No "red magic" for Heinz.

Many companies engage in stock buyback programs, or redemptions, often for financial reasons but occasionally for tax purposes. In May, the Court of Federal Claims denied a $42.5 million refund sought by processed-food manufacturer H.J. Heinz Co. for a claimed loss relating to a redemption.

In the early 1980s, Heinz created H.J. Heinz Credit Co. (HCC), a Delaware-based wholly owned subsidiary, to finance subsidiary operations and minimize its state tax burden. In 1994 and 1995, HCC bought 3.5 million shares of Heinz common stock on the open market. It sold 3,325,000 shares back to its parent at their then-fair market value, in exchange for zero-coupon debt convertible into 3,510,000 shares of Heinz. HCC then sold its remaining Heinz shares to an unrelated third party. HCC reported a capital loss on the sale of $124 million, which the government disallowed.

HCC determined its loss based on IRC sections 302 and 318. Section 302 determines whether a stock redemption is to be treated as a sale or a dividend, depending on how much the transaction affects the seller's ownership of the corporation redeeming the stock. Section 318 mandates that the ownership determination must include stock on which the seller holds an option to purchase. The convertible debt was treated as such an option. Thus, the redemption did not change HCC's ownership of Heinz, and it was treated as a dividend. The regulations under section 302 permit the seller to tack the basis of the redeemed stock onto the remaining stock owned, which HCC said allowed it to claim a loss when it sold the remaining stock.

The IRS challenged the claim on several grounds. First, it argued that HCC never really owned the Heinz stock. The court rejected this argument, noting that HCC had all the benefits and burdens of true ownership, including title and dividend income, and sold the stock for an actual value different from the purchase price.

The IRS then challenged the loss as the result of a sham transaction, requiring HCC to prove that the transaction had a business purpose and economic substance. HCC argued that it acquired the stock as an investment and to add substance to its activities, to counter state challenges to its existence. On this argument, the court sided with the IRS. The record showed that Heinz negotiated the redemption price before HCC even bought the stock, negating the argument that the acquisition was an investment. The record also failed to show Heinz's tax department ever recommended the transaction to protect HCC's corporate existence. As often happens, the taxpayer was hurt by its own workpapers and actions, which contradicted or fared to support its claim in the courtroom.

The court could have stopped there but chose to examine whether the step transaction doctrine applied, by both the "end-result" and "interdependence" tests. It found that both tests would treat the transaction as a single step, the purchase by Heinz of its stock in the open market. There was no question that Heinz intended to redeem the stock shortly after it was purchased by HCC and that running the stock through HCC's hands did nothing to change the outcome or effect of the transaction. Heinz could have purchased the stock directly and saved money The court emphasized a different aspect of the interdependence test than normal. Usually, the test looks to see if each step had an independent economic effect. Since the court had already concluded that HCC was the tree owner of the stock and received a dividend, the answer to this question could have been "yes." However, the court asked whether HCC would have undertaken the purchase without knowledge of the redemption. The redemption was planned, and the sale of the remaining stock had to he at a price less than the purchase price since it was purchased on the open market and sold in a private placement. Given those facts, the court concluded HCC would not have undertaken the purchase as an independent investment. Therefore, the steps were interdependent and collapsed into a single step--a direct purchase of stock by Heinz.

In his opinion, Judge Francis Allegra turned the tables on Heinz's ketchup advertising slogan "It's Red Magic time," writing, "No amount of magic, red or otherwise, can hide the meat of the transactions in question, the connective tissues and gristle of which have been revealed by the multi-tined substance-over-form doctrine." The case highlights the scrutiny that will be used on all related-party transactions and how important it is that all the documentation support the taxpayer's motives and arguments.

* H. J. Heinz Co. v. U.5., 99 AFTR2d, 2007-2940.

Prepared by Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accountancy and director, MTA Program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.