Northern Indiana
Public Services Co. v. United States (1997)
NORTHERN INDIANA PUBLIC SERVICE
COMPANY, Petitioner-Appellee, Cross-Appellant, v. COMMISSIONER OF INTERNAL
REVENUE, Respondent-Appellant, Cross-Appellee.
Nos. 96-1659, 96-1758
UNITED STATES COURT OF APPEALS FOR
THE SEVENTH CIRCUIT
115 F.3d 506; 97-1 U.S. Tax Cas. (CCH)
P50,474; 79 A.F.T.R.2d (P-H) 2862
February 20, 1997, ARGUED
June 6, 1997, DECIDED
SUBSEQUENT HISTORY: Also reported at: 1997 U.S. App.
LEXIS 12811.
PRIOR HISTORY: Appeal from the United States Tax
Court. No. 24468-91. Robert P.
Ruwe, Judge.
DISPOSITION: AFFIRMED.
COUNSEL: For NORTHERN INDIANA PUBLIC SERVICE
CORPORATION, INCORPORATED,
Petitioner - Appellee (96-1659): Michael L. Brody,
Lawrence H. Jacobson, SCHIFF,
HARDIN & WAITE, Chicago, IL USA. David C. Jensen,
EICHHORN & EICHHORN, Hammond,
IN USA.
For COMMISSIONER OF INTERNAL REVENUE, Respondent -
Appellant (96-1659): Gary R.
Allen, David E. Carmack, Edward T. Perelmuter,
DEPARTMENT OF JUSTICE, Tax
Division, Appellate Section, Washington, DC USA.
For NORTHERN INDIANA PUBLIC SERVICE CORPORATION,
INCORPORATED, Petitioner -
Appellant (96-1758): Michael L. Brody, Lawrence H.
Jacobson, SCHIFF, HARDIN &
WAITE, Chicago, IL USA. David C. Jensen, EICHHORN
& EICHHORN, Hammond, IN USA.
For COMMISSIONER OF INTERNAL REVENUE, Respondent -
Appellee (96-1758): Gary R.
Allen, David E. Carmack, Edward T. Perelmuter,
DEPARTMENT OF JUSTICE, Tax
Division, Appellate Section, Washington, DC USA.
JUDGES: Before BAUER, HARLINGTON WOOD, JR., and
COFFEY, Circuit Judges.
OPINIONBY: BAUER
OPINION: BAUER, Circuit Judge. This appeal from the
United States Tax
Court requires us to examine whether interest payments
on a note made by a
domestic corporation to its wholly-owned Netherlands
Antilles subsidiary are
exempt from United States withholding tax, under the
United States Netherlands
Income Tax Convention. The Tax Court determined that
the payments fall within
the ambit of the Convention and are exempt from United
States taxation. We
affirm.
BACKGROUND
Northern Indiana Public Service Company
("Taxpayer") is a domestic public
utility company. In 1981, Taxpayer formed a foreign
subsidiary corporation,
Northern Indiana Public Service Finance N.V.
("Finance"), in the Netherlands
Antilles. Finance was organized for the purpose of
obtaining funds so that
Taxpayer could construct additions to its utility
properties. To accomplish
this, Finance issued notes in the Eurobond market and
then lent the proceeds to
Taxpayer. n1
- - - - - - - - - - - - - - - - - -Footnotes- - - - -
- - - - - - - - - - - - -
n1 The Eurobond market was described in 1984 by the
Senate Finance Committee
as follows:
A major capital market outside the United States is
the Eurobond market. It
is not an organized exchange, but rather a network of
underwriters and financial
institutions that market bonds issued by private
corporations (including but not
limited to finance subsidiaries of U.S. companies),
foreign governments and
government agencies, and other borrowers.
In addition to individuals, purchasers of the bonds
include institutions such
as banks (frequently purchasing on behalf of investors
with custodial accounts
managed by the banks), investment companies, insurance
companies, and pension
funds. Staff of Senate Comm. on Finance, 98th Cong.,
2d Sess., Deficit Reduction
Act of 1984: Explanation of Provisions Approved by the
Committee 417 (Comm.
Print 1984). In the early 1980s, United States
corporations commonly sought
access to the Eurobond market in the following manner:
U.S. corporations currently issue bonds in the
Eurobond market free of U.S.
withholding tax through the use of international
finance subsidiaries, almost
all of which are incorporated in the Netherlands
Antilles.
Finance subsidiaries of U.S. corporations are usually
paper corporations,
often without employees or fixed assets, which are
organized to make one or more
offerings in the Eurobond market, with the proceeds to
be relent to the U.S.
parent or to domestic or foreign affiliates. The
finance subsidiary's
indebtedness to the foreign bondholders is guaranteed
by the U.S. parent (or
other affiliates). Alternatively, the subsidiary's
indebtedness is secured by
notes of the U.S. parent (or other affiliates) issued
to the Antilles subsidiary
in exchange for the loan proceeds of the bond issue.
Under this arrangement, the
U.S. parent (or other U.S. affiliate) receives the
cash proceeds of the bond
issue but pays the interest to the Antilles finance
subsidiary rather than
directly to the foreign bondholders. Id. at 418.
- - - - - - - - - - - - - - - - -End Footnotes- - - -
- - - - - - - - - - - - -
Taxpayer's use of a Netherlands Antilles subsidiary to
borrow funds
in the European market was a financially-strategic
measure. During the early
1980s, domestic interest rates hovered around twenty
percent. To circumvent the
high interest rates, United States companies turned to
foreign investors. By
using a Netherlands Antilles subsidiary to borrow
funds in the European market,
United States companies were able to obtain tax
advantages not available through
direct borrowing in that market. Section 1441 of the
Internal Revenue Code
generally requires a domestic taxpayer to withhold a
thirty-percent tax on
interest paid to nonresident aliens or foreign
corporations. However, at the
time the transactions in this case occurred, interest
payments by a United
States corporation to a Netherlands Antilles
corporation were exempt from
withholding tax pursuant to Article VIII of the United
States-Netherlands Income
Tax Convention ("the Treaty").
On October 15, 1981, Finance issued $ 70 million worth
of notes in the
Eurobond market ("the Euronotes"), at an
annual interest rate of 17.25 percent.
Taxpayer unconditionally guaranteed timely payment of
the interest and principal
on the Euronotes. Also on October 15, 1981, Taxpayer
issued to Finance
a $ 70 million note ("the Note"), bearing
annual interest of 18.25 percent. In
exchange, Finance remitted to Taxpayer $ 68,525,000-
-the net proceeds of the
Euronote offering. The Euronotes and the Note had the
same maturity date of
October 15, 1988 and contained the same early payment
penalty provisions.
In 1982, 1983, 1984 and 1985, respectively, Finance
received from Taxpayer
interest payments of $ 12,775,000, which Finance
deposited in its corporate bank
account. In each of those years, Finance made interest
payments of $ 12,075,000
to the Euronote holders. The spread created by this
borrowing and lending
yielded Finance an annual profit of $ 700,000 (an
aggregate of $ 2,800,000 for
the four years). Finance invested this income to earn
additional interest
income. Taxpayer did not withhold any United States
tax on its payments to
Finance.
On October 10, 1985, Taxpayer repaid the principal
amount of the Note ($ 70
million), plus accrued interest ($ 12,775,000) and an
early payment penalty
($1,050,000) to Finance. On October 15, 1985, Finance
redeemed the Euronotes by
repaying the principal ($ 70 million), together with
accrued interest
($ 12,075,000), and an early payment penalty ($
1,050,000). Finance was
liquidated on September 22, 1986, and its assets were
distributed to Taxpayer.
For each of the years in issue, Taxpayer filed Forms
1042 (United States
Annual Return of Income Tax to be Paid at Source) and
Forms 1042S (Foreign
Person's United States Source Income Subject to
Withholding). The interest
payments made by Finance on the Euronotes were not
reported on any of these
forms, nor on any attached schedule or statement.
On August 1, 1991, the Commissioner of Internal
Revenue ("the
Commissioner") issued a notice of deficiency to
Taxpayer, claiming annual tax
deficiencies of $ 3,785,250 for the taxable years 1982
through 1985. The notice
stated:
It has been determined that your 100% owned foreign
subsidiary, incorporated in
the Netherlands Antilles, was not properly
capitalized, therefore the interest
paid by that subsidiary on debt obligations (Euronotes)
is treated as being paid
directly by you. Consequently, you are liable for the
30% withholding which was
not withheld on interest payments made to the holders
of the Euronotes . . . .
On October 25, 1991, Taxpayer filed a petition in the
United States Tax
Court contesting the Commissioner's deficiency
determination based on the terms
of the Treaty. In litigating the matter, the
Commissioner took the position that
the Treaty was inapplicable because Finance was a mere
"conduit" or "agent" in
the borrowing and interest-paying process, and
Taxpayer should be viewed as
having paid interest directly to the Euronote holders.
In an opinion dated November 6, 1995, the Tax Court
held that Taxpayer was
not liable for the alleged deficiencies. The Tax Court
determined that Finance
was recognizable for tax purposes because it
"engaged in the business activity
of borrowing and lending money at a profit," and
that, therefore, Taxpayer's
interest payments to Finance fell within the terms of
the Treaty and were exempt
from United States taxation. The Commissioner appeals,
and the question
presented is whether the Tax Court erred by
recognizing, for tax purposes, the
transactions between Taxpayer and Finance. Taxpayer
cross-appeals, arguing that
the statute of limitations bars the assessment and
collection of withholding tax
for the taxable year 1982.
ANALYSIS
Before delving into the merits of this appeal, we
pause to review in greater
detail the statutory backdrop against which the
subject transactions
were made. Sections 871 and 881 of the Internal
Revenue Code generally impose a
tax of thirty percent on interest income received by a
nonresident alien or
foreign corporation from sources within the United
States. See I.R.C. @@ 871(a),
881(a). n2 United States sources who pay such interest
generally are required to
deduct and withhold a tax equal to thirty percent of
the amounts they pay. See
I.R.C. @@ 1441(a) and (b). n3 If they fail to do so,
they are liable
for the withholding tax. See I.R.C. @ 1461. n4 Under
this statutory framework,
Taxpayer would have been required to withhold tax on
the interest it paid on the
Note to Finance. (Alternatively, if Finance were
disregarded and Taxpayer were
deemed to have paid interest directly to the Euronote
holders, Taxpayer would
have been required to withhold tax on those interest
payments.) However, the
Code also provides that, to the extent required by any
treaty obligation of the
United States, income of any kind is exempt from
taxation and excluded from
gross income. See I.R.C. @ 894. n5 During the tax
years relevant to this appeal,
Article VIII of the United States Netherlands Income
Tax Convention, as
extended to the Netherlands Antilles, provided that
"interest (on bonds,
securities, notes, debentures, or on any other form of
indebtedness), . . .
derived from sources within the United States by a
resident or corporation of
the Netherlands not engaged in trade or business in
the United States through a
permanent establishment shall be exempt from United
States tax[.]" See
Convention with Respect to Taxes on Income, Apr. 29,
1948, United States
Netherlands, 62 Stat. 1757, T.I.A.S. No. 1855
(extended to the Netherlands
Antilles by Protocol, June 15, 1955, 6 U.S.T. 3696,
T.I.A.S. No. 3366; amended
by Protocol, Oct. 23, 1963, 15 U.S.T. 1900, T.I.A.S.
No. 5665; modified by
Convention, Dec. 30, 1965, 17 U.S.T. 896, T.I.A.S. No.
6051). n6 Based on this
provision, Taxpayer did not withhold tax on its
interest payments to Finance.
- - - - - - - - - - - - - - - - - -Footnotes- - - - -
- - - - - - - - - - - - -
n2 @ 871. Tax on nonresident alien individuals
(a) Income not connected with United States business--
30 percent tax.--
(1) Income other than capital gains.--Except as
provided in subsection (h),
there is hereby imposed for each taxable year a tax of
30 percent of the amount
received from sources within the United States by a
nonresident alien individual
as--
(A) interest (other than original issue discount as
defined in section 1273),
dividends, rents, salaries, wages, premiums,
annuities, compensations,
remunerations, emoluments, and other fixed or
determinable annual or periodical
gains, profits, and income . . . .
@ 881. Tax on income of foreign corporations not
connected with United States
business
(a) Imposition of tax.--Except as provided in
subsection (c), there is hereby
imposed for each taxable year a tax of 30 percent of
the amount received from
sources within the United States by a foreign
corporation as--
(1) interest (other than original issue discount as
defined in section 1273),
dividends, rents, salaries, wages, premiums,
annuities, compensations,
remunerations, emoluments, and other fixed or
determinable annual or periodical
gains, profits, and income . . . .
n3 @ 1441. Withholding of tax on nonresident aliens
(a) General rule.--Except as otherwise provided in
subsection (c), all persons,
in whatever capacity acting (including lessees or
mortgagors of real or personal
property, fiduciaries, employers, and all officers and
employees of the United
States) having the control, receipt, custody,
disposal, or payment of any of the
items of income specified in subsection (b) (to the
extent that any of such
items constitutes gross income from sources within the
United States), of any
nonresident alien individual or of any foreign
partnership shall (except as
otherwise provided in regulations prescribed by the
Secretary under section 874)
deduct and withhold from such items a tax equal to 30
percent thereof . . . .
(b) Income items.--The items of income referred to in
subsection (a) are
interest (other than original issue discount as
defined in section 1273) . . . .
n4 @ 1461. Liability for withheld tax
Every person required to deduct and withhold any tax
under this chapter is
hereby made liable for such tax and is hereby
indemnified against the claims and
demands of any person for the amount of any payments
made in accordance with the
provisions of this chapter.
n5 @ 894. Income affected by treaty
(a) Treaty provisions.--
(1) In general.--The provisions of this title shall be
applied to any
taxpayer with due regard to any treaty obligation of
the United States which
applies to such taxpayer.
n6 In 1984, Congress eliminated the thirty-percent
withholding tax on
"portfolio interest" (including Eurobonds)
received by a nonresident individual
or foreign corporation from sources within the United
States. See Deficit
Reduction Act of 1984, Pub. L. No. 98-369, @ 127, 98
Stat. 494, 648 (1984)
("DEFRA"); see also I.R.C. @@ 871(h),
881(c), 1441(c)(9) and 1442. In so doing,
it essentially provided United States taxpayers direct
tax-free access to the
Eurobond market and removed the major incentive for
using Netherlands Antilles
finance subsidiaries to issue Eurobonds. Although the
amendments made by @ 127
of DEFRA generally apply to interest received after
the effective date of the
Act (July 18, 1984), @ 127(g)(3) established safe
harbor rules applicable to
certain controlled foreign corporations in existence
on or before June 22, 1984.
We need not determine whether the requirements of the
safe harbor provisions
were complied with in this case. As the Tax Court
found, Congress did not intend
@ 127(g)(3) to be the exclusive means by which a
taxpayer may claim exemption
from the thirty-percent withholding tax. If we
determine that the transactions
between Taxpayer and Finance fall within the terms of
the Treaty, Taxpayer will
not be liable for the withholding tax, regardless of
the safe harbor rules of
DEFRA.
- - - - - - - - - - - - - - - - -End Footnotes- - - -
- - - - - - - - - - - - -
Under the terms of the Treaty, interest on a note that
is "derived from" a
United States corporation by a Netherlands corporation
is exempt from United
States taxation. The question presented to the Tax
Court was whether Finance and
its transactions with Taxpayer were recognizable for
tax purposes, making
Taxpayer's interest payments to Finance subject to the
Treaty. The Tax Court
determined that Taxpayer's interest payments should be
recognized as having been
paid to Finance, rather than directly to the Euronote
holders. Northern Ind.
Pub. Serv. Co. v. Commissioner, 105 T.C. 341 (1995).
That being so, the payments
to Finance fell within the terms of the Treaty, they
were not taxable under @@
871 or 881, and Taxpayer was not obligated to withhold
tax pursuant to @ 1441 or
liable for failing to do so under @ 1461.
Our review of decisions regarding the economic
substance of transactions for
federal income tax purposes is for clear error. Yosha
v. Commissioner, 861 F.2d
494, 499 (7th Cir. 1988). We may affirm the decision
of the Tax Court on any
grounds found in the record, regardless of the
rationale relied upon below.
United States v. Flores-Sandoval, 94 F.3d 346, 349
(7th Cir. 1996)
(citation omitted). At the outset, we acknowledge the
need for liberal
construction in determining the applicability of a
given treaty. See
Aiken Indus., Inc. v. Commissioner, 56 T.C. 925, 933
(1971) (citing Jordan v.
Tashiro, 278 U.S. 123, 127, 73 L. Ed. 214, 49 S. Ct.
47 (1928)).
The Commissioner has suggested that Taxpayer's
tax-avoidance motive in
creating Finance might provide one possible basis for
disregarding the interest
transactions between Taxpayer and Finance. The parties
agree that Taxpayer
formed Finance to access the Eurobond market because,
in the early 1980s,
prevailing market conditions made the overall cost of
borrowing abroad less than
the cost of borrowing domestically. It is also
undisputed that Taxpayer
structured its transactions with Finance in order to
obtain a tax benefit--
specifically, to avoid the thirty-percent withholding
tax. What is in dispute is
the legal significance of Taxpayer's tax-avoidance
motive.
A tax-avoidance motive is not inherently fatal to a
transaction. A taxpayer
has a legal right to conduct his business so as to
decrease (or altogether
avoid) the amount of what otherwise would be his
taxes. Gregory v. Helvering,
293 U.S. 465, 469, 79 L. Ed. 596, 55 S. Ct. 266
(1935); see also Yosha,
861 F.2d at 497 ("There is no rule against taking
advantage of
opportunities created by Congress or the Treasury
Department for beating
taxes."); Aiken Indus., 56 T.C. at 933 ("The
fact that the actions taken by the
parties in this case were taken to minimize their tax
burden may not by itself
be utilized to deny a benefit to which the parties are
otherwise entitled under
the convention."); Bass v. Commissioner, 50 T.C.
595, 600 (1968) ("[A] taxpayer
may adopt any form he desires for the conduct of his
business, and . . . the
chosen form cannot be ignored merely because it
results in a tax saving.").
However, the form the taxpayer chooses for conducting
business that results in
tax-avoidance "must be a viable business entity,
that is, it must have been
formed for a substantial business purpose or actually
engage in substantive
business activity." Bass, 50 T.C. at 600; see
also Yosha, 861 F.2d at 497
("There is a doctrine that a transaction utterly
devoid of economic substance
will not be allowed to confer [a tax]
advantage."). This rule ensures that "what
was done, apart from the tax motive, was the thing
which the [treaty] intended."
Gregory, 293 U.S. at 469.
The Tax Court relied on a line of cases for the
principle that so
long as a foreign subsidiary conducts substantive
business activity--even
minimal activity--the subsidiary will not be
disregarded for federal tax
purposes, notwithstanding the fact that the subsidiary
was created with a view
to reducing taxes. See Moline Properties, Inc. v.
Commissioner, 319 U.S. 436, 87
L. Ed. 1499, 63 S. Ct. 1132 (1943); Hospital Corp. of
Am. v. Commissioner, 81
T.C. 520 (1983); Ross Glove Co. v. Commissioner, 60
T.C. 569 (1973); Bass v.
Commissioner, 50 T.C. 595 (1968); Nat Harrison Assoc.,
Inc. v. Commissioner, 42
T.C. 601 (1964). These cases involve domestic
corporations which attempted to
avoid taxes by creating subsidiaries--foreign
subsidiaries in the majority of
the cases--which conducted some transactions solely
for tax-avoidance and other
transactions which were not tax-motivated.
The Commissioner insists that these cases are
inapposite to the present case
because they involve the issue of whether income
earned by a subsidiary should
be allocated to its parent company on the ground that
the subsidiary was a
"sham." The Commissioner has abandoned any
argument on appeal that Finance was a
"conduit" or "agent" of Taxpayer.
Those buzzwords which we generally
use to describe a "sham" corporation are
absent from the Commissioner's briefs.
The Commissioner argues that it was error for the Tax
Court to rely on the
above-cited cases because the issue here is not
whether Finance is properly
characterized as a "sham," but, rather,
whether the transactions between Finance
and Taxpayer should be disregarded for tax purposes.
The Commissioner urges that
we look solely at the interest transactions between
Taxpayer and Finance without
concerning ourselves with Finance's legitimacy or its
other economic activities.
To bolster her argument, the Commissioner cites
Knetsch v. United States, 364
U.S. 361, 5 L. Ed. 2d 128, 81 S. Ct. 132 (1960), and a
line of
captive insurance company cases for the propositions
that even legitimate
corporations may engage in transactions lacking
economic substance and that the
Commissioner may disregard transactions between
related legitimate corporations.
See Malone & Hyde, Inc. v. Commissioner, 62 F.3d
835 (6th Cir. 1995); Gulf Oil
Corp. v. Commissioner, 914 F.2d 396 (3d Cir. 1990);
Clougherty Packing Co. v.
Commissioner, 811 F.2d 1297 (9th Cir. 1987);
Stearns-Roger Corp. v. United
States, 774 F.2d 414 (10th Cir. 1985). In Knetsch, the
taxpayer
borrowed money at a certain interest rate and used the
loan proceeds to buy an
annuity bearing a lower interest rate. The transaction
was unrelated to any
business or other economic activity, but was designed
solely to generate large
interest deductions. The Supreme Court affirmed the
Tax Court's denial of the
taxpayer's claimed interest expense deduction for the
transaction because the
transaction did not engender "indebtedness"
for federal tax purposes. In
addition, in each of the captive insurance company
cases cited by the
Commissioner, claimed business expense deductions for
purported insurance
transactions between a parent corporation and its
wholly-owned legitimate
captive insurance subsidiary were denied on the ground
that the transactions did
not constitute "insurance" for federal tax
purposes.
The Commissioner's argument is creative, but
unpersuasive. Regardless of the
words the Commissioner uses to make her argument, in
substance, the Commissioner
is asking us to disregard Finance and to deem the
interest payments made by
Taxpayer as having gone directly to the Euronote
holders. We are looking at the
interest transactions and not deciding whether Finance
was a "sham."
However, it is unnecessary, and we think
inappropriate, for us to sever a
corporation from its transactions in analyzing a case,
such as this one, where
the corporation was formed with the intent of
structuring its economic
transactions to take advantage of laws that afford tax
savings. Finance's
existence, its interest transactions with Taxpayer and
its other economic
activities are all relevant to our analysis. Moreover,
Knetsch and the captive
insurance company cases do not dictate the outcome the
Commissioner desires.
Those cases allow the Commissioner to disregard
transactions which are designed
to manipulate the Tax Code so as to create artificial
tax deductions. They do
not allow the Commissioner to disregard economic
transactions, such as the
transactions in this case, which result in actual,
non-tax-related changes in
economic position.
All of this is to say that the Tax Court was entitled
to rely on Moline
Properties, Hospital Corp., Ross Glove, Bass and Nat
Harrison. These cases
engender the principle that a corporation and the form
of its transactions are
recognizable for tax purposes, despite any
tax-avoidance motive, so long as the
corporation engages in bona fide economically-based
business
transactions. The Commissioner insists that Taxpayer
cannot seek refuge in this
maxim because Taxpayer's desire to avoid the
thirty-percent withholding tax was
its sole purpose in transacting business with Finance
and because Finance
engaged in no meaningful economic activity. We
disagree. "Whether a corporation
is carrying on sufficient business activity to require
its recognition as a
separate entity for tax purposes is a question of fact
and [Taxpayer] had the
burden of proof." Bass, 50 T.C. at 602. The Tax
Court determined that Taxpayer
met its burden, finding that "Finance engaged in
the business activity of
borrowing and lending money at a profit . . . ."
The Commissioner relies on two cases in its attempt to
show that Finance
engaged in no meaningful economic activity. The first
is Gregory v. Helvering,
293 U.S. 465, 79 L. Ed. 596, 55 S. Ct. 266 (1935). In
Gregory, the Supreme Court
disregarded a corporation which was created for the
sole purpose of receiving
passive assets and distributing its stock in a
purported reorganization. The
corporation was liquidated six days after it was
formed. The transaction was
designed to take advantage of @ 112 of the Revenue Act
of 1928, a
favorable reorganization provision of the tax laws.
The Supreme Court ruled that
the distribution was not made "in pursuance of a
plan of reorganization," as the
statute required, because it was "an operation
having no business or corporate
purpose . . . ." Id. at 469. The Court explained
that the transfer of
assets was:
a mere device which put on the form of a corporate
reorganization as a disguise
for concealing its real character, and the sole object
and accomplishment of
which was the consummation of a preconceived plan, not
to reorganize a business
or any part of a business, but to transfer a parcel of
corporate shares to the
petitioner. No doubt, a new and valid corporation was
created. But that
corporation was nothing more than a contrivance to the
end last described. It
was brought into existence for no other purpose; it
performed, as it was
intended from the beginning it should perform, no
other function. . . . The rule
which excludes from consideration the motive of tax
avoidance is not pertinent
to the situation, because the transaction upon its
face lies outside the plain
intent of the statute.
293 U.S. at 469-70; see also Yosha, 861 F.2d at 498
(explaining that
"reorganizations" like the one in Gregory
"do not add to social
wealth. They do not impinge on the world of business
at all. They merely
transfer wealth from one group of taxpayers to
another.").
The second case the Commissioner relies on is Aiken
Industries, Inc. v.
Commissioner, 56 T.C. 925 (1971). In that case, a
domestic corporation borrowed
$ 2,250,000, at an interest rate of four percent, from
a Bahamian corporation.
The Bahamian corporation owned 99.997 percent of the
domestic corporation's
parent company, also a domestic corporation. The
Bahamian corporation's
wholly-owned Ecuadorian subsidiary incorporated a
company in the Republic of
Honduras. The Bahamian corporation assigned the
domestic corporation's note to
the Honduran corporation in exchange for nine
promissory notes ($ 250,000 each),
which totaled $ 2,250,000 and bore interest of four
percent. Because of this
assignment, the domestic corporation made its
four-percent interest payments to
the Honduran corporation, which, in turn, made its
four-percent interest
payments to the Bahamian corporation. Prior to the
assignment, the domestic
corporation's interest payments to the Bahamian
corporation would have been
subject to the withholding provisions of @ 1441 of the
Internal
Revenue Code. But after the assignment, because there
was an income tax treaty
between the United States and the Republic of
Honduras, the domestic corporation
claimed exemption from the withholding provisions. The
Tax Court held that the
corporate existence of the Honduran corporation could
not be disregarded. It
also held, however, that the interest payments in
issue were not "received by"
the Honduran corporation within the meaning of the
United States-Honduras Income
Tax Treaty, because the Honduran corporation lacked
dominion and control over
the interest payments.
From Gregory and Aiken Industries, we glean the
following: Transactions
involving a foreign corporation are to be disregarded
for lack of meaningful
economic activity if the corporation is merely
transitory, engaging in
absolutely no business activity for profit--in other
words, it is a "mere
skeleton." See Bass, 50 T.C. at 602 n.3.
Transactions will also be disregarded
if the foreign corporation lacks dominion and control
over the interest payments
it collects.
In this case, Finance was set up to obtain capital at
the lowest possible
interest rates. Accessing the Eurobond market through
a Netherlands
Antilles subsidiary was not, at the time, an uncommon
practice to accomplish
this end. The record demonstrates that Finance
"was managed as a viable concern,
and not as simply a lifeless facade." See id. at
602. Finance conducted
recognizable business activity--concededly minimal
activity, but business
activity nonetheless. Significantly, Finance derived a
profit. It earned income
on the spread between the interest rate it charged
Taxpayer on the Note (18.25
percent) and the rate it paid to the Euronote holders
(17.25 percent). The
foreign corporation in Aiken Industries was held to
lack dominion and control
because, unlike Finance, it was literally a mere
conduit, earning no profit on
its borrowing and lending activities. The Tax Court
stated in Aiken Industries:
Industrias [the Honduran corporation] obtained exactly
what it gave up in a
dollar-for-dollar exchange. Thus, it was committed to
pay out exactly
what it collected, and it made no profit on the
[exchange of the notes]. . . .
In these circumstances, where the transfer of . . .
notes . . . left Industrias
with the same inflow and outflow of funds and where
[the domestic corporation,
the Bahamian corporation] and Industrias were all
members of the same
corporate family, we cannot find that this transaction
had any valid economic or
business purpose. Its only purpose was to obtain the
benefits of the exemption
established by the treaty for interest paid by a
United States corporation to a
Honduran corporation.
56 T.C. at 934. By contrast, Finance netted an annual
$ 700,000 from its
borrowing and lending activities. That income stream
had economic substance to
both Taxpayer and Finance. Each time Taxpayer made an
interest payment to
Finance, Taxpayer's economic resources were diminished
while Finance's economic
position was enhanced. Finance also reinvested the
annual $ 700,000 interest
income in order to generate additional interest
income. Taxpayer had no control
over Finance's reinvestments. Finally, the
transactions in Aiken Industries were
entirely between related parties. Finance, on the
other hand, borrowed funds
from unrelated third parties, the Euronote holders.
Relying again on Knetsch, the Commissioner argues that
the income Finance
earned on the transactions with Taxpayer is
irrelevant; that a transaction does
not necessarily have economic substance for tax
purposes merely because
one party profits from the arrangement. The
Commissioner characterizes
the one-percent profit Finance earned from the spread
created by its borrowing
and lending activities as a "fee" for
accommodating Taxpayer in the Eurobond
offering. The Commissioner's argument misses the mark.
As we explained supra,
the transaction in Knetsch was unrelated to any
economic activity. The taxpayer
paid money solely to obtain tax deductions and did not
intend to profit in a
true sense, as evidenced by the fact that the pre-tax
interest outlay would be
greater than the pre-tax interest received. Here, a
profit motive existed from
the start. Each time an interest transaction occurred,
Finance made money and
Taxpayer lost money. Moreover, Finance reinvested the
annual $ 700,000 interest
income it netted on the spread in order to generate
additional interest income,
and none of the profits from these reinvestments are
related to Taxpayer.
Looking at the record as a whole, we find that the Tax
Court did not clearly
err by determining that Finance carried on sufficient
business activity so as to
require recognition of its interest transactions with
Taxpayer for tax purposes.
That being so, it is unnecessary to address Taxpayer's
cross-appeal.
The judgment of the Tax Court is AFFIRMED.
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