Dow's Tax Penalty Loss Creates Uncertainty

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By Erin McManus

May 18 — Dow Chemical Co. preserved its right to raise the substantial authority defense to a tax shelter penalty but couldn't avoid the penalty, because the cited authority didn't fit the deal.

A federal appeals court on May 17 affirmed a 20 percent penalty against Dow for a leaseback transaction through which it claimed substantial deductions for royalty payments but was allocated a small fraction of the income of the partnerships holding the patents. The court said Dow could raise the defense that it relied on substantial authority for its claimed tax benefits, but Dow's claimed substantial authority was “materially distinguishable” from the transactions at issue.

“The decision makes it much more difficult for tax practitioners to predict what a reviewing court may determine is materially distinguishable,” Robert Probasco, of the Probasco Law Firm in Dallas, told Bloomberg BNA May 18.

Shammed Partnerships

Dow contributed 73 patents to partnerships, including Chemtech Royalty Associates LP. Foreign banks invested $200 million in the partnerships for a guaranteed return. Dow then made royalty payments to the partnerships for which it claimed deductions. A federal trial court deemed the partnerships shams and disallowed Dow's claimed tax benefits.

Judge Jerry E. Smith, writing for a U.S. Court of Appeals for the Fifth Circuit panel, said that the cited cases— Morris v. Commissioner13 T.C. 1020 (1949), and Hunt v. Commissioner, T.C. Memo. 1990-248—“can be interpreted as providing some support for the view that Dow possessed the intent to share profits and losses with the foreign banks,” but they weren't substantial authority for Dow's position because they didn't involve contribution-leaseback transactions.

Probasco said, “we don’t know if the Morris and Hunt courts—if faced with same circumstances—would have reached different opinions. The Fifth Circuit’s approach allows a lot of wiggle room, because they weren’t really talking about what the earlier courts thought was material.”

Beneficial to Government

“The approach is beneficial to the government, because they will be distinguishing earlier cases on what they think is important instead of what earlier courts thought was important,” Probasco said.

In 2014, the Fifth Circuit affirmed the U.S. District Court for the Middle District of Louisiana's decision that the partnerships were shams that should be disregarded for tax purposes. The appeals court remanded the case for the district court to determine whether a 40 percent penalty was applicable following the U.S. Supreme Court decision in United States v. Woods.

On remand, the district court found that the 40 percent penalty applied for tax years mid-1998 to 2006 and the 20 percent penalty applied for tax years 1997 to mid-1998. Dow didn't challenge the 40 percent penalty for the later tax years but appealed the 20 percent penalty for the earlier years, claiming that it relied on substantial authority for its tax treatment of the transaction (18 MALR 741, 5/18/15).

Appeal Rights Preserved

Smith rejected both Dow's argument that the first appeals decision “required the district court to consider whether Dow had a reasonable basis and substantial authority for its sham-partnership position,” and the government's argument that Dow didn't preserve its right to raise the substantial authority defense in its first appeal.

Smith said Dow's assertion of the right without extensive briefing in the first appeal was sufficient to preserve the right.

Judges W. Eugene Davis and Stephen A. Higginson joined Smith on the panel.

Kirkland & Ellis LLP, Bingham McCutchen LLP, Taylor, Porter, Brooks & Phillips LLP and Morgan, Lewis & Bockius LLP represented Dow. The Department of Justice Tax Division and the U.S. Attorney's Office represented the government.

To contact the reporter on this story: Erin McManus in Washington at

To contact the editor responsible for this story: Brett Ferguson at

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