Eleventh Circuit to Address Scope of Danielson Rule

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April 1, 2013

With oral argument scheduled for April 18 in Peco Foods v. Commissioner, No. 12-12169, the Eleventh Circuit will soon decide a case that involves the scope of the Danielson rule.  That rule, established in Danielson v. Commissioner, 378 F.2d 771, 775 (3d Cir. 1967), provides that “a party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.”  The Eleventh Circuit has expressly adopted the Danielson rule.

In Peco Foods, the Commissioner used that rule (along with the allocation rules under section 1060) to prevent the taxpayer from subdividing broader classes of purchased assets (to which the purchase agreement had expressly allocated a portion of the purchase price) into discernible subcomponents for depreciation purposes.  The taxpayer is a poultry processor that purchased the assets at two poultry processing plants in the mid- to late-1990s.  In each of the purchase transactions, Peco and the seller agreed to allocate the purchase price among listed assets “for all purposes (including financial accounting and tax purposes).”  The first agreement allocated purchase price among 26 listed assets; the second allocated purchase price among three broad classes of assets.

Prompted by the Tax Court’s decision in Hospital Corporation of America v. Commissioner, 109 T.C. 21 (1997), Peco commissioned a cost segregation study that subdivided the listed assets into subcomponents.  Some of these subcomponents fell into asset classes that are subject to accelerated depreciation methods.  For instance, Peco subdivided the class of assets listed as “Real Property: Improvements” on the original allocation schedule into subcomponents that were tangible personal property subject to a 7- or 15-year depreciation period under section 1245.  If they were classified as structural components of nonresidential real property, the assets would have been subject to a 39-year depreciation period under section 1250.

With the segregation study in hand, Peco applied to change its accounting method for those subcomponents with its 1998 return and claimed higher depreciation deductions on subsequent returns.  The IRS disallowed these deductions and issued a notice of deficiency; the taxpayer filed a petition in Tax Court.

In a Tax Court Memorandum opinion by Judge Laro, T.C. Memo 2012-18, the Tax Court upheld the Commissioner’s deficiencies.  The Tax Court’s decision was based on both the Danielson rule and section 1060(a), the latter of which provides that if the parties in an applicable asset acquisition “agree in writing as to the allocation of any consideration,” the agreement “shall be binding on both the transferee and transferor unless the Secretary determines that such allocation . . . is not appropriate.”  The taxpayer argued that section 1060 serves only to allocate purchase price among assets under the residual method of section 338(b)(5) and that section 1060 does not bar further subdivision of the allocation for purposes of determining useful lives for depreciation.  The Tax Court held that the directive in section 1060 that an allocation by the parties “shall be binding” trumps the application of the residual method of section 338(b)(5).

The Tax Court also rejected the taxpayer’s argument that Danielson was inapposite.  The taxpayer had relied on United States v. Fort, 638 F.3d 1334 (11th Cir. 2011), in which the Eleventh Circuit held that “the Danielson rule applies if a taxpayer ‘challenge[s] the form of a transaction.’”  (citation omitted)  Since the taxpayer in Fort had challenged the specific tax consequences of the form of the transaction but not the form itself, the Eleventh Circuit found that Fort fell outside the scope of the Danielson rule.  The Tax Court held that while the taxpayer in Fort had not challenged the form of the transaction, the taxpayer in Peco—by “seeking to reallocate the purchase price among assets not listed in the original allocation schedules”—sought to challenge the form of the transaction.  Therefore, reasoned the Tax Court, because there was no ambiguity to the allocations in the purchase agreements under the applicable contract laws of the states in which the agreements were entered, Danielson applies to prevent the taxpayer from subdividing the listed into distinct components for depreciation purposes.

On appeal, the taxpayer contests the Tax Court’s holdings with respect to both section 1060 and Danielson.  In its brief, the taxpayer argues that whether an asset is tangible personal property or a structural component of a building is a matter of facts and circumstances and that the words used to describe the asset “are of no utility in connection with its categorization as a structural component.”  The taxpayer also argues that classifying assets for depreciation purposes is not a challenge to the form of the transaction (unlike, for example, treating the transaction as a merger or lease rather than an asset acquisition, which would have been a challenge to form) and therefore, under the holding in Fort, the Danielson rule does not apply.

In his opposition brief, the Commissioner echoes the Tax Court’s holding that the taxpayer’s subdivision of listed assets for depreciation purposes is an attempt to “restructure the form of the transaction” and therefore falls within the purview of the Danielson rule (and is not excluded by the rule articulated in Fort).  The Commissioner then goes a step further, arguing that the taxpayer was not merely “changing the classification of assets” but also “added assets.”  Moreover, the Commissioner insists that what the taxpayer did with respect to depreciation “goes considerably deeper than merely a change to the classification for depreciation purposes.”

Peco Foods – Tax Court Memorandum Opinion

Peco Foods – Taxpayer’s 11th Circuit Brief

Peco Foods – Commissioner’s 11th Circuit Opposition Brief


Government Decides Against Further Review in Washington Mutual

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June 2, 2011

As we previously reported, the Ninth Circuit in Washington Mutual reversed the district court and ruled that the taxpayer did have basis in regulatory rights that it received in connection with a transaction in which it took over failed thrifts during the savings-and-loan crisis of the 1980s.  The government has now allowed the periods for seeking rehearing and certiorari to expire without taking action.  The Ninth Circuit’s decision is therefore final, and the case will move on to further proceedings on remand in the district court to determine the amount of basis.

Briefing Under Way in Anschutz

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May 17, 2011

As we’ve reported in the last few months, several securities lending cases are percolating in the appellate courts (see here and here).  On April 29, 2011, Anschutz Company filed the opening brief in its appeal of the Tax Court’s decision for the government (opinion and brief linked below).

At issue in Anschutz is the appropriate tax treatment of a set of transactions between the taxpayer and Donaldson, Lufkin & Jenrette Securities Corp. (“DLJ”).  The taxpayer sought to leverage long-held shares in publicly-traded railroad companies to obtain financing for other endeavors.  In the taxpayer’s hands, the shares had a low basis relative to their fair market value at the time of the transactions in question.  The transactions involved the use of prepaid variable forward contracts (“PVFCs”) and concurrent share lending agreements (“SLAs”).  Under the PVFCs, DLJ paid the taxpayer a percentage of the current market value of the shares in exchange for the right to receive a number of shares or their cash equivalent at a point in the future.  The number of shares to be delivered (or their cash equivalent) was to be determined by a formula agreed upon at the outset.  In order to secure its obligation, the taxpayer pledged a number of shares sufficient to ensure consummation of the deal at maturity.  In parallel, DLJ entered into an SLA with the taxpayer under which DLJ would take possession of the pledged shares to use them in short sale transactions.  Although each of the two transactions, viewed in isolation, would have passed muster under relevant authorities as non-taxable open transactions, the government challenged the arrangement as constituting in substance a taxable sale of the shares at the inception of the deal.  After a two-day trial, the Tax Court agreed.

On appeal, Anschutz argues that the Tax Court’s decision to view the transactions as two legs of one overall arrangement was error.  Rather, the taxpayer contends that the two transactions should be respected as stand-alone occurrences to be analyzed separately.  Under the taxpayer’s view, the PVFCs are non-taxable open transactions under Rev. Rul. 2003-7, and the SLAs fall within the ambit of I.R.C. section 1058 (stock loans not taxable provided certain conditions are met).  For the Tax Court, the crux of the case was that the PVFCs had the effect of shifting to DLJ all risk of loss and most of the opportunity for gain on the shares.  Under section 1058, a stock lending arrangement cannot reduce the risk of loss or opportunity for gain if it is to be considered non-taxable.  The taxpayer contends, however, that in spite of a master agreement governing both legs of the arrangement, the facts properly construed require the two transactions to be analyzed separately as independent deals, each with their own tax consequences.

The government’s response is now due on June 24, 2011.  We’ll keep you posted on this and other developments in the securities lending cases.

Anschutz TC opinion

Anschutz Opening Brief


The Ninth Circuit Rejects the Government’s Effort to Disregard “Economic Realities” in Washington Mutual

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April 8, 2011

[Note:  Miller & Chevalier is counsel to Washington Mutual in this case.]

In the past decade, the government has often defeated taxpayer claims that tax benefits flowed from certain transactions on the grounds that the economic substance of the transactions did not justify the tax benefits and that the taxpayer’s contrary arguments reflect a hypertechnical reading of the rules.  In Washington Mutual Inc. v. United States (9th Cir. No. 09-36109), the proverbial shoe was on the other foot.  A key element of the taxpayer’s business transaction was the receipt of regulatory rights in exchange for incurring the cost of relieving the government of impending liabilities.  The government argued, however, that, with respect to determining basis in those intangible assets, technical requirements in the reorganization rules trumped the economic reality that the taxpayer had purchased those rights.  The Ninth Circuit rejected that argument and ruled for the taxpayer. 

The controversy stemmed from an acquisition by Washington Mutual’s predecessor, Home Savings, of three failed thrifts during the savings and loan crisis of the early 1980s.  In part due to skyrocketing interest rates, many thrifts at that time had deposit liabilities that exceeded the value of their assets.  The policy of the Federal Savings and Loan Insurance Corporation (FSLIC) was to encourage healthy thrifts to acquire such failed thrifts in what were called “supervisory mergers,” which would spare FSLIC the liability it would otherwise incur if it had to liquidate the thrifts and pay off its insurance obligation to depositors.  In this case, the primary inducement offered to Home to convince it to enter into what would otherwise have been a losing proposition was a pair of regulatory rights (the right to open branches in other states and the right to the accounting treatment for regulatory purposes that was involved in United States v. Winstar Corp., 518 U.S. 839 (1996)). 

Home indisputably incurred a cost in getting FSLIC off the hook in this way because Home inherited the failed thrifts’ net liabilities.  Arguing that the transaction was in substance a purchase of regulatory rights, Washington Mutual contended that basic tax principles dictated that Home took a cost basis in the acquired assets – that is, the two regulatory rights.  Alternatively, Washington Mutual argued that the assets could have a fair market value basis, through the operation of Code section 597, if they were viewed as FSLIC assistance rather than as the object of a purchase.  The government objected to both theories on technical grounds.  It argued that the assignment of a carryover basis to the thrift assets under the “G” reorganization rules precluded assigning a cost basis to the regulatory rights.  And it raised a variety of hypertechnical textual objections to application of section 597.  The district court agreed with the government, holding that the regulatory rights had no basis at all.

The Ninth Circuit reversed in an opinion authored by Judge Betty Fletcher and joined by Judge Bybee, holding that Home took a cost basis in the regulatory rights.  The opinion began by emphasizing the “overarching principle” that, “absent specific provisions, the tax consequences of any particular transaction must reflect the economic reality.”  In this case, “the economic realities of the transaction” were that Home engaged in one “all-encompassing transaction” in which it acquired the failed thrifts and received the regulatory rights as “part of the consideration.”  The majority explained that the government’s argument based on the “G” reorganization rules did not respect the economic reality of this “all-encompassing transaction,” and the majority concluded that those rules were “not incompatible” with the conclusion that Home took a cost basis in the regulatory rights.  In sum, the majority ruled that the tax treatment should follow the economic reality that Home did not acquire the regulatory rights in the “G” reorganization but rather purchased the rights from FSLIC and paid for them by allowing the thrifts, which had negative value, to merge into Home.

Given its ruling on cost basis, the majority did not address the alternative theory that Home took a fair market value basis through the operation of Code section 597.  Judge Fernandez, however, found that theory more persuasive, and he concurred in the reversal of the district court on that ground (remarking that he therefore had “no need to wrestle with” the cost basis question).  Like the majority, he concluded that the government’s technical theories were unsound and could not justify disregarding the economics of the transaction.  “Home Savings greatly benefitted the government at a time of great need,” and “it was given the [regulatory] Rights as part of the inducement to do so. . . .  Whether one accepts the analysis of the majority or mine, the result is that Home Savings did have a basis in them.”

The Ninth Circuit’s decision is a welcome reminder that what’s good for the goose is good for the gander.  In the words of the majority opinion, when a taxpayer enters into a transaction that “has economic substance and is economically realistic,” the taxpayer should benefit from the accompanying tax treatment provided under the law.

The briefs and opinions in the case are linked below.

If the government decides to seek rehearing of the Ninth Circuit’s decision, its petition would be due on April 18.

Washington Mutual – Ninth Circuit Opinion

Washington Mutual – Taxpayer Opening Brief

Washington Mutual – U.S. brief

Washington Mutual – Taxpayer Reply Brief

Washington Mutual – District Court Opinion