Enbridge Energy Co. v. United States

IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT United States Court of Appeals
Fifth Circuit

FILED
November 10, 2009

No. 08-20261 Charles R. Fulbruge III
Clerk

ENBRIDGE ENERGY COMPANY INC; ENBRIDGE MIDCOAST ENERGY
LP, formerly known as Enbridge Midcoast Energy Inc, formerly known as
Midcoast Energy Resources Inc

Plaintiffs - Appellants
v.

UNITED STATES OF AMERICA

Defendant - Appellee

Appeal from the United States District Court
for the Southern District of Texas
USDC No. 4:06-CV-657

Before BARKSDALE, DENNIS, and ELROD, Circuit Judges.
PER CURIAM:*
Plaintiffs-Appellants Enbridge Energy Company, Inc. and Enbridge
Midcoast Energy, L.P. (collectively, “Midcoast”) brought this suit for a refund of
taxes and penalties assessed by the Internal Revenue Service (“IRS” or
“Commissioner”). In 1999, Midcoast acquired the control of the Bishop Group
(“Bishop”), which operated various energy-related pipelines. The change of

*
Pursuant to 5TH CIR . R. 47.5, the court has determined that this opinion should not
be published and is not precedent except under the limited circumstances set forth in 5TH CIR .
R. 47.5.4.
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control took the form of a conduit transaction, whereby Bishop’s sole shareholder
sold his stock to a third-party intermediary (the K-Pipe Merger Corporation, or
“K-Pipe”), which then immediately sold the formerly Bishop assets to Midcoast.
The IRS, applying the “substance over form” doctrine, disregarded the use of the
conduit in the transaction, treating the transaction as a direct stock sale for tax
purposes -- resulting in less favorable tax treatment for Midcoast. After paying
due taxes and penalties under protest, Midcoast brought the instant suit
claiming the IRS erroneously treated the transaction as a direct stock sale and
erroneously assessed a 20% penalty. The district court granted summary
judgment to the IRS on both claims. For the following reasons, we affirm.
I. BACKGROUND
The material facts of this case are undisputed, and the district court ably
and accurately recited them in its memorandum opinion and order. See
Enbridge Energy Co. v. United States, 553 F. Supp. 2d 716 (S.D. Tex. 2008). We
highlight the most salient facts here.
Midcoast and Bishop were in the business of owning and operating
natural gas pipelines. Dennis Langley was Bishop’s sole shareholder, and thus
controlled Bishop’s assets, which consisted primarily of natural gas pipelines.
Beginning in 1999, Langley decided to sell Bishop. Specifically, Langley sought
to sell his stock in Bishop because a direct stock-sale would be substantially
more beneficial to him from a tax perspective than a sale of only the entity’s
assets. Langley arranged with Chase Securities, Inc. to solicit potential buyers
of the Bishop stock.
Midcoast was an interested buyer, but preferred to purchase Bishop’s
assets rather than Langley’s stock. Midcoast’s preference for purchasing the
Bishop’s assets stemmed from a desire to avoid the tax liability that would result
from purchasing Langley’s stock. Midcoast nonetheless submitted a series of
non-binding, conditional bids for the purchase of the stock, none of which led to

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a final sale agreement. In September 1999, after conducting further due
diligence, Midcoast reduced its bid price for the stock to $163 million, a price
below what Langley had sought for the stock. As Midcoast’s general counsel has
averred, this bid “resulted in a significant gap between the price Midcoast was
willing to pay and the price Langley indicated he was willing to accept.”
At approximately this same time, Midcoast consulted with an outside tax
advisor, PricewaterhouseCoopers, LLP (“PWC”), concerning the transaction.
PWC first suggested the idea of using a “midco transaction,” in which Langley
would sell his Bishop stock to a third party, and the third party would in turn
sell the Bishop assets to Midcoast. This arrangement, PWC advised, would
provide tax benefits for both Midcoast and Langley. PWC suggested that
Midcoast use Fortrend International LLC (“Fortrend”), an investment bank, to
facilitate the transaction. Thomas J. Palmisano, then a senior manager with
PWC, testified that his firm contacted Fortrend to facilitate the Midco
transaction specifically so that “Midcoast [would] receive a stepped-up basis in
the [Bishop] assets. And by doing so, it would give [Midcoast] an ability to
increase the amount of consideration for the assets.” Recognizing the benefits
of the Fortrend-facilitated midco transaction, Midcoast agreed because, as
Midcoast’s CFO testified, “this was the only thing that we felt could close” the
gap between Langley’s requested price and Midcoast’s offer.
Fortrend began negotiating with Langley to acquire his Bishop stock, with
Midcoast and PWC participating in the negotiations and often dealing directly
with Langley. Fortrend created an entity, K-Pipe, specifically for the
transaction. K-Pipe had no assets of its own, nor had it conducted any prior
business. On September 30, 1999, K-Pipe submitted a letter of intent to
Langley containing its offer to purchase the Bishop stock. The following day,
October 1, 1999, Midcoast submitted a letter of intent to K-Pipe containing its
offer to purchase the Bishop assets. Approximately one week later, following the

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letters of intent, K-Pipe purchased all of Langley’s Bishop stock; the next day,
K-Pipe sold all of Bishop’s assets to Midcoast, save for a royalty interest
(described as the Butcher Interest) held by Bishop that K-Pipe sold to a
partnership consisting of K-Pipe and Midcoast. K-Pipe financed its purchase of
Langley’s stock with a loan obtained from Rabobank Nederland, a Dutch bank
known for financing midco transactions, which was entirely secured by funds
totaling $191.1 million that Midcoast deposited in escrow with Rabobank. K-
Pipe transferred approximately $122.5 million to Langley in consideration for
the stock; Midcoast transferred $122.6 million to K-Pipe in consideration for the
assets, and an additional $79 million directly to Bishop’s creditors. The
difference in price between the stock purchase price and the asset sale price was
$6.4 million, representing K-Pipe’s (and therefore Fortrend’s) commission.
K-Pipe retained title interest to the Bishop stock, equity in the Butcher
Interest, and certain causes of action against third parties (as well as the
difference between the purchase price of the stock and sale price of the assets).
K-Pipe continued in existence through at least 2002, though its annual tax
filings show that it conducted virtually no business. Subsequent to the stock-
asset sale, in November 2000, Midcoast paid K-Pipe $244,750 for K-Pipe’s equity
in the Butcher Interest by exercising an effectively mandatory purchase option
it retained from the original transaction. Midcoast subsequently terminated the
Butcher Interest and deducted an alleged loss on its 2001 corporate tax return
of approximately $5.7 million.
Midcoast claimed an adjusted basis in the former Bishop assets in tax year
1999 equal to the $192 million it paid for them. In subsequent years, Midcoast
began claiming deductions based on the depreciation of those assets. The IRS
instituted an audit and partially disallowed those deductions, finding that
Midcoast should have paid taxes as though it purchased the stock of Bishop.
Accordingly, the IRS disregarded the form of the conduit transaction and treated

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it as though Midcoast directly purchased the stock of Bishop. The IRS permitted
Midcoast to claim a carryover basis of $35 million in the assets (the basis that
Bishop could have claimed) and make deductions based on that amount. The
IRS also assessed a 20% penalty due to the substantial underpayment of taxes.
Midcoast paid approximately $5.4 million to the IRS under protest. Thereafter,
Midcoast sought a refund of that payment. When the IRS denied the refund,
Midcoast brought the instant suit to obtain the refund.
On the parties’ cross-motions for summary judgment, the district court
granted summary judgment to the United States, concluding that Midcoast
failed to meet its burden to prove that the IRS erroneously disregarded the form
of the conduit transaction. The district court also held that the IRS was
permitted to assess the 20% penalty. Midcoast timely appealed.
II. STANDARD OF REVIEW
“The general characterization of a transaction for tax purposes is a
question of law subject to review.” Frank Lyon Co v. United States, 435 U.S. 561,
581 n.16 (1978). We review the district court’s grant of summary judgment de
novo. Turner v. Baylor Richardson Med. Ctr., 476 F.3d 337, 343 (5th Cir. 2007).
A party is entitled to summary judgment only if “the pleadings, the discovery
and disclosure materials on file, and any affidavits show that there is no genuine
issue as to any material fact and that the movant is entitled to judgment as a
matter of law.” Fed. R. Civ. P. 56(c). On a motion for summary judgment, the
court must view the facts in the light most favorable to the non-moving party
and draw all reasonable inferences in its favor. See Hockman v. Westward
Commc’ns, LLC, 407 F.3d 317, 325 (5th Cir. 2004). In reviewing the evidence,
the court must “refrain from making credibility determinations or weighing the
evidence.” Turner, 476 F.3d at 343.

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III. DISCUSSION
A. Substance Over Form
The Supreme Court held in Commissioner v. Court Holding Co., 324 U.S.
331 (1945), that the IRS may assess taxes based on the substance, rather than
the form, of a conduit transaction. The Court explained:
The incidence of taxation depends upon the substance of a
transaction. The tax consequences which arise from gains from a
sale of property are not finally to be determined solely by the means
employed to transfer legal title. Rather, the transaction must be
viewed as a whole, and each step, from the commencement of the
negotiations to the consummation of the sale, is relevant. 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.

Id. at 334. The Court reaffirmed this holding in United States v. Cumberland
Public Service Co., 338 U.S. 451 (1950), and observed that in applying the
substance-over-form principle, the court “can consider motives, intent, and
conduct in addition to what appears in written instruments used by parties to
control rights as among themselves.” See id. at 455 n.3. The Supreme Court has
also cautioned, however, against disregarding legitimate transactions, stating
that “where . . . 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.”
Frank Lyon, 435 U.S. at 583-84.
We have applied the substance-over-form doctrine on numerous occasions,
beginning with our decision in Davant v. Commissioner, 366 F.2d 874 (5th Cir.
1966), to conclude that the sale of a corporation’s assets through an intermediary

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to avoid capital gains taxation could be treated as a direct sale, thus triggering
a higher rate of taxation. Davant involved taxpayers who sold their stock in a
corporation and attempted to claim a lower capital gains rate for the sale. To
accomplish this, the taxpayers sold their stock to an intermediary who would
“make a reasonable profit” for his role,1 and then the intermediary would sell the
corporation’s assets to a buyer (in this case, another corporation owned by the
taxpayers) and liquidate the target corporation. See id. at 878. The taxpayer
argued that the transaction was a bona fide sale of his stock in the corporation,
while the IRS argued that the transaction should have been treated as a
corporate reorganization and taxed at a higher ordinary income rate. See id. at
879. We agreed with the IRS’s determination, stating that the “courts have
never been shackled to mere paper subterfuges. It is hard to imagine a
transaction more devoid of substance than the purported ‘sale’ to [the
intermediary].” Id. at 880. This court specifically noted that the intermediary
“served no function other than to divert our attention to avoid tax. Stated
another way, his presence served no legitimate nontax-avoidance business
purpose.” Id. at 881. There was thus no merit in the taxpayers’ argument that
a stock sale could not be treated as a sale of assets: “[W]e see that the treatment
of stocks as assets, or assets as stock, has always been utilized by the courts in
harmonizing the statutory language with the single rational plane of taxation
envisioned by Congress.” Id. at 887.
Similarly, in Blueberry Land Co. v. Commissioner, 361 F.2d 93 (5th Cir.
1966), the taxpayers sought to sell their corporations’ assets. After finding a
buyer, the taxpayers and the buyer began negotiating the sale and reached an
agreement, but the deal fell apart because of the perceived adverse tax
consequences. Id. at 94-96. At that time, an intermediary agreed to establish

1
The intermediary received $15,583.30 for his role in the transaction. The entire sale
was for approximately $1 million in consideration. See Davant, 366 F.2d at 878.

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a holding company that would buy the taxpayers’ stock, sell the assets to the
buyer, and liquidate the corporations. Id. at 96-97. The intermediary
established the holding company and accomplished the transaction, retaining a
modest fee for his services. See id. The IRS sought to treat the transaction as
a sham, and we agreed, specifically relying on the fact that the transaction had
been negotiated by the taxpayer with the eventual buyer -- and that the
intermediary “served no real or useful economic purpose apart from tax savings.”
Id. at 102. “Nothing here said is intended to prevent or in any way discourage
a real and bona fide sale of stock by stockholders of one corporation to a second
corporation, and liquidation of the first by the acquiring corporation. . . . But
missing here is that all-important element -- the transaction must be real and
bona fide.” Id.
We also agreed with the IRS’s substance-over-form determination in Reef
Corp. v Commissioner, 368 F.2d 125 (5th Cir. 1966). The taxpayer in that case
was a corporation owed by two groups of shareholders. One group sought to buy
the other’s interest in the corporation. The initial plan for accomplishing this
goal was rejected by the sellers because of the adverse tax consequences, so the
parties developed a new plan for using a new corporate entity and an
intermediary to engage in a stock/asset swap in order to obtain a more favorable
tax basis for the purchased assets. Id. at 128-29. We explained:
[The intermediary] was a mere conduit in a preconceived and
prearranged unified plan to redeem the stock of the [sellers]. His
activity was but a step in the plan. He carried out a sales contract
already entered into between the corporations. He assumed no risk,
incurred no personal liability, paid no expenses and obtained only
bare legal title to the stock. There was an insufficient shifting of
economic interests to [the intermediary]. It is settled that under
such circumstances substance must be given effect over form for
federal tax purposes.

Id. at 130.

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However, we have not always agreed with the IRS’s application of the
substance over form doctrine. In Compaq Computer Corp. v Commissioner, 277
F.3d 778 (5th Cir. 2001), the taxpayer (Compaq) purchased shares of a foreign
corporation using an intermediary. The evidence established that the
intermediary approached Compaq about buying the stock and that the
intermediary “[w]ithout involving Compaq . . . chose both the sizes and prices of
the trades and the identity of the company that would sell the [shares] to
Compaq.” Id. at 779-80. The IRS argued that the transaction should be
disregarded, which would prevent Compaq from claiming favorable tax
treatment on its capital losses and dividends. We disagreed, concluding that the
transaction was motivated by a business purpose unrelated to obtaining tax
benefits and “economic substance.” Id. at 781-82. Specifically, we noted that the
transactions “had both a reasonable possibility of profit attended by a real risk
of loss and an adequate non-tax business purpose. The transaction was not a
mere formality or artifice but occurred in a real market subject to real risks.” Id.
at 788.
B. Application to the Instant Case
The uncontroverted evidence supports the district court’s conclusion that
this was a sham conduit transaction, and that Midcoast is not entitled to claim
a stepped-up basis for the assets it purchased. Langley sought to sell his stock
in Bishop, knowing that a direct asset sale would have negative tax
consequences for him. As Midcoast concedes, Bishop’s assets had appreciated
considerably and the corporation would have to pay significant taxes on those
gains, and Langley in turn would have to pay taxes on distributions he took as
a shareholder from Bishop. Midcoast was one of many interested buyers and
submitted a bid of $157 million for the stock, which it subsequently increased to
$184.2 million, but then -- upon further reflection -- lowered to $163 million.
Langley found this offer unacceptable.

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When Langley rejected Midcoast’s reduced offer, Midcoast asked its tax
advisor, PWC, for suggestions about improving its bid. PWC suggested that the
parties use a third-party intermediary for the transaction and suggested
Fortrend, a corporation that has done a number of conduit transactions. PWC
then brought Fortrend into the fold. The evidence shows that this was done to
“bridge the gap” in the transaction -- referring to the agreed dispute over the sale
price. Midcoast understood that Fortrend would buy Langley’s stock and then
sell the Bishop assets to Midcoast.
Fortrend, rather than buying the stock and selling the assets itself,
formed a special vehicle solely for this purpose: K-Pipe. K-Pipe existed for no
other purpose than to accomplish this transaction, and did no substantive
business before or after it finished the transaction here. Although K-Pipe
obtained financing for its purchase of Langley’s stock, that financing was wholly
secured by Midcoast’s funds equal to the loan deposited in escrow accounts.
Thus, while technically a loan, it was effectively no different than purchasing the
stock with Midcoast’s funds. That financing was obtained through a foreign
bank known to finance these types of midco transactions. K-Pipe did not exist
prior to the transaction’s occurrence; it was created solely to buy the stock and
sell the Bishop assets. The evidence shows that Langley and Midcoast were
discussing the purchase prior to K-Pipe’s involvement, that they met together --
along with PWC -- to discuss the deal, and that the sell/buy transactions
occurred within 24 hours. This evidence supports only the inference that K-Pipe
was merely an intermediary without a bona fide role in the transaction.
Indeed, Midcoast concedes that “Midcoast wanted to acquire the Bishop
pipeline assets. But the only way Midcoast could acquire the Bishop assets at
a price Midcoast was willing to pay was if a third party (K-Pipe) acquired
Bishop’s stock from Langley and then sold the assets to Midcoast.” Midcoast
articulates only three purported business reasons why it used a conduit

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transaction rather than a direct asset purchase. First, Midcoast states that K-
Pipe sought to earn a “profit.” But this does not answer the question of why any
party was willing to pay K-Pipe to be an intermediary. Moreover, as our case
law shows, the mere payment of a fee or profit by the intermediary does not
prevent finding that the transaction was a sham. Second, Midcoast states that
it used the midco transaction form because it “wanted to acquire and operate the
Bishop pipeline assets at a price it was willing and could afford to pay.” This is
not a tax-independent business consideration; the money Midcoast saved by
lessening its tax burden allowed it to pay more for the assets.
Midcoast further contends that this transaction limited its exposure to
litigation because, had it purchased the Bishop stock, it would have been liable
for claims against Bishop. By purchasing only the assets, Midcoast contends, it
could avoid liability on known and unknown claims that might be asserted
against the Bishop corporate entity. But this in no way explains why an
intermediary was necessary: The parties could have achieved the same result
had Midcoast bought the assets directly from Langley and Bishop without using
an intermediary. See Polius v. Clark Equip. Co., 802 F.2d 75, 77 (3d Cir. 1986)
(“Liability continues [in the context of a stock sale] because the corporate body
itself survives. A different rule applies when one corporation purchases the
assets of another. Under the well-settled rule of corporate law, where one
company sells or transfers all of its assets to another, the second entity does not
become liable for the debts and liabilities, including torts, of the transferor.”).
Accordingly, the uncontroverted facts support the district court’s
determination that the IRS was entitled to disregard the form of the transaction
and treat it as a direct sale of stock. Given that the transaction was designed
solely for the purpose of avoiding taxes, and Midcoast has offered no adequate
non-tax reasons for using a conduit entity, the district court did not err in
finding the IRS appropriately disregarded the form of the transaction.

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C. Penalty Determination
In addition to challenging the IRS’s treatment of the conduit transaction,
Midcoast’s suit also challenges the imposition of a 20% underpayment penalty.
We review the district court’s decision on the penalty issue for abuse of
discretion. See Pan Amer. Life Ins. Co. v. United States, 174 F.3d 694, 696 (5th
Cir. 1999).
Midcoast makes two arguments against the district court’s ruling that the
IRS was permitted to assess the 20% penalty. First, Midcoast argues that
because it did not underpay, then no penalty could be assessed. This argument
necessarily fails in light of our decision above that Midcoast understated its
income tax liability for this transaction. Alternatively, Midcoast argues that,
even if the IRS is entitled to disregard the form of the conduit transaction, the
IRS could not assess the penalty because Midcoast had “substantial authority”
to support its actions.
The Internal Revenue Code generally provides for a 20% penalty for the
“substantial understatement of income tax.” 26 U.S.C. § 6662(a)&(b). However,
a taxpayer is not subject to the penalty if the understatement is attributable to
“the tax treatment of any item by the taxpayer if there is or was substantial
authority for such treatment.” Id. § 6662(d)(2)(B)(i). Even if there is substantial
authority supporting the taxpayer’s tax treatment, though, a taxpayer cannot
avoid the penalty in the case of tax shelters. Id. § 6662(d)(2)(C). The Code
defines a tax shelter as, inter alia, an entity or plan or arrangement “if a
significant purpose of such partnership, entity, plan, or arrangement is the
avoidance or evasion of Federal income tax.” Id.
The district court ruled that there was no substantial authority for
Midcoast’s tax treatment of the transaction and that, in any event, the conduit
transaction constituted a “tax shelter,” making the substantial authority
exception inapplicable. This was not abuse of discretion. First, all of the

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available authority indicated that this transaction -- motivated solely by the
avoidance of taxes -- would be disregarded and that Midcoast would not be
entitled to claim a stepped-up basis for the Bishop assets. This authority took
the form of both Supreme Court and Fifth Circuit precedent. Second, the
uncontroverted evidence shows that the arrangement at issue in this case had
the sole purpose of avoiding federal income tax. Thus, it falls squarely within
the Code’s definition of a “tax shelter.” It is clear that tax avoidance was, at a
minimum, a “significant purpose” of the arrangement as required by the statute.
Accordingly, we affirm the district court’s ruling that the IRS was permitted to
assess a penalty against Midcoast pursuant to § 6662.
IV. CONCLUSION
For the foregoing reasons, we AFFIRM the judgment of the district court.

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