Last week the H.J. Heinz Company lost a big "basis shifting" tax shelter case.
The shelter was supposed to work like this:
1. A Heinz subsidiary, Heinz Credit Corporation, bought 3.5 million shares of Heinz stock on the public markets for about $129 million.
2. Heinz redeemed all but 175,000 of the shares in a transaction that (on purpose) did not qualify as a redemption under Sec. 302. That means the transaction is a dividend, and the $120+ million basis in the 3,325,000 shares shifts to the remaining 175,000 shares.
3. The subsidiary sells the remaining 175,000 shares on the public market, generating a $124 million capital loss and more than $40 million in tax refunds.
These basis-shifting transactions were designed to take advantage of an old tax law provision meant to keep people from disguising corporate dividends as stock sale proceeds. This was more important before dividends and capital gains were taxed at the same rate, but it still matters; a dividend is 100% taxable, while a stock sale is taxable only to the extent the proceeds exceed your stock cost ("basis").
While the redemption rules can be complicated, a simple example gives an idea how it works:
If you own all 100 shares of a corporation, a sale of 99 shares back to the corporation still leaves you with 100% ownership, so the tax law ignores the "sale" and treats the transaction as a dividend. The basis of the 99 shares "sold" is reallocated to the remaining 1 share in such a "failed" stock redemption.
The basis-shifting shelters sought to create losses by using "failed" redemptions to inflate the basis of shares and then selling them to outside parties at a loss.
The Court of Federal Claims said that the Heinz basis-shift was a "sham":
This court will not don blinders to the realities of the transaction before it. Stripped of its veneer, the acquisition by HCC of the Heinz stock had one purpose, and one purpose alone -- producing capital losses that could be carried back to wipe out prior capital gains. There was no other genuine business purpose. As such, under the prevailing standard, the transaction in question must be viewed as a sham -- a transaction imbued with no significant tax-independent considerations, but rather characterized, at least in terms of HCC's participation, solely by tax-avoidance features. The tax advantage sought by Heinz via this sham must be denied.
The moral? If you do a deal solely to generate tax losses, the courts might not buy it, no matter how much ketchup you pour on it.
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