (JTS 8, ¶ 46.) Instead, in each year starting in 1996, Schering-Plough reported, for federal income tax purposes, a ratable portion of the consideration received by reducing its deductions for payments made under the swap contracts. (JTS 8, ¶ 46; Compl. ¶¶ 17, 18.)
2. 1992 Swap-and-Assign Transaction
On October 1, 1992, Schering-Plough and ABN entered into a second interest rate swap (―1992 swap‖).*fn10 (JTS 8, ¶ 47.) Under the 1992 swap, Schering-Plough was required to make payments to ABN beginning on October 1, 1992 through October 1, 2012 based upon a total notional principal amount of $950 million and a 12-month LIBOR index for the period running for the term of the swap. (JTS 8, ¶ 48.) In return, ABN would make payments from October 1, 1992 to October 1, 2012 on the same notional principle using an interest rate that would reset every 2 years based upon a 30-day commercial paper rate, plus 0.05%.*fn11 (JTS 8, ¶ 49.) Like the 1991 swap, the 1992 swap permitted Schering-Plough and ABN to net the periodic payments due. (JTS 8, ¶ 51.) The 1992 swap also contained a 60-day credit trigger identical to the default trigger contained in the 1991 swap agreement. (JTS 9, ¶ 58.) As in the 1991 swap, ABN entered into an offsetting mirror swap with Merrill Lynch in which ABN converted its right to receive LIBOR payments into a commercial paper-based income stream, plus a premium of ten basis points. This eliminated ABN's interest rate risk and simultaneously compensated ABN for serving as the transaction intermediary. (1/24/08 Taylor Test. 35:24-39:10; Ex. 206.)
On October 30, 1992, Schering-Plough assigned its right to receive income streams on $25 million of the notional principal to Rabobank Nederland (―Rabobank‖), a third-party bank, for approximately $12 million (the sum was paid to Schering-Plough on November 2, 1992). (Ex. 702.) The purpose of this assignment was again to establish an arms-length pricing arrangement for the assignments to the Swiss subsidiaries. (1/17/08 Ludwig Test. 55:15-21, 92:11-21; 1/18/08 Ludwig Test. 34:20-35:7; 1/15/08 Wyszomierski Test. 134:1-4; Ex. 692; Exs. 700-702; Ex. 711.) Like the arrangement between ABN and Banco di Roma, ABN paid Rabobank $28,000 for its participation in the transaction, and repurchased the receive legs from the third-party bank one week after Schering-Plough had assigned them to Rabobank. (1/17/08 Ludwig Test. 94:21-23; 1/23/08 Den Baas Test. 66:6-67:4; Exs. 18, 245, 246.)
Also on October 30, 1992, Schering-Plough assigned to Scherico the right to receive payments from ABN from years 6-20 on a notional principal amount of $925 million, an assignment for which Scherico paid a sum of $444 million to Schering-Plough on November 2, 1992 (―1992 Scherico Assignment‖). (JTS 9, ¶¶ 59-61.) ABN consented to the assignment, and acknowledged that it would make the payments to Scherico ―independently of, and without reference to, the performance by [Schering-Plough]‖ in making its payments. (JTS 10, ¶ 66.) Unlike the 1991 swap, in the 1992 swap, Scherico and its parent Schering-Plough did not enter into a put option agreement. (JTS 10, ¶ 67.) Schering-Plough paid Merrill Lynch a $2.0 million fee for its work on the 1992 swap and subsequent assignment. (JTS 10, ¶¶ 63, 70.) ScheringPlough accounted for the advisement fees by amortizing them over the contemplated 20-year swap, again referencing SFAS No. 91.
Schering-Plough adopted the same tax approach for the 1992 transaction as it did with the 1991 transaction, and reported the assignments to the Swiss subsidiaries as sales for federal income tax purposes, and applied an accounting method prescribed by Notice 89-21. (JTS 10, ¶ 71; 1/16/08 Nichols Test. 38:23-39:7; Ex. 31.) Schering-Plough did not report the consideration received from Scherico for the assignment as income in 1992, but instead began reporting as income a ratable portion of the consideration received by reducing its deductions for payments made under the swap contracts. (JTS 10, ¶ 72.)
All told, under the 1991 and 1992 swap-and-assign transactions, Schering-Plough received $690.4 million in repatriated lump-sum payments from the Swiss subsidiaries in exchange for the future income streams from ABN. (JTS 6, ¶ 22; 7, ¶ 33; 9, ¶ 61.)
E. Structuring and Funding the Transactions
1.The Transactions Were Structured to Maximize the Amount Repatriated to the United States
Luciano's trial testimony established that before determining the notional principal amounts for the swap transactions, Merrill Lynch needed to know how much cash ScheringPlough wanted to repatriate. (1/15/08 Luciano Test. 80:22-81:8.) After determining the amount to repatriate, Merrill Lynch then back-solved for the notional principal amount. (1/15/08 Luciano Test. 80:22-81:8.) The more money Schering-Plough wanted to repatriate, the higher the notional principal amount would go. Macauley Taylor, a member of Merrill Lynch's swaps group, explained at trial that by entering into a longer-term swap, Schering-Plough was able to more easily manage a larger notional principal amount, and at the same time assign a receive leg to the Swiss subsidiaries with a larger present value, thereby enabling it to receive a larger lump-sum payment. (1/24/08 Taylor Test. 5:7-8, 25:24-26:3.) Thus, by increasing the length of the swap-and-assign transactions and the amount of the notional principal, Schering-Plough was able to bring larger amounts of the offshore E&P to the United States under the swap-and-assign mechanism.
2. Schering-Plough Routed Limited's Irish Cash Through Scherico to Fund the Lump-Sum Payments
Schering-Plough's corporate hierarchy is reflected by the following diagram:
As indicated, Limited had accumulated substantial amounts of previously untaxed foreign E&P that was held in the Essex Chemie cash investment pool. Scherico, by contrast, was in a more favorable tax position: It held relatively little E&P, and most of what it did hold was PTI. Scherico did not report any accumulated earnings and profits, and had $48.5 million in PTI at the end of 1991. At the end of 1992, Scherico had $32.8 million total E&P and $115 million in PTI (Exs. 2000, 2064.) Thus, the majority of the cash that Scherico held was PTI that could be repatriated back to the United States without incurring Subpart F taxation. See I.R.C. § 959.
To make the lump-sum payments to Schering-Plough in exchange for future receive leg rights, Limited advanced to Scherico funds that it owned in the cash investment pool. As Schering-Plough explained it:
Essentially, all ―Irish cash‖ of Schering-Plough, Ltd. is advanced to Scherico. There are no notes or other evidences of indebtedness. It is actually capital contributions which have not been formally declared, as such, in order to avoid significant transactional taxes (stamp taxes) in Switzerland. The funds were used to enable Scherico to make investments, including the swap transactions.*fn12
(Ex. 20; Nichols Dep. 146:11-153:20). The $646.4 million that Scherico paid to ScheringPlough in exchange for the receive leg assignments was funded by Limited's accumulated E&P. Taking into account the $44 million that Limited paid for the assignment that it received, Limited's Irish cash funded the entire lump sum payments that were repatriated to the United States as a result of the 1991 and 1992 swap-and-assign transactions. (JTS, Proc. Agreement, ¶ B.2.)
F. Aftermath of the Swap-and-Assign Transactions
Parker Douglas, a member of ABN's workout group for managing distressed credit, testified for Schering-Plough that, while he could not recall the exact timing, in the early 2000s, Schering-Plough's credit ratings dipped, which led it to begin negotiations with ABN about amending the 60-day credit trigger provisions in the swap agreements. (1/22/08 Douglas Test. 81:22-82:13.) Kevin Moore, a Schering-Plough vice-president and treasurer responsible for managing the company's debt positions, testified that the parties agreed to amend the provisions from the original AA-/Aa3 threshold to A/A, and changed the trigger from an event of default to an event permitting either party to terminate the running agreement. (1/29/08 Moore Test. 47:20-48:20; Exs. 118, 274.) Schering-Plough agreed to compensate ABN $36 million over the remainder of the swaps' duration for this accommodation. (1/22/08 Douglas Test. 105:20-106:22; 1/29/08 Moore Test. 71:10-13; Ex. 274.) As Moore recounted, the original swap agreement required Schering-Plough to pay ABN a gross amount of $748 million if it breached the credit default provision.*fn13 (1/29/08 Moore Test. 64:17-65:8; Ex. 119.) Moore agreed that Schering-Plough would fund such a payment using a taxable dividend from its Swiss subsidiaries, which would result in a $185 million tax liability, and that avoiding such a taxable event ―was a consideration for not having [the] Swiss subsidiaries declare a dividend to Schering-Plough.‖ (1/29/08 Moore Test. 68:13-16.)
Despite the renegotiated credit trigger, Schering-Plough's credit ratings did fall below the amended threshold in 2004, and the company decided to terminate the swap agreement. (1/22/08 Douglas Test. 109:3-13; 1/29/08 Moore Test. 73:19-74:7; Ex. 280.) Moore testified that Schering-Plough first reacquired the receive legs from the Swiss subsidiaries for $395 million so that it could avoid making the $748 million gross payment to ABN. (1/29/08 Moore Test. 50:24-51:8, 77:3-78:18, 80:10-18; Exs. 43, 123, 126, 127, 128.) The swap agreements were ultimately terminated on May 6, 2004. (1/29/08 Moore Test. 79:3-13.)
G. IRS Audits and Assessments
Following audits for the years of 1991 and 1992, the IRS issued a Notice of Deficiency, dated April 8, 2004, which stated that the 1991 and 1992 transactions were either constructive dividends or loans under § 956 of the Internal Revenue Code. According to the Notice of Deficiency:
For the taxable years 1991 and 1992, it has been determined that the substance of the transactions between [Schering-Plough] and [ABN], which resulted in the transfer, in part through conduits, by [Limited] to [Schering-Plough], of $246,400,000.00 in 1991 and $444,000,000.00 in 1992, was not consistent with the form of these transactions, and that these transactions lacked economic substance. Therefore, the characterization of these transactions as sales of portions of the notional principal contracts should not be respected. Further, these transactions should properly be characterized, consistently with their substance, or under the step transaction doctrine, as either loans, for purposes of section 956(c)(1)(C), or constructive dividends.
As a result, Schering-Plough International, Inc. must include in gross income for the taxable years 1991 and 1992, its pro rata share of the increase in earnings invested in United States property by [Limited], (deemed distribution) or in the alternative [ScheringPlough] must include in gross income as a constructive dividend, the following amounts . . . .‖ IRS Notice of Deficiency (Apr. 8, 2004.) The IRS thereafter increased Schering-Plough's 1991 taxable income by $242,331,758.00 and its 1992 taxable income by $462,587,882.00. (JTS 17, ¶ 130.)
For the 1991 taxable year, the IRS determined that International should have included within its gross income the pro rata share of the increase in earnings invested in United States property by Limited ($242,331,758.00), or that Schering-Plough alternatively should have included that amount in gross income as a ―constructive dividend.‖ (JTS 15, ¶ 125.) The IRS also examined other smaller-scale adjustments to Schering-Plough's 1991 tax return, and adjusted Schering-Plough's taxable income upward by disallowing the amortization of $83,000.00 in fees paid for the 1991 swap. (JTS 15, ¶ 125.)
With respect to the 1992 taxable year, the IRS determined Schering-Plough's taxable income was to be increased by $462,587,882.00 because International was required to include that amount in gross income as its pro rata share of investment in United States property by Limited. (JTS 16, ¶ 126.) Like the 1991 swap, it determined that the deduction of $110,000.00 for fees was improper because the fees did not qualify as an ―ordinary and necessary business expense.‖ (JTS 16, ¶ 126.) As a result of the audit, the IRS assessed a tax deficiency as follows: For 1989, $8,624,448.00, plus interest of $11,855,683.21, totaling $20,480,131.21*fn14 ; for 1991, it assessed a deficiency of $70,146,376.00, plus interest of $109,529,102.86, totaling $179,675,478.86; and for 1992, it assessed $114,843,573.00, plus interest of $157,870,859.62, totaling $272,714,432.62. (JTS 18, ¶ 131.) Thus, the grand total the IRS required Schering-Plough to pay in back taxes and interest relating to the 1991 and 1992 swap-and-assign transactions was $472,870,042.69.*fn15 (JTS 18, ¶ 131.)
Schering-Plough paid the assessment under protest on September 13, 2004, and on December 23, 2004 filed a timely claim for refund of the back taxes, plus interest. (JTS 18, ¶¶ 132-33.) On February 16, 2005, the IRS denied Schering-Plough's claims for a refund. (JTS 18, ¶ 134.)
H. Commencement of Refund Action and Prior Motion Practice
On May 16, 2005, Schering-Plough filed suit in this Court under 28 U.S.C. § 1346(a), seeking a refund of the 1989, 1991 and 1992 tax assessments, plus interest and costs.*fn16 (JTS 18, ¶ 135.) The Court has previously found that Schering-Plough's complaint raises essentially two grounds for refund: The government mischaracterized the transactions as loans or constructive dividends; and the government treated Schering-Plough differently from other similarly situated taxpayers. The parties refer to the latter ground as the ―disparate treatment claim,‖ and it was the basis of a motion for summary judgment brought by the government. The Court filed a written opinion [D.E. # 124], finding in favor of the government. In identifying the issue at the core of the disparate treatment claim, the Court wrote:
An unrelated taxpayer (―First Taxpayer‖), who is a direct competitor to Schering-Plough, entered into a transaction that was identical in all material respects to the swap and assignment transactions entered into by Schering-Plough. (Gov't. Statement of Material Facts ¶¶ A, B.) IRS auditors sought legal advice about First Taxpayer's swap and assignment transaction from the IRS's Office of the Chief Counsel, which was given in the form of a Field Service Advice Memorandum (―FSA‖). (Schering-Plough Statement of Material Facts ¶¶ 4-5.) The Commissioner of the IRS determined that IRS Notice 89-21 applied, and ―therefore First Taxpayer[']s transaction was not taxable in the year in which it was executed.‖ (Gov't. Statement of Material Facts ¶ C.) See also 1997 FSA LEXIS 206 (Aug. 29 1997). IRS auditors for ScheringPlough had also requested legal advice about swap and assignment transactions from the Office of the Chief Counsel. (ScheringPlough Statement of Material Facts ¶ 7.) As the parties explain it:
Notice 89-21 was in effect until the IRS adopted new regulations in 1993. Those new regulations reversed the basic conclusion of Notice 89-21, and provided that such a lump-sum payment may be recharacterized as a ―loan‖ that is ...