The IRS recently resolved disputed tax issues with the pharmaceutical manufacturer, Merck & Co. and its subsidiaries. The settlement resulted in payment of approximately $2.3 billion in federal tax, net interest, and penalties for tax years 1993-2001. The settlement is the largest with a single taxpayer in the history of the IRS.

Many boards of public companies are now on a house-cleaning campaign to eliminate tax liability, whether real or only possible, that would spur further investigation and/or depress future earnings. This financial reality has not gone unnoticed by IRS in driving hard bargains in tax shelter settlements.

Terms of settlement

The settlement agreement focused on three issues. All three issues involved Merck's use of a tax shelter scheme, referred to by the IRS as minority equity interest financing transactions. A tax shelter transaction is a transaction for which the sole purpose is to avoid or evade taxes. There are substantial penalties for taxpayers involved in tax shelter transactions.

The three tax-shelter based issues were:

• Proposed tax adjustment disallowing royalties and other expenses to the partnership Merck entered into in 1993 with a British Bank.
• Proposed disallowance of a capital loss and re-characterize a loan from a foreign subsidiary to Merck as a taxable distribution.
• Proposed inclusion of a loan to Merck characterized as a tax shelter transaction from a foreign subsidiary in the company's income.

(Treasury "Blue Book" on FY 2008 Revenue Proposals)