ACM Partnership v. Commissioner IRS (Part I)

Opinions of the United
1998 Decisions States Court of Appeals
for the Third Circuit
10-13-1998
ACM Partnership v. Commissioner IRS (Part I)
Precedential or Non-Precedential:
Docket 97-7484,97-7527
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Volume 1 of 2
Filed October 13, 1998
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
Nos. 97-7484 and 97-7527
ACM PARTNERSHIP,
SOUTHAMPTON-HAMILTON COMPANY,
TAX MATTERS PARTNER,
Appellant in No. 97-7484
v.
COMMISSIONER OF INTERNAL REVENUE
ACM PARTNERSHIP,
SOUTHAMPTON-HAMILTON COMPANY,
TAX MATTERS PARTNER,
v.
COMMISSIONER OF INTERNAL REVENUE
Appellant in No. 97-7527
On Appeal from the United States Tax Court
(Tax Court No. 10472-93)
Argued June 23, 1998
BEFORE: GREENBERG, ALITO, and McKEE,
Circuit Judges
(Filed October 13, 1998)
Albert H. Turkus (argued)
Fred T. Goldberg, Jr.
Pamela F. Olson
Skadden, Arps, Slate
Meagher & Flom, LLP
1440 New York Avenue, N.W.
Washington, D.C. 20005
William L. Goldman
Christopher Kliefoth
McDermott, Will & Emery
600 Thirteenth Street, N.W.
Washington, D.C. 20005
Attorneys for Appellant
and Cross Appellee ACM
Partnership, Southampton-Hamilton
Company, Tax Matters Partner
Loretta C. Argrett
Assistant Attorney General
Richard Farber
Edward T. Perelmuter (argued)
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044
Attorneys for Appellee
and Cross Appellant
Commissioner of Internal Revenue
OPINION OF THE COURT
GREENBERG, Circuit Judge.
I. INTRODUCTION
Appellant ACM Partnership ("ACM"), through its tax
matters partner Southampton-Hamilton Company
("Southampton"), appeals from a decision of the United
States Tax Court dated June 12, 1997. The Tax Court's
jurisdiction rested on I.R.C. SS 7442, 6213 and 6226 based
2
on appellant's timely filing of a petition seeking
redetermination of a deficiency and review of a Final
Partnership Administrative Adjustment. Appellate
jurisdiction rests on I.R.C. S 7482(a)(1). Venue is proper
pursuant to I.R.C. S 7482(b)(1)(A) as Southampton
maintained its principal place of business within this
circuit at the time it filed its petition. For the reasons that
follow, we will affirm in part, reverse in part, dismiss the
Commissioner of Internal Revenue's cross appeal, and
remand for further proceedings.
II. FACTUAL AND PROCEDURAL HISTORY
This appeal concerns the tax consequences of a series of
transactions executed between November 1989 and
December 1991 by appellant ACM, a partnership formed on
October 27, 1989, with its principal place of business in
Curacao, Netherlands Antilles. Each of ACM's three
partners was created as a subsidiary of a larger entity
several days before ACM's formation. Southampton was
incorporated under Delaware law on October 24, 1989, as
a wholly-owned subsidiary of Colgate-Palmolive Company
("Colgate"), an international consumer products company.
Kannex Corporation N.V. ("Kannex") was incorporated
under Netherlands Antilles law on October 25, 1989, as an
entity controlled by Algemene Bank Nederland N.V. ("ABN"),
a major Dutch bank. ACM's third partner, Merrill Lynch
MLCS, Inc. ("MLCS"), was incorporated under Delaware law
on October 27, 1989, as a wholly owned subsidiary of
Merrill Lynch Capital Services, an affiliate of the financial
services holding company Merrill Lynch & Co., Inc. ("Merrill
Lynch"). See ACM Partnership v. Commissioner, 73 T.C.M.
(CCH) 2189, 2190, 2197 (1997); app. at 81-84, 89-91.
A. The Proposed Partnership
The concept behind the ACM partnership originated in a
proposal which Merrill Lynch presented to Colgate in May
1989. During the previous year, Colgate had reported
$104,743,250 in long-term capital gains which were
attributable in significant part to the sale of its wholly
owned subsidiary The Kendall Company ("Kendall"). See
3
app. at 74-75. Colgate had considered and rejected several
proposals to reduce the tax liability arising from those 1988
capital gains, see app. at 664, when Merrill Lynch
representative Macauley Taylor approached Colgate's
Assistant Treasurer Hans Pohlschroeder in May 1989 and
proposed an investment partnership that would generate
capital losses which Colgate could use to offset some of its
1988 capital gains. App. at 674-76, 784, 965.1
Pohlschroeder related the plan to Colgate's Vice President
of Taxation Steven Belasco, who expressed reservations
because the plan entailed substantial costs, might not be
recognized for tax purposes, and did not seem to serve
Colgate's non-tax business purposes, and thus might not
be well-received by Colgate's legal, financial, and
accounting departments who would be required to
participate in the plan. See 73 T.C.M. at 2191; app. at
1234-36. Colgate consulted a law firm for advice on the
proposed transaction, which the law firm summarized as
follows:
A (a foreign entity), B, and C form the ABC Partnership
(ABC) on June 30, 1989 with respective cash
contributions of $75, $24 and $1. Immediately
thereafter, ABC invests $100 in short-term securities
which it sells on December 30, 1989, to an unrelated
party. The fair market value and face amount of the
short-term securities at the time of the sale is still
$100. In consideration for the sale, ABC receives $70
cash and an installment note that provides for six
semiannual payments . . . Each payment equals the
sum of a notional principal amount multiplied by the
London Interbank Offering Rate (LIBOR) at the start of
the semiannual period.2 ABC uses the $70 cash and
the first payment on the installment note to liquidate
A's interest in ABC and uses the subsequent interest
payments to purchase long-term securities.
_________________________________________________________________
1. The proposal was premised on I.R.C. S 1212(a), which permits a
taxpayer to carry back a capital loss to offset capital gains recognized
within the preceding three years.
2. The LIBOR [London Interbank Offering Rate] is the primary fixed
income index reference rate used in [Europeanfinancial] markets.
(Footnote is by Tax Court.)
4
73 T.C.M. at 2191.
The law firm advised that the sale of the short-term
securities would be reported as a contingent installment
sale under the installment method which governs
"dispositions[s] of property where at least 1 payment is to
be received after the close of the taxable year in which the
disposition occurs," I.R.C. S 453, and the ratable basis
recovery rule which provides that,
[w]hen a stated maximum selling price cannot be
determined as of the close of the taxable year in which
the sale or other disposition occurs, but the maximum
period over which payments may be received under the
contingent sale price agreement is fixed, the taxpayer's
basis (inclusive of selling expenses) shall be allocated
to the taxable years in which payment may be received
under the agreement in equal annual increments.
Temp. Treas. Reg. S 15a.453-1(c)(3)(i).3 Thus, the law firm
advised, ABC would recover $25 of its basis in each of the
4 taxable years from 1989 through 1992, and ABC would
recognize gain to the extent that the payments received in
any year exceeded the $25 or loss to the extent that the
payments fell below the $25, but only if the loss were
carried over to a year with sufficient reported gains against
which to offset that loss. See 73 T.C.M. at 2191.
On July 18, Pohlschroeder and Taylor, who had
presented Merrill Lynch's proposal to Pohlschroeder's
colleagues in Colgate's treasury department, discussed
Colgate's concerns about the proposed partnership
transaction, including its costs and its potential to serve
Colgate's business purposes. Pohlschroeder's handwritten
notes of the conversation read as follows:
. . .
Based on bus. purpose
Economic profit
Is this partnership profitable?
_________________________________________________________________
3. All citations to the Internal Revenue Code and Treasury regulations
with respect to both this case and the cases we cite are to the versions
in effect at the time of the relevant transactions.
5
Every single step to be substantiated
invest in your own debt
Consolidation of effective control but not majority
ownership.
App. at 634, 791.
Colgate was interested in the concept of using the
proposed partnership to invest in its own debt because of
recent developments which had weighted Colgate's debt
portfolio toward fixed-rate long-term debt, leaving Colgate
vulnerable to a decline in interest rates.4 Moreover,
persistent rumors that Colgate was a likely target for a
hostile takeover or leveraged buyout had decreased the
value of Colgate's debt issues due to the risk that Colgate's
credit rating would be downgraded if Colgate became more
highly leveraged. Because of these factors, Colgate
perceived an opportunity to rebalance its debt profile, thus
decreasing its exposure to falling interest rates, by
acquiring its long-term debt issues at their presently
discounted prices. See app. at 666-68, 880-82, 2762-63,
2765, 2769-70; 73 T.C.M. at 2192.
Colgate and Merrill Lynch discussed the possibility of
using the proposed partnership to achieve these objectives.
The acquisition of its own debt issues would decrease
Colgate's exposure to falling interest rates because by
acquiring those debt issues as an asset, Colgate effectively
would reap the benefits of receiving the above-market
interest payments due on those issues, thus hedging
against the burdens associated with owing those payments.
See 73 T.C.M. at 2193. Acquiring the debt through the
partnership instead of directly would keep the acquisitions
off Colgate's books, thus permitting Colgate to carry out its
_________________________________________________________________
4. The elevated proportion of long-term debt in Colgate's debt structure
arose in part from Colgate's use of the proceeds from the Kendall sale to
retire significant amounts of short-term debt and its issuance of long-
term debt to finance an employee retirement plan. See 73 T.C.M. at
2192; app. at 77-78, 669-70, 2761, 2764-70. This high proportion of
long-term fixed-rate debt exposed Colgate to risk in the event of
declining
interest rates, as Colgate would receive diminished returns from its cash
balances and short-term deposits, but would continue to owe interest on
its debts at the higher fixed rate.
6
debt acquisition strategy without alerting potential
acquirors to the internal accumulation of debt issues
which, by increasing the capacity for internal leverage,
would increase Colgate's vulnerability to a hostile takeover
bid. See 73 T.C.M. at 2192-93; app. at 101, 3249-50, 1921-
26, 2793-99, 2810, 2819-20, 3255-61. Thus, the
acquisition of Colgate debt through the partnership would
allow Colgate to use partnership capital to acquire its debt
issues immediately at advantageous prices, then to retire
and reissue the debt when market conditions were more
favorable. In the interim, the debt effectively would be
retired because Colgate would not owe the obligations
thereon to third parties, yet the debt would remain
outstanding for accounting purposes, reducing Colgate's
vulnerability to potential acquirors. See app. at 673; 73
T.C.M. at 2193.
On July 28, 1989, Merrill Lynch presented a proposed
partnership transaction summary which incorporated
Colgate's debt acquisition objectives into the tax reduction
proposal involving the contingent installment sale which
Merrill Lynch had presented to Colgate in May 1989. See
app. at 678-79. Merrill Lynch revised its proposals
throughout the summer and approached ABN about
participating in the partnership with Colgate and Merrill
Lynch. Merrill Lynch explained to ABN that the partnership
would invest in Colgate long-term debt to serve Colgate's
debt management objectives, would engage in a contingent
installment sale, and would require ABN's participation for
no more than 2-3 years. ABN agreed to meet with Colgate
representatives in the middle of October 1989. See 73
T.C.M. at 2193-94.5
In a document dated August 17, 1989, Merrill Lynch set
forth revisions to the planned partnership transactions
which it had presented to Colgate on July 28, 1989. See
app. at 275-77. This document, entitled "Revised
_________________________________________________________________
5. ABN was familiar with its role in the proposed transaction, as Merrill
Lynch had approached ABN in early 1989 while it was developing the
proposal and had sought ABN's participation in a similar partnership
arranged on behalf of another Merrill Lynch client. See 73 T.C.M. at
2194; app. at 1670-75, 1103.
7
Partnership Transaction Summary," see app. at 263-67, set
forth the following proposal incorporating both the
contingent installment sales transaction which Merrill
Lynch initially had proposed in May 1989 and the debt
acquisitions which Merrill Lynch had incorporated in its
July 28 proposal:6
1) A Colgate subsidiary contributes $30 million, A BN
contributes $169.3 million and Merrill Lynch
contributes $.7 million.
2) The partnership invests its entire $200 million
capitalization in short-term, floating rate private
placement securities as "Interim Investments prior to
the acquisition of [Colgate] debt" which are to "earn a
return greater than comparably rated commercial
paper or bank deposits."
3) The partnership sells the short-term notes for a
combination of cash and LIBOR-based notes and uses
the cash to acquire Colgate debt. "The purpose of the
LIBOR notes will be to partly hedge the interest rate
sensitivity of long-term [Colgate] debt acquired by the
Partnership."
4) The partnership exchanges a portion of the long -
term Colgate debt for newly issued medium-term
Colgate debt, pursuant to a provision which affords
Colgate the option of making such exchanges through
the partnership.
5) The partnership adjusts its LIBOR note holdings. If
the partnership retains a substantial amount of long-
term debt, the Partnership "would likely . . . acquire
additional LIBOR-based assets or . . . other hedges to
reduce interest rate sensitivity of Partnership assets.
Alternatively, if a substantial amount of long-term
[Colgate] debt is exchanged, the Partnership would
_________________________________________________________________
6. The August 17 transaction summary referred to Colgate as "XYZ
corporation," ABN as "Partner A," and Merrill Lynch as "Partner B."
However, the identity of the parties is clear from the role that each of
them played in the ensuing transactions and from Pohlschroeder's
testimony. See app. at 685. Except where there are direct quotations we
have paraphrased the summary.
8
likely reduce its holding of LIBOR notes. Such a
reduction would be necessary because the Medium-
Term Debt, received in exchange for long-term [Colgate]
debt, is less interest rate sensitive than the long-term
[Colgate] debt. LIBOR Notes may either be sold directly
or distributed to one or more Partners in a non-
liquidating distribution."
6) If the partnership has not invested all of its capital
in Colgate debt and LIBOR instruments, the
partnership "may liquidate some or all of the remaining
Short-Term Notes and distribute the proceeds to one or
more of the partners."7
7) "Possible redemption of [ABN's] Partne rship interest.
Commencing one year after formation of the
Partnership, [ABN] has the right to have its Partnership
interest redeemed by the Partnership . . . . The
Partnership may redeem [ABN] in kind with
Partnership property of its choosing or in cash. For
example, assuming no change in asset values, the
Partnership could borrow $169.3 million collateralized
by its assets and use the proceeds to redeem [ABN]."
8) "If [ABN] is redeemed, the Partnership must be
consolidated with [Colgate] for financial reporting
purposes. Accordingly, all assets, including [Colgate]
debt . . . will appear on the [Colgate] consolidated
balance sheet. The [Colgate] debt will be effectively
retired at that time. . . . [I]f the [Colgate] debt were
acquired at a premium or a discount, [Colgate] would
recognize a loss or gain, respectively, for income
statement purposes. It would be most reasonable for
the Partnership to sell the LIBOR Note . . . if[ABN] is
redeemed. Since the principal asset of the Partnership,
other than LIBOR Notes . . . is likely to be [Colgate]
debt and [Colgate] would be a 98% partner, the hedge
protection provided by the LIBOR Notes . . . is no
longer necessary."
_________________________________________________________________
7. This item was designated "Step 7." "Step 6" addressed a possible
investment in Colgate receivables as an alternative to the LIBOR notes.
Because ACM did not invest in Colgate receivables, this aspect of the
proposal is immaterial.
9
9) "After a period of years it might be advanta geous for
[Colgate] affiliates to purchase [Merrill Lynch's]
Partnership interest. Alternatively, the Partnership
might be liquidated with [Colgate] receiving[Colgate]
debt as proceeds of the liquidation."
App. at 275-77. The final page of that document addressed
the tax considerations of the arrangement and stated,
the liquidation of $200 million of Short-Term Notes in
exchange for approximately $140 million of cash and
$60 million market value of LIBOR notes should result
in approximately $106 million of gain to the
Partnership. 15% of such gain, $16 million, will be
allocable to [Colgate]. If . . . LIBOR notes are
distributed to [Colgate], each $10 million market value
of the LIBOR notes distributed should have a tax basis
of approximately $28 million. In a succeeding tax year,
the Partnership will recognize a loss on sale or at
maturity of the remaining LIBOR Notes. 98% of such
loss will be allocable to [Colgate] because[Colgate] will
be a 98% partner at such time. Combined, losses on
sale of LIBOR Notes distributed to [Colgate] and losses
on sale of LIBOR Notes by the Partnership should
exceed $106 million. Accordingly, [Colgate] should
recognize a net loss of approximately $90 million. After
discounting and transactions costs . . . the transaction
produces over $20 million present value benefits to
[Colgate].
App. at 279.
A representative of ABN's legal department testified that
the partnership, as he understood it, was to:
enter into transactions that would create a capital gain
and in a later stage a capital loss, and that . . .
depending on the percentage of your participation, you
would either take part in the gain or the loss. So by
having us being the majority partner at the start, we
would take the majority of the gain, while in a later
stage one of the other partners would take the loss.
App. at 1298.
10
In a memorandum dated October 3, 1989, Pohlschroeder
recommended the partnership to Colgate Treasurer Brian
Heidtke. See App. at 310-21. Pohlschroeder outlined the
advantages of repurchasing outstanding Colgate debt
through a partnership, and stated that "[t]he partnership
would temporarily invest the funds in some short-term
instruments and, at the same time, start the repurchasing
program." App. at 312. The memorandum identified three
sets of Colgate debt issues targeted for repurchase: 1) a set
of 9.625% 30-year notes due in 2017 ("Long Bonds"); 2) a
set of Eurodollar debentures due in 1996 ("Euro notes");
and 3) a set of 8.4% private placement notes held by
Metropolitan Life Insurance Company ("Metropolitan") and
due in 1998 ("Met Notes"). The memorandum stated that
"pursuant to an inquiry to Metropolitan, we feel confident
that the partnership can purchase sufficient Colgate debt"
to carry out the proposed plan. App. at 313-14.8
The memorandum's "Interest Rate Outlook" predicted
that although the Federal Reserve Bank was not expected
to "quickly lower interest rates in the near future," it was
expected to "reduce the . . . rate" by late 1989 or early 1990
to a level that would allow Colgate to "lock in attractive
medium term interest rates." App. at 311. The
memorandum then analyzed the impact of a one to two
percent interest rate increase or decrease on the LIBOR
notes and the Colgate debt issues that the partnership
expected to acquire. According to the analysis, a given
decrease in interest rates would increase the value of the
long-term Colgate debt and decrease the value of the LIBOR
notes in roughly equal and offsetting amounts because the
value of the LIBOR notes was directly dependent on interest
rates whereas the value of the fixed-rate debt issues was
inversely proportional to interest rates. See app. at 951-52,
313. Thus, the memorandum concluded, "the LIBOR note is
an effective hedge of fixed rate assets for the partnership."
App. at 313. The memorandum stated that it would be
necessary to establish a "Desired Hedge Ratio" of LIBOR
holdings to long-term debt holdings, so that the
_________________________________________________________________
8. Pohlschroder testified that as of August 1989, he had received calls
from traders indicating that the Long Bonds also were potentially
available for purchase. See app. at 688.
11
partnership's assets would be "fully hedged" against
changes in value due to interest rate fluctuations. App. at
314.
The memorandum recommended that Colgate proceed
with the partnership as a means "to actively manage its
liability structure," and stated that the "Next Steps" after
executing a partnership agreement, establishing the
partnership in a "Foreign Jurisdiction" and funding the
partnership were the following:
-Short-term investment securities acquired.
- . . . . Disposition of short-term investment securities
to fund acquisition of Colgate debt.
App. at 321.
In a document marked "REVISED 9/1/89," Merrill Lynch
provided Colgate a "Cost Component Analysis," which
estimated after-tax costs associated with the proposed
acquisition and disposition of short-term notes and
acquisition of LIBOR notes. Merrill Lynch estimated that
the short-term notes would entail an "origination" cost of
$1.32 million, while the "remarketing" of the LIBOR notes
would cost $1.29 million in addition to $.17 million in legal
expenses and $1.32 million in Merrill Lynch advisory fees.
See app. at 294.
A September 20, 1989 document delineated the details of
the proposed partnership transactions and their anticipated
tax consequences under I.R.C. S 453 and the ratable basis
recovery rule, Temp. Treas. Reg. S 15a.453. See app. at
296-308. The document contemplated using the
partnership's $200 million in cash investments to acquire
short-term notes, see app. at 303, disposing of the short-
term notes in exchange for $140 million in cash and LIBOR
instruments which would generate contingent payments
with a present value of $60 million, and using the $140
million in cash to purchase Colgate debt. App. at 300-01,
304-05. Because the partnership was to receive payments
on the exchange over the course of six years, the $200
million basis in the short-term notes was to be recovered
ratably over six tax years in equal increments of $33.3
million per year pursuant to S 15a.453. Thus, according to
12
this document, the transaction would result in significant
capital gains in the first year, consisting of the $106.7
million difference between the $140 million cash received
that year and the $33.3 million basis recovered that year,
and would result in capital losses in each of the ensuing
years because the contingent payments received in each of
those years considering imputed interest would fall short of
the $33.3 million basis to be recovered in each of those
years. See app. at 301. The aggregate projected capital
losses in the ensuing years equaled precisely the amount of
capital gains reported in the first year, and the document
stated that the recognition of those losses "may be
accelerated in any year subsequent to 1989 by sale of the
remaining LIBOR notes." App. at 301.
The document also contemplates Colgate's increasing its
share in the partnership from 15% to 97% after the
partnership recognized the $106.7 million capital gain in
year 1 but before it recognized the capital losses in the
ensuing years. See app. at 305-08. According to the
document, the LIBOR notes eventually would be sold for a
capital loss of $80 million, 97% of which would be allocated
to Colgate based on its 97% partnership interest by the
time the loss was incurred. See app. at 304, 308-09.
At an October 12, 1989 meeting of Colgate's Board of
Directors, the Directors considered the proposal and stated
that it:
had originally been presented . . . with a view toward
minimizing the capital gains tax arising out of the
disposition of the Kendall business. However, major
changes were made . . . so that the program would
provide the important business advantages of
accumulating [Colgate] debt in friendly hands and
permitting [Colgate] to obtain flexibility in managing
the ratio balance between short and long term debt
and the resulting interest exposure. Without these
treasury advantages, management would not have
recommended this transaction.
. . . . Over the life of the partnership, significant tax
benefits should be generated for Colgate, but even
without these benefits, Colgate would earn a pre-tax
return of approximately 6% on its investment.
13
App. at 337. According to Steven Belasco, Colgate's Vice
President of Taxation, the incorporation of Colgate's debt
acquisition objectives into Merrill Lynch's initial proposal
afforded sufficient business advantages to overcome
Colgate's hesitations about Merrill Lynch's initial proposal
which served only the tax objectives of generating a capital
loss to offset 1988 capital gains. See app. at 1235-36.
B. The Partnership
In late September and early October 1989, as Colgate
was contemplating final approval of its participation in the
proposed partnership, Merrill Lynch was finalizing
arrangements for ABN's participation in the partnership. An
ABN document dated October 11, 1989, stated that it
would agree to enter the partnership on the conditions that:
1) "[t]he timing of the purchases and sales of the various
securities be adhered to as proposed;" 2) "Colgate's
obligation to purchase Kannex's interest in the partnership
. . . is unconditional;" and 3) Merrill Lynch agrees to
repurchase the securities "at par on November 29, 1989."
73 T.C.M. at 2197; app. at 1061, 1064-65.9
Between October 24 and October 27, 1989, ABN
established Kannex, Colgate established Southampton, and
Merrill Lynch established MLCS to participate in the ACM
partnership. See 73 T.C.M. at 2197; app. at 81-84, 89-91.
The October 27, 1989 partnership agreement among these
newly created entities provided that Kannex was to receive
a preferred return of the first $1.24 million in any
partnership profits otherwise allocable to Southampton. See
app. at 101; 73 T.C.M. at 2198-99.10
_________________________________________________________________
9. The document referred to the securities as "MTNs" or medium-term
notes. However, it is apparent from the November 29, 1989 date by
which those notes were to be resold that these were the same securities
which the partnership was to purchase initially and dispose of shortly
thereafter in exchange for cash which would be used to purchase Colgate
debt and for LIBOR notes. See app. at 321, 300-05.
10. This "preferred return" provision was a component of the proposed
partnership from its inception. In a document dated September 1, 1989,
Merrill Lynch advised Colgate that this aspect of the partnership would
cost Colgate $740,000. See app. at 294.
14
On October 27, 1989, after executing the partnership
agreement, the partners met and authorized Merrill Lynch
to find willing sellers of Colgate debt issues, including the
Euro Notes, Met Notes, and Long Bonds which had been
identified in Pohlschroeder's October 3 memorandum. See
app. at 313, 386. The partners resolved that "in order to
maximize the investment return on its assets pending the
acquisition" of these debt issues, Merrill Lynch was
authorized "to arrange the purchase (in a private
placement) of $205 million of . . . unsecured debt." App. at
386-87.
The minutes of the partnership meeting reported that
Colgate's treasury department had contacted Metropolitan
with a proposal to purchase $100,000,000 of the Met notes,
and that Metropolitan "if interested, would come to
Bermuda on November 17, 1989 in order to negotiate and
make final such transaction." App. at 387. 11 Earlier in the
fall of 1989, Pohlschroeder had initiated discussions with
Metropolitan about selling the notes after Metropolitan
contacted him to express concern about certain terms in
the notes. See app. 690-91, 742. Before the November 17
meeting, a Metropolitan representative left Pohlschroeder a
message indicating the price at which Metropolitan was
prepared to sell the Met notes. Pohlschroeder did not
respond to the call. See 73 T.C.M. at 2200; app. at 883.
Pohlschroeder previously had conferred with Merrill Lynch's
Henry Yordan about acquiring the Met Notes, Euro Notes,
and Long Bonds. See app. at 117-18; 73 T.C.M. at 2200.
Pohlschroeder's handwritten memorandum of the
conversations regarding the Met notes concludes with a
notation of the date November 17, while his notations
regarding the acquisition of the Long Bonds and Euro Notes
state that Kannex would instruct Merrill Lynch after
purchase of Citicorp notes which, as discussed below, were
to serve as the initial short-term investment contemplated
in the partnership proposals. 73 T.C.M. at 2200; app. at
880; 889-90.
_________________________________________________________________
11. Pohlschroeder had contacted Metropolitan shortly after the first
partnership meeting in October 1989 and had instructed Metropolitan to
send a representative to the November 17 meeting if Metropolitan was
interested in selling the Met notes. See app. at 743.
15
C. The Transactions
On November 2, 1989, Kannex contributed $169.4
million, Southampton contributed $35 million, and MLCS
contributed $0.6 million to the newly created ACM
partnership for a total partnership capitalization of $205
million. See app. at 98. Based on these contributions,
Kannex held an 82.6% share of the partnership,
Southampton held a 17.1% share, and MLCS held a 0.3%
share. 73 T.C.M. at 2197; app. at 98. ACM deposited the
$205 million in an account at ABN's New York branch
paying interest at an annual rate of 8.75%. ACM withdrew
the funds the following day and purchased ten private
placement Citicorp notes in an aggregate amount of $205
million. The Citicorp notes paid interest monthly at a
floating rate that was to be reset monthly. The initial rate
was 8.78%, three basis points above the rate the funds
were earning in the ABN account.12 On November 15, 1989,
Citicorp made an interest payment and reset the interest
rate to 8.65%. 73 T.C.M. at 2200.
In late October 1989, before ACM's November 3
acquisition of the Citicorp notes, Merrill Lynch had
approached Bank of Tokyo ("BOT") and Banque Francaise
du Commerce Exterieure ("BFCE") to negotiate selling them
those notes.13 During the first week of November, Merrill
Lynch forwarded BOT and BFCE specific terms of the
proposed sale in which those two banks would purchase an
aggregate of $175 million of the notes for $140 million in
cash plus LIBOR notes providing for a five-year stream of
quarterly payments with a net present value of
approximately $35 million. See 73 T.C.M. at 2200; app. at
107-08.14 On November 9, 1989, BOT representatives
_________________________________________________________________
12. A basis point, a common unit of measure for interest rates, equals
one one-hundredth of a percent.
13. Pohlschroeder testified that ACM expected to sell the Citicorp notes
for cash and LIBOR notes within several weeks to make the cash
available to purchase Colgate debt. App. at 739-40. Pohlschroeder also
stated that the Citicorp exchange was designed "to accomplish a tax
aspect of the transaction." App. at 740.
14. In negotiating the transactions with BOT and BFCE, Merrill Lynch
also agreed to arrange a series of swaps which would hedge the banks'
interest rate risks and provide them additional return on their purchase
of the Citicorp notes. See 73 T.C.M. at 2206-10.
16
requested approval from their head office, attaching
documents which set forth "all details of the transaction."
On November 10, 1989, Merrill Lynch confirmed that it
would sell $125 million in Citicorp notes to BOT and $50
million to BFCE. See app. at 111-14; 73 T.C.M. at 2200.
On November 17, 1989, ACM convened its second
partnership meeting in Bermuda. A Metropolitan
representative attended pursuant to Pohlschroeder's
invitation to attend if interested in selling the Met Notes.
After brief negotiations, ACM and Metropolitan agreed that
ACM would purchase $100 million principal amount of Met
Notes effective December 4, 1989. App. at 118-19, 390; 73
T.C.M. at 2201. Pohlschroeder stated that ACM would need
to raise cash by the time of the December 4 purchase and
that the acquisition of long-term fixed-rate debt"would
create a risk to the partnership in the event that interest
rates increased." Accordingly, he recommended that ACM
"hedge its risk by purchasing notional principal contracts
with a floating rate of interest." App. at 391. ACM thus
resolved "to arrange the sale of $175 million principal
amount of Citicorp Notes" to BOT and BFCE "for cash and
other LIBOR-based consideration, upon substantially the
terms of a draft Installment Purchase Agreement presented
to the meeting . . . in order to pay Metropolitan the
amounts to be due . . . and to hedge . . . exposure to
interest rate changes." App. at 391.
ACM completed the sale of the Citicorp notes on
November 27, 1989, in accordance with the terms which
Merrill Lynch had negotiated by November 10 and which
ACM had approved on November 17, selling $125 million of
the notes to BOT and $50 million of them to BFCE for a
total of $140 million in cash and eight LIBOR notes issued
by BOT and BFCE. The LIBOR notes provided for a stream
of 20 quarterly contingent payments commencing on March
1, 1990, whose amount was derived from the three-month
LIBOR multiplied by a notional principal amount of $97.76
million.15
_________________________________________________________________
15. The notional principal amount did not represent an amount owed,
but rather was designated as a multiplier to determine the amount of the
LIBOR-based contingent payments.
17
In exchange for the $175,000,000 Citicorp notes, ACM
received consideration totaling $174,410,814, which
represented the $175,000,000 value of the Citicorp notes,
reduced by the $1,093,750 in transaction costs for
arranging the sale of these illiquid private placement
instruments, but increased by the $504,564 in interest that
had accrued on the Citicorp notes during the 12 days since
their last interest payment on November 15. Accordingly,
the LIBOR notes effectively cost ACM $35,504,564, the
difference between the $175,504,564 in value which ACM
relinquished and the $140,000,000 in cash which ACM
received in return, but had a present value of $34,410,814
to reflect the $1,093,750 in transaction costs. See 73
T.C.M. 2201 02, 2206-10; app. at 751. The LIBOR notes
issued by BOT accounted for $25,360,403 of the aggregate
cost and $24,579,153 of the aggregate present value, while
those issued by BFCE accounted for $10,144,161 of the
aggregate cost and $9,831,661 of the aggregate present
value of the LIBOR notes acquired in the exchange. See 73
T.C.M. at 2201.
Upon selling the Citicorp notes on November 27, ACM
invested the $140 million in cash proceeds in time deposits
and certificates of deposit due seven days later on
December 4, 1989, and bearing interest at 8.15% to 8.20%.
In several transactions between December 4 and 8, ACM
purchased Colgate debt including $100 million of the Met
Notes pursuant to the November 17 agreement, $5 million
of the Euro Notes, and $31 million of the Long Bonds. See
app. at 118-20. ACM purchased an additional $18.75
million in Colgate long-term debt issues between June and
October 1990. See 73 T.C.M. at 2205; app. at 119-20, 122-
23.
During the weeks preceding ACM's November 27
acquisition of the LIBOR notes, Merrill Lynch began
arranging to sell a portion of them. In a November 13, 1989
memorandum entitled "Analysis of Partnership Hedging
Activity," Merrill Lynch stated that certain events would
warrant a reduction in the desired amount of LIBOR
holdings. Specifically, Merrill Lynch explained that if
Southampton elected to increase its share of the
partnership's interest rate risk, as it was entitled to do
18
under a provision of the partnership agreement, see app. at
101; 73 T.C.M. at 2198-99, or if ACM exchanged the Long
Bonds for a new issue of five-year Colgate debt, ACM
should reduce its LIBOR note holdings in light of its
diminished need for their hedging function. See 73 T.C.M.
at 2202. Merrill Lynch approached a major Danish bank,
Sparekassen SDS ("Sparekassen"), offering it the BFCE
LIBOR notes which totaled approximately $10 million,
along with collateral swaps which provided Sparekassen
risk protection and a return on its investment. On
December 5, 1989, Sparekassen set aside a $10 million
credit line in preparation for the transaction. See 73 T.C.M.
at 2202.
At ACM's third partnership meeting on December 12,
1989, Southampton elected to increase its share of ACM's
interest rate exposure and ACM exchanged a portion of the
Long Bonds for shorter-term debt issues pursuant to"the
terms of a Note Purchase Agreement presented to the
meeting." See app. at 101, 396-97; 73 T.C.M. at 2205.
Merrill Lynch advised that ACM decrease its LIBOR note
holdings in light of these factors reducing its interest rate
exposure. App. at 397. ACM resolved to distribute the
BFCE LIBOR notes to Southampton as a return of
contributed capital, and executed Assignment Agreements
conveying those notes to Southampton. See app. at 124,
398.
On December 22, 1989, Southampton sold the BFCE
notes to Sparekassen for aggregate consideration of
$9,406,180, an amount $425,481 below the $9,831,661
present value of the notes when ACM acquired them on
November 27. See app. at 125-26; 73 T.C.M. at 2201,
2202-03 & n.10. Of this discrepancy, $390,000 resulted
from the transaction costs and bid-ask spread necessary to
market the LIBOR notes, while the remaining shortfall
resulted from the decreased value of the notes due to the
decline in interest rates since November 27 and from a
quarterly payment on the notes which reduced their
remaining value. See 73 T.C.M. at 2202; app. at 1560-61,
1628.
On June 25, 1991, Colgate acquired a 38.31% share in
ACM from Kannex for $85,897,203.60 and Southampton
19
acquired an additional 6.69% share from Kannex for
$15,000,000, giving Colgate-Southampton a majority
interest in ACM. App. at 131-32, 414. Because it had
acquired a majority interest in ACM, Colgate consolidated
ACM's holdings with its own on its books, revealing its
control of the debt issues which theretofore had remained
outstanding on its books. See app. at 3249-50. ACM
retained $30 million in Citicorp notes until October 16,
1991, when it put them to Citicorp at par pursuant to an
option provision. ACM earned $4,329,191 of interest on the
portion of the Citicorp notes which it held until 1991. See
app. at 507-67, 570-98.
On November 27, 1991, ACM redeemed Kannex's
remaining partnership interest for $100,775,915, leaving
Colgate and Southampton with a combined 99.7% interest
in ACM. App. at 137-38. At a December 5, 1991
partnership meeting, Merrill Lynch stated that because
Colgate owned virtually the entire partnership, its"net
economic exposure to the risk of interest rate fluctuations
in the value of the Colgate debt was effectively minimal, and
the Partnership need not maintain its position in the
[LIBOR notes] to hedge against such exposure." App. at
408. Thus, Merrill Lynch explained, without the need for
hedging, it was "unwise for the Partnership to hold" this
"highly volatile investment" given the market's declining
interest rates. ACM resolved to sell its remaining LIBOR
notes, which were those issued by BOT, the BFCE LIBOR
notes having been distributed to Southampton and
subsequently sold to Sparekassen. App. at 409. On
December 17, 1991, ACM sold the BOT LIBOR notes to
BFCE for $10,961,581, a price that reflected a significant
loss in value due to declining interest rates which had
reduced the three-month LIBOR from 8.5% to 5.7% and
transaction costs of $440,000 arising from the bid-ask
spread needed to remarket the notes. See 73 T.C.M. at
2206; app. at 138.
D. Tax and Financial Accounting of the Transactions
On its partnership return for the tax year ended
November 30, 1989, ACM treated the November 27, 1989
exchange of the Citicorp notes as an installment sale under
20
I.R.C. S 453, as ACM was to receive part of the
consideration for that exchange "after the close of the
taxable year in which the disposition occurs" pursuant to
S 453(b)(1). App. at 109. Because the quarterly LIBOR note
payments would vary based on fluctuations in the LIBOR,
there was no "stated maximum selling price" that could be
identified "as of the close of the taxable year in which the
. . . . disposition occurs." Thus, the transaction came within
the terms of Temp. Treas. Reg. S 15a.453-1(c), whose
ratable basis recovery rule provides that the taxpayer's
basis "shall be allocated to the taxable years in which
payment may be received under the agreement in equal
annual increments."
Accordingly, ACM divided its $175,504,564 basis in the
Citicorp notes, consisting of their $175 million purchase
price and $504,564 of accrued payable interest, equally
among the six years over which payments were to be
received in exchange for those notes, and thus recovered
one sixth of that basis, or $29,250,761, during 1989.16
Subtracting this basis from the $140 million in cash
consideration for the Citicorp notes, ACM reported a 1989
capital gain of $110,749,239.42 which it allocated among
its partners according to their partnership shares, resulting
in an allocation of $91,516,689 of the gain to Kannex,
$18,908,407 to Southampton, and $324,144 to MLCS. See
app. at 109, 144-66; 73 T.C.M. at 2203. Southampton and
MLCS were subject to United States income tax on their
respective shares of the gain, but Kannex as a foreign
corporation was not. App. at 226-35.17
Under the ratable basis recovery rule the tax basis
remaining to be recovered over the following five years
became $146,253,803, representing the difference between
_________________________________________________________________
16. ACM divided the basis across six years instead of five, although the
LIBOR payments were to be received over 20 quarters commencing in
1990, because it received the cash portion of the consideration three
days before the end of the 1989 tax year, making 1989 a year "in which
payment may be received" under S 15a.453.
17. According to the Tax Court the share allocated to Kannex was not
taxed in any jurisdiction but we, of course, are focusing only on the
United States tax aspects of the transaction.
21
the $175,504,564 value of the Citicorp notes which ACM
relinquished to acquire those notes and the $29,250,761 in
basis recovered during the first year of the transaction. See
app. at 110. Of the $146,253,803 reported as the remaining
unrecovered tax basis after 1989, $41,786,801 was
attributable to the BFCE LIBOR notes, whose actual cost
was $10,144,161, while $104,467,002 was attributable to
the BOT LIBOR notes, whose actual cost was $25,360,403.
See 73 T.C.M. at 2201, 2203 & n.11.
On its 1989 tax return, Southampton reported its
$18,908,407 share of the capital gain from the
$140,000,000 cash received in exchange for the Citicorp
notes, and reported a $32,429,839 capital loss from its
December 22, 1989 sale to Sparekassen of the BFCE LIBOR
notes which it had received in the December 12, 1989
distribution from ACM.18 Because these capital losses
completely offset the capital gains, Southampton reported a
net 1989 capital loss of $13,521,432 and did not report any
net tax liability on its share of ACM's gain from the
disposition of the Citicorp notes. See 73 T.C.M. at 2203.
ACM retained the Curacao office of Arthur Andersen &
Co. as its accountants. In reviewing ACM's financial and
tax accounting for 1989, the Arthur Andersen auditors
noted that ACM's records were inconsistent in their
treatment of the $1,093,750 spread between the amount of
consideration ACM had paid for the LIBOR notes and their
market value at the time of acquisition. Specifically, the
auditors noted, ACM had not accounted for this transaction
cost in its income statement, but had included it in the
book value of the LIBOR notes contrary to a provision in
the partnership agreement requiring that assets be
recorded at fair market value. Due to this discrepancy,
ACM's records effectively overstated the market value of the
LIBOR notes and understated the transaction costs
involved in acquiring them through the contingent
installment sale. See 73 T.C.M. at 2204.
_________________________________________________________________
18. This $32,429,839 loss was computed based upon the $9,406,180
cash proceeds from the sale, minus the $41,786,601 tax basis in the
notes, minus $48,693 in accrued interest payable on the notes. See 73
T.C.M. at 2203.
22
The audit manager wrote the following memorandum in
February 1990 to his colleagues regarding the discrepancy:
Colgate does not want the cost to sell [the Citicorp
notes] of US $1,093,750 . . . in the . . . income
statement of ACM. The reasons are mainly tax driven,
as inclusion might set the IRS on top of the reasons
why the partnership was constructed in the first place
and thus the planned tax losses might be denied by
the IRS. We . . . were requested to think with Colgate
in order to keep the cost to sell out of the balance
sheet.
Id.; see also app. at 141. Arthur Andersen proposed that to
avoid accounting for the costs associated with the LIBOR
notes, ACM could continue to record the transaction costs
as part of the value of the LIBOR notes and could resolve
the conflict with the market valuation provision of the
partnership agreement by issuing "a side letter to the
partnership agreement stating that the LIBOR notes are the
one exception to the valuation rules which now state
valuation at market and would . . . then state valuation at
market increased by the cost to sell the original Citicorp
notes." Id.
At its February 28, 1990 partnership meeting, ACM
adopted this approach and enacted special valuation rules
which provided that the LIBOR notes, unlike other
partnership assets, would be valued on ACM's books "at
cost" rather than at market value and would be adjusted
upon distribution of the note to a partner, redemption of
the partnership interest of any partner, or liquidation of the
partnership. See app. at 402, 407.19 This provision
effectively transferred the transaction costs associated with
exchanging the Citicorp notes for LIBOR notes to the
partner that eventually received the notes in a distribution,
as the market value would be less than the reported value
of the distribution. See 73 T.C.M. at 2204. Thus, ACM's
December 12, 1989 distribution of the BFCE LIBOR notes
_________________________________________________________________
19. The rules described the LIBOR notes as the "[c]ontingent payment
notes with no stated principal value, with payments resulting from the
product of a notional amount and a floating rate of interest." App. at
407.
23
effectively passed those transaction costs to Southampton
in accordance with the partners' understanding that
Colgate and Southampton would bear the transaction costs
associated with trading private placement notes. See app.
at 1622-25.
For its tax year ended December 31, 1991, ACM reported
a capital loss of $84,997,111 from its December 17, 1991
sale of the BOT LIBOR notes.20 This loss consisted of the
difference between the $10,961,581 that ACM received for
those notes and the remaining $95,958,692 basis in those
notes. App. at 202-25. Of this amount of loss, $5.8 million
resulted from a decline in the value of the LIBOR notes due
to declining interest rates while $79,106,599 resulted from
the application of the ratable basis recovery rule which
effectively added to the tax basis of the LIBOR notes 5/6 of
the $140 million value of the Citicorp notes which had been
exchanged for cash. See 73 T.C.M. at 2206. 21 Because
Colgate, together with its subsidiary Southampton, by that
time owned 99.7% of the partnership, Colgate claimed
99.7% of the $84,997,111 capital loss on its 1991 return
for a total capital loss of $84,537,479. App. at 247-51.
Colgate then filed an amended 1988 return reporting this
_________________________________________________________________
20. This appeal concerns adjustments to ACM's 1989 and 1991 tax
returns. Although the Commissioner's Final Partnership Administrative
Adjustment and the Tax Court's decision made adjustments to ACM's
1990 tax return, these adjustments affected only the basis in certain
assets with no effect on net tax liability for 1990. See app. at 3444.
Thus, we do not discuss the 1990 return further.
21. Had it not applied the ratable basis recovery rule, ACM would have
subtracted from the consideration it received upon disposition of the
BOT LIBOR notes only the remaining portion of the LIBOR notes'
aggregate $35,504,564 actual cost basis rather than the remaining
portion of their aggregate $175,504,564 tax basis which ACM derived by
aggregating the $140 million cash portion of the Citicorp note
transaction with the $35 million LIBOR note portion of the transaction
and adjusting the aggregate basis for accrued interest, yielding
$95,958,692 in unrecovered basis at the time of the disposition of the
BOT LIBOR notes. ACM also treated a portion of the proceeds from the
notes as interest income rather than capital gains. See 73 T.C.M. at
2206; app. at 3388.
24
loss as a carryback pursuant to I.R.C. S 1212 to offset a
portion of its 1988 capital gains. See app. at 252-62.22
E. The Tax Court Decision
On March 12, 1993, the Commissioner of Internal
Revenue ("Commissioner") issued ACM a Notice of Final
Partnership Administrative Adjustment ("FPAA") eliminating
ACM's $110,749,239.42 installment gain from the sale of
the Citicorp notes in November 1989, redetermining ACM's
tax basis in the BFCE LIBOR notes distributed in December
1989, and disallowing the $84,997,111 capital loss
deduction which ACM reported in 1991. See app. at 28-42.
In writing this opinion we primarily focus on the capital
loss aspects of the case, though it should be understood
that the gain and loss are part of a single integrated plan.
The Commissioner asserted in the FPAA that the
transactions involving the purchase and sale of the Citicorp
notes in exchange for cash and LIBOR notes, "were shams
in that they were prearranged and predetermined. . ..
[S]aid transactions were devoid of economic substance
necessary for recognition for federal income tax purposes
and were totally lacking in economic reality. The
transactions were created solely for tax motivated purposes
without any realistic expectation of profit." App. at 39. On
May 24, 1993, Southampton, in its capacity as ACM's tax
matters partner, filed a petition in the Tax Court contesting
the Commissioner's adjustments.23 ACM argued that its
transactions
were bona fide arm's length transactions at fair market
value and had economic substance. . . . The purchase
of the Citicorp notes on November 3, 1989, and the
sale of a portion of the Citicorp notes on November 27,
1989, were not prearranged or predetermined, and
both had economic substance. . . . . The sale of the
_________________________________________________________________
22. This capital loss of $84,537,479, combined with Colgate's reported
1989 net capital loss of $13,521,432, gave rise to total reported capital
losses of $98,058,911 over the course of Colgate's participation in ACM's
transactions. See 73 T.C.M. at 2206.
23. A designated tax matters partner represents the partnership in
proceedings before the Tax Court. See I.R.C. SS 6231(a)(7), 6226(a).
25
Citicorp notes by ACM in exchange for fixed payments
and contingent payments under the LIBOR Notes
qualified for installment sale treatment under Treas.
Reg. S 15a.453-1(c)(3).
App. at 25.
The Tax Court tried the case over a month-long period in
1996 and on March 5, 1997, issued a memorandum
opinion upholding the Commissioner's adjustments on the
grounds that "[a] taxpayer is not entitled to recognize a
phantom loss from a transaction that lacks economic
substance." 73 T.C.M. at 2215. In reaching the conclusion
that ACM was not entitled to deduct its claimed capital
losses, the court examined the stated purposes and
anticipated economic consequences of the transaction, and
found that the claimed losses were "not economically
inherent in" the transactions but rather were"created
artificially" by machinations whose only purpose and effect
was to give rise to the desired tax consequences. Id. On
April 4, 1997, ACM moved for reconsideration of the court's
opinion, arguing that the transactions had sufficient
economic substance to be respected for tax purposes. See
app. at 3311-47. The court denied the motion on June 9,
1997. See app. at 3439-41.
The parties filed memoranda, pursuant to Tax Court Rule
of Practice and Procedure 155, regarding the computation
of tax liability in accordance with the Tax Court's
memorandum opinion. See app. at 3385-444. ACM
proposed a computation which disallowed deductions for
the losses resulting from its application of the ratable basis
recovery rule but which allowed the deduction of
approximately $6,000,000 in actual economic losses
resulting from the loss in value of the LIBOR notes. See
app. at 3348-51, 3385-98. In a decision entered June 12,
1997, the Tax Court rejected ACM's computations and
eliminated the entire $84,997,111 capital loss reported in
1991 as well as the 1989 capital gains reported in the first
year of the Citicorp note transaction. See app. at 3444.
ACM filed a timely notice of appeal on September 8, 1997.
See app. at 39-40. The Commissioner filed a protective
cross appeal seeking to preserve the right to proceed on
alternate theories for sustaining the adjustments in the
26
event that the Tax Court's application of the economic
substance doctrine were reversed. See app. at 3447.24
III. DISCUSSION
A. Economic Substance and the Sham Transaction
Doctrine
We must decide whether the Tax Court erred in
disallowing ACM's claimed $110,749,239.42 capital gain in
1989 and its $84,997,111 capital loss which the court
characterized as a "phantom loss from a transaction that
lacks economic substance." 73 T.C.M. at 2215. While we
conduct plenary review of the Tax Court's legal conclusions,
we review its factual findings, including its ultimate finding
as to the economic substance of a transaction, for clear
error. See Fredericks v. Commissioner, 126 F.3d 433, 436
(3d Cir. 1997); Harbor Bancorp v. Commissioner, 115 F.3d
722, 727 (9th Cir. 1997), cert. denied, 118 S. Ct. 1035(1998); Northern Indiana Pub. Serv. Co. v. Commissioner,
115 F.3d 506, 510 (7th Cir. 1997); Ferguson v.
Commissioner, 29 F.3d 98, 101 (2d Cir. 1994); Lukens v.
Commissioner, 945 F.2d 92, 97 (5th Cir. 1991); Karr v.
Commissioner, 924 F.2d 1018, 1022 (11th Cir. 1991); Rice's
Toyota World, Inc. v. Commissioner, 752 F.2d 89, 92 (4th
Cir. 1985).25
ACM contends that, because its transactions on their
face satisfied each requirement of the contingent
_________________________________________________________________
24. Inasmuch as we agree with the Tax Court's decision sustaining the
adjustments based on the lack of economic substance behind the
transactions, we, like the Tax Court, need not consider the
Commissioner's alternate theories. See 73 T.C.M. at 2190. In view of the
elimination of the 1989 gain the parties apparently were spared from
applying the complex mitigation provisions in the Internal Revenue Code.
See Koss v. United States, 69 F.3d 705 (3d Cir. 1995), cert. denied, 117
S.Ct. 54 (1996).
25. We review findings of ultimate fact, like other findings of fact, only
for
clear error, contrary to our former practice of reviewing such findings de
novo. See Geftman v. Commissioner, ___ F.3d ___, 1998 WL 460172, No.
97-7313, slip op. at 11 n.9 (3d Cir. Aug. 10, 1998); Pleasant Summit
Land Corp. v. Commissioner, 863 F.2d 263, 268 (3d Cir. 1988).
27
installment sale provisions and regulations thereunder, it
properly deducted the losses arising from its
"straightforward application" of these provisions, which
required it to recover only one sixth of the basis in the
Citicorp notes during the first of the six years over which it
was to receive payments. See Temp. Treas. Reg. S 15a.453-
1(c).26 Thus, ACM contends, it properly subtracted the basis
in the LIBOR notes to include the remaining five sixths of
the basis in the Citicorp notes used to acquire them.27
Consequently, ACM argues it properly subtracted the
approximately $96 million remaining unrecovered basis in
the BOT LIBOR notes from the approximately $11 million
consideration it received upon disposition of those notes,
see br. at 32; app. at 202-03, and correctly recognized and
reported the gains and losses arising from its sale or
exchange of property in accordance with I.R.C. S 1001.
While ACM's transactions, at least in form, satisfied each
requirement of the contingent installment sale provisions
and ratable basis recovery rule,28 ACM acknowledges that
_________________________________________________________________
26. Although the LIBOR notes generated 20 quarterly payments
spanning five years rather than six, ACM reported the "maximum period
over which payments may be received under the contingent sale price
agreement" as six years by including the year of the disposition in which
it received the $140 million cash payment, although no quarterly
payments were to be received before the tax year ended on November 30,
1989, three days after the disposition. See 73 T.C.M. at 2200.
27. The basis in the LIBOR notes was derived from the basis in the
Citicorp notes which ACM exchanged for the LIBOR notes. See I.R.C.
S 1031(d). Because ACM recovered one sixth of the basis of the Citicorp
notes, or $29,250,761, during the first year of the transaction, the basis
in the LIBOR notes after that year was $146,253,283. See app. at 110.
While the actual cost basis of the LIBOR notes amounted to the
$35,504,564 difference between the value of the Citicorp notes that ACM
relinquished and the $140 million in cash that ACM received in return,
under the ratable basis recovery rule, the cash portion of the transaction
was aggregated with the contingent exchange portion of the transaction,
effectively adding the $140 million in cash to the tax basis of the LIBOR
notes.
28. ACM exchanged the Citicorp notes, which as private placement
securities were eligible for treatment under the contingent installment
sale provisions, see I.R.C. S 453(k)(2)(A), for the LIBOR notes' stream of
28
even where the "form of the taxpayer's activities
indisputably satisfie[s] the literal requirements" of the
relevant statutory language, the courts must examine
"whether the substance of those transactions was
consistent with their form," br. at 21, because a transaction
that is "devoid of economic substance . . . simply is not
recognized for federal taxation purposes." Lerman v.
Commissioner, 939 F.2d 44, 45 (3d Cir. 1991).
We begin our economic substance analysis with Gregory
v. Helvering, 293 U.S. 465, 55 S.Ct. 266 (1935), the
Supreme Court's foundational exposition of economic
substance principles under the Internal Revenue Code. In
Gregory, as in this case, the transactions on their face
satisfied "every element required by" the relevant statutory
language. Gregory, 293 U.S. at 468, 55 S.Ct. at 267.29 The
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quarterly payments over 20 quarters so that "at least 1 payment" was to
be "received after the close of the taxable year in which the disposition
occurs." S 453(b). Because the amount of each quarterly payment would
depend on the variable three-month LIBOR, the "maximum selling price"
could "not be determined as of the close of the taxable year in which the
. . . disposition occurr[ed]." Temp. Treas. Reg. S 15a.453-1(c).
Accordingly, ACM's transactions satisfied the literal terms of each
requirement necessary to trigger the application of the ratable basis
recovery rule providing for recovery of the basis of the relinquished
assets "in equal annual increments" over each of the "taxable years in
which payment may be received." S 15a.453-1(c).
29. We analyze the economic substance of ACM's transactions according
to principles that were well established when the transactions occurred,
but note that partnership transactions carried out on or after May 12,
1994, also would be subject to Treasury Regulations which provide that
partnership transactions "must be entered into for a substantial
business purpose," that the "[t]he form of each partnership transaction
must be respected under substance over form principles," and that "the
tax consequences . . . to each partner of partnership operations . . .
must accurately reflect the partners' income agreement." Treas. Reg.
S 1.701-2(a). These regulations further provide that "if a partnership is
formed or availed of in connection with a transaction a principal purpose
of which is to reduce substantially the present value of the partners'
aggregate federal tax liability . . . the Commissioner can recast the
transaction for federal tax purposes" by determining that "[t]he
partnership's items of income, gain, loss, deduction or credit should be
29
taxpayer, instead of transferring stock from her wholly-
owned corporation directly to herself which would have
generated taxable dividends, created a new corporation,
transferred the stock to the new corporation, then
liquidated the new corporation, transferred the stock to
herself, and asserted that she had not recognized any
taxable gain because she had received the stock"in
pursuance of a plan of reorganization" within the meaning
of I.R.C. S 112(g). Although the transactions satisfied each
element of the statute, which defined "reorganization" as a
transfer of assets between corporations under common
control, the Court found that "[t]he whole undertaking,
though conducted according to the [statutory] terms . . .
was in fact an elaborate and devious form of conveyance
masquerading as a corporate reorganization." Id. at 469, 55
S.Ct. at 268.
The Court stated that "if a reorganization in reality was
effected" any "ulterior [tax avoidance] purpose . . . will be
disregarded" and the transaction will be respected for tax
purposes. Id., 55 S.Ct. at 267. The Court emphasized,
however, that where the transactions merely "put on the
form of a corporate reorganization as a disguise for
concealing its real character" which was a "preconceived
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reallocated . . . or [t]he claimed tax treatment should otherwise be
adjusted or modified." Treas. Reg. S 1.701-2(b).
The regulations set forth, as an example of a transaction whose tax
consequences would be altered or disregarded thereunder, a transaction
in which a foreign corporation, a domestic corporation, and a promoter
form a partnership "[p]ursuant to a plan a principal purpose of which is
to generate artificial losses and thereby shelter from federal taxation a
substantial amount of income," and engage in a series of offsetting
purchases and sales in which "any purported business purpose for the
transaction is insignificant in comparison to the tax benefits that would
result if the transaction were respected for federal tax purposes." Treas.
Reg. S 1.701-2(d), Example 7. Because these regulations do not apply to
ACM's transactions, which were completed well before the 1994 effective
date of the regulations, we have no occasion to consider whether the
economic substance analysis required under these regulations would
differ from the analysis required under the judicially defined economic
substance doctrines that we apply.
30
plan . . . not to reorganize a business," but rather "to
transfer . . . . shares to the [taxpayer]," the transaction was
not, in reality, "the thing which the statute intended."
Viewed according to their substance rather than their form,
the Court found, the transactions fell "outside the plain
intent of the statute" and therefore could not be treated in
accordance with their form without "exalt[ing] artifice above
reality." Id. at 469-70, 55 S.Ct. at 267-68. Thus, pursuant
to Gregory, we must "look beyond the form of [the]
transaction" to determine whether it has the"economic
substance that [its] form represents," Kirchman v.
Commissioner, 862 F.2d 1486, 1490 (11th Cir. 1989),
because regardless of its form, a transaction that is "devoid
of economic substance" must be disregarded for tax
purposes and "cannot be the basis for a deductible loss."
Lerman, 939 F.2d at 45; accord United States v. Wexler, 31
F.3d 117, 122 (3d Cir. 1994).30
In applying these principles, we must view the
transactions "as a whole, and each step, from the
commencement . . . to the consummation . . . is relevant."
Weller v. Commissioner, 270 F.2d 294, 297 (3d Cir. 1959);
accord Commissioner v. Court Holding Co., 324 U.S. 331,
334, 65 S.Ct. 707, 708 (1945). The inquiry into whether the
taxpayer's transactions had sufficient economic substance
to be respected for tax purposes turns on both the
"objective economic substance of the transactions" and the
"subjective business motivation" behind them. Casebeer v.
Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990); accord
Lerman, 939 F.2d at 53-54 (noting that sham transaction
has been defined as a transaction that "has no business
purpose or economic effect other than the creation of tax
deductions" and holding that taxpayer was not entitled "to
claim ``losses' when none in fact were sustained"). However,
these distinct aspects of the economic sham inquiry do not
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30. The courts have distinguished between "shams in fact" where the
reported transactions never occurred and "shams in substance" which
"actually occurred but that lack the substance their form represents."
Kirchman, 862 F.2d at 1492; accord Lerman, 939 F.2d at 49 n.6.
Because it is undisputed that ACM's transactions actually occurred, we
confine our inquiry to the question of whether their economic substance
corresponds to their form.
31
constitute discrete prongs of a "rigid two-step analysis," but
rather represent related factors both of which inform the
analysis of whether the transaction had sufficient
substance, apart from its tax consequences, to be respected
for tax purposes. Casebeer, 909 F.2d at 1363; accord
James v. Commissioner, 899 F.2d 905, 908-09 (10th Cir.
1990); Rose v. Commissioner, 868 F.2d 851, 854 (6th Cir.
1989). For the reasons that follow, we find that both the
objective analysis of the actual economic consequences of
ACM's transactions and the subjective analysis of their
intended purposes support the Tax Court's conclusion that
ACM's transactions did not have sufficient economic
substance to be respected for tax purposes.31
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31. While it is clear that a transaction such as ACM's that has neither
objective non-tax economic effects nor subjective non-tax purposes
constitutes an economic sham whose tax consequences must be
disregarded, and equally clear that a transaction that has both objective
non-tax economic significance and subjective non-tax purposes
constitutes an economically substantive transaction whose tax
consequences must be respected, it is also well established that where
a transaction objectively affects the taxpayer's net economic position,
legal relations, or non-tax business interests, it will not be disregarded
merely because it was motivated by tax considerations. See, e.g.,
Gregory, 293 U.S. at 468-69, 55 S.Ct. at 267 ("if a reorganization in
reality was effected . . . the ulterior purpose will be disregarded"),
Northern Indiana Pub. Serv. Co., 115 F.3d at 512 (emphasizing that
Gregory and its progeny "do not allow the Commissioner to disregard
economic transactions . . . which result in actual, non-tax-related
changes in economic position" regardless of "tax-avoidance motive" and
refusing to disregard role of taxpayer's foreign subsidiary which
performed a "recognizable business activity" of securing loans and
processing payments for parent in foreign markets in exchange for
legitimate profit); Kraft Foods Co. v. Commissioner, 232 F.2d 118, 127-28
& n.19 (2d Cir. 1956) (refusing to disregard tax effects of debenture
issue
which "affected . . . legal relations" between taxpayer and its corporate
parent by financing subsidiary's acquisition of venture used to further
its
non-tax business interests). In analyzing both the objective and
subjective aspects of ACM's transaction in this case where the objective
attributes of an economically substantive transaction were lacking, we
do not intend to suggest that a transaction which has actual, objective
effects on a taxpayer's non-tax affairs must be disregarded merely
because it was motivated by tax considerations.
32
1. Objective Aspects of the Economic Sham Analysis
In assessing the economic substance of a taxpayer's
transactions, the courts have examined "whether the
transaction has any practical economic effects other than
the creation of income tax losses," Jacobson v.
Commissioner, 915 F.2d 832, 837 (2d Cir. 1990) (citations
and internal quotations omitted), and have refused to
recognize the tax consequences of transactions that were
devoid of "nontax substance" because they"did not
appreciably affect [the taxpayer's] beneficial interest except
to reduce his tax." Knetsch v. United States, 364 U.S. 361,
366, 81 S.Ct. 130, 135 (1960). In Knetsch, the taxpayer had
purchased annuity savings bonds from an insurance
company, borrowed virtually their entire value against
them, made payments back to the insurance company, and
characterized those payments as deductible interest.
Because the borrowing against the bonds had reduced their
value to a mere "pittance," leaving the taxpayer with
nothing of value apart from tax deductions, the Court
concluded that the net effect of the transfers between the
taxpayer and the insurance company amounted only to
payment of a "fee for providing the facade of ``loans' whereby
the [taxpayers] sought to reduce their . . . taxes" and
therefore could not be characterized as payment of interest
on a debt. Id. at 366, 81 S.Ct. at 135 (citation and internal
quotation omitted).
In Weller, 270 F.2d 294, we examined a similar series of
transactions in which the taxpayer purchased annuity
policies, pledged them as collateral to borrow funds, used
the borrowed funds to prepay future annual premiums on
the policies, prepaid ``interest' on an anticipated additional
loans against the policies, then used the proceeds of the
additional loans to repay the earlier loans, and sought to
deduct the prepayments as interest. See id. at 295-96.
Applying Gregory, we disallowed the deduction on the
grounds that "transactions which do not vary control or
change the flow of economic benefits are to be dismissed
from consideration" if they "do not appreciably change the
taxpayer's financial position." Id. at 297 (citations and
internal quotations omitted). We therefore disregarded the
transactions for tax purposes even though the taxpayer had
33
made actual payments which satisfied the statutory
definition of an "amount paid . . . on indebtedness incurred
. . . to purchase a single premium life insurance contract,"
much as the Supreme Court had disregarded the
transaction in Gregory despite the fact that the taxpayer
had created "a real, valid, corporate entity" and carried out
a transaction that was "within the terms of the statute." Id.
at 296-98.
In the context of property dispositions, the courts have
applied the economic substance doctrine in a similar
manner to disregard transactions which, although involving
actual transactions disposing of property at a loss, had no
net economic effect on the taxpayer's economic position,
either because the taxpayer retained the opportunity to
reacquire the property at the same price, or because the
taxpayer offset the economic effect of the disposition by
acquiring assets virtually identical to those relinquished.
See, e.g., Lerman, 939 F.2d at 48; Merryman v.
Commissioner, 873 F.2d 879 (5th Cir. 1989); Kirchman, 862
F.2d at 1488, 1492-93; Yosha v. Commissioner, 861 F.2d
494, 501 (7th Cir. 1988). Although the taxpayers in these
cases actually and objectively disposed of their property,
the courts examined the dispositions in their broader
economic context and refused to recognize them for tax
purposes where other aspects of the taxpayers' transactions
offset the consequences of the disposition, resulting in no
net change in the taxpayer's economic position. In light of
these cases, we must determine whether the Tax Court
erred in concluding that ACM's exchange of the Citicorp
notes for contingent-payment LIBOR notes which gave rise
to the tax consequences at issue generated only "a
phantom loss" that was not "economically inherent in the
object of the sale" and did not have "economic substance
separate and distinct from economic benefit achieved solely
by tax reduction." 73 T.C.M. at 2215. For the following
reasons, we conclude that it did not.
2. Objective Economic Consequences of ACM's
Transactions
While the Tax Court's analysis focused on the lack of
non-tax purposes behind ACM's transactions rather than
34
on their objective economic consequences, the court made
numerous findings that were indicative of the lack of
objective economic consequences arising from ACM's short-
swing acquisition and disposition of the Citicorp notes
between November 3 and November 27, 1989. The court
noted that ACM sold the Citicorp notes "for consideration
equal to [their] purchase price" and thus did not realize any
gain or loss in the notes' principal value. 73 T.C.M. at 2215
n.19.32 Moreover, as the court observed, the lack of change
in principal value was not merely coincidental, but was
inherent in the terms of the notes and of the transactions
in which they were traded. See id. at 2219-20. Likewise, the
court found that the interest income generated by the notes
could not have a material effect on ACM's financial position
because the Citicorp notes paid interest at a rate that
varied only nominally from the rate that ACM's cash
contributions "were already earning . . . in . . . deposit
accounts before the notes were acquired," resulting in only
a $3,500 difference in yield over the 24-day holding period,
a difference which was obliterated by the transaction costs
associated with marketing private placement notes to third
parties. Id. at 2218, 2220-21.
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32. As contemplated in transaction proposals drafted before ACM was
formed, the Citicorp notes were sold for an amount equal to their
purchase price. See app. at 275-77, 321, 300.
35