New York Law Journal: Disputes and Consequences

By Jeffrey A. Galant

Well-settled in the tax law is the notion that the character of amounts received in the settlement of a claim turns on the underlying nature of the claim. See Lyeth v. Hoey, 305 U.S. 188 (1930) and its progeny. The same holds true in characterizing amounts paid in settlements and is sometimes referred to as the “origin of the claim doctrine.” See, e.g., United States v. Gilmore, 372 U.S. 39 (1963), Woodland v. Commissioner, 397 U.S. 572 (1970), United States v. Hilton Hotels Corp., 397 U.S. 580 (1970). The payment in Lyeth,made in settlement of an heir’s claim against his grandmother’s Will, was held to be exempt from income tax as an inheritance for tax purposes. The payments in the Gilmore, Woodland and Hilton Hotel Corp. cases broadly concerned whether they were deductible for tax purposes by the payor as “ordinary and necessary . . . expenses” with the result in each case based upon an analysis of the underlying claims.

Brass Tacks

What if the settlement encompasses a sale or exchange of property? When does a sale or exchange occur for federal income tax purposes? A “sale” is generally defined as a transfer of property for money or a promise to pay money. Commissioner v. Brown, 380 U.S. 563, 571 (1965). However, taking a closer look as to whether a sale occurred, the substance rather than the form of the transaction controls. Frank Lyon Co. v. United States, 435 U.S. 561, 572-573 (1978). Thus, in determining whether ownership has been transferred, there must be a factual inquiry into which party has ended up with both the benefits and the burdens of ownership.

The foregoing frames the basic question and is a corollary of the fundamental tax principle articulated many moons ago by the US Supreme Court in Corliss v. Bowers, 281 U.S. 376 (1930) at 378, as follows: “Taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed – the actual benefit for which the tax is paid.”               

The Berwind Cases and Section 483

Of recent vintage, the Berwind cases reflect two sides of the same story. The cases are Charles G. Berwind Trust for David M. Berwind,, T.C. Memo 2023-146 (referred to as “Berwind” and the petitioner therein is referred to as “David’s Trust”) and Colorcon, Inc. v. United States, 110 Fed. Cl. 650 (2013) (referred to as “Colorcon” and the plaintiff therein is referred to as “BPSI”). These cases concern the seemingly simple question of when a sale of property occurs, or more precisely, when a “sale or exchange” of property occurs within the meaning of Section 483 of the Internal Revenue Code.

To refresh our tax knowledge, Section 483, a section imbued with time value of money concepts, requires characterizing as interest for federal tax purposes that portion of a deferred payment which is made pursuant to a contract for the sale or exchange of property that consists of “total unstated interest” as calculated under Section 483.

Tax symmetry and whipsaw come to mind when analyzing the respective outcomes for David’s Trust and BPSI due to BPSI paying David’s Trust approximately $191 million in exchange for 16.4% of BPSI common stock. But first let us briefly examine the history.

The Berwind Story

Founded in 1883, the Berwind Corporation, a highly successful privately owned family business in Pennsylvania, began in the coal mining industry and eventually diversified into pharmaceutical and health related industries. By the 1960s, Charles Berwind was in control of the family enterprise. In 1963, Charles established separate trusts for his four children, and transferred 28% of the outstanding shares of Berwind Corporation to the trust for his son Graham, the heir apparent, and 24% of the Berwind shares to each of the trusts for his remaining children, namely, daughters Margaret and Emery, and son David.

Not to get too bogged down in the details of the ensuing family saga, suffice it to say that by 1999, Graham and his trust managed to gain control of the Berwind Corporation and its affiliates. By that time, David’s Trust no longer had an interest in the Berwind Corporation but did own 16.4% of the common stock of BPSI, an important subsidiary of the Berwind Corporation. David, having sought his fortune elsewhere, and never having participated in the family business, was apparently content with selling the BPSI common stock. Thus, David’s Trust was looking to be bought out at a fair price, and Graham, his Trust and the Berwind Corporation were interested in acquiring the stock.

“This is a dispute between two brothers over ownership and control of a pharmaceutical company.” Scirica, Circuit Judge, Warden v. McLelland, 288 F. 3d 105 (3rd Cir. 2002).

Things did not go smoothly between the brothers, et. al., and as a result Graham and the Berwind Corporation, through its BPSI subsidiary, resorted to a so-called “squeeze-out merger” which eventually occurred in December 1999 pursuant to Pennsylvania law. The trustees of David’s Trust vigorously contested the validity of the merger in the federal district court in the eastern district of Pennsylvania and pursued dissenter’s rights in Pennsylvania state court.

The Settlement

To shorten a very long most likely very expensive and of course contentious story, in November of 2002, the parties agreed to a settlement basically acknowledging a sale by David’s Trust of its 16.4% common stock interest in BPSI to BPSI for approximately $191 million. However, according to the Tax Court, the settlement agreement did not state that the merger was invalid, nor did it expressly provide when the sale occurred, although it did acknowledge that the parties had differing views. This is the heart of the matter.

And we are getting closer to the meat of our story!

BPSI paid David’s Trust the approximate $191 million in late December 2002 in accordance with the settlement agreement. David’s Trust reported the transaction for federal income tax purposes, as a sale or exchange of the BPSI shares resulting from the settlement in 2002 and treated the receipt of the $191 million proceeds as capital in nature. BPSI, on the other hand, reported the transaction as a payment made in 2002 in accordance with a sale or exchange that resulted from the “squeeze-out merger” in 1999, and therefore deducted the imputed interest, calculated as required by Section 483, of approximately $31 million.

Imputation of Interest

To reiterate, Section 483 requires the imputation of total unstated interest when a deferred payment is made pursuant to a contract for the sale or exchange of property. Generally, any such interest would be includible in the recipient’s gross income and deductible by the payor.

The ultimate question was whether there was a deferred payment, and this of course required a determination of when the sale occurred. The government in Colorcon, and David’s Trust in Berwind, each argued that there was no deferred payment since the sale or exchange occurred in late 2002 when the parties settled, with the payment following shortly thereafter.

Not surprisingly, a different tact was taken by the government in Berwind where it mimicked BPSI’s position in Colorcon, to the effect that there was a deferred payment since the 2002 payment was made pursuant to the sale occurring in 1999, when the “squeeze-out merger” took place.

It is noteworthy that the Federal Claims Court and the Tax Court each held that Pennsylvania law applied for purposes of determining whether the merger was a “sale or exchange” for purposes of Section 483. Following precedent, including a quote from Lyeth v. Hoey, 305 U.S. 188 at 194, that “state law may control if [the] federal taxing act implicates a dependence on [the] operation of state law,” the two courts basically agreed that Pennsylvania law should apply to determine the meaning of “sale or exchange” since Section 483 did not expressly do so. Also noteworthy was the Tax Court’s assessment that although it was not bound by the Federal Claims Court’s decision in Colorcon, it found the court’s reasoning on various issues persuasive.

The Denouement

Presumably, to avoid being whipsawed, the IRS disallowed BPSI’s deduction for imputed interest, and included the imputed interest in the gross income of David’s Trust. BPSI paid the additional tax and sued the government in the U.S. Court of Federal Claims once its refund claim was denied. David’s trust, on the other hand, challenged the gross income inclusion of the imputed interest by petitioning the U.S. Tax Court.

In 2013, the U.S. Court of Federal Claims found in BPSI’s favor and against the government holding that there was a deferred payment since the sale occurred in 1999 upon the effectiveness of the merger and the payment was made later in 2002. In 2023, the U.S. Tax Court similarly held, in this case in the government’s favor and against David’s Trust, that the sale occurred in 1999 upon the merger. The upshot was that tax symmetry was maintained with the government avoiding whipsaw, due to the decisions of the respective courts that in 2002, David’s Trust had interest income of approximately $31 million and BPSI had an interest deduction of approximately $31 million.

Reprinted with permission from the New York Law Journal, An ALM Publication

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