Curtis Investment Company, LLC v. Commissioner of Internal Revenue ( 2018 )

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[PUBLISH]
IN THE UNITED STATES COURT OF APPEALS
FOR THE ELEVENTH CIRCUIT
________________________
No. 17-14573
________________________
Agency No. 010181-08
CURTIS INVESTMENT COMPANY, LLC,
Plaintiff - Appellant,
versus
COMMISSIONER OF INTERNAL REVENUE,
Defendant - Appellee.
________________________
Petition for Review of a Decision of the
U.S. Tax Court
________________________
(December 6, 2018)
Before WILSON and JORDAN, Circuit Judges, and GRAHAM, ∗ District Judge.
WILSON, Circuit Judge:
In 2000, Curtis Investment Company (CIC) entered into a tax avoidance
scheme known as a CARDS transaction, allowing it to claim a $27,724,620 capital
∗ Honorable James L. Graham, United States District Judge for the Southern District of Ohio,
sitting by designation.
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loss on its annual tax return. In 2007, the Internal Revenue Service (IRS)
Commissioner issued a Final Partnership Administrative Adjustment (FPAA)
disallowing CIC’s claimed capital loss and fee deductions on its 2000 tax return.
The IRS also applied a gross valuation misstatement penalty under 26 U.S.C.
§§ 6662 and 6664. CIC challenged the FPAA and penalties in Tax Court; the court
upheld both. CIC now contends that the Tax Court erred by incorrectly applying
the “economic substance” analysis and ignoring facts that supported CIC’s
reasonable cause defense. After review and with the benefit of oral argument, we
affirm the Tax Court’s determinations.
I. Factual and Procedural Background
A. CARDS Basics
A Custom Adjustable Rate Debt Structure (CARDS) transaction is a tax-
avoidance scheme involving a series of pre-arranged steps whereby (1) a tax-
indifferent party not subject to U.S. taxation borrows foreign currency from a
foreign bank, with interest due annually and principal due in a single “balloon”
payment 30 years in the future, (2) a U.S. taxpayer purchases a small percentage of
the loan proceeds—in the form of foreign currency or the bank’s promissory
note—in exchange for taking on joint liability for the entire loan, and (3) the U.S.
taxpayer then exchanges the purchased foreign currency for U.S. dollars or
redeems the promissory note. Currency exchanges and promissory note
2
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redemptions are taxable occurrences. The U.S. taxpayer claims that its tax basis in
the exchanged currency or redeemed note is the full amount of the loan proceeds,
not just the small percentage it actually paid for.
Section 1012 of the Internal Revenue Code provides that a taxpayer’s basis
in property is generally equal to its “cost” of acquiring the property, including any
assumption of a seller’s liabilities. This rule is premised on the expectation that
buyers will fully pay the assumed liabilities. See Comm’r v. Tufts, 461 U.S. 300,
308–09, 103 S. Ct. 1826, 1831–32 (1983). In a CARDS transaction, the U.S.
taxpayer is nominally responsible for payment of the entire principal amount of the
tax-indifferent party’s loan and thus can claim the entire amount as its basis. In
these transactions, however, banks always “call” such loans after about one year,
when a large percentage of the tax-indifferent party’s loan proceeds are available to
pay the loan at that time. Thus, the U.S. taxpayer is responsible for only slightly
more than its small share of the loan proceeds rather than the entire loan amount
but can still claim a large, artificially inflated tax loss to shelter unrelated income.
In August 2000, the IRS issued Notice 2000-44, warning taxpayers about
generating artificial losses from schemes that purported to inflate their basis in
assets. I.R.S. Notice 2000-44, 2000-2 C.B. 255. In March 2002, the IRS issued
another notice that more specifically targeted the technical argument underlying
CARDS transactions and imposed disclosure obligations on CARDS shelters’
3
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promoters and participants. See I.R.S. Notice 2002-21, 2002-1 C.B. 730. In 2005,
the IRS offered a settlement initiative whereby taxpayers could avoid litigation and
liability for a gross valuation misstatement penalty by conceding the claimed tax
benefits from their CARDS shelters and paying a reduced penalty. See I.R.S.
Announcement 2005-80, 2005-2 C.B. 967.
B. CIC’s Background
Curtis Investment Company (CIC) is an investment holding company
formed by Henry Curtis for the benefit of his family. Lonnie Baxter was named
CIC’s managing partner in 1986. 1 Prior to 1995, Baxter made CIC’s investment
decisions with assistance from private money managers. In 1995, CIC hired Eric
Zimmerman as an internal investment advisor. CIC alleges that, since 1997, it has
also relied upon business experts including Matt Levin, Barbara Coats, and others
at Windham Brannon (Windham), as well as Thomas Rogers and his firm, Rogers
& Watkins, for tax and business advice.
In 1998, Henry “Jay” Bird—son of Lonnie Baxter and president of a
mortgage company called Birdhouse Mortgages—became managing partner of
CIC. Bird formed an Investment Committee that, along with Zimmerman, created
an asset-allocation plan for CIC. CIC planned to diversify its portfolio, borrowing
1
Lonnie Baxter and her husband, Guy, individually participated in a CARDS scheme as well;
their tax deficiency case was consolidated with CIC’s in Tax Court. The Baxters are appealing
their case in the Fourth Circuit. Baxter v. Comm’r, No. 17-2402 (4th Cir. filed Dec. 7, 2017).
4
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funds at a low interest rate to make investments that would yield returns greater
than the interest cost.
CIC’s principal asset prior to February 2000 consisted of stock in American
Business Products (ABP). ABP was sold via stock sale in February 2000,
generating a $27–28 million capital gain for CIC. CIC’s accountants estimated
that CIC’s partners would owe approximately $7 million in taxes on the gain
realized on the ABP stock sale.
C. CIC’s CARDS Transaction
In the fall of 2000, Barbara Coats of Windham learned about CARDS
transactions from Roy Hahn, founder of Chenery Associates, Inc. (Chenery). 2
After advisors from Windham met with Hahn, he presented a CARDS transaction
proposal to Henry Bird and CIC. The transaction would involve a 30-year €35.3
million loan from HVB, a foreign bank,3 to Brondesbury Financial Trading, LLC
(Brondesbury), a foreign tax-indifferent entity. 4 The loan included a €5.295
million promissory note; CIC would purchase this note and assume joint and
several liability on the full €35.3 million loan. Brondesbury would hold the
2
Chenery was a San Francisco-based investment firm that developed and marketed CARDS
plans.
3
HVB stands for HVB Structured Finance, Inc., a subsidiary of Bayerische Hypo-Und
Vereinbank, AG. HVB was the bank that provided the loan in this CARDS transaction.
4
Brondesbury was formed on December 11, 2000, and consisted of two British residents.
5
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residual €30 million in a HVB deposit account to pay interest, making CIC’s
€5.295 million note interest-free.
CIC contends that its advisors investigated the proposed transaction and
parties involved. CIC negotiated loan terms and refused to proceed with the
transaction unless it could invest its interest-free loan proceeds in other investment
opportunities. CIC allegedly relied on Rogers & Watkins and Windham to
independently analyze the tax consequences of CARDS transactions. These
advisors studied a draft opinion letter from Brown & Wood (B&W), a New York
law firm, which suggested that it was “more likely than not” that CARDS
transactions had economic substance. While Chenery said that CIC’s tax benefits
resulting from the CARDS transaction would be permanent, CIC alleges that its
advisors at Windham said its taxes would be spread, not eliminated. In December
2000, CIC’s Investment Committee approved a “Capital Leverage” plan including
the CARDS transaction.
HVB deposited 85% of the €35.3 million loan proceeds into a one-year time
deposit at HVB, and disbursed the remainder in the form of a one-year €5.592
million promissory note payable to Brondesbury. CIC purchased the €5.592
million note from Brondesbury and, in exchange, took on joint and several liability
for 100% of Brondesbury’s €35.3 million debt to HVB. CIC agreed to comply
with the HVB/Brondesbury credit agreement and to provide a $6.7 million letter of
6
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credit from Canadian Imperial Bank of Commerce (CIBC) in favor of HVB as
substitute collateral in place of the HVB note.5 In December 2000, CIC entered
into a one-year forward contract with HVB which would allow CIC to convert U.S.
dollars into euros on December 14, 2001 at a specified rate: 0.9402 dollar-to-euro. 6
Brondesbury’s collateral—the €30.005 million time deposit— was the first
source of payment for all obligations to HVB under the credit agreement. CIC
alleges that HVB confirmed that the €35.3 million loan would last for 30 years,
until December 14, 2030.7 If the credit agreement remained in place,
Brondesbury’s collateral would decrease over time due to net outflows of interest,
and CIC would have to increase the CIBC line of credit. If the loan lasted for 30
years, CIC would pay interest directly to HVB for the last four years of the term.
After purchasing the €5.592 million note from Brondesbury, CIC redeemed
the note and directed HVB to exchange it for $4,892,580, which CIC deposited
into a CIBC interest-bearing account. CIC allocated the proceeds among its
chosen asset managers six weeks later, at the next Investment Committee meeting
on February 15, 2001.
5
This letter of credit was to terminate on December 27, 2001.
6
Forward contracts allow parties to exchange an asset at a specified time for a specified amount.
7
Although the agreement’s expiration date was December 14, 2030, provisions of the agreement
and related financial instruments had one-year terms, and Brondesbury’s 85% collateral was kept
in a one-year time deposit.
7
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CIC paid Chenery $1,938,465 for its CARDS plan and paid CIBC $241,000
in upfront fees for its letter of credit. CIC’s payment to Chenery included indirect
payments to Brondesbury and HVB, as well as an indirect payment of $50,000 to
B&W for an opinion letter regarding the legality of CARDS plans.8 In total, these
CARDS transaction fees constituted around 45% of the amount received by CIC.
On November 13, 2001, CIC’s advisors learned that HVB planned to call its
loans to CIC and the Baxters. 9 CIC then received a mandatory prepayment
election, negotiated a traditional margin loan from CIBC for $8.5 million, and used
part of that margin loan to satisfy its obligations to HVB. Because Brondesbury’s
collateral account at HVB still contained most of the original loan amount, CIC
only paid the equivalent of $5,378,764.49 to retire the entire €35.3 million HVB
loan. CIC used $5,369,208.60 of the margin loan proceeds to purchase €5,710,709
from HVB pursuant to their December 2000 forward contract, which it then
applied to its HVB loan obligation; the forward contract proceeds covered all but
approximately $9,550 of CIC’s final payment obligation on the €35.3 million loan.
On its U.S. Return of Partnership Income (Form 1065) for 2000, CIC
reported a long-term capital gain of $28,597,759 from the ABP stock sale and
8
The Tax Court noted that this letter was promised as part of the CARDS package and
Chenery’s fees were used to pay B&W, indicating that B&W had a conflict of interest.
Furthermore, executive actors at Chenery (Roy Hahn) and B&W (R.J. Ruble, CIC’s contact at
the firm) were clearly connected.
9
Levin testified that HVB told him it was withdrawing due to the events of September 11, 2001.
8
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claimed a $27,724,620 capital loss generated through its CARDS transaction. In
calculating this loss, CIC treated the full amount of the HVB debt ($32,617,200) as
its basis in the HVB promissory note that it redeemed for $4,892,580, under the
theory that CIC had assumed joint and several liability for the entire HVB loan.
CIC also claimed a fee deduction of $1,400 for amortized loan origination fees
paid as part of the CARDS transaction. CIC alleges that it relied upon Windham to
prepare its tax returns and that Windham assured CIC that it viewed the tax
treatment as correct.
D. Post-CARDS Transaction
In 2007, the IRS issued a FPAA disallowing CIC’s claimed $27,724,620
capital loss and $1,400 fee deductions on its 2000 tax return. The IRS raised
alternative grounds for disallowing the claimed loss, including (1) CIC’s failure to
establish its claimed basis and (2) the lack of economic substance in the CARDS
transaction.10 The IRS also imposed a gross valuation misstatement penalty.
In 2008, CIC petitioned for redetermination of its 2000 FPAA. The Tax
Court held a condensed four-day trial for CIC and the Baxters (collectively
referred to as Taxpayers). Curtis Inv. Co., LLC v. Comm’r, No. 10181–08, 16835–
08, 2017 WL 3314283, 114 T.C.M. 141 (2017).11 During the trial, CIC
10
In addition, the IRS maintained that CIC’s claimed fee deduction lacked economic substance.
11
The Tax Court made findings with respect to all Taxpayers in a single opinion.
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presented two experts 12 to challenge its FPAA determination, and the IRS
introduced an expert report by A. Lawrence Kolbe. 13 Dr. Kolbe focused on
Taxpayers’ CARDS transactions as financing decisions and did not analyze
subsequent investments, concluding that the transactions were not economically
rational because the expected rate of return did not exceed or equal the expected
rate of return in capital markets on alternative investments of equivalent risk.14
According to the report, the transaction fees were substantially higher than those
for a loan that would yield similar proceeds, and the loan interest rate was higher
than market interest rates, without fees. The report determined that the loans were
unprofitable financing decisions. CIC challenged Dr. Kolbe’s report under Federal
Rule of Evidence 702, arguing that he should not be admitted as an expert witness.
The Tax Court admitted Dr. Kolbe’s testimony.
After trial, the Tax Court issued an opinion upholding the FPAA
determinations, concluding that the CARDS transactions objectively lacked
economic substance. The court also held that Taxpayers lacked a business purpose
12
James A. Walker, Jr. testified regarding commercial lending practices but did not address the
profit potential or business purpose of the CARDS transaction. Walker has 47 years of banking
experience and an M.B.A. from Georgia State University. Dr. Conrad S. Ciccotello testified that
Taxpayers could have profited from CARDS transactions if their annual returns exceeded 9.5%.
Dr. Ciccotello has a Ph.D in finance from Pennsylvania State University and is a professor at
Georgia State University.
13
Dr. Kolbe holds a Ph.D. in economics from the Massachusetts Institute of Technology and
previously served as an expert witness in Tax Court cases involving CARDS transactions.
14
Dr. Kolbe’s analysis suggested that the loans would reduce Taxpayers’ wealth by €2.19
million regardless of the return from the investments.
10
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for engaging in the CARDS transactions. Finally, the court upheld imposition of
accuracy-related penalties, finding that (1) Taxpayers’ claimed basis in their
redeemed notes was entirely eliminated, and (2) Taxpayers lacked reasonable
cause for their tax positions. CIC appealed. On February 27, 2018, CIC also filed
a letter with this Court pursuant to Rule 28(j) of the Federal Rules of Appellate
Procedure,15 asserting a new challenge to the Tax Court’s imposition of an
underpayment penalty under 26 U.S.C. § 6571(b)(1).
II. Economic Substance and Business Purpose of the CARDS Transaction
A. The Tax Court’s Analysis
CIC argues that the Tax Court failed to consider part of the transaction at
issue here, leading the court to incorrectly conclude that CIC’s transaction lacked
economic substance or business purpose other than the generation of tax benefits.
We review the Tax Court’s legal conclusions regarding the Internal Revenue Code
de novo, and its findings of fact for clear error. Campbell v. Comm’r, 658 F.3d
1255, 1258 (11th Cir. 2011) (per curiam). Under the clear error standard, “where
15
Rule 28(j) states:
If pertinent and significant authorities come to a party’s attention
after the party’s brief has been filed—or after oral argument but
before decision—a party may promptly advise the circuit clerk by
letter, with a copy to all other parties, setting forth the citations. The
letter must state the reasons for the supplemental citations, referring
either to the page of the brief or to a point argued orally. The body
of the letter must not exceed 350 words. Any response must be
made promptly and must be similarly limited.
FED. R. APP. P. 28(j).
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there are two permissible views of the evidence, the tax court’s choice between
them cannot be clearly erroneous.” Piggly Wiggly S., Inc. v. Comm’r, 803 F.2d
1572, 1576 (11th Cir. 1986). Factual findings based on credibility assessments are
entitled to particular deference. See id.
Section 165(a) of the Internal Revenue Code allows deductions for any
losses that are actually sustained, and not otherwise compensated for, during the
taxable year. 26 U.S.C. § 165(a). “Only a bona fide loss is allowable. Substance
and not mere form shall govern in determining a deductible loss.” Treas. Reg.
§ 1.165-1(b). “[F]ederal tax law disregards transactions lacking an economic
purpose which are undertaken only to generate a tax savings. Federal tax law is
concerned with the economic substance of the transaction under scrutiny and not
the form by which it is masked.” United States v. Heller, 866 F.2d 1336, 1341
(11th Cir. 1989). A transaction is not entitled to tax respect if it “lacks economic
effects or substance other than the generation of tax benefits, or if the transaction
serves no business purpose.” Winn-Dixie Stores, Inc. v. Comm’r, 254 F.3d 1313,
1316 (11th Cir. 2001) (per curiam). If a transaction lacks either objective
economic effects or subjective business purpose, it will be disregarded for tax
savings. See Kearney Partners Fund, LLC v. United States, 803 F.3d 1280, 1295
(11th Cir. 2015) (per curiam); United Parcel Serv. of Am., Inc. v. Comm’r, 254
F.3d 1014, 1018 (11th Cir. 2001).
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Courts evaluating a transaction for economic substance and business purpose
should exercise common sense, looking at the totality of evidence and focusing on
“the specific transactions at issue, not the activities of the entity as a whole.”
Kearney Partners Fund, 803 F.3d at 1295. A transaction objectively has economic
substance when it has economic effects other than creation of tax deductions—that
is, it has “a reasonable possibility of making a profit.” Id. “The kind of ‘economic
effects’ required to entitle a transaction to respect in taxation include the creation
of genuine obligations enforceable by an unrelated party.” United Parcel Serv. of
Am., 254 F.3d at 1018. Taxpayers may use the Internal Revenue Code to their
advantage, and therefore our subjective “business purpose” analysis distinguishes
between legitimate transactions structured in a particular way to obtain tax benefits
and illegitimate transactions created to generate tax benefits. Kearney Partners
Fund, 803 F.3d at 1295.
The Tax Court properly focused on the CARDS transaction as the specific
transaction generating the tax benefit—the artificial loss—at issue in CIC’s 2000
tax returns. See Gustashaw v. Comm’r, 696 F.3d 1124, 1136–37 (11th Cir. 2012)
(finding that a taxpayer’s “tax underpayments were ‘attributable to’ a gross
valuation misstatement within the meaning of § 6662” because the taxpayer
“report[ed] an artificially inflated basis in currency” and “the abusive tax shelter is
built upon the basis misstatement, and the transaction’s lack of economic substance
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is directly attributable to that misstatement”). CIC argues that it was motivated by
a business purpose and its transaction had economic effects other than tax
consequences because CIC planned to make a net profit from investments with
proceeds of the interest-free loan it obtained in its CARDS transaction. These
investments, however, were collateral to the CARDS transaction and did not
contribute to CIC’s ability to claim a tax benefit—thus, they are not considered to
be part of the “specific transaction.”16 If we were to accept CIC’s reasoning and
include its investments in the relevant “transaction” here, any taxpayer could
manufacture a transaction to obtain tax benefits and justify it as a financing
decision with a legitimate business purpose by planning to use the potentially ill-
gotten proceeds in a peripheral high-return investment. All taxpayers are legally
permitted to structure transactions to obtain tax benefits, but they may not
manufacture certain transactions solely to avoid paying taxes, which is what CIC
did here. See Kearney Partners Fund, 803 F.3d at 1295.
The Tax Court concluded that the CARDS transactions reduced Taxpayers’
wealth by over €2 million and would have cost even more after one year—
therefore, there was no reasonable possibility of profit. While CIC may have had a
business purpose to borrow funds for long-term investment, it had no legitimate
16
CIC’s 2000 tax return claimed a loss equal to the amount of HVB’s loan to Brondesbury less
the amount of the promissory note redeemed by CIC, supporting the conclusion that the CARDS
financing scheme alone was the loss-generating transaction, making it subject to analysis here.
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business purpose for choosing this particular financing plan, which left
considerably less money for investment than conventional financing. Moreover,
the Tax Court found that CIC did not consider financing alternatives and made no
attempt to reduce its cost of borrowing to maximize funds available for investment.
Instead, CIC used a new bank—HVB—and paid financing costs of approximately
45% of the proceeds of its loan.17 The Tax Court discussed further evidence,
including multiple one-year timeframes in documents related to the transaction,18
suggesting that CIC did not truly enter into the CARDS transaction for long-term
investment purposes and did not reasonably believe that it had taken on a genuine
enforceable obligation to repay the full HVB debt. The court thus concluded that
CIC’s CARDS transaction objectively lacked economic substance and subjectively
lacked a non-tax business purpose. The CARDS transaction is not entitled to tax
respect if it lacks either of these qualities; the Tax Court found that it lacked both,
17
The Tax Court determined that the fees CIC paid to Chenery and CIBC were significantly
above market rates for comparable financing options, creating a substantial and unnecessary drag
on the profitability of any investments. Taking these fees into account, CIC only obtained
around $2.25 million in investable funds.
18
The Tax Court noted that several items—including Brondesbury’s time deposit at HVB, CIC’s
forward contract with HVB, and CIC’s CIBC letter of credit—had one-year timeframes,
indicating the loan would not last for 30 years. The Tax Court thus did not find credible CIC’s
claim that HVB called the loan due to the events of September 11, 2001, nor that CIC believed it
would liable for the full HVB debt as the primary obligor bearing direct recourse liability to
Brondesbury for 30 years. Furthermore, CIC rushed to finalize its CARDS transaction before the
end of tax year 2000, but did not invest the resulting proceeds for nearly six weeks. The Tax
Court found that the specific timing of the transaction and subsequent investment of proceeds cut
against CIC’s claim that it pursued the CARDS transaction for investment purposes.
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and thus should be disregarded for tax savings. The findings of fact and credibility
determinations made in reaching this conclusion do not constitute clear error.
B. Expert Witness Testimony
In concluding that CIC’s CARDS transaction lacked economic substance
and business purpose, the Tax Court relied heavily on a report from the IRS expert
witness, Dr. Kolbe. Relying on Rule 702 of the Federal Rules of Evidence, CIC
argues that Dr. Kolbe should have been excluded from testifying as an expert
because he is not qualified, he is unreliable, and his methodology incorrectly
segregates finance from investment.
We review a trial court’s decision to admit expert testimony for abuse of
discretion. Kumho Tire Co. v. Carmichael, 526 U.S. 137, 152, 119 S. Ct. 1167,
1170 (1999). “That standard applies as much to the trial court’s decisions about
how to determine reliability as to its ultimate conclusion.” Id.; see also Knight
through Kerr v. Miami-Dade Cty., 856 F.3d 795, 808 (11th Cir. 2017).
Federal Rule of Evidence 702 governs admission of expert testimony in Tax
Court. 26 U.S.C. § 7453, FED. R. EVID. 702. 19 In Daubert v. Merrell Dow
19
Rule 702 states:
A witness who is qualified as an expert by knowledge, skill,
experience, training, or education may testify in the form of an
opinion or otherwise if:
(a) the expert’s scientific, technical, or other specialized knowledge
will help the trier of fact to understand the evidence or to determine
a fact in issue;
(b) the testimony is based on sufficient facts or data;
16
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Pharmaceuticals, Inc., the Supreme Court held that Rule 702 compels district
courts to screen expert scientific evidence for admissibility, and elaborated upon
what courts should consider in applying the Rule. 509 U.S. 579, 589–595, 113 S.
Ct. 2786, 2795–98 (1993). In United States v. Frazier, we summarized
considerations for trial courts determining the admissibility of expert testimony:
(1) [If] the expert is qualified to testify competently
regarding the matters he intends to address; (2) [if] the
methodology by which the expert reaches his conclusions
is sufficiently reliable as determined by the sort of inquiry
mandated in Daubert; and (3) [if] the testimony assists the
trier of fact, through the application of scientific, technical,
or specialized expertise, to understand the evidence or to
determine a fact in issue.
387 F.3d 1244, 1260 (11th Cir. 2004) (en banc). The basic requirements—
qualification, reliability, and helpfulness—are distinct, but may overlap. Id. A
witness’s knowledge, training, skill, education, or experience may qualify her as an
expert. Id. at 1260–61.
When determining the reliability of an expert’s opinion, a trial court must
assess “whether the reasoning or methodology underlying the testimony is
scientifically valid and . . . whether that reasoning or methodology properly can be
applied to the facts in issue.” Id. at 1261–62. The court should consider, to the
(c) the testimony is the product of reliable principles and methods;
and
(d) the expert has reliably applied the principles and methods to the
facts of the case.
FED. R. EVID. 702.
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extent practicable, (1) whether the expert’s theory can be and has been tested; (2)
whether the theory has been subjected to peer review and publication; (3) the
known or potential rate of error; and (4) whether the method is generally accepted
in the relevant community. Id. at 1262; see also Kumho Tire Co. v. Carmichael,
526 U.S. 137, 149, 119 S. Ct. 1167, 1174–75 (1999) (extending this analysis to
experts with “specialized knowledge”). “These factors are illustrative, not
exhaustive; not all of them will apply in every case, and in some cases other factors
will be equally important in evaluating the reliability of proffered expert opinion.”
Frazier, 387 F.3d at 1262. This flexible analysis requires that trial judges “have
considerable leeway in deciding in a particular case how to go about determining
whether particular expert testimony is reliable.” Id. (citing Kumho Tire Co., 526
U.S. at 152, 119 S. Ct. at 1176 (1999)).
“[A]pplication of an abuse-of-discretion standard recognizes a range of
possible conclusions that the trial judge may reach.” Id. at 1266. The Tax Court’s
initial decision to admit the testimony of all three proffered experts with extensive
cross-examination and argument, and then to rely primarily on the testimony of Dr.
Kolbe, was within its discretion. The Tax Court noted Dr. Kolbe’s relevant
qualifications20 and considered CIC’s evidence regarding his unreliability—
20
CIC asserts that Dr. Kolbe has no experience as a loan officer or broker, and did not consult
any banks in evaluating CIC’s CARDS transaction. We do not, however, require that all expert
18
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particularly his potential bias due to significant compensation from the IRS for
expert testimony in prior cases—before determining that Dr. Kolbe was qualified,
reliable, and provided useful testimony. Moreover, the court considered the
testimony and cross-examination of all expert witnesses to determine that Dr.
Kolbe’s method—focusing on the transaction that generated CIC’s claimed tax
benefit—was the most reliable and instructive evaluation. Given its thorough
analysis, the Tax Court did not abuse its discretion in admitting, weighing, or
relying upon Dr. Kolbe’s testimony.
III. Imposition of the Underpayment Penalty
CIC argues that, even if its CARDS transaction lacked economic substance
and business purpose, CIC should not be subject to an underpayment penalty for
the amount of the loss resulting from the CARDS transaction because it made the
understatement on its 2000 return with reasonable cause and good faith. “Whether
a taxpayer acted with reasonable cause and in good faith with regard to an
underpayment of tax is a question of fact that we review for clear error.”
Gustashaw, 696 F.3d at 1134. Section 6662(a) imposes a 20% accuracy-related
penalty on underpayment of tax for reasons listed in § 6662(b), including “[a]ny
witnesses be qualified by virtue of experience or consultation with other entities. Experts may be
qualified in various ways. Frazier, 387 F.2d at 1260–61.
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substantial valuation misstatement.” 26 U.S.C. §§ 6662(a), 6662(b)(3) (2000).21
Section 6662(h) increases the penalty to 40% for “gross” valuation misstatements.
A substantial valuation misstatement is an overstatement of 200% or more of the
correct value or basis, and a gross valuation misstatement is an overstatement of
400% or more of the correct value or basis. See id. at §§ 6662(e), (h). Treasury
Regulation § 1.6662-5(g) provides:
The value or adjusted basis claimed on a return of any
property with a[n] . . . adjusted basis of zero is considered
to be 400 percent or more of the correct amount. There is
a gross valuation misstatement with respect to such
property, therefore, and the applicable penalty rate is 40
percent.
The IRS bears the burden of production with respect to a taxpayer’s liability
for a § 6662(a) penalty and must produce sufficient evidence supporting imposition
of the penalty. See 26 U.S.C. § 7491(c). If the IRS meets this burden, “[t]he
taxpayer bears the burden of establishing that he acted with reasonable cause and
in good faith” in underpayment in order to avoid the imposition of misstatement
penalties described in 26 U.S.C. § 6662. Gustashaw, 696 F.3d at 1139 (citing 26
U.S.C. § 6664(c)(1) (2000)).
21
Sections 6662 and 6664 were amended after 2000; they now (1) carry lesser percentage
requirements for valuation misstatements and (2) expressly address “reasonable cause” and
“economic substance.” The 2000 versions of these sections apply to CIC’s 2000 tax return. The
applicability of any penalty attributable to an adjustment to a partnership item was determined at
the partnership level in 2000. See id. at §§ 6221, 6226(f) (2000).
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“Under the regulations, the determination of whether the taxpayer has
established reasonable cause is made based on all the pertinent facts and
circumstances.” Id.; see also Treas. Reg. § 1.6664-4(b)(1) (describing the
evaluation of reasonable cause and good faith as a finding of fact based on the
totality of the circumstances). “Circumstances that may indicate reasonable cause
and good faith include an honest misunderstanding of fact or law that is reasonable
in light of all of the facts and circumstances, including the experience, knowledge,
and education of the taxpayer.” Treas. Reg. § 1.6664-4(b)(1). Reasonable cause
and good faith may exist in cases of “first impression” when taxpayers take
reasonably debatable positions on their return, see Williams v. Comm’r, 123 T.C.
144, 153–54 (2004), or when taxpayers take positions on initial interpretation of
unclear statutory text, see Bunney v. Comm’r, 114 T.C. 259, 266 (2000). “A return
position that is ‘arguable, but fairly unlikely to prevail in court’ satisfies the
reasonable basis standard.” Bunney, 114 T.C. 266 (quoting Treas. Reg.
§ 1.6662-4(d)(2)).
A taxpayer may also establish reasonable cause by showing that he
“reasonably relied in good faith on the advice of an independent professional, such
as a tax advisor, lawyer, or accountant, as to the transaction’s tax treatment.”
Gustashaw, 696 F.3d at 1139. The professional advice must: (1) rely on the law
applied to all pertinent facts and circumstances; (2) not rely on another’s
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unreasonable factual or legal assumptions or unreasonable representations; and (3)
be objectively reasonable. Id. The advice must contemplate “the taxpayer’s
purposes (and the relative weight of such purposes) for entering into a transaction
and for structuring a transaction in a particular manner.” 22 Treas. Reg. § 1.6664-
4(c)(1)(i). Reliance is not reasonable if the advisor promoted the transaction or
otherwise had a conflict of interest about which the taxpayer knew or should have
known. Gustashaw, 696 F.3d at 1139. Reliance is likewise unreasonable “when
the taxpayer knew or should have known that the transaction was too good to be
true in light of all the circumstances.” Id. (internal quotation marks omitted).
The 40% gross valuation misstatement penalty applies to CIC’s reported tax
loss from the CARDS transaction because (1) the transaction lacked economic
substance, and (2) the correct basis of CIC’s redeemed note was zero, causing
underpayments in CIC’s partners’ taxes for 2000. Treas. Reg. § 1.6662-5(g); see
also United States v. Woods, 571 U.S. 31, 43–44, 134 S. Ct. 557, 565–66 (2013).
Thus, CIC is subject to this 40% penalty unless it can show that it had reasonable
cause for its underpayment and acted in good faith. CIC argues that it should not
be subject to this penalty because it did have reasonable cause to claim the
22
“[A]dvice must not be based upon a representation or assumption which the taxpayer knows,
or has reason to know, is unlikely to be true, such as an inaccurate representation or assumption
as to the taxpayer’s purposes for entering into a transaction or for structuring a transaction in a
particular manner.” Treas. Reg. § 1.6664-4(c)(1)(ii).
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$27,724,620 capital loss on its 2000 tax return, and acted in good faith. CIC
claims that it had reasonable cause because (1) CIC’s managers reasonably relied
upon counsel of professional advisors—including advice in an opinion letter from
B&W and the assurances of CIC’s other advisors—regarding the tax treatment of
CARDS transactions, and (2) CIC took a reasonable position in its 2000 tax return
under the unclear law that existed at the time.
The Tax Court addressed CIC’s argument that it had reasonably relied on the
counsel of professional advisors in claiming a $27,724,620 loss, finding that CIC’s
reliance upon professional advice from B&W or any of its other advisors was
objectively unreasonable in light of the facts. The court evaluated witness
credibility and the facts in the record to conclude that CIC knew or should have
known that B&W’s opinion letter was not independent advice but was provided as
part of Chenery’s promotion of the CARDS plan, and CIC also knew or should
have known that the CARDS transaction was too good to be true, regardless of
what any advisors may have said.23 The court also concluded that CIC did not
23
The Tax Court noted that Chenery selected B&W to evaluate the CARDS transaction. In the
initial stages of setting up the CARDS transaction, the chief CARDS promoter at Chenery, Mr.
Hahn, cited as a reference Mr. Ruble, CIC’s contact at B&W. Moreover, B&W’s opinion letter
was promised as part of the CARDS package and CIC paid B&W indirectly through Chenery,
clearly indicating that B&W had a conflict of interest.
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reasonably rely upon its local advisors at Windham or Rogers & Watkins for tax
advice, because this advice was based on B&W’s opinion letter.24
In evaluating the reasonableness of CIC’s reliance and good faith with
respect to the position that it took on its 2000 tax return, the Tax Court determined
that CIC’s managers were not as “unsophisticated” as they claimed to be. CIC
argued that its managers lacked tax sophistication, but the court properly
considered the “education, sophistication, and business experience” of the
managers and the CIC Investment Committee more broadly. 25 See Treas. Reg.
§ 1.6664-4(b)(1). The court found relevant the CIC managers’ substantial
knowledge and experience with respect to loans and investment, suggesting that
they were familiar with ordinary financing transactions and tax consequences. The
court noted how CIC’s managers had considerable experience in financing
transactions but did not investigate alternative financing options despite the high
cost of the CARDS transaction. Ultimately, the court concluded that CIC did not
reasonably rely on professional advice in drafting its 2000 tax returns.
CIC also argued that it had reasonable cause for its underpayment in 2000
because CARDS plans were a novel legal issue at that time, and CIC took a
24
CIC’s advisors looked into some of the materials cited in the letter but failed to conduct any
independent legal research despite the clearly apparent conflict of interest created by the evident
relationship between Chenery and B&W.
25
The Committee included an individual with an executive MBA, an individual with a business
degree, and several people with investment experience. Lonnie Baxter and Henry Bird,
managers of CIC and members of the Committee, both had significant experience with loans.
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reasonable position given the unclear nature of the law. Although CARDS was a
new tax structure in 2000, the legal theory underlying the FPAA issued to CIC was
already established: transactions lacking economic substance are disregarded for
tax purposes. The IRS issued Notice 2000-44 in August 2000, warning taxpayers
about generating artificial losses from schemes that purported to inflate basis in
assets. I.R.S. Notice 2000-44, 2000-2 C.B. 255. The IRS stressed that it would not
recognize transactions lacking economic substance or business purpose for tax
purposes, and taxpayers who claimed artificial tax benefits through such schemes
would be subject to penalties. Id.
Notice 2000-44 did not explicitly address the illegality of a CARDS
transaction, but described improper methods by which taxpayers attempted to
inflate their adjusted basis to claim a loss in their taxes. Specifically, Notice 2000-
44 stated that “a loss is allowable as a deduction for federal income tax purposes
only if it is bona fide and reflects actual economic consequences. An artificial loss
lacking economic substance is not allowable.” Id. Notice 2000-44 then cited ACM
Partnership v. Commissioner, which described “bona fide losses” and recognized
the relevant “transactions whose economic substance is at issue” as the
“exchange . . . which gave rise to the disputed tax consequences.” 157 F.3d 231,
252, 260 (3d Cir. 1998).
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Notice 2000-44 also cited Scully v. United States, 840 F.2d 478, 486 (7th
Cir. 1988) (finding that deductible losses must be “genuine economic loss[es]”),
and Shoenberg v. Commissioner, 77 F.2d 446, 448 (8th Cir. 1935), to provide
guidance regarding the nature of bona fide losses with economic substance. In
Shoenberg, the Eighth Circuit recognized that it was proper to “examin[e] all
matters, relating to the sale by the taxpayer, which bear upon the deductible
character of the loss shown by that sale.” 77 F.2d at 448. The Eighth Circuit
stated that the specific transaction to examine was “the entire transaction on
account of which the deduction was claimed.” Id. at 448–49. When CIC engaged
in a CARDS transaction, it knew—based on a reading of B&W’s opinion letter—
that the IRS had issued Notice 2000-44. The Tax Court determined that CIC was
not dealing with a novel tax law issue in 2000, and CIC should have reasonably
concluded based on the existing law and language in Notice 2000-44 that its
CARDS loss-generating scheme—which would allow it to overstate its adjusted
basis—was a plan to “generate an artificial tax loss,” and thus would be subject to
penalty. I.R.S. Notice 2000-44, 2000-2 C.B. 255.
Regardless of whether a novel issue existed, the Tax Court considered all
facts and circumstances in evaluating reasonability and good faith. See Treas. Reg.
§ 1.6664-4(b)(1). Here, the court considered CIC’s alleged reliance on its
professional advisors, the sophistication and experience of CIC’s managers, and
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the applicability of existing law in 2000 to determine that CIC lacked reasonable
cause and good faith. The court supported its findings in its opinion by including
facts and credibility determinations upon which it relied. Based on the totality of
circumstances, the Tax Court chose a permissible view of the evidence and did not
clearly err in finding that CIC lacked reasonable cause and good faith in
underpayment.
IV. Challenge Under 26 U.S.C. § 6751(b)(1)
Finally, CIC challenges the IRS imposition of a penalty in this case by
asserting that the IRS did not comply with 26 U.S.C. § 6751(b)(1), which provides
that “[n]o penalty under this title shall be assessed unless the initial determination
of such assessment is personally approved (in writing) by the immediate supervisor
of the individual making such determination or such higher level official as the
Secretary may designate.” CIC claims that the recent resolution of Graev v.
Commissioner, 149 T.C. No. 23 (2017), provided new grounds for challenging the
Tax Court’s imposition of penalties in the present case under § 6751(b)(1). CIC
has waived this challenge, and we decline to consider it now.
Appellate courts have discretion to decide whether to consider a legal issue
or theory raised for the first time on appeal. United States v. S. Fabricating Co.,
764 F.2d 780, 781–82 (11th Cir. 1985) (per curiam). Parties cannot raise new
issues at supplemental briefing, even if the issues arise based on intervening
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decisions or new developments. See United States v. Nealy, 232 F.3d 825, 830
(11th Cir. 2000); see also McGinnis v. Ingram Equip. Co., Inc., 918 F.2d 1491,
1495–96 (11th Cir. 1990) (noting that waiver usually bars “new arguments and
issues not presented until a late stage of the proceedings,” but not “new law that
could be applied to arguments already developed”).
CIC could have brought a challenge under § 6751(b)(1) during or after Tax
Court proceedings prior to appeal, as other taxpayers have done. See, e.g., Chai v.
Comm’r, 851 F.3d 190, 203 (2d Cir. 2017). CIC failed to do so, instead raising the
issue for the first time in supplemental appellate briefing. We decline to consider
this non-jurisdictional challenge for the first time now. Accord Mellow Partners v.
Comm’r, 890 F.3d 1070, 1080–82 (D.C. Cir. 2018) (refusing to consider a § 6751
challenge brought for the first time on appeal in similar circumstances); cf. Chai,
851 F.3d at 223 (holding that a taxpayer properly raised a challenge under § 6751
in a post-trial brief to the Tax Court, thus preserving the issue for appeal).
V. Conclusion
The Tax Court did not err in concluding that CIC’s CARDS transaction
lacked economic substance or business purpose, nor in finding that CIC was liable
for a 40% gross valuation misstatement penalty for its 2000 tax return. Finally, the
Tax Court did not clearly err in determining that CIC lacked reasonable cause and
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good faith in making an understatement on its 2000 tax return. Accordingly, we
affirm.
AFFIRMED.
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