Coltec Industries, Inc. v. United States

Error: Bad annotation destination
United States Court of Appeals for the Federal Circuit

05-5111

COLTEC INDUSTRIES, INC.,
Plaintiff-Appellee,

v.

UNITED STATES,

Defendant-Appellant.

Stephen D. Gardner, Kronish Lieb Weiner & Hellman LLP, of New York, New York,
argued for plaintiff-appellee. With him on the brief were William H. O’Brien, Ann-Elizabeth
Purintun, Stephen A. Wieder, and Clint E. Massengill.

Judith A. Hagley, Attorney, Tax Division, Appellate Section, United States
Department of Justice, of Washington, DC, argued for defendant-appellant. With her on
the brief were Eileen J. O’Connor, Assistant Attorney General; Richard T. Morrison,
Deputy Assistant Attorney General; Gilbert S. Rothenberg and Richard Farber, Attorneys.

Appealed from: United States Court of Federal Claims

Judge Susan G. Braden
 United States Court of Appeals for the Federal Circuit

05-5111

COLTEC INDUSTRIES, INC.,

Plaintiff-Appellee,

v.

UNITED STATES,

Defendant-Appellant.

___________________________

DECIDED: July 12, 2006
___________________________

Before BRYSON, GAJARSA, and DYK, Circuit Judges.

DYK, Circuit Judge.

In 1996, Coltec Industries, Inc. (“Coltec”) reported a capital loss of approximately

$378.7 million on its consolidated tax return. This loss was generated by Coltec’s

selling of high-basis stock for a relatively low price. The Internal Revenue Service

(“IRS”) disallowed the loss and assessed additional taxes. Coltec paid the assessment

and then filed a refund action for $82,803,049 in the United States Court of Federal

Claims. That court awarded Coltec a full refund. The United States appealed. We

conclude that, although Coltec’s claimed capital loss fell within the literal terms of the

statute, the transaction that created the high basis in the stock lacked economic

substance and therefore must be disregarded for tax purposes. We vacate and remand

for a recomputation of the allowable capital loss deduction.
 BACKGROUND

I

In 1996 Coltec was a publicly traded company with numerous subsidiaries. In

that year, Coltec sold one of its businesses, Holley Automotive, Inc., for a gain of

approximately $240.9 million. Coltec then met with its tax advisors at Arthur Andersen

LLP to discuss, among other things, strategies to offset this gain. Coltec Indus., Inc. v.

United States, 62 Fed. Cl. 716, 723 (2004). Arthur Andersen proposed a transaction

that had been used in the past to generate capital losses. The transaction essentially

involved three steps. First, the parent company would reorganize a dormant subsidiary

into a special purpose entity. Second, the parent would transfer property and

contingent liabilities to the newly reorganized subsidiary in exchange for stock in that

subsidiary. Finally, the parent would sell the stock to a third-party for a nominal sum.

The parent would treat its basis in the stock as equal to the property it transferred to the

subsidiary but not reduced by the liabilities the subsidiary assumed. The parent would

then suffer a significant loss from the sale of the stock because the sale price of the

stock would be drastically lower than its basis.

Coltec found Arthur Andersen’s proposal appealing. For one thing, Coltec had

contingent liabilities, namely asbestos liabilities, which were a prerequisite for this type

of transaction. For many years, asbestos was widely used in the manufacture of a

variety of products. Coltec, 62 Fed. Cl. at 718. Since the 1970s, however,

manufacturers and distributors of asbestos products have faced a flood of claims from

workers and other individuals who subsequently suffered from asbestos-related

diseases. Id. at 719. This growing asbestos litigation had enormous implications for

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manufacturers and distributors dealing in asbestos products, costing these companies

and their insurers billions of dollars and sending many into bankruptcy. Id. Coltec was

at risk from the asbestos problem, as one of its subsidiaries, Garlock, Inc. (“Garlock”)

and one of Garlock’s subsidiaries, Anchor Packing Company (“Anchor”) had both

previously manufactured or distributed asbestos products. Indeed, by the early 1990s,

Garlock and Anchor had been named defendants in 100,000 asbestos cases. Id. at

721. Corporate veil-piercing claims were not uncommon in asbestos cases.

Coltec decided to implement the Arthur Andersen proposal, and has admitted

that tax avoidance was one of its reasons for doing so. Coltec’s first step was to

rename one of its dormant subsidiaries, Pennsylvania Coal and Coke, Inc., the

“Garrison Litigation Management Group, Ltd.” (“Garrison”). Coltec caused Garrison to

issue 99,800 shares of common stock and 1,300,000 shares of Class A stock to Coltec

in exchange for a payment of $13,998,000. In a separate transaction, Garrison issued

100,000 shares of common stock to Garlock (representing approximately a 6.6%

interest in Garrison), and assumed all the managerial responsibilities for handling the

asbestos related claims against Garlock. Garrison also assumed, and agreed to

indemnify Garlock against, all losses and liabilities incurred in connection with asbestos-

related claims against Garlock.1 Garlock transferred to Garrison all outstanding Anchor

stock, certain records and insurance policies relating to asbestos liabilities, and

furniture. Garlock also transferred to Garrison a promissory note from one of its other

1
Garrison did not directly assume the asbestos liabilities of Anchor. However,
Garrison did agree to indemnify Garlock from all future asbestos-related claims, which
would include veil-piercing claims against Garlock based on Anchor’s asbestos
liabilities.

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subsidiaries, Stemco, Inc., in the amount of $375 million.2 Garlock agreed to advance

further funds as needed (up to $200 million) to cover Garrison’s capital needs.

Coltec explicitly admits that Garrison’s assumption of the asbestos liabilities was

in exchange for the Stemco note. Coltec’s Br. at 39 (“Garrison received the Stemco

note in exchange for assuming Garlock’s asbestos liabilities.”). In fact, the $375 million

amount was calculated to cover the estimated future asbestos liabilities of Garlock,

including the Anchor liabilities. Coltec obtained a range of liability estimates from the

combined work of two consulting firms. The consulting firms estimated the projected

gross future liabilities and the potential insurance coverage. One of the estimates

provided by the firms was $371.2 million, which Coltec deemed to be a “high” estimate

of the net future asbestos liabilities. Ultimately, the $375 million figure was adopted.

See J.A. at 2302 (memo from Arthur Andersen to Coltec stating “[t]he settlement,

judgment and litigation costs [of future asbestos related claims], net of [ ] assets and

insurance coverage are currently estimated to be $375 million”). Thus, Garrison

assumed responsibility for Garlock’s potential asbestos liabilities in exchange for a

promissory note in the amount of approximately $375 million.

The third and final step involved Garlock’s sale of its newly-acquired Garrison

stock. On December 20, 1996, as previously contemplated, Garlock sold all of its

2
Stemco was indebted to Garlock, but rather than have Stemco transfer the
promissory note directly to Garlock, Garlock had Stemco transfer the note to Garrison.
See J.A. at 7318-19; Coltec’s Br. at 51. The reason for utilizing a note from another
entity was so that Garlock’s basis in the note would be $375 million rather than zero. If
Garlock had issued its own promissory note to Garrison, then Garlock’s basis in that
note would be treated as zero by the IRS because Garlock incurred no cost in making
the note. See Boris I. Bittker & James S. Eustice, Federal Income Taxation of
Corporations and Shareholders, ¶ 3.06[4][b] at 3-35-3-36 & n.127 (7th ed. 2002).

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100,000 shares of Garrison stock to two banks for $500,000. The amount received was

only slightly greater than half the transaction costs for establishing Garrison. As a

condition of this sale, Coltec agreed to indemnify the banks against any veil-piercing

claims for asbestos liabilities. Coltec, after this transaction, continued to own 93% of

Garrison.3

In its consolidated tax return for 1996, Coltec asserted that Garlock’s basis in the

Garrison stock was $379.2 million (representing the $375 million Stemco note plus the

other property given to Garrison valued at approximately $4 million, but not reduced by

the liabilities assumed by Garrison). Thus Garlock claimed to suffer a $378.7 million

loss when it sold the stock for only $500,000. This $378.7 million loss more than offset

Coltec’s gains for that tax year. The unused loss was carried forward to offset gain in

future tax years. Significantly, the loss was recognized only for tax purposes and not for

book purposes, and the loss was not reported on the taxpayer’s public financial reports.

II

Understanding how tax benefits could be claimed to result from this three-step

transaction requires a review of the statutory scheme. It is undisputed that the

underlying transaction between Garlock and Garrison—which resulted in Garlock’s

claiming a high basis in the Garrison stock—is governed by 26 U.S.C. § 351. Section

351(a) provides that certain transactions that involve controlled corporations will be tax-

free. Specifically, when property is transferred to a controlled corporation solely in

3
Two years later, Coltec sold 45,000 of its Garrison shares to attorneys in
regional defense firms involved in asbestos litigation.

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exchange for stock in that corporation, then in general no gain or loss is immediately

recognized. 26 U.S.C. § 351(a) (1996).

The critical question here is the basis for the stock. In a simple property-for-stock

exchange under § 351, § 358(a)(1) provides that the transferor’s basis of the stock

received will be equal to the basis of the property transferred. 26 U.S.C. § 358(a)(1)

(1996). However, a transaction under § 351 can become more complicated if, for

example, in addition to receiving stock, “money” is also received from a controlled

corporation. In such cases, the transferor’s basis in the stock received is no longer

simply equal to the basis of property transferred. Instead, the transferor’s basis in the

stock received is equal to the basis of the property transferred decreased by the “money

received” by the transferor though increased by the amount of gain recognized. §

358(a)(1)(A). The central statutory dispute here is whether the assumption of Garlock’s

liabilities by Garrison constituted “money received” by Garlock. If it did, then Garlock’s

basis in the stock would have to be reduced by the amount of the liabilities assumed.

Under the tax code, “liabilities” that are assumed in a § 351 exchange generally

must be treated as “money received” by the transferor for basis purposes. 26 U.S.C. §§

358(a)(1)(A), 358(d)(1). However, § 358(d)(2) provides an exception to this general

rule, excluding as “money received” for basis calculation purposes “the amount of any

liability excluded under section 357(c)(3).” As will be explained in greater detail below,

Coltec’s primary theory is that Garlock did not have to decrease its basis in its Garrison

stock by the amount of liabilities Garrison assumed, because these liabilities fell under

the § 358(d)(2) exception and thus escaped “money received” treatment. On the other

hand, the government contends that the § 358(d)(2) exception is not available to Coltec.

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 III

Upon audit, the IRS disallowed the $378.7 million loss and assessed a tax liability

for the year 1996 in the amount of $82,708,152. Coltec paid the assessment and sued

for a refund in the Court of Federal Claims. The government contended that the loss

should be disallowed because Garlock was not entitled to the claimed basis for the

Garrison stock. The government offered three separate theories. First, the government

argued that the contingent asbestos liabilities were not excluded from “money received”

treatment by § 358(d)(2), because § 357(c)(3) was inapplicable, as it refers to liabilities

which would “give rise to a deduction” and the contingent liabilities here would not “give

rise to a deduction.” Second, the government argued that the transaction in which

Garlock transferred a $375 million note to Garrison in exchange for the assumption of

the asbestos liabilities had an improper purpose and should thus result in “money

received” treatment under the statutory anti-abuse provision.4 Finally, the government

argued that the transaction in which the note was exchanged for the liability assumption

should be disregarded under the general economic substance doctrine with the result

that the basis would not be increased by the amount of the Stemco note.

The Court of Federal Claims, after a bench trial, rejected the government’s three

arguments. The court held that the liabilities would “give rise to a deduction” under

4
The anti-abuse provision (26 U.S.C. § 357(b)(1)) provides:
(1) In general.--If, taking into consideration the nature of the liability and the
circumstances in the light of which the arrangement for the assumption or acquisition
was made, it appears that the principal purpose of the taxpayer with respect to the
assumption or acquisition described in subsection (a)—
(A) was a purpose to avoid Federal income tax on the exchange, or
(B) if not such purpose, was not a bona fide business purpose, then such assumption or
acquisition (in the total amount of the liability assumed or acquired pursuant to such

05-5111 7
§ 357(c)(3). See Coltec, 62 Fed. Cl. at 743-44.5 The court also determined that that

transaction should not result in “money received” treatment under § 357(b)(1), the

statutory anti-abuse provision, because the principal purpose of the transaction was not

tax avoidance; rather, it was a bona fide business purpose. Id. at 738-43. The Court of

Federal Claims finally rejected the government’s alternative argument under the general

economic substance doctrine, concluding that the doctrine was unconstitutional as a

violation of separation of powers. Id. at 756. The court went on to hold alternatively

that the doctrine did not apply to the present case because the transaction had a bona

fide business purpose. The government timely appealed. We have jurisdiction

pursuant to 28 U.S.C. § 1295(a)(3).

DISCUSSION

We find nothing in the literal terms of the statute that required Garlock to reduce

its basis in the stock by the amount of liabilities assumed by Garrison. However, we

conclude that the Court of Federal Claims erred in rejecting the long-standing economic

substance doctrine and in its application of that doctrine. The underlying transaction

between Garlock and Garrison, in which a $375 million note was transferred to Garrison

in exchange for the assumption of the contingent asbestos liabilities, had no meaningful

economic purpose, save the tax benefits to Coltec. As such, that transaction must be

ignored for tax purposes.

exchange) shall . . . be considered as money received by the taxpayer on the exchange.
5
As an alternative ground for allowing the loss, the Court of Federal Claims held
that Coltec was not required to reduce its basis in the stock by the amount of contingent
liabilities, because the events necessary to establish the fact of the liability had not yet
occurred. Coltec Indus., 62 Fed. Cl. at 737-38. The court thus determined that
“contingent liabilities” did not qualify as “liabilities” under § 358(d).

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 I

We turn first to the arguments based on the literal language of the code

provisions. Section 358(a) provides that the basis of the property received in a tax-free

exchange under § 351, i.e., the stock received by the transferor, “shall be the same as

that of the property exchanged . . . decreased by . . . the amount of any money received

by the taxpayer . . . .” 26 U.S.C. § 358(a) (emphasis added). Section 358(d)(1) further

provides:

In general.--Where, as part of the consideration to the taxpayer, another
party to the exchange assumed a liability of the taxpayer . . . such
assumption . . . (in the amount of the liability) shall, for purposes of this
section, be treated as money received by the taxpayer on the exchange.

§ 358(d)(1) (emphases added). Thus, a liability transferred by the taxpayer is generally

treated as “money received” when calculating the basis of the property received.

A

The Court of Federal Claims held that § 358(d) was inapplicable because

“contingent liabilities” are not “liabilities” under the statute. We disagree. The fact that

an obligation is contingent upon a particular condition (such as a successful suit in

court) does not make that obligation any less of a “liability.” Coltec argues that under

Brown v. Helvering, 291 U.S. 193 (1934), contingent liabilities are not considered as

liabilities for tax purposes. Brown and similar cases cited, in fact, assume that

contingent liabilities are liabilities and address when a taxpayer can deduct a liability for

income tax purposes, not whether a taxpayer who transfers a liability must adjust its

basis in the property it received. See Brown, 291 U.S. at 200-01; see also 26 C.F.R. §

1.461-1(a)(2)(i) (1996) (providing that a liability is “incurred” in the taxable year in which

all events have occurred to establish the fact of the liability).

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 It is widely recognized that when one party in an exchange assumes a contingent

liability of another party, that contingent liability, like all other liabilities, forms an integral

part of the purchase price in the exchange. See, e.g., Ill. Tool Works, Inc. v. Comm’r of

Internal Revenue, 355 F.3d 997, 1003 (7th Cir. 2004); Holdcroft Transp. Co. v. Comm’r

of Internal Revenue, 153 F.2d 323, 324 (8th Cir. 1946); cf. United States v. Smith, 418

F.2d 589, 592 (5th Cir. 1969). That a contingent liability assumed by the transferee

forms part of the purchase price paid by the transferee reveals that there is no

meaningful distinction between contingent and non-contingent liabilities with respect to

what is received (i.e., “money received”) by the transferor. We conclude that

“contingent” liabilities are “liabilities” under § 358(d). This conclusion is further

supported by leading tax commentators.6

6
Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations
and Shareholders (7th ed. 2002), states:

At the time of a § 351 exchange, it is not ordinarily necessary to determine
whether a liability that is assumed by the transferee corporation or to
which the transferred property is subject is too contingent to be taken into
account or is instead fixed so as to qualify for the exemption of § 357(a);
either way, it does not require the recognition of gain. The debt must be
properly classified, however, in applying §§ 357(b) and 357(c) (relating to
tax avoidance transfers and debt-in-excess of basis, respectively.) If a
borderline liability is sufficiently fixed for § 357(b) or § 357(c) purposes,
then it would seem that the transferor should be required to reduce (or
adjust) his basis in the stock received for the property under
§358(a)(1)(A)(ii).

Id. at ¶ 3.10[3], at 3-60 (emphasis added, footnote omitted). See also Lee Sheppard,
Cognitive Dissonance on Contingent Liabilities in Asset Acquisitions, 78 Tax Notes 142,
143-44 (1998), stating:

[A] sound alternative to deferred purchase price adjustments is for the
parties to estimate the contingent liabilities at the time of sale, with the
seller taking the estimate into income and the buyer adding it to its basis in
the purchased assets. This would allow the seller to walk away. Valuing

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 Consequently, under the general rule, the liabilities assumed by Garrison would

be treated as “money received” by Garlock. Thus under the general rule, Garlock’s

basis in its newly acquired Garrison stock would be decreased by the amount of the

contingent liabilities assumed by Garrison.7

B

However, there is an exception to this general rule for calculating basis. Section

358(d)(2) provides that § 358(d)(1) “shall not apply to the amount of any liability

excluded under section 357(c)(3).” Section 357(c)(3), in turn, states:

If a taxpayer transfers, in an exchange to which section 351 applies, a
liability the payment of which . . . would give rise to a deduction . . . then,

contingent liabilities, although difficult, turns out not to be as difficult as
incorporating those estimates into tax rules that are premised on precision
and symmetrical results.
7
Coltec also contends that the addition of §358(h) to the tax code in 2000
supports its position that contingent liabilities are not “liabilities.” Section 358(h)
provides:

If, after application of the other provisions of this section to an exchange or
series of exchanges, the basis of property to which subsection (a)(1)
applies exceeds the fair market value of such property, then such basis
shall be reduced (but not below such fair market value) by the amount
(determined as of the date of the exchange) of any liability-- (A) which is
assumed by another person as part of the exchange, and (B) with respect
to which subsection (d)(1) does not apply to the assumption.

26 U.S.C. § 358(h)(1). Section 358(h) explicitly includes “contingent obligation[s]” as
“liabilities” under that subsection. 26 U.S.C. § 358(h)(3). Coltec thus argues the
inclusion of “contingent liabilities” in § 358(h) means that “contingent liabilities” are not
included in § 358(d). However, § 358(h) by its own terms operates only when § 358(d)
does not apply. Thus, we find § 358(h) to be of little utility in our analysis even if we
were to assume that a 2000 amendment had interpretive value for construing the
earlier code provisions involved here.

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 for purposes of [§ 357(c)(1)], the amount of such liability shall be excluded
in determining the amount of liabilities assumed or to which the property
transferred is subject.

The government asserts that the liabilities at issue do not fall under § 358(d)(2)’s

exception. The government’s argument requires that we consider the interaction of four

code provisions: sections 358(d)(2), 357(c)(3), 357(c)(1), and 357(b)(1).

i. Application of § 357(c)(3)

In order to fall under the § 358(d)(2) exception, the language of § 358(d)(2)

requires that the liability must be “excluded under section 357(c)(3).” The reference to §

357(c)(3) is somewhat odd because § 357(c)(3) is a provision relating to the calculation

of gain rather than the calculation of basis, and the rules for gain recognition are

themselves complex. Briefly, by virtue of § 351(a) and (b)(1), gain generally need not

be recognized in an exempt transaction except to the extent of “money received.” But,

under § 357(a), “money received” generally does not include liabilities assumed.

However, by virtue of § 357(c)(1), when liabilities exceed basis, gain must be

recognized to that limited extent. Section 357(c)(3) excludes certain liabilities from

subsection (c)(1). Nonetheless § 357(b)(1) provides that (c)(1) is inapplicable and the

full amount of the liabilities assumed must be recognized as gain when the assumption

of liabilities was principally for tax avoidance or lacked a bona fide business purpose.8

The parties first dispute whether the liabilities here “would give rise to a

deduction” as § 357(c)(3) requires. The government contends that the liability is not the

kind that “would give rise to a deduction” under § 357(c)(3) because § 357(c)(3) only

8
Section 357(c)(2) states that § 357(c)(1) “shall not apply to any exchange . . .
to which subsection (b)(1) of this section applies . . . .”

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applies where the transferor (here Garlock) transferred both a liability and the

underlying business that generated that liability. Because Garlock transferred its

asbestos liabilities but kept its core business, the government urges that the liabilities do

not fall within the scope of § 357(c)(3). It is true that the central purpose of § 357(c)(3)

was to protect taxpayers who transferred the assets of their business along with

liabilities of their business (such as accounts payable) from having to recognize gain if

the liabilities exceeded the assets. The theory was that the transferor corporation

should not have to recognize gain when it had lost the tax deduction that would flow

from payment of the liabilities. S. Rep. No. 95-1263, at 184-85 (1978). Section

357(c)(3) “rescue[s] the taxpayer[ ] from this harsh result” because the taxpayer would

not be obtaining a tax benefit from the transfer of liabilities. Bittker & Eustice, ¶

3.06[4][c] at 3-37 & n.131; see S. Rep. 95-1263, at 185-85. However, we find the

government’s interpretation to be inconsistent with the plain language of § 357(c)(3).

Nothing in the plain language of § 357(c)(3) limits the liabilities excludable to only those

that were transferred along with an underlying business.9

Accordingly, we conclude that § 357(c)(3) does not limit excludable liabilities to

only those that were transferred with an underlying business, and that the liabilities here

satisfy the “would give rise to a deduction” requirement. In so holding, we join the only

9
The government points to a statement in the legislative history of § 357(c)
which states: “In general, liabilities the payment of which would give rise to a deduction
include trade accounts payable and other liabilities (e.g., interest and trades) which
relate to the transferred trade or business.” S. Rep. No. 96-498, at 62 (1979). This
statement of legislative history does not suggest that a transfer of a trade or business is
a necessary element of the transaction; it merely explains that liabilities that relate to a
trade or business are “include[d]” among the liabilities which would give rise to a
deduction.

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other court of appeals to have considered this exact issue. See Black & Decker Corp.

v. United States, 436 F.3d 431, 437 (4th Cir. 2006) (“The prototypical transaction

Congress had in mind in drafting § 357(c)(3) may well have been one in which a

corporation exchanged liabilities as part of a transfer of an entire trade or business to a

controlled subsidiary, but nothing in the section’s plain language embraces such a

limitation.”).

ii. Applicability of § 357(b)(1)’s Anti-Abuse Provision

Section 357(c)(3) states that if the liability qualifies, then “for purposes of [(§

357(c)(1)], the amount of such liability shall be excluded in determining the amount of

liabilities assumed . . . .” (emphasis added). Section 357(c)(1) provides:

Liabilities in excess of basis.—
(1) In general.--In the case of an exchange . . . to which section 351
applies . . . if the sum of the amount of the liabilities assumed, plus the
amount of the liabilities to which the property is subject, exceeds the total
of the adjusted basis of the property transferred pursuant to such
exchange, then such excess shall be considered as a gain from the sale
or exchange of a capital asset or of property which is not a capital asset,
as the case may be.

Id. (emphasis added). Basically, § 357(c)(1) sets forth a gain-recognition calculation

where one of the variables is the “amount of liabilities assumed.” Section 357(c)(3)

excludes certain liabilities from this gain-recognition calculus.

However, § 357(c)(1) does not apply when an exchange triggers § 357(b)(1)’s

anti-abuse provision. 26 U.S.C. § 357(c)(2). Section 357(b)(1)’s anti-abuse provision

applies where liabilities are assumed principally for tax avoidance purposes or lack a

bona fide business purpose:

Tax avoidance purpose.—

(1) In general.--If, taking into consideration the nature of the liability and

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 the circumstances in the light of which the arrangement for the assumption
or acquisition was made, it appears that the principal purpose of the
taxpayer with respect to the assumption or acquisition described in
subsection (a)—
(A) was a purpose to avoid Federal income tax on the exchange, or
(B) if not such purpose, was not a bona fide business purpose,
then such assumption or acquisition (in the total amount of the liability
assumed or acquired pursuant to such exchange) shall, for purposes of
section 351 or 361 (as the case may be), be considered as money
received by the taxpayer on the exchange.

When it applies, the effect of § 357(b)(1) is two-fold. First, it supplants § 357(c)(1) and

requires that assumed liabilities be treated as “money received” for purposes of

§ 351(b), so that the full amount of gain must be recognized to the extent of liabilities

assumed rather than merely (as (c)(1) requires) the amount that liabilities exceed basis.

Second, it eliminates the § 357(c)(3) exclusion. In other words, § 357(c)(3)’s exclusion

may be rendered inapplicable by (b)(1) if there is a principal tax avoidance purpose or

an absence of bona fide business purpose.

The government argues that the transaction here falls within § 357(b)(1) because

the principal purpose behind the assumption of liabilities by Garrison was to avoid taxes

or was otherwise not a bona fide business purpose. Although neither § 358(d)(2) nor

§ 357(c)(3) (the sections directly involved here) makes a direct reference to § 357(b)(1)

(the anti-abuse provision), the government argues that: § 357(c)(3) refers to

§ 357(c)(1); § 357(c)(1) can only apply when § 357(b)(1) does not apply; and that

therefore, § 357(c)(3) cannot apply where § 357(b)(1) applies.

We disagree with the government’s construction of these code provisions. These

code provisions are not a model of statutory draftsmanship. The real question is what is

meant by § 358(d)(2) when it refers to a “liability excluded under section 357(c)(3).”

This could have two possible meanings. It could mean that a liability is excluded “under

05-5111 15
section 357(c)(3)” if—looking at § 357(c)(3) in a vacuum—the liability is of the type

excluded from the § 357(c)(1) calculation. On the other hand, it could mean that the

liability is “excluded” only if it is actually excluded from gain recognition under

§ 357(c)(1) by operation of § 357(c)(3)—that is, if the (c)(3) exclusion is meaningful

because §357(c)(1) is operative and not overridden by § 357(b)(1). In essence, the

taxpayer urges the former interpretation, and the government urges the latter

interpretation. We think the taxpayer’s interpretation is the better of the two.

In construing statutory provisions, we appropriately consult dictionaries in use at

the time the statute was enacted.10 See, e.g., Amoco Prod. Co. v. S. Ute Indian Tribe,

526 U.S. 865, 874 (1999); Am. Express Co. v. United States, 262 F.3d 1376, 1381 n.5

(Fed. Cir. 2001). The use of the term “under” in § 358(d)(2) suggests limiting

consideration to (c)(3) itself since the dictionary definition of “under” in this context is

“required by” or “in accordance with.” Webster’s Third New International Dictionary of

the English Language Unabridged 2487 (1976). In other words, the dictionary definition

of the term “under” suggests looking only to the operation of § 357(c)(3) itself. The

section says nothing about excluding liabilities from gain recognition. It deals only with

excluding liabilities from the § 357(c)(1) computation. Moreover, we think that Congress

likely would have done one of the following if it wished § 357(b)(1) to apply in this

situation. On the one hand, it could have made explicit reference to the basis provision

of § 358 in § 357(b)(1); instead that section refers only to treating an assumption of

liabilities as “money received” for “purposes of section 351 or 361” (which deal only with

10
Paragraph 2 of § 358(d) was added to the statute by the Revenue Act of 1978,
Pub. L. No. 95-600, § 365, 92 Stat. 2736, 2855 (1978).

05-5111 16
gain recognition and not basis reduction). Alternatively, Congress could have made

explicit reference to § 357(b)(1) in § 358(d)(2) if it intended to require that § 358(d)(2)

apply only if § 357(c)(3)’s exclusion was not rendered inoperative by § 357(b)(1). In

other words, if Congress wanted the operation of § 357(b)(1) to preclude the benefit of §

358(d)(2), it could have said in § 358(d)(2) something like, “§ 358(d)(1) shall not apply to

the amount of any assumed liability excluded under § 357(c)(3) unless the assumption

involved a prohibited purpose described in § 357(b)(1).” (The added underscored

language would achieve the supposedly desired result.).

We thus conclude that if the liability is excluded by § 357(c)(3) standing alone,

then § 358(d)(2)’s exception may be invoked. It does not matter whether the anti-abuse

provision of § 357(b)(1) applies and overrides the actual operation of § 357(c)(1). The

interpretation we adopt in this respect is identical to the interpretation adopted by the

Fourth Circuit in Black & Decker, though we reach this result by a somewhat different

interpretive path. We therefore conclude that the liabilities fall within § 357(c)(3); that

§ 357(b)(1) is not relevant here; and that § 358(d)(2) excludes the liabilities from “money

received” treatment. The consequence is that under the literal terms of the statute the

basis of Garlock’s Garrison stock is increased by the Stemco note and is not reduced by

the assumed contingent asbestos liabilities. Ultimately, the taxpayer would not be

disqualified from claiming the capital loss.

II

Having concluded that Garlock’s loss from the sale of its Garrison stock falls

within the literal terms of the statute, we now turn to the government’s argument under

the general economic substance doctrine. We must first consider the Court of Federal

05-5111 17
Claims’ holding that “the use of the economic substance doctrine to trump mere

compliance with the Code would violate the separation of powers.” Coltec Indus., Inc.,

62 Fed. Cl. at 756 (internal quotation marks omitted). That holding is untenable. In

rejecting the economic substance doctrine, the court failed to follow binding precedent

of the Supreme Court and this court and its predecessor court, the Court of Claims.

Over the last seventy years, the economic substance doctrine has required

disregarding, for tax purposes, transactions that comply with the literal terms of the tax

code but lack economic reality.11 This principle has its roots in several Supreme Court

cases. For example, in Gregory v. Helvering, 293 U.S. 465 (1935), the Supreme Court

disregarded a transaction which complied with the literal terms of the tax code, where

the taxpayer, solely to avoid a dividend tax, caused her wholly-owned corporation to

transfer stock to a new corporation which then transferred the stock directly to the

taxpayer. Id. at 469-70. So too in Commissioner of Internal Revenue v. Court Holding

Co., 324 U.S. 331 (1945), the Supreme Court disregarded a transaction where the

taxpayer, in order to avoid a large corporate income tax, transferred an asset in the form

of a dividend to two shareholders who in turn conveyed the asset to a purchaser who

had originally negotiated with the corporation to purchase the asset. Id. at 332. The

Supreme Court has continued to embrace principles of economic substance in later

cases. See Knetsch v. United States, 364 U.S. 361, 366 (1960) (disregarding a

transaction where the taxpayers paid a “fee for providing the façade of ‘loans’ whereby

the [taxpayers] sought to reduce their . . . taxes[,]” because “there was nothing of

11
See, e.g., Bittker & Eustice, ¶ 1.05[2]; Martin D. Ginsburg & Jack S. Levin,
Mergers, Acquisitions, and Buyouts, ¶ 609.1 (2004); Jeff Rector, Comment, A Review of
the Economic Substance Doctrine, 10 Stan. J.L. Bus & Fin. 173, 173 (2004).

05-5111 18
substance to be realized by [the taxpayer] from this transaction beyond a tax

deduction”); see also Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1978)

(allowing a transaction because there was “a genuine multiple-party transaction with

economic substance which [was] compelled or encouraged by business . . . realities . . .

and [was] not shaped solely by tax-avoidance features . . . .”).

The economic substance doctrine has also been repeatedly applied by our

predecessor court. For example, in Ballagh v. United States, 331 F.2d 874 (Ct. Cl.

1964), the Court of Claims disallowed a deduction for interest payments because the

transaction which gave rise to the interest payment lacked economic substance as it did

“not appreciably affect [taxpayer’s] beneficial interest except to reduce his tax.” Id. at

877-79. Likewise, in Basic Inc. v. United States, 549 F.2d 740 (Ct. Cl. 1977), the Court

of Claims disregarded an inter-company transfer of stock because the transfer had no

purpose other than to give the parent a transferred basis in the stock, so that the parent

could report less taxable gain on its subsequent sale of that stock. Id. at 745-46. See

also Rothschild v. United States, 407 F.2d 404, 417 (Ct. Cl. 1969). Further, our own

cases have recognized the economic substance doctrine. See Falconwood Corp. v.

United States, 422 F.3d 1339, 1349-51 (Fed. Cir. 2005); Terry Haggerty Tire Co., Inc. v.

United States, 899 F.2d 1199, 1201 n.2 (Fed. Cir. 1990); Holiday Vill. Shopping Center

v. United States, 773 F.2d 276, 280 (Fed. Cir. 1985). The various tax treatises also

recognize the doctrine’s continued viability.12

12
See Ginsburg & Levin, ¶ 609.1, at 6-205 (“[I]t is clear enough today that a
reorganization must satisfy the business purpose requirement . . . .”); Bittker & Eustice
at ¶ 1.05[2][b], at 1-21 (“It is often said that a transaction is not given effect for tax
purposes unless it serves some purpose other than tax avoidance. The leading case in

05-5111 19
 There can be no question that the Court of Federal Claims is required to follow

the precedent of the Supreme Court, our court, and our predecessor court, the Court of

Claims. First Hartford Corp. Pension Plan & Trust v. United States, 194 F.3d 1279,

1290 n.3 (Fed. Cir. 1999) (“[B]oth we and the Court of Federal Claims are bound by the

decisions of the Court of Claims, this court’s predecessor court.”); see also Strickland v.

United States, 423 F.3d 1335, 1338 & n.3 (Fed. Cir. 2005).

Despite acknowledging that “the [Supreme] Court has decided tax cases invoking

[the economic substance] doctrine,” the Court of Federal Claims chose not to follow this

precedent because “[a] careful reading of other cases cited by the Government[ ] . . .

reveals that the Court resolved the tax question at issue first by looking to the Code and

utilized doctrinal language only to further support its conclusion.” Coltec Indus., Inc., 62

Fed. Cl. at 753 (emphasis added). We fail to see how the existence of other Supreme

Court cases that do not rely on the doctrine undermine the authority of those that do.

The Court of Federal Claims also speculated that “the current vitality of the ‘economic

substance’ doctrine certainly is not clear,” id., citing to Nebraska Department of

Revenue v. Lowenstein, 513 U.S. 123 (1994). We do not read Lowenstein to be

revisiting the validity of the economic substance doctrine. To the contrary, Lowenstein

noted that “the substance and economic realities” of the transaction at issue supported

the Court’s conclusion that a trust received “interest” on cash lent to a seller. 513 U.S.

at 134. Of course, even if the economic substance decisions of the Supreme Court

have been eroded, the Court of Federal Claims would still be required to follow them as

this area is Gregory v. Helvering . . . and the theory has had its fullest flowering in the
area of tax law . . . .”).

05-5111 20
binding precedent. Hohn v. United States, 524 U.S. 236, 252-53 (1998); State Oil Co. v

Khan, 522 U.S. 3, 20 (1997); Rodriguez de Quijas v. Shearson/Am. Exp., Inc., 490 U.S.

477, 484 (1989).

Even if we were to assume that the decisions of the Supreme Court and our

predecessor court recognizing the economic substance doctrine are not binding, we

cannot agree that the doctrine is somehow unconstitutional. Even Coltec makes no

effort to defend this proposition on appeal. The Court of Federal Claims has cited no

authority supporting its determination that the doctrine is unconstitutional. The court

cited only one case, Seggerman Farms, Inc. v. Commissioner of Internal Revenue, 308

F.3d 803 (7th Cir. 2002), that even discussed the concept of separation of powers in

light of the tax code, and that case simply suggested that separation of powers counsels

against finding that a code provision exceeds Congress’ taxing authority. Id. at 808 n.8.

The economic substance doctrine represents a judicial effort to enforce the

statutory purpose of the tax code. From its inception, the economic substance doctrine

has been used to prevent taxpayers from subverting the legislative purpose of the tax

code by engaging in transactions that are fictitious or lack economic reality simply to

reap a tax benefit. In this regard, the economic substance doctrine is not unlike other

canons of construction that are employed in circumstances where the literal terms of a

statute can undermine the ultimate purpose of the statute. See, e.g., Wisc. Dep’t of

Revenue v. William Wrigley, Jr., Co., 505 U.S. 214, 230 (1992) (noting that the maxim

de minimis non curat lex—that “the law cares not for trifles” or extremely minor

transgressions—“is part of the established background of legal principles against which

all enactments are adopted”); United States v. Native Vill. of Unalakleet, 411 F.2d 1255,

05-5111 21
1258 (Ct. Cl. 1969) (“[W]e may at times construe a statute contrary to its ‘plain

language’ if a literal interpretation makes a discrimination for which no rational ground

can be suggested.”).

The Supreme Court has explicitly held that when the judiciary goes beyond the

literal language of a statute in order to give effect to its purpose, the separation of

powers is not violated. In Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Curran, 456

U.S. 353 (1982), the Supreme Court considered whether the Commodity Exchange Act,

7 U.S.C. § 1 et. seq. (1976), which did not explicitly create a private right of action,

should be construed to create an implied private right of action to recover damages

based on alleged statutory violations. Id. at 356, 369. The petitioners argued that “the

judicial recognition of an implied private remedy [would] violate[ ] the separation-of-

powers doctrine.” Id. at 376. The Court explicitly rejected this argument, noting that:

Courts . . . are organs with historic antecedents which bring with them
well-defined powers. They do not require explicit statutory authorization for
familiar remedies to enforce statutory obligations. A duty declared by
Congress does not evaporate for want of a formulated sanction. . . . our
function is to decide what remedies are appropriate in the light of the
statutory language and purpose and of the traditional modes by which
courts compel performance of legal obligations. If civil liability is
appropriate to effectuate the purposes of a statute, courts are not denied
this traditional remedy because it is not specifically authorized.

Id. at 376 (emphasis added) (quoting Montana-Dakota Co. v. Nw. Pub. Serv. Co., 341

U.S. 246, 261-62 (1951) (Frankfurter, J., dissenting)) (internal citations omitted). The

Court went on to recognize an implied right of action under the statute, explaining that

the statute was enacted in a legal context that historically recognized implied rights of

actions. Id. at 375, 381.

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 Here, the economic substance doctrine is merely a judicial tool for effectuating

the underlying Congressional purpose that, despite literal compliance with the statute,

tax benefits not be afforded based on transactions lacking in economic substance. We

conclude that there is no basis for holding the economic substance doctrine

unconstitutional.

III

Although the Court of Federal Claims found the economic substance doctrine

unconstitutional, it went on to hold that the doctrine was inapplicable in any event,

relying on the findings that it made in connection with the statutory tax avoidance test.

Coltec Indus., Inc., 62 Fed. Cl. at 754. A review of that determination requires us to

consider the basic principles of the economic substance doctrine, as well as its

applicability to this case.

A. General Principles

The Supreme Court, various courts of appeals, and our predecessor court, have

identified a number of different factors pertinent to the determination of whether a

transaction lacks economic substance and thus should be disregarded for tax purposes.

We understand the economic substance doctrine to incorporate the following principles.

First, although the taxpayer has an unquestioned right to decrease or avoid his

taxes by means which the law permits, Gregory, 293 U.S. at 469, the law does not

permit the taxpayer to reap tax benefits from a transaction that lacks economic reality.

This principle emerged early on in Gregory, where the Supreme Court disregarded

intermediate transfers of stocks as falling outside the tax code because the transfers

had “no business or corporate purpose” and performed no “function” other than to

05-5111 23
reduce taxes. 293 U.S. at 469. The Supreme Court later explained that “[if] . . . the

Gregory case is viewed as a precedent for the disregard of a transfer of assets without

a business purpose . . . it gives support to the natural conclusion that transactions,

which do not vary control or change the flow of economic benefits, are to be dismissed

from consideration.” Higgins v. Smith, 308 U.S. 473, 476 (1940) (emphasis added).

Our court and our predecessor court have followed a similar approach. See Terry

Haggerty Tire Co., 899 F.2d at 1201 n.2; Holiday Vill. Shopping Ctr., 773 F.2d at 280;

Basic Inc., 549 F.2d at 745-46; Rothschild, 407 F.2d at 417; Ballagh, 331 F.2d at 875-

76. Several other courts of appeals have adopted similar positions. See Dow Chem.

Co. v. United States, 435 F.3d 594, 599 (6th Cir. 2006); Boca Investerings P’ship v.

United States, 314 F.3d 625, 631 (D.C. Cir. 2003); In re CM Holdings, Inc., 301 F.3d 96,

102 (3d Cir. 2002); United Parcel Serv. of Am., Inc. v. Comm’r of Internal Revenue, 254

F.3d 1014, 1018 (11th Cir. 2001).

While the doctrine may well also apply if the taxpayer’s sole subjective motivation

is tax avoidance even if the transaction has economic substance,13 a lack of economic

substance is sufficient to disqualify the transaction without proof that the taxpayer’s sole

motive is tax avoidance.14

13
See, e.g., Dow Chem. Co., 435 F.3d at 599 (noting that a transaction that has
economic substance may nonetheless be disregarded if the taxpayer had no subjective
business profit motivation); Ginsburg & Levin, ¶ 609.1, at 6-205; see also Frank Lyon
Co., 435 U.S. at 583-84 (holding that a transaction will be honored by the government
where “there is a genuine multiple-party transaction with economic substance which is
compelled or encouraged by business or regulatory realities . . . and is not shaped
solely by tax-avoidance features”).
14
See, e.g., United Parcel Serv. of Am., Inc., 254 F.3d 1014 (refusing to respect
a transaction if it lacks economic effect). We think that the rule adopted by the Fourth
Circuit and reiterated in Black & Decker—that a transaction will be disregarded only if it

05-5111 24
 Second, when the taxpayer claims a deduction, it is the taxpayer who bears the

burden of proving that the transaction has economic substance. In describing the

history of the economic substance doctrine, our predecessor court in Rothschild stated,

“Gregory v. Helvering requires that a taxpayer carry an unusually heavy burden when

he 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.” 407

F.2d at 411 (quoting Diggs v. Comm’r of Internal Revenue, 281 F.2d 326, 330 (2d Cir.

1960)). Other circuits have similarly held that “[e]conomic substance is a prerequisite to

the application of any Code provision allowing deductions [and therefore that] . . . [t]he

taxpayer has the burden of showing that the form of the transaction accurately reflects

its substance, and the deductions are permissible.” In re CM Holdings, Inc., 301 F.3d at

102.15

Third, the economic substance of a transaction must be viewed objectively rather

than subjectively. The Supreme Court cases and our predecessor court’s cases have

repeatedly looked to the objective economic reality of the transaction in applying the

economic substance doctrine.16 While the taxpayer’s subjective motivation may be

both lacks economic substance and is motivated solely by tax avoidance—is not
consistent with the Supreme Court’s pronouncements in cases such as Frank Lyon.
15
See also Kirchman v. Comm’r of Internal Revenue, 862 F.2d 1486, 1490 (11th
Cir. 1989); Stewart v. Comm’r of Internal Revenue, 714 F.2d 977, 990-91 (9th Cir.
1983); cf. Dow Chem. Co., 435 F.3d at 599.
16
See Gregory, 293 U.S. at 469-70; Frank Lyon Co., 435 U.S. at 584; see also
Ballagh, 331 F.2d at 875-78 (finding that where the taxpayer obtained a bank loan to
prepay all his annual life annuity premiums, and then borrowed from the annuity
company itself to pay back the bank loan, the loan payments to the annuity company
were not deductible interest payments because that transaction did “not appreciably
affect his beneficial interest except to reduce his tax”) (emphasis added); Rothschild,

05-5111 25
pertinent to the existence of a tax avoidance purpose, all courts have looked to the

objective reality of the transaction is assessing its economic substance. See, e.g.,

Black & Decker, 436 F.3d at 441-42 (noting that economic substance inquiry requires

an “objective determination of whether a reasonable possibility of profit from the

transaction existed”) (internal quotation marks omitted, first two emphases added); Dow

Chem. Co., 435 F.3d at 599; In re CM Holdings, Inc., 301 F.3d at 103 (stating that the

objective economic substance inquiry is “whether the transaction affected the taxpayer’s

financial position in any way”); United Parcel Serv. of Am., Inc., 254 F.3d at 1018; Rice’s

Toyota World, Inc. v. Comm’r of Internal Revenue, 752 F.2d 89, 94 (4th Cir. 1985).

Fourth, the transaction to be analyzed is the one that gave rise to the alleged tax

benefit. For example, in Basic Inc., where the taxpayer underwent an inter-company

transfer of stock to allow the parent to sell the stock to a third party with little taxable

gain, our predecessor court looked for the economic substance of the inter-company

transfer of stock—not of the ultimate sale of stock to the third party. 549 F.2d at 745-

46. The court explained that if the business purpose of the ultimate sale could be used

to justify the unnecessary inter-company transfer, then “all manner of intermediate

transfers could lay claim to ‘business purpose’ simply by showing some factual

407 F.2d at 411, 414, 417 (describing the historic economic substance analysis as
whether the transaction has “realistic financial benefit” and finding that where the
taxpayer borrowed funds to invest in treasury notes with a lower interest rate than the
borrowed funds themselves, taxpayer could not deduct interest payments on borrowed
funds because “there was neither a possibility nor opportunity of profit to the taxpayer
separate and apart from the tax deduction”) (emphasis added); Basic Inc., 549 F.2d at
745-47 (finding that where a parent company had its first-tier subsidiary distribute to it
all the outstanding stock of a second-tier subsidiary so that the parent could directly sell
the stock to a third party and realize less gain, the inter-company transaction should be
disregarded because it had no “valid business grounds”) (emphasis added).

05-5111 26
connection, no matter how remote, to an otherwise legitimate transaction existing at the

end of the line.” Id. at 745. Similarly, in Ballagh, where the taxpayer obtained a series

of loans to prepay annual annuity premiums so that he could characterize his payments

as deductible interest, the Court of Claims focused on the purpose for the loan from the

annuity company—not the purpose of the initial annuity contract, when evaluating the

economic substance of the transaction. 331 F.2d at 878. So also the Fourth Circuit has

stated that in economic substance cases, the focus is on “the specific transaction whose

tax consequences are in dispute,” Black & Decker, 436 F.3d at 441, and the Second

Circuit has stated that “[t]he relevant inquiry is whether the transaction that generated

the claimed deductions . . . had economic substance,” Nicole Rose Corp. v. Comm’r of

Internal Revenue, 320 F.3d 282, 284 (2d Cir. 2002). See also ACM P’ship v. Comm’r of

Internal Revenue, 157 F.3d 231, 260 & n.57 (3d Cir. 1998). These cases recognize that

there is a material difference between structuring a real transaction in a particular way

to provide a tax benefit (which is legitimate), and creating a transaction, without a

business purpose, in order to create a tax benefit (which is illegitimate).

Finally, arrangements with subsidiaries that do not affect the economic interest of

independent third parties deserve particularly close scrutiny. The transaction in Gregory

is illustrative. There, the Supreme Court found that the transfer of stock from a wholly

owned corporation to a newly created corporation and then directly to the taxpayer,

lacked economic substance because the “sole object and accomplishment of [the

transfer] was the consummation of a preconceived plan, not to reorganize a business . .

. but to transfer a parcel of corporate shares to the petitioner” in such a way as to avoid

taxes. 293 U.S. at 469. Similarly, our predecessor court in Basic Inc. disregarded an

05-5111 27
inter-company transfer of stock whereby a subsidiary, “through its controlling parent,

was caused to transfer the property whose sale the parent had decided upon for its own

separate purposes.” 549 F.2d at 746. The court found it noteworthy that the inter-

company transfer was part of a transaction which “was a foregone conclusion that might

just as well have been carried out in reverse order . . . .” Id.; see also Frank Lyon Co.,

435 U.S. at 575, 583 (in holding that a “genuine multiple-party transaction” had

economic substance, the Supreme Court distinguished more “familial” arrangements

involving only two parties); United Parcel Serv. Of Am., Inc., 254 F.3d at 1018-19

(finding that a transaction had economic substance because it created “genuine

obligations enforceable by an unrelated party” that was not under the taxpayer’s

control).

B. Application of the Economic Substance Doctrine

Under these principles, Coltec had the burden of proving that this transaction,

which admittedly had a tax avoidance purpose, had an economic reality. The Court of

Federal Claims held that Coltec had met this burden. The ultimate conclusion as to

business purpose is a legal conclusion, which we review without deference, and the

underlying relevant facts are in large part undisputed.

In urging that the transaction had economic substance, Coltec focused

particularly on its objective to make the company as a whole a more attractive

acquisition target as well as on its objective to make other potential target companies

view Coltec as a desirable acquirer. Coltec offered two arguments for why the liabilities-

note transaction had economic substance in this context: (1) because the creation of

Garrison to manage the asbestos liabilities would make Coltec more attractive and (2)

05-5111 28
because the transaction would add a barrier to veil-piercing claims against Coltec.

Neither of these theories suggests that the transaction at issue has economic

substance.

The first asserted business purpose focuses on the wrong transaction—the

creation of Garrison as a separate subsidiary to manage asbestos liabilities. Coltec

contends that the transaction had an economic purpose because, by having a separate

corporation like Garrison manage Garlock’s asbestos liabilities, Coltec became more

attractive. The following colloquy with John Guffey, Coltec’s CEO, is illustrative:

Q. [Coltec’s Counsel:] . . . “[W]hat [effect] if any did a separate
corporation like Garrison to manage the asbestos liabilities have on your
ability either to be acquired, Coltec be acquired or for Coltec to do the
acquiring?”

A. [Mr. Guffy:] Oh, I think . . . that was a real plus to us. . . . [W]e
could talk to the investment community about what we were doing with
asbestos, how we were managing it, how we looked at quantifying it, what
it meant to us in their time frame. . . . [h]aving a separate entity defining
the management of it and having experts within that entity to define what
they were doing about the management of it, I think proved to be a plus.

Coltec Indus., Inc., 62 Fed. Cl. at 739-40 (emphasis omitted). The Court of Federal

Claims also found that “[T]he management and minimization of [the asbestos] liabilities

were essential to the continued viability of Anchor and potentially Garlock. Therefore,

the conversion of these businesses into corporate form was clearly to serve a bona fide

business purpose.” 62 Fed. Cl. at 743. (emphasis added) (internal quotation marks

omitted).

The government does not dispute that the transfer of management activities may

have had economic substance. Government’s Br. at 42. The transfer of management

activities, however, is not the transaction at issue. Here, just as in Basic Inc., we must

05-5111 29
focus on the transaction that gave the taxpayer a high basis in the stock and thus gave

rise to the alleged benefit upon sale. That transaction is Garrison’s assumption of

Garlock’s asbestos liabilities in exchange for the $375 million note. Coltec admits that

“Garrison received the Stemco note in exchange for assuming Garlock’s asbestos

liabilities.” Coltec’s Br. at 39. It is this exchange that provided Garlock with the high

basis in the Garrison stock, this exchange whose tax consequence is in dispute, and

therefore it is this exchange on which we must focus.

The transfer of the liabilities in exchange for the note is separate and distinct

from the fact that Garrison took a managerial role in administering the asbestos

liabilities, as demonstrated by the fact that Garrison managed another entity’s asbestos

liabilities (Anchor’s liabilities) without actually assuming Anchor’s liabilities. The

taxpayer has not demonstrated any business purpose to be served by linking Garrison’s

assumption of the liabilities to the centralization of litigation management.17

Coltec’s second argument for why the transaction has economic substance—that

the transaction was designed to strengthen Coltec’s position against potential veil-

17
Coltec in its brief argues that “Garrison obtained the right to any ‘upside’ if the
future asbestos liabilities turned out to be less than the High estimate at the time of the
contribution . . . .” Coltec’s Br. at 49. There is no indication that this was viewed as a
business purpose at the time of the transaction. In any event, the nominal amount
($500,000) that the banks paid for the stock – a little more than half of the transaction
costs – demonstrates that creating this supposed “upside” potential had no real-world
appeal to potential purchasers. Coltec also argues that the transaction created other
benefits such as allowing Garrison to recover legal costs from its insurers, to issue
settlement checks more quickly, and to negotiate its own vendor contracts. All of these
benefits, however, flowed from the creation of Garrison as a separate entity to manage
the asbestos liabilities, not from Garrison’s assumption of the asbestos liabilities
themselves.

05-5111 30
piercing claims—focuses on the appropriate transaction but is also unavailing.18 Coltec

argues, and the Court of Federal Claims agreed, that the transfer of the liabilities for the

note was designed to strengthen Coltec’s core business from veil-piercing claims,

because Garrison would serve as another corporate layer between asbestos claimants

and Coltec. Coltec correctly points out that the asbestos liabilities of subsidiary

companies such as Garlock frequently exceeded the assets of those companies, and

that plaintiffs in asbestos liability cases routinely sought to pierce the corporate veil to

reach the assets of parent companies. Understandably, this was a matter of

considerable concern to parent companies such as Coltec. The problem is that there is

no objective basis for suggesting that the assumption of these liabilities by another

subsidiary (in this case Garrison) would in any way ameliorate this veil-piercing problem.

In this respect, Coltec relied entirely on the testimony of various Coltec

executives about the veil-piercing benefits that they perceived from the Garlock-

Garrison transaction. For example, Timothy O’Reilly, who was the head of Garlock’s

Asbestos Litigation Department and later Garrison’s president, explained:

The principal motive [of the Garrison transaction] was a further building of
the corporate veil, isolating the liabilities, getting the asbestos litigation
management department or department into a separate subsidiary for the
reimbursement possibilities from the insurance carriers . . . . And it was to
create within Coltec the asbestos liability box.

J.A. at 7227. Joseph Andolino, Coltec’s tax director, stated:

18
Coltec also argues that the transaction had business purpose because it
helped to facilitate the later sale of stock by Coltec to regional defense counsel. We
agree with the Court of Federal Claims’ determination on this issue—that this second
sale of stock was too distant in time from the transaction to serve as a legitimate
business purpose.

05-5111 31
 I felt that incorporating the liability management activities would
ameliorate some of the very serious and grave concerns we had about veil
piercing. I felt that it added to the story that we had about isolating the
liability from the operations of the company.

J.A. at 7040. Further, as the Court of Federal Claims explained, Coltec’s CEO, John

Guffey “testified that he would have approved the restructuring in any event because of

the benefits of protecting the assets of Coltec and Garlock from veil piercing claims.” 62

Fed. Cl. at 723.

These subjective views of Coltec’s executives, even if credited, as they were by

the Court of Federal Claims, are insufficient to establish economic substance. As we

have discussed, economic substance is measured from an objective, reasonable

viewpoint, not by the subjective views of the taxpayer’s corporate officers. Looking at

the transaction objectively, there is no basis in reality for the idea that a corporation can

avoid exposure for past acts by transferring liabilities to a subsidiary.

The transfer of the liabilities for the note could only strengthen Coltec’s defense

against veil-piercing if third parties would be obligated to pursue Garrison instead of

Garlock. It is perfectly clear that the transaction had no such result. We are not aware

of, nor has Coltec brought to our attention, any authority suggesting otherwise. Nor has

Coltec pointed to testimony from any third party that there could be such a benefit. The

Court of Federal Claims made no such finding, and even Coltec concedes that

Garrison’s assumption of Garlock’s asbestos liabilities did not actually shield Garlock or

Coltec from direct liability, conceding that “Coltec could not, of course, effect a release

of Garlock’s liabilities to third parties.” Coltec’s Brief at 15 n.9.

Thus the transaction here could only affect relations among Coltec and its own

subsidiaries—it has absolutely no affect on third party asbestos claimants. It simply

05-5111 32
made a corporate subsidiary a conduit for the payment of asbestos liability claims. As

the Supreme Court held in a related context, “[a] sale by one person cannot be

transformed for tax purposes into a sale by another by using the latter as a conduit

through which to pass title. To permit the true nature of a transaction to be disguised by

mere formalisms, which exist solely to alter tax liabilities, would seriously impair the

effective administration of the tax policies of Congress.” Court Holding Co., 324 U.S. at

334.

Far from making Garrison more attractive to third party acquirers such as the

banks here, the assumption of the asbestos liabilities made the Garrison stock less

attractive. The banks were willing to acquire Garrison stock from Garlock only by

establishing “separate subsidiaries to insulate their banking business from any potential

veil-piercing claims” and they insisted on being indemnified by Coltec against veil-

piercing claims. Coltec Indus., 62 Fed. Cl. at 728-29; id. at 750.19 The banks also

insisted on keeping the entire transaction confidential. Id. at 751.

We therefore see nothing indicating that the transfer of liabilities in exchange for

the note effected any real change in the “flow of economic benefits,” provided any real

“opportunity to make a profit,” or “appreciably affected” Coltec’s beneficial interests

aside from creating a tax advantage. See supra. Garrison’s assumption of Garlock’s

liabilities in exchange for the Stemco note served no purpose other than to artificially

inflate Garlock’s basis in its Garrison stock. That transaction must be disregarded for

19
“[T]he banks sufficiently were concerned about veil piercing that they too
formed separate corporations to insulate their main business and required further
indemnification from Coltec.” Id.

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tax purposes. When that transaction is disregarded, the basis in the Garrison stock is

unaffected by the Stemco note/assumed liability exchange.

Coltec may nonetheless be entitled to a capital loss deduction because the value

of the other property transferred (roughly amounting to $4 million) which formed the

basis for the Garrison stock exceeded the sale price of the stock by the banks. We

therefore vacate the judgment below and remand for a limited purpose—so that the

Court of Federal Claims may determine whether Coltec is entitled to a partial refund

based on the sale of stock with a basis of approximately $4 million for a price of

$500,000.

CONCLUSION

For the foregoing reasons, the decision by the Court of Federal Claims is vacated

and remanded for further proceedings in accordance with this opinion.

VACATED AND REMANDED

COSTS

No costs.

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