Dow Chemical Transactions Disregarded for Lack of Economic Substance; Penalties Imposed

Two basic types of tax benefits are at issue in this case that were created when Dow converted an asset's equity into a tax deduction. In Chemtech I, the basic tax benefit is a deduction by Dow of royalty expenses paid for the use of its own patents. In Chemtech II, the benefit created is a deduction for the depreciation of a chemical plant asset that had already, for the most part, been depreciated down to zero.

The resolution of this case turns, in large part, on this Court's application of judicial doctrines that have been developed by the courts for more than three-quarters of a century. For the reasons which follow, the Court finds that the Chemtech transactions should be disregarded for tax purposes because: a) the transactions fail both tests under the economic substance doctrine; b) the partnership was a sham and had no legitimate business purpose; and c) even if this Court were to respect the partnership as a separate entity for tax purposes, it would not treat the banks as true equity partners. Finally, the Court finds that a 20% penalty applies for substantial understatement and negligence.

Goldman Sachs ("Goldman") is a global investment banking firm headquartered in New York City. One of the products that Goldman developed in the early 1990s was called Special Limited Investment Partnerships, or "SLIPs." SLIPs was a complex marketed tax transaction, the ultimate goal of which was to locate "equity that was tax deductible."¹ Goldman employees worked closely with the law firm of Andrews & Kurth in the development of SLIPs. Lawyers from Andrews & Kurth advised Goldman that, under the tax law in force at the time, business purposes other than tax savings were important for the completion of the transaction. In particular, lawyers stressed that the business purpose of off-balance sheet financing ("OBSF") was essential.²

Goldman sold SLIPs to various well-known clients other than Dow, including Merck and International Paper. In 1992, Goldman began marketing SLIPs to Dow in a series of slideshow presentations. Prior to the presentations, Goldman and Dow reached a confidentiality agreement, prohibiting Dow from disclosing information about SLIPs to "any outside legal, tax or accounting advisors without [Goldman's] permission."³

The first presentation took place in April 1992. During that presentation, Goldman described a partnership made up of a foreign subsidiary of Dow along with a foreign investor. Goldman kept the mention of tax benefits to a minimum, but emphasized that if there were any adverse U.S. tax consequences for foreign investors, Dow would indemnify them. In June 1992, Goldman offered another presentation to Dow, in which it described the tax provision at the source of SLIPs. Also during the meeting, Dow first expressed its interest in using patents as the assets to contribute to the partnership. In November of that year, Goldman made a third presentation to Dow which focused on patents. In December, Dow obtained an opinion letter from Andrews & Kurth addressing whether the potential partnership formed by the SLIPs transaction would be disregarded as a sham, whether the transaction itself would be disregarded as a sham under various judicial doctrines employed against abusive tax transactions, and whether an investment by foreign banks would be considered debt, and not equity.⁴ Dow's focus on tax issues from the outset, and concern for its validity in that regard, reflects its primary motive for entering into the SLIPs transaction.

In 1993, Goldman began the process of identifying European banks that might be interested in participating in the SLIPs transaction with Dow. Dow had become concerned about the guarantees it had to make to the foreign banks as part of the transaction (indemnifying them for any potential tax exposure), and wanted to make various "core modifications."⁵ In response, Goldman reminded Dow that it was the only party receiving the tax benefits of the transaction, and that "[B]ecause [the financial institutions] do not share in the tax benefits of the structure they will not accept any structural tax risk. . . . No financing premium will justify the potential tax exposure."⁶ Goldman further advised Dow not to make the transaction any more complicated, stating, "We are already approaching the structural limits of the marketplace and we have significant doubts that the additional complexity raised by the proposed changes can be competently evaluated by investors."⁷

In a March 1993 memorandum to Dow, Goldman reiterated that Dow must indemnify the foreign banks for any tax liability in order to protect the banks "fully from both Dow/[Marion Merrell Dow] actions and structural flaws in the partnership agreements."⁸ On April 8, 1993, Dow's Board of Directors approved Dow's entry into a SLIPs transaction, establishing a partnership, "Chemtech I," with its principal place of business in Horgen, Switzerland.

B. Chemtech I

Dow owned the patents, and by entering into the licensing agreement with Chemtech, it was obligated to make royalty payments. Chemtech then had the right to license the technology contributed by Dow provided it gave 90 days notice to Dow. Therefore, as an investor in Chemtech, Dow could not expect to receive any additional revenue unless Chemtech licensed the patents to third parties. Two factors combined to make licensing of the patents unlikely: 1) the patents included in Chemtech were those that Dow practiced; and 2) with respect to most of the patents, Dow did not contribute all technology that would have been necessary for third party licensees. A third party would have therefore needed to deal with both Chemtech and Dow in order to license a patent.

Sharon Oriel, an employee involved in the management of patents for Dow, acknowledged that Chemtech I did not change in the manner in which Dow used its patents, and that placing the patents into the Chemtech partnership did not increase the value of those patents to Dow.¹⁰

Diamond Technology Partnership Company, ("DTPC"), a Dow subsidiary incorporated in Delaware with its principle place of business in Hamilton, Bermuda, as a Class A limited partner in Chemtech. DTPC transferred U.S. patents (valued at $866,996,000), to Chemtech as a contribution to its capital. Ultimately, DTPC owned roughly 88% of Chemtech.

DESA and DTPC also created Chemtech Portfolio, Inc., ("CPI"), a subsidiary of Chemtech incorporated in Texas with its principle place of business in Midland, Michigan. In addition to the Patent Assets contributed to Chemtech by DTPC, DTPC also contributed 100% of its CPI stock into Chemtech's capital.

Subsequently, Essex Specialty Products, Inc., ("Essex"), a Dow subsidiary, became involved in Chemtech when it acquired roughly 5% of the common stock of DTPC in exchange for up to $1,000 and the assignment of five U.S. patents to DTPC. In other words, DTPC owned approximately 88% of Chemtech, and Essex owned about 5% of DTPC.

Ifco, Inc., ("Ifco"), another subsidiary of DTPC incorporated in Delaware with its principle place of business in Hamilton, Bermuda, was designated as a Class B limited partner of Chemtech. Ifco acquired a limited partnership interest by contributing $100 million to its capital.

On April 30, 1993, Dow contributed 68 patents and 100 shares of CPI stock to DTPC in exchange for 776 shares of DTPC. Additionally, Essex contributed 5 patents to DTPC in exchange for 113 shares of DTPC.

Also on April 30, DTPC and Chemtech executed a Contribution Agreement whereby DTPC contributed those combined 73 patents and 100 shares of capital stock of CPI to Chemtech in exchange for a Class B Limited Partner interest in Chemtech. The contributed patents had a tax basis of $53,345; the CPI stock had a tax basis of $2,481,532. Additionally, an Agreement of Limited Partnership of Chemtech Royalty Associates, L.P., (the "Partnership Agreement"), was executed among DESA, (the General Partner), and DTPC and Ifco, (the Limited Partners).

In summary, at this stage in its formation, the three partners of Chemtech included DESA, DTPC, and Ifco. DESA, as general partner, contributed $10 million to Chemtech's capital and owned about 1% of the partnership. DTPC, as a limited partner, contributed Patent Assets, (valued at $866,996,000), and 100% of its stock in CPI to Chemtech's capital, and owned roughly 88% of the partnership. Ifco, the other limited partner, contributed $100 million to Chemtech's capital and owned about 10% of the partnership.

In addition, on April 30, 1993, Dow agreed to lease back the patents from Chemtech using the "triple net leases" described by Goldman.¹¹ This created a "circular flow" of the patents: Dow contributed the patents to DTPC, who contributed the patents to Chemtech, who leased back the patents to Dow. At this point, the foreign investors entered the picture.

Eventually, five foreign banks agreed to participate in Chemtech I by contributing a total of $200 million:

             Bank                                  Amount invested

      Entity                   Classification            Ownership %

Dow paid royalty fees to Chemtech for the use of the patents it had previously assigned. Chemtech then paid the foreign banks a fixed fee the equivalent of an approximate 7% interest payment on $200 million of investments.¹⁵ The Chemtech partnership then took the remaining cash and contributed it to its subsidiary corporation, Chemtech Portfolio ("CPI"). CPI then loaned the money back to the Dow corporate group.

Chemtech I operated between 1993 and 1998. The foreign banks were invested in the partnership during 1993 and 1998 for only a small part of the year. Therefore, the cash flows from 1994-97 best illustrate the economics of Chemtech I. During that time money flowed into Chemtech from a primary source, Dow, which made royalty payments as required in the lease agreement. After the money was paid to Chemtech, several transfers of cash occurred. First, a guaranteed payment was made to DTPC. Second, a $760,000 management fee was made to DESA (a European Dow subsidiary). Third, a priority return was made to the foreign banks. Fourth, relatively small tax distributions were made to the Swiss tax authorities on behalf of Dow (DESA and DTPC) and the foreign banks. Next, Chemtech contributed excess cash to its subsidiary CPI. Finally, loans were made from CPI to Dow (Dow Chemical International).¹⁶

The 1994 cash flows break down as follows:

Indeed, Dow claimed a royalty expense deduction on its corporate income tax returns. But, as shown below, that cash was returned to Dow without triggering any significant income tax. In 1994 the major tax flows of Chemtech I were as follows:

Similar flows of cash and tax consequences continued in the following years.

1995 Chemtech I

Cash Flows:

Cash Flows:

Cash Flows:

In the preamble to its temporary regulation, the U.S. Department of the Treasury noted that the result of a tax exemption in both countries (U.S. and the jurisdiction of residence) was both "inappropriate" and "unintended."²² Furthermore, the Treasury noted, the result is contrary to the intent of the tax treaties between the countries, which "[C]ontemplate that income relieved from taxation in the source country will be subject to tax in the treaty country."²³

In December 1997, DESA informed the foreign banks of the change in United States tax law, noting that the new regulations may cause the payments to the foreign banks as "Class A Limited Partners" to be subject to a 30% withholding tax.

              Bank                                Amount of Payment

A dispute soon arose over the amount of value the patents had gained -- the banks believed it to be greater than $82 million. However, their complaints regarding the patent valuation met deaf ears, as Dow pointed out that the partnership agreement required a specific methodology for determining the market-to-market gain. The banks' position could have required an additional $1 million distribution, and Dow refused to pay anything additional. An internal Dow memo noted that the foreign banks appeared to be upset because "Dow has made so much money on this deal."²⁷ Furthermore, a high-ranking Dow officer testified that the banks were being "too greedy" in their attempts to gain more in distribution of the increased value.

The Court notes that, if Chemtech were a true joint venture, all parties would be pleased with high gains in mark-to-market valuation of the patents. However, that does not appear to be the case. The foreign banks had a collective 1% interest in the increased value of the patent assets. Therefore, if they believed they could be due up to an additional $1 million dollars, their valuation had the potential to be $100 million greater than Dow's -- roughly $180 million. Dow's valuation showed a $82 million gain. Dow was due 99% of any market-to-market value gain. Therefore, a $100 million increase in calculation would have allocated an additional $99 million to Dow (along with the additional $1 million to the banks); yet Dow dismissed the banks' objection and held to their original valuation.

Given Dow's assertion that Chemtech was a true partnership and joint venture, its unwavering position on the valuation of market-to-market gains in the patents eludes this Court's understanding. The only way the Court can understand Dow's position is if Chemtech were, in fact, something other than a true partnership where each party had a real ownership stake in the patents. Dow appeared to view the patents as its own property, and preferred the banks to come away with as little value in that property as possible.

C. Chemtech II

In determining the assets to contribute to the new Chemtech partnership, Dow sought to ensure the transaction wouldn't affect day-to-day operations of the company, and that the assets had value in excess of their book value. When Dow chose the Louisiana chemical plant as the asset to be contributed to the partnership, internal communications between its corporate officers sent in February 1998 revealed that the plant would "remain under Dow's control," and that Dow intended "not to affect in any manner the operation of these [plant assets]."³⁰

During the transition from Chemtech I to Chemtech II, Dow planned to retire DTPC as a partner. DTPC contributed the patent assets to Chemtech, and Dow sought to regain control of those patents. In addition, Dow planned to distribute to DTPC 67% of the Chemtech Portfolio ("CPI") stock held by the Chemtech partnership. CPI was comprised entirely of cash, securities, and Dow demand notes valued at over $750 million as of February 1998. The sum was split into just over $50 million in securities and just over $700 million in inter-company Dow demand notes. The plan was to use the patents and CPI stock "to take out DTPC's capital."³¹

However, a problem arose. Dow learned that the CPI assets would be considered "marketable securities," triggering a tax pursuant to Internal Revenue Code § 731. Dow's plan to avoid this tax was to exchange those securities for a "deeply subordinated 33-year note."³² Internal Dow memoranda support these facts. In one memo, Dow explained that "[t]he key to the tax treatment [of the exchange] is a 754 election which was made when the partnership assets were distributed."³³ The 754 election allowed Dow to receive a $380 million boost to the basis of its chemical plant, enabling Dow "to strip the basis from the CPI stock that was distributed to DTPC and apply it to the plant assets which were contributed. This allowed for an increase in the tax basis of the plant assets from $27 million to over $400 million."³⁴ Dow believed the marketable security matter to be the most important part of the Chemtech II transaction.³⁵

In its internal memo, Dow described no business purpose for the securities-for-note exchange, but emphasized the tax benefits of Chemtech II. In particular, Dow noted that the $380 million boost to the basis of the Louisiana chemical plant enabled it to depreciate the basis on a five-year schedule. The Chemtech partnership agreement allocated this depreciation to IFCO, the general partner of Chemtech. IFCO, a Dow subsidiary, is part of the Dow consolidated tax return "and therefore Dow will receive the tax benefits."³⁶ On June 12, 1998, Dow exchanged the three demand notes for a single term note with a face value of $781.6 million

Just over one month later, in August 1998, Dow was looking ahead to a planned Chemtech III transaction. Dow emails show employees discussing the terms of the notes used in Chemtech II, seeking to ensure they would still be in place "until Chemtech III is set up," so that the loan could be "converted to the same type of note that CPI [had] in place."³⁷ This communication reveals, among other things, Dow's plan to initiate a third version of the Chemtech tax shelter without any discernible business purpose in place. That is, any purpose other than using the transaction as a tax shelter.

On June 25, 2008, DTPC was retired from Chemtech in exchange for 70% of the stock of CPI and all of the remaining patents.

On June 26, 1998, RBDC, Inc., a United States affiliate of Rabobank,³⁹ was admitted to Chemtech after Rabobank purchased $200 million of Credit Default Swaps from Dow.⁴⁰ The Credit Default Swaps show that Rabobank wanted to protect itself in its dealings with Dow, and that Dow was the ultimate source of repayment and the real credit risk in the transaction.⁴¹ There were three partners to Chemtech II: IFCO (Dow subsidiary), DCDC (Dow subsidiary), and RBCD, which held the following interests:

 Partner              Capital Investment              % Interest

The § 754 election essentially transferred Chemtech's inside basis in CPI to the Louisiana chemical plant, which in turn provided Chemtech with artificially large depreciation deductions. In Chemtech I, the cash generally flowed from Dow to Chemtech to CPI back to Dow. When Chemtech transferred its cash to CPI, its basis in CPI increased. When Chemtech I transitioned to Chemtech II, Chemtech's basis in that portion of the CPI stock was roughly $450 million. This is the amount of basis transferred to the plant through the § 754 election.

1999 Cash Flows

1999 Tax Flows

 Chemtech II total numbers reported:

2000 Chemtech II Cash and Tax Flows

2000 Cash Flows:

 Chemtech II total numbers reported:

2001 Cash flows:

 Chemtech II total numbers reported:

2002 Cash flows:

 Chemtech II total numbers reported:

The cash and tax flows from 2003 show a slightly lower payment to RBDC because of a restructured agreement that effectively represented a lower interest rate.

2003 Cash flows:

 Chemtech II total numbers reported:

D. Class A Partners' Interest in Chemtech

Equity claims represent the ownership interest in a business enterprise, and carry with them a residual claim on business profits, voting rights, and are more permanent as capital investments in a business. Debt, by contract, involves an obligation by a borrower to repay a lender an amount by a certain date, typically accompanied by interest payments. Debt differs from equity in that debt provides for "a priority claim on operating profits, no voting rights, finite life, periodic payments that reduce risk, restrictive terms that protect the debt investors, and the right to force liquidation or reorganization."⁴⁶

Dow asserts the interests were preferred equity, which would require this Court, assuming both a legitimate business purpose other than tax motivations and economic substance to the transactions, to recognize that the foreign banks were partners for tax purposes. The government asserts the interests "fall[ ], overwhelmingly, on the debt side of the spectrum."⁴⁷ The consequences of such a finding are crucial. It would provide this Court with an alternative ground upon which to disregard the Chemtech transactions, ignoring for this purpose the motivations behind the transactions or whether they had any economic substance. Therefore, this characterization represents an important part of this case.

During the early development of the SLIPs transactions, Dow knew how important it would be to classify the foreign banks' interest as equity. Andrews & Kurth⁴⁸ wrote an opinion letter for Dow, explaining that "[t]he anticipated tax consequences of the [SLIPs] [t]ransaction would be substantially altered if the [Internal Revenue] Service was successful in recharacterizing the [Class "A"] Preferred Interest as debt for tax purposes."⁴⁹ The promoters of the SLIPs transaction agreed, and noted that all Partners would be required to enter into a covenant against taking any action that could be seen as inconsistent with the idea that the foreign banks were equity partners.

Despite this covenant, Bank Brussels Lambert ("BBL") placed a condition on its $25 million transfer to Chemtech that its bank commission, the Commission Bancaire, agree that the investment "be considered as loans and not equity."⁵⁰ BBL also internally viewed the transaction as a loan.⁵¹ The transaction was also analyzed under German banking law before investors committed. That analysis, performed by Price Waterhouse, revealed that, under German substance over form principles, the bank's interest would be a loan. Stated plainly, ". . . FORCO [The Foreign Investor] does not have partner status for tax purposes."⁵² Rabobank (parent company of RBDC) stated that their participation in the Chemtech II transaction was a "5-year loan to an SPV [Special Purpose Vehicle] that holds fixed assets (the Louisiana chemical plant) and Dow demand notes."⁵³

During trial, Merle Erickson,⁵⁴ Dow's expert witness in accounting, testified that the Class A interests in this case were most comparable to preferred stock instruments commonly characterized as equity.⁵⁵ Professor Erickson was concerned with whether, under generally accepted accounting principles ("GAAP"), the investments in this case would be considered debt or equity. Dow's auditor, Deloitte & Touche, also classified the Class A interests as equity based on their similarity to preferred stock. Joel Finard, an expert witness for the United States in capital markets and structured transactions, confirmed during the trial that Deloitte bases its characterization of instruments on their underlying substance, not just the label given to them by the parties involved.

The parties' characterization of the interests alone, while persuasive and significant, does not lead this Court to find the Class A interests were debt rather than equity, or vice versa. A look at several important factors that distinguish the two types of interests is required, and both parties provided expert testimony on the various factors.

 Guaranty or Protection for Bank               Summary of Provision

The foreign banks also had the opportunity to share in residual profits, which would be generated if Chemtech's net income per year exceeded approximately $14.03 million. This is also a characteristic of equity -- participation in profits but it is clear in this case that such participation was secondary to the fixed payments the foreign banks received. If a patent began to generate greater than expected profits, Dow was able to retire the patent assets in order to prevent excess profits from "leaking" through to the foreign banks. Evidence produced by Dow shows that such a circumstance occurred with patent portfolio 14.3, which was removed from Chemtech "because it produces high profits (less leakage)."⁵⁷

The foreign banks, as "limited partners", did not have any right to manage or control the Chemtech partnership or affect its business or affairs in any way. The foreign banks were also granted limited voting rights "on those matters specifically reserved for their vote. . . ."⁶⁰ In reality, however, the banks were not involved in the management of Chemtech. Dow's outside counsel referred to the banks as "passive" investors, and recalled a Chemtech meeting where no bank representatives attended at all. The Court agrees with Dr. Glen Hubbard's assessment that, because the banks clearly had rights in theory but not as clearly in practice, this factor is inconclusive.

E. Dow's Purpose for Forming the Chemtech Partnership

Dow asserts its primary reason for entering into SLIPs was maintenance of a high quality credit rating, enabling it to raise capital at a reasonable or low cost. The chemical industry is characterized by multi-year business cycles with peaks and valleys during which demand fluctuates substantially. According to Dow, managing these industry dynamics required that Dow maintain access to capital and financial flexibility. Dow's ability to raise capital depended, in significant part, on its credit rating.

This rating depended heavily on Dow's debt-to-total capital ratio. To maintain a ratio that would result in a high credit rating, Dow claims it relied upon substantial amounts of "off-balance sheet financing" ("OBSF") to obtain funds that were not classified as debt on its balance sheet. Dow asserts the 1993 and 1998 Chemtech transactions provided it with $200 million of financing from limited partner investors. This financing was treated as "minority equity" rather than debt on Dow's balance sheet at times when business conditions placed Dow's debt ratio under pressure. Chemtech also enabled Dow to monetize economic assets -- patents in 1993, a chemical plant in 1998 -- that were carried at near zero on Dow's balance sheet by contributing the assets to the Chemtech partnership and attracting third-party limited investors.

In summary, Dow asserts it participated in the Chemtech transactions because a) it needed the ability to raise low cost capital during tough economic conditions; b) a high rating from the credit rating agencies was essential to access such capital; c) a primary factor used by the agencies was the debt-to-total capital ratio; and d) OBSF was an effective tool for raising money without increasing debt. This Court's findings differ dramatically from Dow's assertions.

Corporate finance relates generally to the ways corporations raise capital from investors in order to pursue business opportunities. A corporation must decide, time and again, which investments it must make, and how to pay for, or finance, those investments. Typically, a corporation will first identify a specific profitable project, and then seek financing at the lowest possible cost. No evidence was presented in this case showing that Dow identified any specific project prior to the Chemtech transaction that reflected a purpose other than the generation of large tax benefits.

Instead, Dow declared that it wished to generally maintain a sense of "financial stability in difficult times," and its employees were not able to think of a specific use of any funds coming from Chemtech Portfolio to Dow.⁶¹ In addition, high-ranking Dow officials weren't able to recall the role of Dow Chemical International, Ltd. ("DCIL"), even though it purportedly "borrowed" roughly $1 billion from CPI, or about 10% of Dow's total debt in 1993.

Dow claims the weak economic conditions at the time of the formation of Chemtech I forced it to look to OBSF to maintain its credit rating. However, rating agencies recognize the turning of the business cycle, as shown in an especially telling statement from Standard & Poor's Corporate Finance Criteria: "[T]he level of risk over time is important, rather than at any specific point in time. Certainly, S&P looks at performance over the anticipated course of a full business cycle and not what is viewed as a peak or trough year. . . . Since ratings are designed to be valid over the entire business cycle, [debt-to-total capital] ratios of a particular firm at any point in the cycle may not appear to be in line with its assigned debt rating."⁶²

No documentation exists showing Dow had any critical need for cash at the time of the Chemtech transaction, and an analysis of Dow's financial statements and other evidence, as shown in Dr. Hubbard's Rebuttal Report and in multiple exhibits, does not support the conclusion that Dow had a need for financial flexibility or capital expenditures.

No evidence shows that Dow evaluated less costly alternative to the Chemtech transaction when, in fact, other forms of financing existed that would have allowed Dow to achieve OBSF. Trust Preferred Stock is one such alternative to SLIPs, and the transaction costs for this alternative at the time of Chemtech I was roughly 3.5%, compared to 6.3% in Chemtech (excluding any termination fees).

According to Dow and its experts, there are significant economic benefits of OBSF. For example, unwary investors may ignore OBSF and set lower interest rates for loans than those warranted by the underlying risk levels.⁶³ Dow relies on maintenance of its debt-to-total capital ratio as the primary factor for entering into OBSF. Labeling the funds from the foreign banks as equity rather than debt helped achieve this goal. Essentially, supporters of OBSF contend that investors and credit rating agencies care as much about the labels placed on transactions as they do about the substance of the transactions themselves. However, as Dr. Hubbard explained, empirical evidence shows that investors favor substance over form. Ratios were only a part of the equation and, according to S&P's Corporate Finance Criteria at the time of Chemtech I, "[I]t is a mistake to oversimplify the entire thought process behind a specific rating by relying solely on these numbers."⁶⁴

In addition, the asset management side of the Chemtech transactions did not result in any profits for Dow. Dow continued to use the patents in the same manner as it had prior to Chemtech I. It did not license any single patent contributed to Chemtech to a third party. Moreover, placement of the patents into the partnership did not increase their value to Dow. Dow employees claim to have generated a growth in Dow's licensing income from $25 to $100 million in the 1990s, but Chemtech had nothing to do with that growth.

Dow's professed business purpose is a false wall in the maze of the Chemtech transactions. Upon closer inspection, the path does not end at OBSF or credit ratings, but continues to the heart of the case: tax benefits. The evidence in this case leads this Court to find that Dow had no business purpose for entering into the Chemtech transactions other than to obtain tax benefits. Tax law was the basis for the SLIPs transaction from the beginning. Moreover, Dow had no apparent need for the $200 million investment as it was Goldman Sachs who marketed the SLIPs product to Dow in 1992. As much as a year into organizing the transaction with Goldman, Dow had no particular amount in mind for the value of the patents it planned to "monetize," but was throwing around figures between $200 million and $1 billion. The fact that Goldman and Dow had little discussion of taxes appears to be a product of design rather than function, as at least one high-ranking Dow officer reminded himself prior to a meeting that, "We can't talk about the tax impact on [The Dow Chemical Company]." Finally, in at least one of its calculations of the net present value of the Chemtech transactions, Dow considered risk factors after the transaction had taken place. The only risk to the project after the transaction occurred was that the tax benefits would be disallowed.

F. The Litigation

On April 15, 2005, IRS agents delivered to Dow a document that Defendant, the United States, contends was a draft Notice of Final Partnership Administrative Adjustment ("FPAA"). This document outlined adjustments that may be made to partnership items of Chemtech for the 1993 and 1994 taxable years. Defendant contends the document was not issued to the tax matters partner ("TMP") of the partnership as required by statute, nor was it issued by an IRS official with authority to issue an FPAA. Plaintiff contends the document was a valid FPAA for the 1993 and 1994 taxable years.

On July 13, 2005, DESA, as TMP of Chemtech, timely petitioned this Court for readjustment of its partnership items for the 1993 and 1994 taxable years. The case was docketed as No. 05-944-C-M3. The parties agree that: (i) if the document referred to in the previous paragraph is a valid FPAA, then this Court would have jurisdiction in case No. 05-944 to resolve the dispute over the 1993 and 1994 tax years; (ii) if the document is not a valid FPAA, then this Court would have jurisdiction to resolve the dispute over the 1993 and 1994 tax years in Case No. 06-248-RET-CN, part of this consolidated action. Since the parties agree that this Court has jurisdiction to resolve the 1993 and 1994 taxable years under one of these case numbers, there is no need to resolve the factual question of whether the April 15, 2005 document is a valid FPAA.

On January 13, 2006, the IRS issued an FPAA to DESA in its capacity as TMP of Chemtech, adjusting certain partnership items for the 1993-97 tax periods. On April 4, 2006, DESA, as TMP of Chemtech, timely petitioned this Court for readjustment of its partnership items for the 1993-97 tax years. This case was docketed as 06-258-RET-CN. On April 7, 2006, the cases were consolidated to enable the Court to address the tax dispute relating to all years in one proceeding.

The United States filed an answer on June 5, 2006. On December 4, 2006, DESA filed an amended complaint, and that same day the United States filed an amended answer and counterclaim. In its counterclaim, the United States seeks a 20% penalty for the 1997 tax year based on negligence and/or substantial understatement of income tax.

On March 30, 2007, the IRS issued a FPAA to Ifco in its capacity as TMP of Chemtech II, adjusting certain partnership items of Chemtech II for the 1998-2003 taxable years. On June 8, 2007, Ifco timely petitioned this Court for readjustment of its partnership items for those years. The case was docketed as 07-405-RET-DLD. On June 25, 2007, the parties moved to consolidate the cases relating to the 1993-2003 taxable years of the Chemtech Partnership. On July 27, 2007, this Court ordered the cases consolidated.

In this case, as any tax case, the Court must "distinguish the mere avoidance of taxes from legally circumscribed tax evasion."⁶⁵ Every individual has the right to avoid a tax by remaining outside the reach of the law that imposes it. "Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant."⁶⁶ The Supreme Court shares this view, and has held that taxpayers undoubtedly have the right to decrease the amount of the taxes they owe within the limits of the law.⁶⁷ The question that must be answered is "whether what was done, apart from the tax motive, was the thing which the statute intended."⁶⁸ When entering into a transaction, a subjective motive of tax avoidance is permissible if "Congress intends to encourage an activity, and to use taxpayers' desire to avoid taxes as a means to do it."⁶⁹ But when no legitimate business activity accompanies the goal of tax avoidance, a transaction or other business engagement may be disregarded for tax purposes.

Whether the Chemtech transactions carried on a legitimate business activity is a central issue in this case. Dow claims the IRS, in readjusting certain partnership items, has incorrectly characterized the Chemtech transactions as "shams." According to Dow, the transactions have legitimate business purpose, chief among them the maintenance of Dow's credit rating and access to low-cost capital for the development of future products. The United States asserts there was no purpose other than tax avoidance, and contends the nature of the transactions require this Court to reject Dow's claimed tax benefits under two judicial doctrines, economic substance and sham partnership, as well as debt and equity principles. In addition, the United States asks the Court to affirm its imposition of penalties against Dow for substantial understatement of taxes, negligence, and a valuation misstatement.

A. The Economic Substance Doctrine

The United States first asks this Court to reject Dow's claimed tax benefits based on the economic substance doctrine. This doctrine is one of several judicial doctrines to emerge since the Supreme Court's decision in Gregory v. Helvering.⁷⁰ The Fifth Circuit applies these doctrines broadly, noting that "[t]he principle of looking through form to substance . . . is the cornerstone of sound taxation. . . ."⁷¹ And that "'Tax law deals in economic realities, not legal abstractions.'"⁷² Congress recognizes that its ability to draft tax statutes does not compare to the skill of sophisticated tax lawyers and financial advisors. It has stated that "[a] strictly rule-based tax system cannot efficiently prescribe the appropriate outcome of every conceivable transaction that might be devised and is, as a result, incapable of preventing all unintended consequences."⁷³ "Even the smartest drafters of legislation and regulation cannot be expected to anticipate every device."⁷⁴ Judicial doctrines such as the economic substance doctrine "reduce [ ] the incentive to engage in such essentially wasteful activity."⁷⁵

The economic substance doctrine allows courts to enforce the legislative purpose of the Internal Revenue Code by prohibiting "the taxpayer to reap tax benefits from a transaction that lacks economic reality."⁷⁶ Therefore, transactions with no economic effect other than creating income tax deductions will not be recognized for tax purposes.⁷⁷ In other words, after Gregory, courts will look through the form of transactions manufactured for tax purposes and examine their true substance. Even if a transaction complies formally with provisions of the Internal Revenue Code, "a deduction will be disallowed if the transaction is an economic sham."⁷⁸

The Supreme Court has held that "[w]here . . . there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties."⁷⁹ The conjunctive phrasing of the above factors is important: the absence of any one of them renders the transaction void for tax purposes.⁸⁰

In Klamath, the Fifth Circuit derived from Frank Lyon a three-part test for determining whether a transaction has sufficient economic substance to be respected for tax purposes; it asks whether the transaction "(1) has economic substance compelled by business or regulatory realities, (2) is imbued with tax-independent considerations, and (3) is not shaped totally by tax avoidance features.⁸¹ Thus, in the Fifth Circuit, a taxpayer must establish that: a) the transaction had a reasonable possibility of profit (the "objective" economic substance test), and b) that the taxpayer was motivated to enter into the transaction for a legitimate non-tax business purpose (the "subjective" test").⁸²

The tax benefits in the instant case were created by exploiting the partnership provisions of § 704 of the Internal Revenue Code. The Court therefore will focus on those transactions that pertain to the creation and use of the Chemtech "partnership." The transfer of assets to the partnership (the patents in Chemtech I and the chemical plant in Chemtech II) did not result in any economic advantage to Dow.

The SLIPs transaction did not change Dow's financial position. There was no increase in the value of the patents contributed, and not one patent was licensed to a third party. This means no income was generated by forming the Chemtech partnership. Furthermore, the circular flow of money, as described in great detail above, convinces the Court that none of the cash flows had any economic substance whatsoever.

Although the Court will address the alleged purpose of off-balance-sheet financing in the second prong of its economic substance analysis, it is necessary to determine whether any economic advantages were gained, or value obtained, from the financing. Both Dr. Hubbard and Dow's economic expert, Andrew Carron, agree that "[t]he net present value of financing transactions is at most zero."⁸⁷ The only net present value computations Dow made in this case related to the tax savings, not to any quantifiable advantage it might obtain by its off-balance-sheet financing. As for the off-balance-sheet aspect of the financing, the Court agrees with Dr. Hubbard that Dow did not prove it had any appreciable affect or value to Dow.⁸⁸

In addition, the note exchange that occurred in 1998 during the transition from Chemtech I to Chemtech II lacked economic substance. The particular transaction to be analyzed is Dow's exchange of three term notes for a single, deeply subordinated note with a term of 33 years. At the time of the exchange, no foreign banks were involved in Chemtech. A corporation's dealings "with subsidiaries that do not affect the interest of independent third parties deserve particularly close scrutiny."⁸⁹

During this period, Dow recognized it could not structure the transition between Chemtech I and Chemtech II merely by directing Chemtech to distribute the patents back to Dow, via a liquidation of DTPC's interest in Chemtech. To do so would trigger a tax pursuant to section 731 of the Internal Revenue Code because the Dow notes would be considered "marketable" securities. In order to avoid this tax, Dow converted the demand notes into a single note for $781.6 million with a 33-year term payable in October 2032. Because Dow was both borrower and lender to the note, the transaction is without economic substance and must be disregarded for tax purposes.

The objective economic substance inquiry boils down to "whether the transaction affected the taxpayer's financial position in any way."⁹⁰ The Court concludes that the Chemtech transactions had no such effect and therefore do not satisfy the objective prong of the economic substance doctrine.

Certainly taxpayers are not prohibited from considering tax consequences in their business dealings.⁹⁴ However, a taxpayer may not structure a transaction "to such extreme lengths that the business purpose is no more than a façade."⁹⁵ "Gregory v. Helvering requires that a taxpayer carry an unusually heavy burden when [it] attempts to demonstrate that Congress intended to give favorable tax treatment to the kind of transaction that would never occur absent the motive of tax avoidance."⁹⁶ In determining a taxpayer's subjective purpose, a court may consider, among other things, evidence of the experience and sophistication of the taxpayer.⁹⁷

If the purported purpose of a transaction is to make a profit, courts require that there be a reasonable possibility of a profit that is substantial in relation to the tax benefits generated.⁹⁸ In this case, Dow does not contend that it entered into the transaction to make a profit, but rather to obtain benefits that would sustain its credit rating. Specifically, Dow claims a business purpose of obtaining "off balance sheet" financing ("OBSF") through the use of SLIPs in Chemtech I, and a King & Spalding designed partnership in Chemtech II. SLIPs was a marketed tax shelter presented to Dow by Goldman Sachs, a factor that the Court properly takes into account when analyzing Dow's claimed business purpose.⁹⁹

Dow's business is capital intensive, and it requires access to financing in order to fund its business projects. Dow asserts it was interested in obtaining OBSF as a method of maintaining its debt-to-total capital ratio, which in turn would preserve its high credit rating. However, as described in the findings of fact, Dow's purpose in entering into the Chemtech transactions was to obtain tax benefits. "Everything other than tax motivation fades under the glare of analysis."¹⁰⁰

There were cheaper and less complex alternatives to SLIPs that could achieve the goal of obtaining OBSF. A prudent business owner would not have chosen SLIPs in such a situation unless his business was seeking only the tax benefits derived from a transaction.

Two Dow executives testified at trial that the purpose of SLIPs was for Dow to obtain the accounting advantages of OBSF. However, these two executives, Enrique Falla and Geoffrey Merszei, were not closely involved with Dow's decision to enter into SLIPs. Falla was Dow's Chief Financial Officer during Chemtech I. He never met with Goldman about SLIPs and never saw the partnership agreement.¹⁰¹ Although Falla did bring the transaction to Dow's Board of Directors, he only spent a half hour studying the transaction.¹⁰²

Merszei was treasurer of DESA during the time Dow was considering entering into SLIPs. Goldman developed SLIPs with the intention of using foreign banks as "partners" in order to take advantage of their tax exempt status. Merszei was pushed, but eventually acknowledged that if Dow had entered into SLIPs in order to obtain the advantages of OBSF, it could have accomplished the same goal with a domestic bank.¹⁰³ Yet, no domestic banks were approached. Moreover, Merszei was unaware of the role of CPI in the cash flow cycle of Chemtech I. If Merszei was closely involved in Chemtech I, he would have known CPI's role in recycling cash back to Dow.

The note exchange executed by Dow in the transition from Chemtech I to Chemtech II also did not have a business purpose. Unlike the SLIPs transaction, Dow does not assert a legitimate business purpose for this exchange. As described in detail above, the note exchange was a key step in enabling Dow to increase the tax basis of the chemical plant by roughly $380 million. The Court has not identified any other purpose for the exchange.

The Court concludes there was no legitimate business purpose other than tax avoidance behind the Chemtech transactions. Therefore, the transactions fail both the objective and subjective prongs of the economic substance analysis, and are an economic sham.

B. The Sham Partnership Doctrine

In determining whether a partnership exists for tax purposes, the question set forth in Culbertson is, "[W]hether, considering all of the facts . . . the parties in good faith and acting with a business purpose joined together in the present conduct of the enterprise."¹⁰⁶ This determination is made in light of all relevant facts and circumstances, including "the agreement, the conduct of the parties in execution of its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent."¹⁰⁷

That a transaction has tax benefits "does not automatically mean it is a sham so long as it is imbued with tax-independent considerations."¹⁰⁸ However, if a partnership's underlying business activities have economic substance, that fact "does not, standing alone, immunize the partnership from judicial scrutiny."¹⁰⁹ "The parties' selection of the partnership form must have been driven by a genuine business purpose."¹¹⁰ In other words, "the issue . . . is not whether [the business operations of Chemtech I and Chemtech II] had economic substance, but whether the formation of the partnership had such substance."¹¹¹ "If there was not a legitimate [business] reason to operate as a partnership, then the partnership will not be respected for tax purposes even if it engaged in transactions that had economic substance."¹¹²

Dow argues that Chemtech must be recognized as a separate entity for tax purposes under the either/or test announced in Moline Properties v. Comm'r.¹¹³ Under that test, a partnership must be respected for tax purposes if it was formed for a business purpose or actually carried on a business activity.¹¹⁴ However, as the court recognized in Southgate, the Moline Properties test conflicts with the Fifth Circuit's holding in Merryman.¹¹⁵ Moreover, like the plaintiff in Southgate, Dow misreads Moline Properties. The Moline Properties test is not a two-pronged inquiry, but a unitary test under which "the existence of a formal business activity is a given but the inquiry turns on the existence of a nontax business motive."¹¹⁶

Chemtech's partnership tax returns report that its business purpose was "patent management."¹¹⁷ As a chemical industry expert for the United States explained, this was common in the chemical industry. Parties would enter into such an agreement in order to maximize the profitability of the patents. But, when Dow selected the patents for SLIPs, it made no attempt to identify patents that would be attractive to a third party seeking a license in exchange for royalty payments. Instead, as discussed above in the Court's findings of fact, Dow selected patents that would: a) allow it to continue using the patents as if no transfer had occurred, b) would aid it meeting its goal of contributing close to $1 billion worth of patents to Chemtech, and c) would otherwise conform to its tax strategy.

It is obvious to this Court that Dow never had an intention to derive any additional revenue by transferring the patents to Chemtech. It would be unreasonable to conclude that third parties would license patents from Chemtech which Dow was already using in its operations. Indeed, at trial, Dow abandoned the idea that the Chemtech partnership was designed to manage patents or maximize the revenues of the patents by licensing them to third parties.

A circular flow of funds, similar to what occurred in this case, is also indicative of a sham partnership. The Fifth Circuit in Merryman noted "Throughout [the partnership's] existence, money flowed back and forth but the economic positions of the parties were not altered. . . . Such a circular flow of funds among related entities does not indicate a substantive economic transaction for tax purposes."¹¹⁸ This case, like Merryman, involves a circular flow of funds among related entities -- Dow and its subsidiaries. As described in detail above, Dow would make a payment, royalty or rental, to Chemtech, and would then receive a loan in return from CPI for a substantial portion of the original payment. The cash flowed out, and flowed back in to Dow.

The allocation of risks and losses in Chemtech is another factor which leads this Court to conclude there was no true partnership. A partner whose risks are all insured at the expense of another partner "hardly fits within the traditional notion of a partnership."¹¹⁹ A valid partnership is not formed where, among other things, one partner receives a guaranteed, specific return.¹²⁰

While the foreign banks in Chemtech I, and RBDC in Chemtech II, faced some risks, they were not like the risks of a true partner or entrepreneur, who "puts money into a venture with the hope that it might grow in amount but with the knowledge that it may well shrink."¹²¹ The banks were extremely concerned about any downside exposure, but, in the end, they viewed their investment as safer than an ordinary secured loan. Any hope that the venture with Dow might grow was illusory: the partnership agreement allocated 99% of any growth to Dow. In addition, when the foreign banks and Dow disputed the mark-to-market gain of the value of the patents in Chemtech I, Dow called the foreign banks "greedy" when they attempted to collect on the possibility of their 1% gain. Dow then directed the banks' attention to definitions in the partnership agreement that required the use of a methodology that, in the banks' opinion, did not lead to a true determination of the remaining patents' fair market value.

It is clear to this Court that, viewing the Chemtech transactions in their totality, the agreements between Dow and the foreign banks did not form true partnerships because they lacked a true "business purpose" as required by Culbertson.

C. The foreign banks were not true partners

In Part B, the Court disregarded the entire Chemtech partnerships as shams. In this section, the Court also concludes that the foreign banks also were not partners for tax purposes. As discussed at length in the findings of fact, the foreign banks' interests were in the nature of debt, not equity.

In applying the Culbertson test, the Second Circuit noted, "consideration [of] whether an interest has the prevailing character of debt or equity can be helpful in analyzing whether, for tax purposes, the interest should be deemed a bona fide equity participation in a partnership."¹²² "It is often said that the essential difference between a creditor and a stockholder is that the latter intends to make an investment and take the risks of the venture, while the former seeks a definite obligation, payable in any event."¹²³

In Castle Harbour II, the Second Circuit had before it a different version of the SLIPs transaction created by Babcock & Brown, a global investment firm based in Australia that has since gone into liquidation. The foreign banks in Castle Harbour II had "no meaningful risk of being paid anything less than the reimbursement of their investment at the Applicable Rate of return."¹²⁴ So too here. Indeed, this is not the only similarity the banks in the instant case share with those in Castle Harbour II: "(1) They were promised the reimbursement, on a previously agreed schedule, of their initial investment at an agreed annual rate of return; (2) their repayment was secured by [a] guaranty; (3) they were fully protected against risk of loss, except as to a tiny amount in highly unlikely circumstances . . ."¹²⁵

The banks were essentially guaranteed a return on their investment, and the actual operations of Chemtech support what was reasonably anticipated at the beginning of the deal: The banks received their guaranteed return, and the partnership never came close to being unable to make that return. For their contribution to Chemtech, the banks were guaranteed a return just under 7% each year. Goldman and Dow worked together to ensure the banks' risk of loss would be de minimis. Early in the development of Chemtech, Dow proposed changes to the SLIPs transaction to reduce its potential exposure. Goldman balked at this suggestion, noting that the banks must be convinced of "the immateriality of the [possibility] of the 1% loss [ ]."¹²⁶

Insofar as any "equity-like" distribution, or the possibility thereof, such a distribution was not meaningful when compared to the guaranteed return on the investment. And, as previously discussed, Dow took steps to deny the banks their equity-like return, although it was only 1% of any growth in value. Dow retained the remaining 99%.

The only risk to the banks that posed any real threat was the I.R.S., which could see through the Chemtech scheme and pursue the foreign banks for taxes. However, the foreign banks were protected against this risk because Dow provided the banks with an indemnity agreement should such a situation occur. In the findings of fact above, the Court has laid out many more factors that support the conclusion that the banks' interest in the Chemtech schemes was not an equity interest. The foreign banks, therefore, were not partners in Chemtech for tax purposes.

D. The Court Declines to Reach Other Arguments

The United States submitted several other arguments in support of the FPAA. The Court declines to address those arguments as the theories discussed in this ruling are sufficient to disregard the Chemtech transactions and partnerships for tax purposes.

E. Penalties

Congress designed accuracy-related penalties in order to provide a "downside risk" to tax avoidance schemes.¹²⁷ Without accuracy-related penalties

Section 6662 of the Internal Revenue Code imposes a penalty equal to 20% of the portion of any underpayment of tax attributable to one or more of the following: (i) negligence; (ii) substantial understatement of income tax; and (iii) substantial valuation misstatement.¹²⁹ The valuation-misstatement penalty is increased to 40% in the case of a gross valuation misstatement.¹³⁰ The Internal Revenue Service determined that each of the above penalties applies to the Chemtech transactions. For Chemtech II, the IRS determined that all penalties applied. For Chemtech I, the IRS determined that only two of the penalties, the 20% negligence penalty and the 20% substantial understatement penalty, applied. Penalties under section 6662 are applied alternatively, not cumulatively. They are not stacked, so the maximum penalty is either 20% or 40% of the underpayment of tax, even if an underpayment is attributable to more than one type of misconduct.¹³¹

The issue of penalties is governed by TEFRA, 26 U.S.C. §§ 6221-33. Under TEFRA, "the tax treatment of any partnership item (and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item) shall be determined at the partnership level."¹³² The scope of judicial review is set forth as follows:

However, positions in a tax return that have a reasonable basis are not attributable to negligence.¹³⁷ "Reasonable basis" is a significantly higher standard than "not frivolous" or "not patently improper;" it cannot be a merely arguable or merely colorable claim.¹³⁸ "Reasonable basis" requires reliance on legal authorities and not on opinions rendered by tax professionals.¹³⁹

The applicability of the negligence penalty depends upon the conduct of the partnership, their managing members, and the other parties.¹⁴⁰ Therefore, in determining whether the negligence penalty is applicable, the Court must evaluate whether, with respect to the Chemtech transactions, Dow, which controlled Chemtech I and II, and the general partners and tax matters partners of both, exercised ordinary and reasonable care in the preparation of the partnership returns and that it made a reasonable attempt to comply with the provisions of the Code.

As discussed earlier, through the Chemtech I scheme, Dow claimed hundreds of millions of dollars of deductions for royalty payments made to use its own patents. Through Chemtech II, Dow claimed depreciation deductions using $360 million of artificial basis for a chemical plant that had already been depreciated (in addition to millions of dollars of deductions for payment made to "lease" its own chemical plant). These artificial tax benefits would seem "too good to be true" to a reasonable and prudent person, let alone to a highly sophisticated Fortune 100 company and its numerous lawyers and tax professionals.

Dow was aware that the tax benefits of Chemtech I and II could be disregarded under various judicial doctrines and principles of debt and equity. Andrews & Kurth, the law firm that helped develop SLIPs, wrote a lengthy memorandum describing these and other issues at the outset of the transactions.¹⁴¹ The constant refrain of business objectives is contrived, and wholly consistent with what Andrews & Kurth told Goldman Employees who developed SLIPs -- that a business purpose was needed in order for the transaction to work.

Additionally, an internal Dow memorandum and notes discussing the transition from Chemtech I to Chemtech II confirms Dow's tax motive behind Chemtech.¹⁴² As explained earlier, in May 1998, Dow recognized that if CPI's assets were considered "marketable securities" for the purposes of section 731, the transition from Chemtech I to Chemtech II would trigger a tax under that statute. Even though Dow knew that CPI's assets were in fact "currently marketable," it decided to "[e]xchange these marketable securities for a deeply subordinated 33-year note." No business purpose whatsoever for exchanging the Dow demand notes for a 33-year term note was asserted. It was only to avoid the tax under § 731. Notably, a few months later Dow characterized the "marketable security" matter as "the most important aspect" of its Chemtech II tax shelter.¹⁴³

The Dow memorandum also described the process in Chemtech II that led to Rabo being given an equity-like aspect to its agreement to participate in the transaction: "In order to get equity treatment, [Rabo] had to have both equity upside and downside risk. This was accomplished by having them participate in the FMV mark-to-market on the partnership assets upon a liquidation."¹⁴⁴ This all but confirms that the mark-to-market gain was nothing but window dressing, or "a disguise for concealing [the transaction's] real character."¹⁴⁵

In a 1999 report, the Staff of the Joint Committee on Taxation noted several factors behind the tax shelter problem:

The Court concludes that the "negligence or disregard of rules or regulations" penalty of 26 U.S.C. § 6662(a) and (b)(1) therefore applies to Chemtech I for the 1997 tax year, and to Chemtech II for the 1998-2003 tax years.

The calculations necessary to determine the amount of an understatement are conducted at the partner level.¹⁵⁰ However, to the extent the tax treatment at issue was claimed by the partnership, certain factual determinations that may affect whether a reduction in any understatement is warranted for the reasons set forth in 26 U.S.C. § 6662(d)(2)(B) can be conducted at the partnership level. Under that section, a reduction in the amount of an understatement of tax may be allowed if (1) the tax treatment claimed is based upon "substantial authority" or (2) if the taxpayer demonstrates a "reasonable basis" for the tax treatment claimed and "the relevant facts affecting the item's tax treatment are adequately disclosed in the return or in a statement attached to the return." However, that relief is unavailable where the understatement is "attributable to a tax shelter."¹⁵¹

The types of authorities to be considered include the Internal Revenue Code, as well as other statutory provisions, Treasury regulations, revenue filings and the like; case law; congressional intent; and other IRS memoranda, notices, and publications.¹⁵⁵ Opinions rendered by tax professionals are not considered authority.¹⁵⁶

The Court finds there was not substantial authority for the positions taken by Dow in the Chemtech transactions. The Court has already held the Chemtech transactions lack any underlying economic substance, and were entered into solely for the purpose of creating tax benefits. As such, the facts of this case fall in line with cases from other circuits and courts where a finding of no substantial authority accompanied a finding of lack of economic substance.¹⁵⁷

During the Chemtech I years, a tax shelter was defined as a partnership, entity, plan, or arrangement "if the principal purpose of the entity, plan or arrangement, based on objective evidence, is to avoid or evade Federal income tax."¹⁶⁰ The principal purpose is tax avoidance or evasion "if that purpose exceeds any other purpose."¹⁶¹ The Court has already determined the principal purpose of the Chemtech transactions was tax avoidance. Therefore, they are tax shelters within the meaning of the Treasury Regulations, and Dow is not entitled to rely on the substantial authority exception for the applicable periods.

A gross-valuation misstatement exists if the value or adjusted basis of property claimed on the return is 400% more than the amount determined to be the correct amount of such value or adjusted basis.¹⁶⁴ No valuation misstatement penalty may be imposed "unless the portion of the underpayment for the taxable year attributable to substantial valuation misstatements under chapter 1 exceeds $5,000."¹⁶⁵

The Fifth Circuit, in Todd v. Comm'r¹⁶⁶ and Heasley v. Comm'r,¹⁶⁷ held that a valuation misstatement penalty is not applicable where an entire transaction is disregarded under the economic substance doctrine.¹⁶⁸ In other words, these penalties are not applicable if the IRS's disallowance of tax benefits is not "attributable to" a valuation misstatement.¹⁶⁹ In Todd, the Fifth Circuit held that because deductions and credits were disallowed for a reason totally unrelated to any valuation overstatement, the resulting underpayment could not be "attributable to a valuation overstatement" and misstatement penalties therefore should not apply.¹⁷⁰ In Heasley, the taxpayers did not dispute the disallowance of their advanced rental deductions and investment tax credits claimed with respect to leased energy savings units, but did dispute their liability for the over-valuation penalty.¹⁷¹ Relying on its holding in Todd, the Fifth Circuit in Heasley announced the following rule:

The Government contends that the Heasley rule does not apply in the instant case for two reasons. First, the Government argues that because the IRS's rejection of the Chemtech II scheme will not disallow all of Dow's basis in the chemical plant, but only the "artificial portion" of the basis, the Heasley rule does not apply. However, this distinction has no merit. While the FPAA would not disallow all of Dow's basis in the chemical plant, it would disallow the entirety of the basis created by the Chemtech II transaction via the 754 election discussed earlier. Therefore, the Heasley rule does apply in this case, and the gross valuation misstatement penalty is not appropriate.

Second, the Government argues that the Heasley rule does not apply because of regulations promulgated subsequent to Heasley to which the Court is required to defer. Specifically, the Government asserts that Treasury Regulation § 1.6662-5(g) mandates a finding that, when basis is reduced to zero, the deemed valuation misstatement is automatically considered a gross valuation misstatement. The Court is not persuaded by this argument, just as the Fifth Circuit was not when it said, "[T]he regulation does not purport to negate the holdings in the [Todd/Heasley line of cases] -- that the valuation misstatement penalty does not apply when the IRS completely disallows a deduction on other grounds. It only helps determine whether a valuation misstatement is a gross misstatement."¹⁷⁴ In other words, the regulation does not change the character of the grounds for disallowance, but only helps clarify the degree of a particular ground: a valuation misstatement.

In sum, the Court determines that a 20% penalty for negligence and substantial understatement is appropriate in the instant case. Neither the 20% nor the 40% penalty for valuation misstatement is appropriate. The penalties are not cumulative, so a total penalty of 20% is appropriate.

Baton Rouge, Louisiana, February 26, 2013.

² OBSF is "the structuring of debt, financial instruments, business transactions, guarantees, sale of assets, and other financial activities such that these items are not included on the balance sheet of the firm." Elwin Ray Rogers and Grant Lindstrom, Ethical Implications of Off-Balance-Sheet Financing, BUS. & PROF. ETHICS J., vol. 15, no. 2, 19-32 (1996).

³ Joint Exhibit 7, at Bates 70679.

⁴ Dow does not rely on the opinion of Andrews & Kurth in this case, and the Court does not take it into consideration in this opinion.

⁵ Joint Exhibit 22.

⁶ Joint Exhibit 22.

⁷ Joint Exhibit 22.

⁸ Joint Exhibit 23. (emphasis removed)

⁹ Stern defined a "defensive patent" as one Dow did not use in practice, but increased the value of the patents Dow did in fact use.

¹⁰ Trial Transcript vol. 4, at 27.

¹¹ Such a lease makes the lessee (Dow) responsible for all of the costs relating to the assets (patents) being leased in addition to the rent fee.

¹² Report of Joel Finard, United States' expert on capital markets and structured transactions, at pp. 13-14.

¹³ The presentation materials stated the following:

¹⁴See infra, at 7.

¹⁵ The parties dispute whether this investment was debt or equity. That issue will be addressed in the conclusions of law, infra.

¹⁶ Joint Financial Stipulations, Exhibit D. In addition to the cash received from Dow, Chemtech and its subsidiary, CPI, also received interest and dividend income generated by its portfolio, which included mostly marketable securities. Joint Exhibit 326, at Bates 5570. CPI paid taxes on this income, and the excess was distributed back to Dow, resulting in more cash flowing back to Dow during the operating years than Dow paid to Chemtech.

¹⁷ Including subsidiaries Dow Chemical International, Ltd. (DCIL), Dow Europe, S.A. (DESA), and Diamond Technology Partnership Corporation (DTPC).

¹⁸ The numbers each year do not zero-out. This is a result of additional income of CPI, Chemtech's subsidiary. For an explanation, see note 12, infra.

¹⁹ Treasury Decision 8722, Temp. Reg. § 1.894-1(d).

²⁰ Joint Exhibit 513.

²¹ Joint Exhibit 513. In this exhibit, Chemtech advised the foreign banks that "[u]nder the new regulations, the withholding tax applies unless Chemtech is treated as a flow through entity in the country of residence of each Partner."

²² Treasury Decision 8722.

²³ Treasury Decision 8722.

²⁴ Joint Exhibit 528. The banks "expressed regret" at the termination of the transaction, and two in particular, Kredietbank and Dresdner, expressed an interest in being invited again if Dow ever entered into a similar transaction.

²⁵ Not all funds were received on March 27, but that was the termination date of the banks' interest in Chemtech I.

²⁶ Ifco was a limited partner in Chemtech I prior to the involvement of the foreign banks, at which time it exited the partnership.

²⁷ Joint Exhibit 678, at Bates 4064.

²⁸ Joint Exhibit 710. The law firm of King & Spalding was also involved in the structuring of the Chemtech I transaction.

²⁹ Joint Exhibit 710, at Bates 83153. For funding transactions, Dow would typically analyze the financial aspects of the transaction, then consider tax and legal consequences, and finally make a decision based on those factors. Net present value calculations were typically done in structured financing transactions.

³⁰ Joint Exhibit 523.

³¹ United States Exhibit 15.

³²Id.

³³ Joint Exhibit 607

³⁴Id. at Bates 83153.

³⁵ An internal memorandum states, "The most important aspect of the 754 election was that the assets in CPI be non-marketable." Id.

³⁶Id.

³⁷ Joint Exhibit 705.

³⁸ DCDC was, until that time, a dormant wholly owned subsidiary of Dow.

³⁹ Rabobank was one of the five foreign banks invested in Chemtech I.

⁴⁰ A Credit Default Swap guarantees the purchaser protection in case the seller defaults or goes into bankruptcy.

⁴¹ Joint Exhibit 824.

⁴² Joint Exhibit 710. The CPI stock had a large basis as a result of the contributions that Chemtech made to CPI, described above.

⁴³ After 1999, rental payments increased because plant expansion required a higher rental value.

⁴⁴ Trial Transcript vol. 5, at 13.

⁴⁵Id. at 14.

⁴⁶ Report of Dr. Glen Hubbard, at 17.

⁴⁷ United States' Post Trial Brief, at 19. (emphasis added)

⁴⁸ Andrews & Kurth was involved in the SLIPs transaction at the very beginning, meeting with employees from Goldman Sachs to ensure the product would be declared legitimate under then-existing law.

⁴⁹ Joint Exhibit 14, at Bates 70443.

⁵⁰ Joint Exhibit 77.

⁵¹ Deposition of Patrick Mcguire, at 14-15.

⁵² United States Exhibit D2.

⁵³ Joint Exhibit 856, at Bates 8703.

⁵⁴ Erickson is a professor at the University of Chicago.

⁵⁵ Trial Transcript vol. 3, at 166-92.

⁵⁶ Courts have noted that "Congress appears to have intended that the 'significant factor' in differentiating between the two [debt and equity] be whether 'the funds were advanced with reasonable expectations of repayment regardless of the success of the venture or were placed at the risk of business." Castle Harbour II, 459 F.3d at 232 (2d. Cir. 2009) (quoting Gilbert v. Comm'r, 248 F.2d 399 (2d Cir. 1957).

⁵⁷ United States Exhibit D33.

⁵⁸ Deposition of Andrew Sherman, at 116-18.

⁵⁹ Joint Exhibit 22; Report of Dr. Glen Hubbard, at 35.

⁶⁰ Joint Exhibit 2L, at Bates 36541.

⁶¹ As for the first loan from Chemtech to Dow, totaling $99 million, an assistant controller at Dow testified that she thought it was invested in the various financial needs of the company.

⁶² Rebuttal Report of Dr. Glen Hubbard, at 20 (quoting Standard & Poor's Debt Rating, S&P's corporate Finance Criteria, 1992, at 63, 67).

⁶³ Report of Merle Erickson, at 70-83.

⁶⁴ Hubbard Rebuttal Report, at 35 (quoting S&P 1992 Corporate Finance Criteria).

⁶⁵Trans-Serve, Inc. v. United States, 2006 WL 2588008, *6 (W.D. La. 2006).

⁶⁶Commissioner v. Newman, 159 F.2d 848, 850-51 (2d Cir. 1947) (L. Hand, J. dissenting), cert. denied, 331 U.S. 859 (1947).

⁶⁷Gregory v. Helvering, 293 U.S. 465 (1935).

⁶⁸Id. at 468.

⁶⁹In re CM Holdings, Inc., 301 F.3d 96, 106 (3d Cir. 2002).

⁷⁰ 293 U.S. 465 (1935).

⁷¹Estate of Weinert v. Comm'r, 294 F.2d 750, 755 (5th Cir. 1961).

⁷²Id. (quoting Comm'r v. Southwest Exploration Co., 350 U.S. 308, 315 (1956)).

⁷³ H.R. Rep. No. 111-443, at 295.

⁷⁴ASA Investerings Partnership v. Comm'r, 201 F.3d 505, 513 (D.C. Cir. 2000).

⁷⁵Id.

⁷⁶Southgate Master Fund, LLC, ex rel. Montgomery Capital Advisors, LLC v. United States, 659 F.3d 466, 479 (5th Cir. 2011) (quoting Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006)).

⁷⁷Boynton v. Comm'r, 649 F.2d 1168 (5th Cir. 1981).

⁷⁸Am. Elec. Power Co. v. United States, 326 F.3d 737, 741 (6th Cir. 2003).

⁷⁹Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1978).

⁸⁰Klamath Strategic Investment Fund ex rel St. Croix Ventures v. United States, 568 F.3d 537, 544 (5th Cir. 2009).

⁸¹Id.

⁸²Southgate Master Fund, LLC ex rel Montgomery Capital Advisers, LLC v. United States, 651 F. Supp. 2d 596, 654 (N.D. Texas 2009), aff'd, 659 F.3d 466 (5th Cir. 2011).

⁸³Klamath, 568 F.3d at 545.

⁸⁴Id. at 543 (citing Higgins v. Smith, 308 U.S. 473, 476 (1940)).

⁸⁵Southgate, 651 F. Supp. 2d at 654 (quoting Weller v. Comm'r, 270 F.2d 294, 297 (3d cir. 1959)).

⁸⁶Coltec Industries v. United States, 454 F.3d at 1355 (Fed. Cir. 2006). See also United Parcel Serv. Of Am., Inc. v. Comm'r, 254 F.3d 1014, 1018 (11th Cir. 2001); ACM Partnership v. Comm'r, 157 F.3d 231, 247 (3d Cir. 1998); James v. Comm'r, 899 F.2d 905, 908-09 (10th Cir. 1990)).

⁸⁷ Trial Transcript vol. 5, at 17, 151.

⁸⁸See id. at 15; Defendant's Exhibit 5, at 34-43.

⁸⁹Coltec, 454 F.3d at 1356-57.

⁹⁰In re CM Holdings, Inc., 301 F.3d 96, 103 (3d Cir. 2002).

⁹¹Southgate, 659 F.3d at 481.

⁹² 435 U.S. at 584.

⁹³Coltec, 454 F.3d at 1355.

⁹⁴See Frank Lyon, 435 U.S. at 580 ("The fact that favorable tax consequences were taken into account . . . on entering into the transaction is no reason for disallowing those consequences. We cannot ignore the reality that the tax laws affect the shape of nearly every business transaction.")

⁹⁵ASA Investerings, 201 F.3d at 513.

⁹⁶Coltec, 454 F.3d at 1355-56.

⁹⁷See id. at 1364.

⁹⁸Nevada Partners Fund, LLC ex rel Sapphire II, Inc. v. United States, 714 F. Supp. 2d 598, 632 (S.D. Miss. 2010).

⁹⁹See In re CM Holdings, 301 F.3d at 107.

¹⁰⁰Haberman Farms Inc. v. United States, 305 F.2d 787, 793 (8th Cir. 1962).

¹⁰¹ Trial Transcript vol. 1, at 224, 242.

¹⁰²Id. at 251-54.

¹⁰³ Trial Transcript vol. 2, at 45-47.

¹⁰⁴Comm'r v. Culbertson, 337 U.S. 733, 741 (1949).

¹⁰⁵TIFD III-E, Inc. v. United States (Castle Harbor II), 459 F.3d 220, 232 (2d Cir. 2006).

¹⁰⁶Culbertson, 337 U.S. at 742.

¹⁰⁷Id.

¹⁰⁸Merryman v. Comm'r, 873 F.2d 879, 881 (5th Cir. 1989) (citing Halladay v. Comm'r, 649 F.2d 1176, 1179 (5th Cir. 1981)).

¹⁰⁹Southgate, 659 F.3d at 484 (citing Castle Harbour II, 459 F.3d at 231).

¹¹⁰Id.

¹¹¹Merryman, 873 F.2d at 881.

¹¹²Southgate, 659 F.3d at 484.

¹¹³ 319 U.S. 436 (1943).

¹¹⁴Id.

¹¹⁵ 659 F.3d at 484 n.64.

¹¹⁶ASA Investerings, 201 F.3d at 512 (citing Knetsch v. United States, 364 U.S. 361, 364-66 (1960)).

¹¹⁷ Joint Exhibits 213, 265, 343, 446, 632.

¹¹⁸Merryman, 873 F.2d at 882.

¹¹⁹ASA Investerings, 201 F.3d at 515.

¹²⁰Saba Partnership v. Comm'r, 273 F.3d 1135, 1141 (D.C. Cir. 2001).

¹²¹Virginia Historic Tax Credit v. Comm'r, 639 F.3d 129, 145-46 (4th Cir. 2011).

¹²²Castle Harbour II, 459 F.3d at 232.

¹²³Comm'r v. Meridian & Thirteen R. Co., 132 F.2d 182, 186 (7th Cir. 1942).

¹²⁴ 459 F.3d at 233.

¹²⁵Id. at 229.

¹²⁶ Joint Exhibit 23, at Bates 70909.

¹²⁷ S. Rep. No. 97-494, at 272-73 (1982).

¹²⁸Id.

¹²⁹ 26 U.S.C. § 6662(b)(1-3), (h).

¹³⁰Id. § 6662(h)(1).

¹³¹ Treas. Reg. § 1.6662(c).

¹³² 26 U.S.C. § 6221.

¹³³Id. § 6226(f).

¹³⁴Klamath, 568 F.3d at 547.

¹³⁵ 26 U.S.C. 6662(c).

¹³⁶ Treas. Reg. § 1.6662-3(b)(1)(ii). See Neonatology Associates, P.A. v. Comm'r, 299 F.3d 221, 234 (3d Cir. 2002) ("When . . . a taxpayer is presented with what would appear to be a fabulous opportunity to avoid tax obligations, he should recognize that he proceeds at his own peril.")

¹³⁷ Treas. Reg. § 1.6662-3(b)(1)(ii).

¹³⁸Id. § 1.6662-3(b)(3).

¹³⁹Id. § 1.6662-4(d)(2).

¹⁴⁰Jade Trading, LLC v. United States, 80 Fed. Cl. 11, 55 (Fed. Cl. 2007), aff'd in part, vacated in part, rev'd in part on other grounds, Jade Trading LLC ex rel Ervin v. United States, 598 F.3d 1372 (Fed. Cir. 2010); accord Klamath, 568 F.3d 537, 548 (considering reasonable cause and good faith defense at partnership level by looking to actions of managing members).

¹⁴¹ Joint Exhibit 14.

¹⁴² Joint Exhibit 710; United States Exhibit 15.

¹⁴³ Joint Exhibit 710, at Bates 83153.

¹⁴⁴ Joint Exhibit 710, at Bates 83153-54.

¹⁴⁵Gregory, 293 U.S. at 469.

¹⁴⁶ Staff, Joint Committee on Taxation, Study of Present-Law Penalty and Interest Provisions as Required by Section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998 (Including Provisions Relating to Corporate Tax Shelters), Vol. I at 221 (July 22, 1999). Also in this report, the Staff of the Joint committee identifies several common characteristics of corporate tax shelters. These characteristics include: (a) an insignificant pretax profit in comparison to tax benefits; (b) the involvement of a tax-indifferent participant to "absorb" the undesirable tax consequences without suffering any adverse economic consequences from the arrangement (i.e., tax income materially in excess of economic income); and (c) the use of guarantees, tax indemnities, or similar arrangements designed to recompense the corporate participant in the event that it is not entitled to all or any portion of the anticipated tax benefits. Id. at 220-21. Each of these characteristics is present in the Chemtech transactions.

¹⁴⁷ Joint Exhibit 19, at Bates 70472.

¹⁴⁸ 26 U.S.C. § 6662(b)(2).

¹⁴⁹Id. § 6662(d)(1).

¹⁵⁰ Treas. Reg. § 301.6221-1(d).

¹⁵¹ 26 U.S.C. § 6662(d)(2)(C).

¹⁵² Treas. Reg. § 1.6662-4(d)(3)(i).

¹⁵³Id. § 1.6662-4(d)(2).

¹⁵⁴Id.

¹⁵⁵Id. § 1.6662-4(d)(3)(iii).

¹⁵⁶Id.

¹⁵⁷See Castle Harbour III, 666 F.3d 836, 848-50 (2d Cir. 2012); Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122, 204-05 (D. Conn. 2004); Santa Monica Pictures, LLC v. Comm'r, T.C. Memo 2005-104, 2005 WL 1111792, at *100-01.

¹⁵⁸ Treas. Reg. § 1.6662-4(g)(i).

¹⁵⁹ Pub. L. No. 108-357, § 812(d).

¹⁶⁰ Treas. Reg. § 1.6662-4(g)(i)(A) (1997).

¹⁶¹Id.

¹⁶² 26 U.S.C. § 6662(b)(3).

¹⁶³Id. § 6662(h)(1).

¹⁶⁴See 26 U.S.C. § 6662(a), (b)(3), (e)(2), (h)(1-2).

¹⁶⁵Id. § 6662(e)(2). (emphasis added)

¹⁶⁶ 862 F.2d 540 (5th cir. 1988).

¹⁶⁷ 902 F.2d 380 (5th Cir. 1990).

¹⁶⁸See Todd, 862 F.2d at 541-42; Heasley, 902 F.2d at 382-83.

¹⁶⁹Southgate, 651 F. Supp. 2d. at 664, aff'd, 659 F.3d 466 (5th Cir. 2011) (quoting Klamath 472 F. Supp. 2d at 899-900, aff'd in, part, 568 F.3d at 553 (holding that a disallowance was not "attributable to" a valuation misstatement when the IRS disallowed a transaction as lacking economic substance)).

¹⁷⁰Todd, 862 F.2d at 542.

¹⁷¹ 902 F.2d at 380.

¹⁷²Id. at 383. (emphasis added)

¹⁷³See, e.g., Weiner v. United States, 389 F.3d 152 (5th Cir. 2004); Bemont Investments, LLC ex rel Tax Matters Partner v. United States, 679 F.3d 339 (5th Cir. 2012).

¹⁷⁴Bemont, 679 F.3d at 348 n.5.

¹⁷⁵ 26 U.S.C. § 6664(c).

¹⁷⁶ Treas. Reg. § 301.6221-1(c).

¹⁷⁷Klamath, 568 F.3d at 548.