The government got a big victory in the U.S. Court of Federal Claims, winning a reversal of a 2004 decision in a case legal experts say will go a long way in defining what constitutes an illegal tax shelter by reestablishing the economic substance test.

The court's decision against Coltec Industries Inc. is a notable decision in the war over corporate tax shelters. In 1996, Coltec reported a capital loss of more than $378 million on its tax return -- a loss generated by the company selling high-basis stock for a relatively low price. Now-defunct accounting firm Arthur Andersen suggested, and signed off on, the strategy.

The Internal Revenue Service disallowed the loss and assessed additional taxes; Coltec then followed its payment by promptly filing a refund action for more than$82 million. In 2004, the U.S. Court of Federal Claims awarded Coltec a full refund.

In the appeal decision, the court ruled that although Coltec's claimed capital loss fell within the literal terms of the statute, the transaction that created the high basis in the stock lacked economic substance and therefore must be disregarded for tax purposes. However, the court did say that the company could be entitled to a partial refund on the sale of stock with a basis of approximately $4 million for a price of $500,000.

"Today's decision ... confirms that illusionary losses purportedly created by the so-called 'contingent liability' tax shelter are not deductible against actual taxable income," said assistant Attorney General Eileen J. O'Connor, in a statement . "[The] decision is the second from a U.S. Court of Appeals to address this tax shelter scheme, and represents a significant advance in the Justice Department's ongoing effort to combat abusive tax shelters and restore integrity to the tax laws."

Previously on WebCPA:

Conn. Judge Rules Against IRS in Tax Shelter Case (Nov. 8, 2004)

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