## Facts

- Coltec Industries, Inc. realized a capital gain from selling Holley Automotive, Inc. and sought to offset that gain.
- Coltec implemented a multi-step plan involving a dormant subsidiary converted into a special purpose entity, Garrison Litigation Management Group, Ltd.
- A Coltec subsidiary with significant asbestos exposure transferred contingent asbestos-related liabilities to Garrison and received Garrison stock; Coltec also issued a $375 million note connected to the structure.
- Coltec treated the transfers as tax-free under I.R.C. § 351 and claimed a high basis in the Garrison stock without a corresponding reduction for the contingent liabilities assumed.
- Coltec sold the Garrison stock to third-party investors for a nominal price and claimed an approximately $378.7 million capital loss on its consolidated return.
- The IRS disallowed the loss and assessed additional tax; Coltec paid and sued for a refund in the Court of Federal Claims.
- The Court of Federal Claims awarded Coltec the refund, rejected statutory and economic substance arguments, and questioned the legitimacy of using economic substance to override literal statutory text.
- The United States appealed.

## Issues

1. Whether the loss-generating transaction should be disregarded because it lacked economic substance, even if it complied with the literal terms of the Internal Revenue Code.
2. Whether the Court of Federal Claims erred in treating the economic substance doctrine as illegitimate or unconstitutional.
3. Whether, under I.R.C. §§ 351, 357, and 358, Garrison’s assumption of contingent liabilities reduced Coltec’s basis in the Garrison stock, including the effect of statutory exceptions and anti-abuse provisions.
4. Whether Coltec was entitled to any capital loss deduction after excluding tax effects attributable to any non-substantive steps.

## Decision

- The Federal Circuit vacated the refund judgment and remanded.
- The court held that the transaction creating the inflated stock basis lacked economic substance and had to be disregarded for tax purposes.
- The court rejected the trial court’s constitutional/legitimacy concerns, treating economic substance as a valid, long-standing interpretive doctrine grounded in Supreme Court precedent.
- The court stated that economic substance is evaluated at the level of the specific transaction producing the claimed tax benefit, not by reference to the taxpayer’s broader business activities.
- The court directed the Court of Federal Claims to recompute any allowable capital loss consistent with excluding effects of the non-substantive transaction.

## Legal Principles

- A taxpayer claiming a tax benefit must show the transaction generating the benefit is of a type the statute was intended to respect; substance controls over form in federal tax law.
- Compliance with the literal language of the Code does not require recognition of tax results from transactions lacking practical economic effects other than tax reduction.
- Economic substance analysis focuses on the discrete loss-generating transaction, not on the overall legitimacy of the taxpayer’s business.
- Courts may disregard transactions that do not meaningfully change the taxpayer’s economic position and that lack a substantial non-tax purpose, even where statutory text can be read to permit the claimed treatment.
- When a claimed loss is tied to an artificial basis-inflation structure, the loss may be denied to the extent it depends on steps lacking economic substance, with any remaining deductible loss determined on remand.

## Conclusion

The Federal Circuit held that Coltec could not claim a large capital loss produced by a basis-inflation structure because the loss-generating transaction lacked economic substance; it vacated the refund award and remanded for recomputation of any permissible loss after excluding tax effects attributable to the non-substantive steps.


Coltec Indus., Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006)