AVENTIS, INC. AND SUBSIDIARIES v. COMMISSIONER OF INTERNAL REVENUE

The $38 Million FASIT Flop

Aventis, a subsidiary of Sanofi, is facing a hefty tax bill of approximately $38 million after the Tax Court disallowed its use of a financial asset securitization investment trust (FASIT). At the heart of the dispute was Aventis' attempt to deduct dividends paid to its French affiliate, Sanofi-Aventis Amerique du Nord S.A. (SAAN), as interest expenses. The IRS successfully argued that the purported FASIT was invalid, that the "grandfather" clause enacted upon the FASIT's repeal did not apply, and, crucially, that the payments to SAAN should be re-characterized as equity distributions, not deductible interest.

The Scheme: Converting Dividends to Deductions

In 2000, seeking to expand its North American operations, Aventis explored funding options, including the use of a financial asset securitization investment trust (FASIT). Investment banking firm Babcock & Brown, Inc., presented a proposal to securitize intercompany loans using a FASIT, aiming to achieve tax benefits stemming from differing tax treatments between the United States and foreign jurisdictions. Specifically, the plan involved converting dividend payments into deductible interest expenses.

The FASIT was created on July 21, 2000, through an Amended and Restated Asset Management Agreement (2000 AMA) between RPR (later Aventis), Sanofi-Aventis Amerique du Nord S.A. (SAAN), BBH Capital, Inc. (BBH), Chase, and Dynamo, a wholly-owned subsidiary of Babcock & Brown. Under this arrangement, BBH assigned its rights and obligations to Dynamo and Chase.

The core of the scheme hinged on the creation of a "Series A/E Stock." The goal was to have this stock designated as a "regular interest" within the FASIT. Under Section 860H(c)(1), a valid regular interest of a FASIT is generally treated as debt regardless of its form. The arrangement was designed so that the dividends paid on the Series A/E Stock would be treated as deductible interest for U.S. tax purposes, but as tax-exempt dividends under French tax law, exploiting a tax arbitrage opportunity.

A presentation document on Aventis' letterhead, titled "Approval of FASIT Transaction," explicitly stated that payments on these "regular interests" would be deductible, regardless of their actual form, even referring to the payments as "preferred dividends." Aventis anticipated annual savings of $12 million through this structure.

To fund the FASIT, Aventis designated a segregated pool of $571 million in intercompany loans as the initial assets. These assets consisted of debt instruments issued by RPR (UK) Holdings, Ltd., to Aventis, along with associated currency and interest rate swaps.

Despite the American Jobs Creation Act of 2004, which repealed the FASIT regime effective January 1, 2005, Aventis attempted to keep the structure alive until 2015, arguing that the "grandfathering" provisions of the repeal allowed its FASIT to continue operating.

The Statutory Failure: Not a 'Regular Interest'

Despite the American Jobs Creation Act of 2004, which repealed the FASIT regime effective January 1, 2005, Aventis attempted to keep the structure alive until 2015, arguing that the "grandfathering" provisions of the repeal allowed its FASIT to continue operating.

The Tax Court, however, delivered a major blow to this argument, finding that the arrangement never qualified as a valid FASIT from its inception. Under Section 860L(a)(1), a FASIT must meet five statutory requirements. The court found that the arrangement failed the requirement in Section 860L(a)(1)(B) that all interests in the entity be "regular interests" or the ownership interest. The Series A/E Stock failed to meet the statutory definition of a 'regular interest.'

Section 860L(b)(1)(A) defines a "regular interest" as one issued by the FASIT that is designated as such, has fixed terms, and satisfies five specific requirements. Two of these requirements proved fatal to Aventis's position. First, Section 860L(b)(1)(A)(i) requires that the interest "unconditionally entitles the holder to receive a specified principal amount (or other similar amount)." Second, Section 860L(b)(1)(A)(ii) requires that "interest payments (or other similar amounts), if any, with respect to such interest are determined based on a fixed rate, or... at a variable rate permitted under section 860G(a)(1)(B)(i)."

The court found that the Series A/E Stock failed both of these tests. The liquidation preference, intended to function as a return of principal, was contingent on the fair market value (FMV) of the FASIT assets at the time of liquidation, and the fees and expenses incurred in managing those assets. The court emphasized that FMV, as defined in United States v. Cartwright, 411 U.S. 546, 551 (1973), is the price a willing buyer would pay a willing seller, and thus inherently variable. Because the Series A/E Stockholder's return was tied to this fluctuating FMV, it did not "unconditionally" entitle them to a "specified principal amount."

Furthermore, the court determined that the dividends on the Series A/E Stock were not based on a fixed or permitted variable rate. While regulations under Section 860G allow for variable rates tied to benchmarks like LIBOR or weighted average interest rates, the dividends on the Series A/E Stock were declared at the discretion of Aventis's board of directors. The maximum amount payable was capped at the FASIT's earnings, less interest paid to other noteholders and accrued expenses. This discretionary dividend structure, the court reasoned, failed to meet the statutory requirement for a fixed or permitted variable rate.

The consequences of this failure are significant: because the Series A/E Stock did not qualify as a 'regular interest,' the entire FASIT structure was invalid from its inception under Section 860L(a)(1)(B). With no valid interest, there could be no valid FASIT.

Broken Promises: Failed Grandfathering & The Money Market Error

Even though the court determined that the FASIT was invalid from its inception, it went on to explain that the structure failed in other ways after the fact. The court highlighted two specific issues: the allocation of money market account income and Chase's withdrawal from the arrangement.

Beginning in the latter half of 2000, the FASIT invested income in a money market account. While the income generated by the account was treated as FASIT income, it wasn't factored into the principal amount when calculating the FASIT Rate Interest, which is used to determine "Additional Interest" owed to Dynamo. The IRS expert testified that there were three possible ways to allocate the money market income. The approach actually used by the FASIT was similar to a "pro rata" scenario, where the income would be included in the numerator of the FASIT Rate, but the money market account principal was not included in the FASIT assets in the denominator. This increased the FASIT Rate Interest and reduced Additional Interest, resulting in an excess allocation to the Series A/E Stockholder and the Class II Noteholder. According to the court, this allocation deviated from the transaction documents, resulting in the Series A/E Stock’s receiving more interest than the weighted average. Under Section 860L(b)(1)(A)(ii), regular interests must receive dividends based on a weighted average. Because the Series A/E Stock did not, the court found that the FASIT arrangement was invalid. Treasury Regulations Section 1.860G-1(a)(3)(ii)(B) reinforces this point.

The court next considered the impact of Chase's withdrawal from the FASIT in 2003. After Chase withdrew, Dynamo's Class I Note was reduced from $500,000 to $100,000, and a new agreement (the 2003 AMA) was executed. However, the terms governing the allocation of FASIT income remained unchanged, and Dynamo did not file an updated FASIT election. The IRS argued that this failure to update caused the Series A/E Stockholder to accrue interest at a rate higher than a permitted variable rate. The court found that after Chase's withdrawal, the income was allocated as if the Additional Interest formula had been updated; however, the basis point component of the Additional Interest formula was not changed in writing. The result was that money that should have been paid to the holder of the Class I Note instead flowed to the Series A/E Stockholder. This increase in return to the Series A/E Stockholder was not a permitted modification to a weighted average rate. Thus, the court concluded that even if the Series A/E Stock had previously been a valid regular interest, it ceased to be one upon Chase's withdrawal in 2003.

Finally, the court addressed whether the FASIT qualified for the grandfathering provision under the American Jobs Creation Act of 2004 (AJCA § 835(c)(2)). This provision stated that the repeal of the FASIT rules would not apply to FASITs in existence on October 22, 2004, if the regular interests issued by the FASIT remained outstanding in accordance with the original terms of issuance. The original agreements stated that the FASIT would terminate on January 15, 2005, but could be extended for five years with written notice by October 15, 2004. The parties failed to provide this notice by the deadline, but on January 14, 2005, they agreed to extend the FASIT and waive the 90-day renewal requirement. The court determined that this waiver resulted in a modification of the regular interests issued before October 22, 2004, because the regular interests were no longer outstanding in accordance with their original terms. Therefore, the FASIT arrangement did not meet the requirements of the grandfather clause. The original terms of the AMA, the Class I Note, and the Class II Note were modified, rendering the FASIT invalid.

Court Rejects 'Substantial Compliance' Defense

The previous section detailed how the waiver of the 90-day renewal requirement and agreement to extend the FASIT resulted in a modification of the regular interests issued before October 22, 2004, invalidating the FASIT under the grandfather clause. Aventis alternatively argued that even if the FASIT arrangement did not fully comply with all FASIT rules, it should still be treated as valid because Aventis "substantially complied" with those rules, and any errors were minor.

The IRS countered that the "substantial compliance" doctrine, a narrow equitable principle, did not apply in this case. The Tax Court agreed with the IRS. The court explained that when there is a failure to comply with the essential requirements of the governing statute, the defense of substantial compliance is unavailable. Citing Bond v. Commissioner, 100 T.C. 32 (1993), the court distinguished between requirements relating to the "substance or essence" of the statute, which demand strict adherence, and those that are merely "procedural or directory," which may be satisfied by substantial compliance.

The court emphasized that for an arrangement to be treated as a FASIT, statutory requirements had to be met. The court cited Dirks v. Commissioner, T.C. Memo. 2004-138, which declined to apply the substantial compliance doctrine to the 60-day deadline for individual retirement account rollovers under Section 408(d)(3)(A), because "the 60-day rule is not regulatory but is found in the statute itself.”

In this case, the IRS's adjustments stemmed from Code sections. Section 860L(a) provided five requirements, all of which had to be met for an entity to be treated as a FASIT. Furthermore, Section 860L(b)(1)(A) placed limits on the yields that regular interests in a FASIT could provide and required unconditional, pre-specified interest payments and return of principal. Because the Series A/E Stock did not meet the requirements of a regular interest, as required by Section 860L(a)(1)(B), the court determined that Aventis's arrangement failed to meet the statutory requirements for a valid FASIT from its inception. Because the errors related to the 'essence' of the statute, strict adherence was required. Therefore, the court held that the substantial compliance doctrine did not apply.

Equity Masquerading as Debt

As explained above, because the Series A/E Stock did not meet the requirements of a regular interest, as required by Section 860L(a)(1)(B), the court determined that Aventis's arrangement failed to meet the statutory requirements for a valid FASIT from its inception. Because the errors related to the 'essence' of the statute, strict adherence was required. Therefore, the court held that the substantial compliance doctrine did not apply.

The final nail in Aventis's FASIT coffin was the court's determination that, in substance, the Series A/E stock represented equity, not debt. In making this determination, the court applied the sixteen factors articulated in Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968). The Fin Hay factors are used to determine whether, for tax purposes, an investment should be treated as debt or equity. The court emphasized that the ultimate issue under Fin Hay is whether the transaction, measured by objective standards, "would have taken the same form had it been between the corporation and an outside lender."

After reviewing the evidence, the court found that eleven of the sixteen factors favored equity treatment. Among the most salient factors, the court noted that SAAN, as the Series A/E stockholder, had voting rights and the right to elect one member of Aventis's board of directors, indicating participation in management. Further, the Series A/E Stock was deeply subordinated to all other creditors; payments were discretionary, dependent on Aventis's earnings.

Based on this analysis, the court concluded that the Series A/E Stock was in substance equity. As a result, Aventis could not deduct the payments made to SAAN as interest expense. Under Section 162, which allows deductions for ordinary business expenses, payments of dividends are generally not deductible. The court held that Aventis must recognize the interest income generated by the FASIT assets and could not deduct the dividend payments. The court thus unwound the tax shelter, resulting in a significantly increased tax liability for Aventis.