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This Wednesday, June 20, 2012 file photo shows a burger and fries at a Burger King in Richardson, Texas.LM Otero/The Associated Press

Even lawyers like a good mystery. And, when Burger King Worldwide Inc. announced its acquisition of Tim Hortons Inc., Bloomberg View's Matt Levine found a good one: How can the private equity group that owns Burger King get around U.S. rules causing investors to pay tax on the exchange of shares in an international merger transaction, when the new company will be based in Canada?

The nice thing about legal mysteries is that they have a solution and, after speaking with U.S. tax lawyers, spending some quality time with the U.S. Internal Revenue Code, and reading the takeover circular released yesterday, I think I've got a solution. I warn you, though, it's going to get dry before it gets fun.

While I've argued before that this deal isn't just about tax savings, taxes matter, and one reason for relocating in Canada is to shrink the company's tax bill. As the old legal axiom goes, and as harried corporate lawyers quickly find out, tax drives structure. And the structure of the Burger King/Tim Horton's deal is novel. Instead of exchanging their shares for shares in a new company (as is typical), Burger King shareholders can elect, subject to availability, to receive partnership units in a newly-formed Ontario limited partnership controlled by a new parent company. These partnership units can be converted into shares of the new company or cash after one year and are, according to the circular, not subject to rules causing shareholders to recognize a taxable gain on the exchange. Unsurprisingly, 3G Capital, the Brazilian private equity firm funding much of the deal, has elected to receive partnership units.

The mystery is how shareholders will avoid recognizing a taxable gain on their partnership units. In general, under section 351 of the U.S. tax code, shareholders are allowed to exchange their shares in a company for shares in another company without paying tax on the transaction. This makes sense – corporations are bought and sold all the time, and forcing shareholders to recognize taxes on each transaction would discourage M&A. However, if those sections applied to transactions that give U.S. shareholders shares in a foreign corporation, shareholders could routinely avoid paying U.S. tax by transferring their assets into low tax jurisdictions. To prevent this, the U.S. enacted section 367, which denies the protection of section 351 to persons exchanging their shares for shares in a foreign corporation, forcing people exchanging shares internationally to pay capital gains. This gets the IRS its tax revenue and acts as a disincentive to corporations to engage in controversial "tax inversions."

Section 367 operates by saying that for the purposes of a transfer of property to a foreign corporation, that corporation will not be considered to be a corporation, and will therefore be denied the protection of section 351. And, most of the time, this would mean recognizing a gain.

Of course, section 367 anticipates a transfer of property to a foreign corporation, not a foreign partnership. So, under the Code, neither 367 nor 351 apply and, instead, the rules relating to a transfer of property in exchange for partnership units apply. And if you exchange shares for partnership units, the Code doesn't make you pay taxes on that transfer.

In other words, U.S. tax law doesn't anticipate that U.S. shareholders would ever exchange their shares for shares in a foreign partnership. Mystery solved.

While I'd like to take credit for this deduction, I am not M. Poirot – this is basic interpretation of the law. So why did it throw so many commenters, myself included, for a loop?

Mostly, I think, because it seemed unlikely that the Code would contain a loophole that allows a company to use a different legal structure to avoid the government's policy goals. The purpose of section 367 is obviously to prevent transactions like this; the U.S. government wants its tax revenue, it doesn't care if the property is being transferred to a foreign corporation, a foreign partnership or a foreign dog.

Indeed, the takeover circular anticipates that the IRS and the courts may object to this strategy. Even though Burger King's lawyers have done what they can to maintain the integrity of the partnership structure – in particular, the one year hold period and the fact that the exchange can be satisfied with cash – the IRS and the courts will have the final say. Unsurprisingly, given the novelty of the structure, there is no precedent for either side to rely on in a future dispute. So there's a risk that Burger King's clever argument will fail.

But, come on. Tax law is a creature of a large, complex statute, but it's still a creature of statute. Theoretically, tax lawyers – the real M. Poirots – should be able to read the statute, read the regulations, and come to a correct answer. For the IRS to win a potential dispute, they'd have to argue that the words "foreign corporation" actually mean "foreign corporation or partnership." For Burger King, and for you and me come tax time, we should be able to rely on the words of the tax code. not be forced to impute policy reasoning into the legislature's drafting.

This is a case of "fool me once, shame on you; fool me twice, shame on me." If the U.S. wants to prevent these transactions in the future, Congress simply needs to change two words in the Code. But, to retroactively punish Burger King for Congress's drafting error or for Burger King's lawyers cleverness? That's unfair, and bad legal reasoning.

In the end, the real mystery isn't how Burger King plans to avoid capital gains tax on the partnership units, it's how the U.S. Congress failed to anticipate this issue. Though looking at the U.S. Congress, it may be no mystery at all.

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