The U.S. Court of Appeals for the Fifth Circuit has disallowed a midco tax shelter, becoming the first appellate court to disallow one.
The case, Enbridge Energy Co. and Enbridge Midcoast Energy LP v. United States, involved a company that sued the IRS for a refund of $5.4 million in taxes and penalties assessed after an audit. In 1999, Enbridge Midcoast Energy acquired control of the Bishop Group, a company that operated energy pipelines. The change of control took the form of a conduit transaction, in which Bishops sole shareholder sold his stock to a third-party intermediary, the K-Pipe Merger Corporation, which then immediately sold the assets to Midcoast. The IRS, applying the substance over form doctrine, disregarded the use of the conduit in the transaction and treated the transaction as a direct stock sale for tax purposes, resulting in less favorable tax treatment for Midcoast.
After paying the taxes and penalties under protest, Midcoast brought suit, claiming the IRS erroneously treated the transaction as a direct stock sale and erroneously assessed a 20 percent penalty. A district court granted summary judgment to the IRS on both claims, and the appellate court upheld that decision Tuesday.
Midcoast had consulted with PricewaterhouseCoopers concerning the transaction. PwC suggested the idea of using a midco transaction, in which Dennis Langley, Bishops sole shareholder, would sell his Bishop stock to a third party, and the third party in turn would sell the Bishop assets to Midcoast. This arrangement, PwC advised, would provide tax benefits for both Midcoast and Langley. PwC suggested that Midcoast use Fortrend International, an investment bank, to facilitate the transaction.
Thomas J. Palmisano, then a senior manager with PwC, testified that his firm contacted Fortrend to facilitate the midco transaction specifically so that Midcoast [would] receive a stepped-up basis in the [Bishop] assets. And by doing so, it would give [Midcoast] an ability to increase the amount of consideration for the assets. Recognizing the benefits of the Fortrend-facilitated midco transaction, Midcoast agreed because, as Midcoasts CFO testified, this was the only thing that we felt could close the gap between Langleys requested price and Midcoasts offer. Fortrend began negotiating with Langley to acquire his Bishop stock, with Midcoast and PwC participating in the negotiations and often dealing directly with Langley.
The evidence shows that Langley and Midcoast were discussing the purchase prior to K-Pipes involvement, that they met together along with PwC to discuss the deal, and that the sell/buy transactions occurred within 24 hours, wrote the appellate judges. This evidence supports only the inference that K-Pipe was merely an intermediary without a bona fide role in the transaction.
The district court ruled that there was no substantial authority for Midcoasts tax treatment of the transaction and that, in any event, the conduit transaction constituted a tax shelter, making the substantial authority exception inapplicable.
The uncontroverted evidence shows that the arrangement at issue in this case had the sole purpose of avoiding federal income tax, wrote the appellate judges. Thus, it falls squarely within the Codes definition of a tax shelter. It is clear that tax avoidance was, at a minimum, a significant purpose of the arrangement as required by the statute.
