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Accrual of Deduction for Disputed Amount

Originally published in: The New York Law Journal February 16, 2012 Accrual of Deduction for Disputed Amounts By: David E. Kahen and Elliot Pisem A party against whom a claim is made may set aside an amount for payment of the claim, even as that party continues to dispute its liability. For example, the obligor may be required to make a payment in order to continue to dispute the claim under judicial or administrative requirements of a court or taxing jurisdiction; or a set-aside may be necessary as an inducement to prevent the counter-party from seeking to secure its claim through means such as filing a lien or seeking the forced sale of property. If, in the absence of a dispute, payment of the claim would give rise to a deduction for income tax purposes, the question arises whether payment with respect to a disputed claim, made either to the person asserting the claim or to a third party, will provide the obligor with a deduction in the year of payment. In general, an amount may be de-ducted by a taxpayer using an accrual method of accounting only “in the tax-able year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accu-racy, and economic performance has occurred with respect to the liability.” Accordingly, if liability with respect to a claim is contested in good faith, a deduction generally cannot be claimed under the basic “all events” test, since David E. Kahen and Elliot Pisem are partners in the law firm of Roberts & Holland LLP. the existence of the contest indicates uncertainty as to whether the liability is in fact due. Indeed, the existence of a contest was held by the Supreme Court in United States v. Consolidated Edison Co. to preclude a deduction by an ac-crual method taxpayer, even when payment of the amounts involved (in that case, real property taxes) had al-ready been made by the taxpayer to the claimant (the taxing governmental au-thority). Under the rule laid down by the Supreme Court in Consolidated Edison, if a contest was commenced by the taxpayer in the year of payment, no deduction could be claimed before the year of entry of a final judgment by a court against the taxpayer in respect of the amount of the liability. In order to ameliorate the harsh re-sult of Consolidated Edison, section 461(f) was added to the Internal Reve-nue Code (“Code”). Under that provi-sion, “[i]f (1) the taxpayer contests an asserted liability, (2) the taxpayer transfers money or other property to provide for the satisfaction of the as-serted liability, (3) the contest with respect to the asserted liability exists after the time of transfer, and (4) but for the fact that the asserted liability is contested, a deduction would be al-lowed for the taxable year of the trans-fer (or for an earlier taxable year) de-termined after the application of [sec-tion 461(h)],” then the deduction will be allowed in the year of the transfer notwithstanding the ongoing contest. The Treasury Regulations under sec-tion 461(f) have long made clear that the “transfer” described in that provi-sion can be made to a third party trus-tee or escrow agent—rather than to the claimant itself—but only if a series of additional requirements is satisfied. A recent case, Goodrich Corpora-tion v. United States, deals mainly with the second of the four tests under section 461(f)—namely, whether the taxpayer’s actions in establishing and funding a trust were sufficient to con-stitute a “transfer” of money or other property to provide for the satisfaction of the asserted liability. The case is particularly interesting because the “liability” for which the taxpayer wished to claim a deduction was inter-est expense owed with respect to a Federal income tax deficiency, so that the creditor for whose benefit the “transfer” was allegedly made and the taxing authority asserting that no de-duction was available as a result of that transfer were one and the same—the Internal Revenue Service. Facts in Goodrich Corp. Goodrich Corp. (“Goodrich”), the parent of a group which has been in-volved in other reported tax cases in recent years, acquired Rohr, Inc. and its subsidiaries (“Rohr”) in 1997. A tax examination of Rohr for the years 1986 through 1989 was underway at the time of the acquisition. The IRS issued a notice of defi-ciency to Rohr during 2000 (three years after the acquisition), asserting that an additional $85,000,000 of tax was due from Rohr with respect to the tax years 1986 through 1989. As eleven to fourteen years had already passed since the years to which the notice of deficiency related, the interest then claimed by the IRS to be owed with respect to the asserted tax defi-ciencies was $230,000,000, an amount almost three times the underlying tax liability. Goodrich contested that Rohr owed the asserted underlying tax obli-gations, but also sought advice from the accounting firm of Arthur Ander-sen with respect to “trust strategies” that might give rise to tax benefits for contested liabilities. Under a strategy described by Arthur Andersen in a PowerPoint presentation and ultimately implemented by Goodrich and Rohr with Bank One Trust Company, N.A., as trustee, Rohr established a trust in December 2001 for the stated purpose of holding property to be used for the payment of its then-contingent interest liabilities to the IRS; amounts were apparently not set aside with respect to the tax liabilities themselves. Rohr transferred to the newly formed trust unsecured promissory notes with a face value of $250,000,000 that Rohr had received from Goodrich; these notes allegedly evidenced amounts owed to Goodrich by other subsidiaries on account of funds advanced to them by Goodrich and by reason of intercompany sales of goods and services. Goodrich notified the IRS by certified mail that the trust had been established. Goodrich characterized the trans-fer of the bulk of the notes ($229,000,000) as attributable to inter-est that had accrued with respect to the alleged tax deficiencies of Rohr from 1986 through the date of creation of the trust in December 2001. That amount was claimed as an interest ex-pense deduction on Goodrich’s con-solidated Federal income tax return for 2001. The Internal Revenue Service ultimately disallowed that deduction, but the dispute regarding the deducti-bility of the amount claimed on Good-rich’s 2001 return is being disputed by Goodrich in a separate case in the Tax Court and was not considered by the District Court in its recent decision. Interest continued to accrue on the asserted tax deficiencies, and Goodrich characterized a further $13,600,000 portion of the contributed notes as re-lating to interest on the asserted tax deficiencies that accrued from Decem-ber 20, 2001 (the date the trust was created) through June 30, 2002. Good-rich asserted that the it was allowed a deduction during 2002 for this interest expense, and that this deduction gave rise to a net operating loss carryover for that year that could be carried back to 1997. On the basis of this carryback, Goodrich claimed a refund of its 1997 Federal income tax. When that claim for refund was denied by the IRS, Rohr brought this suit in the District Court. One of the notes contributed to the trust was ultimately paid after the set-tlement with the IRS in 2006 of the underlying asserted tax liabilities, with the proceeds of payment of the note being used by the trustee to make payment to the IRS with respect to those liabilities. The other notes were returned by the trustee to Rohr. In the District Court, each side sought summary judgment on the ques-tion of whether the trust arrangement met the requirement of section 461(d) that there be a transfer of money or other property to provide for the satis-faction of the liability. The court ulti-mately agreed with the government that the arrangement did not meet that requirement. The court therefore did not reach the government’s further argument that the arrangement also failed to meet the further requirement of section 461(f) that, but for the fact of the contest, a deduction would be allowed for the taxable year of the transfer; the government argued that Rohr failed to meet this requirement because the property assigned by Rohr to the trust (notes issued to Goodrich by other subsidiaries) could not be used to pay the government. The Treasury Regulations promul-gated under section 461(f) provide that a taxpayer may provide for the satis-faction of an asserted liability by trans-ferring money beyond the taxpayer’s control to “[a]n escrowee or trustee pursuant to a written agreement (among the escrowee or trustee, the taxpayer, and the person who is assert-ing the liability) that the money or other property be delivered in accor-dance with the settlement of the con-test” (emphasis added). Neither party contested the validity of the regulation. The IRS contended that the ar-rangement did not meet this “written agreement” requirement because the person asserting the liability—that is, the IRS itself—was not a party to the trust agreement and did not consent to it. Goodrich responded that the IRS’s failure to respond to the notice (which, by its terms, sought no response) should be interpreted as assent to the creation of the trust, or that equitable estoppel could be applied to the IRS by reason of its failure to respond. The court referred to various cases supporting the proposition that the government’s silence was more sug-gestive of a refusal to voluntarily as-sent; noted that courts have imposed a heavy burden on litigants attempting to asset an estoppel defense against the United States; and found that there was no case applying estoppel against the government in similar circumstances. Accordingly, the court declined to ap-ply the equitable estoppel doctrine here. Goodrich further argued that the IRS had been put on notice of the ar-rangement, because the IRS had been mailed (and had received) a description of the trust and a copy of the trust agreement; and that this alone should suffice to meet the written agreement requirement. In support of this posi-tion, Goodrich cited cases decided by the Court of Appeals for the 8th Circuit and the 9th Circuit in which the re-quirements of section 461(f) had been considered satisfied where the person asserting the claim had knowledge of the arrangement. Cases decided by the Court of Appeals for the Second Cir-cuit and by the Claims Court, however, supported the government’s position here that affirmative assent by the claimant was needed in order for the favorable timing rule of section 461(f) to apply, and the court found this read-ing of the relevant regulation in those cases to be more persuasive. The court also noted that a re-quirement of affirmative assent was consistent with the intent underlying section 461(f) as evidenced by the leg-islative history under the Revenue Act of 1964 for that provision, which was intended to permit a taxpayer to claim a deduction “where the payment has actually been made.” Further, the court observed that, without the claim-ant’s involvement in or consent to a written agreement, an arrangement was more likely to be devised under which a deduction was claimed for the “trans-fer” of funds that were not truly out-side the transferor’s control (inconsis- tent with the rationale of section 461(f)); and that the requirement of involvement of the claimant (especially where the claimant was the govern-ment in an income tax matter) made it less likely that a trust would be over-funded so as to obtain the benefit of an over-generous tax deduction while the underlying claim was being contested. Observations Several facts mentioned in the District Court’s opinion in Goodrich, although not directly relevant to analy-sis of the section 461(f) issue, fore-shadowed a decision against the tax-payer. These included that the underly-ing tax dispute for 1986-1989 (more than 20 years before the Goodrich opinion was issued!) involved an abu-sive tax shelter, and that a “strategy” to accelerate the claiming of interest de-ductions had been promoted to Good-rich by a national accounting firm us-ing PowerPoint slides. With this back-ground, it was sufficient for the Dis-trict Court to find that no qualifying “transfer” had occurred, and it did not need to address a further argument apparently made by the government, to the effect that the arrangement here failed to meet the statutory require-ments because the assets contributed to the trust were notes of affiliates of the taxpayer, rather than some more liquid and easily valued security. Perhaps that issue will be explored in other litiga-tion relating to the same tax “strategy.”