Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Property Purchase or Payment in Kind? The Oxford Paper Conundrum
Robert H. Scarborough*
If a taxpayer undertakes an obligation or assumes a liability in exchange for property, how is the transaction characterized? Did the taxpayer buy the property, paying with its promise? Or did the taxpayer receive the property as payment for its undertaking or assumption?
To anyone other than a tax lawyer, the question may seem semantic, but the tax consequences of the two ways of seeing the same facts are quite different. Under the first characterization (the Purchase Model), the taxpayer can have no income from receiving the property, since a purchase—even at a bargain—is not a taxable event. The taxpayer’s costs are treated as purchase price and are generally capitalized as incurred, except to the extent treated as interest on a deferred payment obligation.
Under the second characterization (the Fee Model), the taxpayer is deemed to receive a payment equal to the value of the property as consideration for what it has agreed to do, and then takes that as its basis in the property. This deemed payment may or may not produce current income, depending on whether the obligation is treated as debt or, if not, on the rules governing advance payments for the kind of obligation undertaken. The taxpayer then takes its costs into account as costs of performing its obligation—the timing of recognition of which depends on the kind of obligation—rather than as purchase price of property.
Whether to apply the Fee Model or the Purchase Model is a persistent issue, and it has arisen repeatedly since the early days of the income tax. This question was presented squarely by the 1936 transaction considered in the three Oxford Paper decisions, which are discussed in detail in this Article. It was hotly debated by the Justice Department and the Service in 1970, and was faced again recently by the Treasury Department and the Service in drafting 2006 regulations on the application of section 338 to taxable acquisitions of insurance companies.
The Oxford Paper issue is also a pervasive one, arising in a variety of contexts. Commentators have discussed extensively the law’s general adoption of the Purchase Model in one setting: taxable acquisition of the assets of a business subject to its liabilities, and some have considered in detail arguments for and against adopting the Fee Model in that setting. But the same issue can arise in other settings where—as in Oxford Paper—only one obligation and one asset are involved and the obligation is not related to the asset. This Article also considers those other settings, which have received less attention.
Part I of this Article illustrates the Oxford Paper issue with a series of examples, showing how it can arise in a variety of situations. Part II explains some of the advantages (and occasional disadvantages) of the Purchase Model to the taxpayer acquiring property and undertaking the obligation. Part III surveys legal authorities—beginning with Oxford Paper—considering the question whether the Purchase Model or the Fee Model applies, concluding that, with a number of exceptions, they adopt the Purchase Model.
To try to reconcile the authorities, Part IV considers a number of ways the law might plausibly choose between the two models in particular cases. This Article concludes that none of them consistently explains the authorities and that some, but not others, are reasonable ways to decide. Part V returns to the examples first used in Part I and applies the possible rules of decision considered in Part IV. Finally, Part VI argues that, in an income tax system that generally ignores contingent liabilities ( i.e., does not allow reserves) and generally does not mark assets and liabilities to market, there is no “right” answer to the question which model should apply.
* Partner, Freshfields Bruckhaus Deringer US LLP, New York, New York