ACM Partnership v. Commissioner IRS (Part II)

Opinions of the United
1998 Decisions States Court of Appeals
for the Third Circuit
10-13-1998
ACM Partnership v. Commissioner IRS (Part II)
Precedential or Non-Precedential:
Docket 97-7484,97-7527
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Volume 2 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)
These findings, which are amply supported by the record,
demonstrate a lack of objective economic consequences
arising from ACM's offsetting acquisition and virtually
immediate disposition of the Citicorp notes.33 On November
3, 1989, ACM invested $175 million of its cash in private
placement Citicorp notes paying just three basis points
more than the cash was earning on deposit, then sold the
same notes 24 days later for consideration equal to their
purchase price, in a transaction whose terms had been
finalized by November 10, 1989, one week after ACM
acquired the notes.34 These transactions, which generated
the disputed capital losses by triggering the application of
the ratable basis recovery rule, offset one another with no
net effect on ACM's financial position. Examining the
sequence of ACM's transactions as a whole as we must in
assessing their economic substance, see Court Holding Co.,
324 U.S. at 334, 65 S.Ct. at 708; Weller, 270 F.2d at 297,
we find that these transactions had only nominal,
incidental effects on ACM's net economic position.
Viewed according to their objective economic effects
rather than their form, ACM's transactions involved only a
fleeting and economically inconsequential investment in
and offsetting divestment from the Citicorp notes. In the
course of this brief interim investment, ACM passed $175
million of its available cash through the Citicorp notes
before converting 80% of them, or $140 million, back into
cash while using the remaining 20%, or $35 million, to
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33. Because we find that the lack of objective economic consequences of
ACM's transactions, which is evident from the Tax Court's well-
supported factual findings, is essential to assessing whether the
transaction's tax consequences may be disregarded and lends significant
support to the court's ultimate finding that ACM's transactions did not
have sufficient substance to be recognized for tax purposes, we proceed
to conduct this portion of the economic substance analysis although the
Tax Court did not do so explicitly. See Northern Indiana Pub. Serv. Co.,
115 F.3d at 510 (holding that court of appeals may affirm Tax Court
decisions on any grounds found in the record regardless of Tax Court's
rationale).
34. The consideration consisted of $140 million in cash and LIBOR notes
whose present value was $34,410,814, or $35,000,000, reduced by the
transaction costs established by Merrill Lynch.
38
acquire an amount of LIBOR notes that was identical, apart
from transaction costs, to the amount of such notes that
ACM could have acquired by investing its $35 million in
cash directly into such assets. Thus, the transactions with
respect to the Citicorp notes left ACM in the same position
it had occupied before engaging in the offsetting acquisition
and disposition of those notes.
Just as the taxpayer in Gregory engaged in offsetting
transactions by creating a new corporation, transferring
stock to the corporation, transferring the stock back out of
the corporation and then liquidating the corporation, just
as the taxpayers in Knetsch and Weller engaged in
offsetting transactions by acquiring annuity policies and
borrowing back virtually their entire value, and just as the
taxpayers in Lerman and the other property disposition
cases engaged in inconsequential transactions by disposing
of property while retaining the opportunity to reacquire the
same or virtually identical property at the same price, so
ACM engaged in mutually offsetting transactions by
acquiring the Citicorp notes only to relinquish them a short
time later under circumstances which assured that their
principal value would remain unchanged and their interest
yield would be virtually identical to the interest yield on the
cash deposits which ACM used to acquire the Citicorp notes.35
Gregory requires us to determine the tax consequences of
a series of transactions based on what "actually occurred."
293 U.S. at 469, 55 S.Ct. at 267. Just as the Gregory Court
found that the intervening creation and dissolution of a
corporation and transfer of stock thereto and therefrom was
a "mere device which put on the form of a corporate
reorganization as a disguise for concealing its real
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35. The variable rate on the Citicorp notes presented a theoretical
possibility that the consequences of owning those notes would vary from
the consequences of leaving ACM's funds on deposit at a rate of interest
virtually identical to the initial rate on the Citicorp notes. However,
ACM's exposure to any fluctuation in the rate of return on its Citicorp
note investment was illusory, as the interest rates were scheduled to be
reset only once per month and ACM had arranged to hold the notes for
only 24 days, encompassing only one interest rate adjustment on
November 15 that would affect the notes for only 12 days before their
disposition. See 73 T.C.M. at 2200.
39
character" which amounts to a mere "transfer .. . of
corporate shares to the [taxpayer]," so we find that ACM's
intervening acquisition and disposition of the Citicorp notes
was a mere device to create the appearance of a contingent
installment sale despite the transaction's actual character
as an investment of $35 million in cash into a roughly
equivalent amount of LIBOR notes.36 Thus, the acquisition
and disposition of the qualifying private placement Citicorp
notes, based upon which ACM characterized its
transactions as a contingent installment sale subject to the
ratable basis recovery rule, had no effect on ACM's net
economic position or non-tax business interests and thus,
as the Tax Court properly found, did not constitute an
economically substantive transaction that may be respected
for tax purposes. See Gregory, 293 U.S. at 469-70, 55 S.Ct.
at 267-68; Knetsch, 364 U.S. at 366; Lerman, 939 F.2d 44;
Weller, 270 F.3d at 297.37
ACM contends that the Tax Court was bound to respect
the tax consequences of ACM's exchange of Citicorp notes
for LIBOR notes because, under Cottage Sav. Ass'n v.
Commissioner, 499 U.S. 554, 111 S.Ct. 1503 (1991), an
exchange of property for "materially different" assets is a
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36. ACM emphasizes that the total consideration it was to receive in
exchange for the Citicorp notes genuinely was contingent, in substance
as well as in form, because the amount depended on afluctuating
market variable "precisely [as] the statute and the regulations
anticipated." Br. at 31-32. However, the receipt of genuinely contingent
payments is necessary but not sufficient to trigger the application of the
ratable basis recovery rule which applies only in the context of a
contingent installment sale. Absent an economically substantive
disposition of qualifying property, the transactions do not constitute a
bona fide contingent installment sale within the meaning of the
provisions which ACM seeks to invoke. See I.R.C. SS 453(b), 453(k);
Temp. Treas. Reg. S 15a.453-1(c).
37. As discussed above, each of these cases involved objective acts which
satisfied the technical requirements of the Internal Revenue Code
provisions that the taxpayer sought to invoke, but which the courts
disregarded for tax purposes because they lacked any net effect on the
taxpayer's economic position or non-tax business interests. Accordingly,
we are unpersuaded by ACM's argument that its transactions must be
regarded as economically substantive because it actually and objectively
engaged in them. See br. at 21.
40
substantive disposition whose tax effects must be
recognized. We find Cottage Savings inapposite. The
taxpayer in that case, a savings and loan association,
owned fixed-rate mortgages whose value had declined as
interest rates had risen during the preceding decade. The
taxpayer simultaneously sold those mortgages and
purchased other mortgages which were approximately equal
in fair market value, but far lower in face value, than the
mortgages which the taxpayer relinquished. The Court
found that the exchange for different mortgages of
equivalent value afforded the taxpayer "legally distinct
entitlements," and thus was a substantive disposition
which entitled the taxpayer to deduct its losses resulting
from the decline in value of the mortgages during the time
that the taxpayer held them. Id. at 566, 111 S.Ct. at 1511.
The distinctions between the exchange at issue in this
case and the exchange before the Court in Cottage Savings
predominate over any superficial similarities between the
two transactions. The taxpayer in Cottage Savings had an
economically substantive investment in assets which it had
acquired a number of years earlier in the course of its
ordinary business operations and which had declined in
actual economic value by over $2 million from
approximately $6.9 million to approximately $4.5 million
from the time of acquisition to the time of disposition. See
Cottage Sav., 499 U.S. at 557-58, 111 S.Ct. at 1506. The
taxpayer's relinquishment of assets so altered in actual
economic value over the course of a long-term investment
stands in stark contrast to ACM's relinquishment of assets
that it had acquired 24 days earlier under circumstances
which assured that their principal value would remain
constant and that their interest payments would not vary
materially from those generated by ACM's cash deposits.38
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38. In Lerman, 939 F.2d at 55-56 & n.14, we observed that Cottage
Savings involved the relinquishment of assets whose value had declined
by over $2 million. Because the transaction in Cottage Savings brought
about the realization of a $2 million economic loss resulting from the
disposition of depreciated assets in which the taxpayer had an
economically substantive investment, we reject ACM's contention, see
reply br. at 15, that the case recognized as an economically substantive
loss any tax loss arising from a transaction in which the taxpayer
disposes of property in an arms'-length transaction. The Cottage Savings
Court had no occasion to address a transaction like that before us in
which the taxpayer relinquished property after a minimal holding period
with no intervening change in economic value.
41
While the dispositions in Cottage Savings and in this case
appear similar in that the taxpayer exchanged the assets
for other assets with the same net present value, beneath
this similarity lies the more fundamental distinction that
the disposition in Cottage Savings precipitated the
realization of actual economic losses arising from a long-
term, economically significant investment, while the
disposition in this case was without economic effect as it
merely terminated a fleeting and economically
inconsequential investment, effectively returning ACM to
the same economic position it had occupied before the
notes' acquisition 24 days earlier.39
As the Supreme Court emphasized in Cottage Savings,
deductions are allowable only where the taxpayer has
sustained a " ``bona fide' " loss as determined by its
" ``[s]ubstance and not mere form.' " 499 U.S. at 567-68, 111
S.Ct. at 1511 (quoting Treas. Reg. S 1.165-1(b)). According
to ACM's own synopsis of the transactions, the contingent
installment exchange would not generate actual economic
losses. Rather, ACM would sell the Citicorp notes for the
same price at which they were acquired, see app. at 275-
77, 321, 300, generating only tax losses which offset
precisely the tax gains reported earlier in the transaction
with no net loss or gain from the disposition. See app. at
301.40 Tax losses such as these, which are purely an
artifact of tax accounting methods and which do not
correspond to any actual economic losses, do not constitute
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39. ACM contends that its disposition of the Citicorp notes was
substantive because it "relinquished the benefits and burdens of owning
the Citicorp notes for the distinct benefits and burdens of owning $140
million of cash and the LIBOR notes." Br. at 28. This argument,
however, erroneously assumes that ACM had acquired the benefits and
burdens associated with the Citicorp notes in an economically
substantive sense, when in reality ACM's brief investment in and
offsetting divestment from these assets exposed ACM only to de minimis
risk of changes in principal value or interest rates.
40. The participation of a foreign partner that was impervious to tax
considerations and that claimed most of the reported gains while
allocating to Colgate virtually all of the losses allowed Colgate as ACM's
major U.S. partner to reap the benefits of the tax losses without
sustaining the burdens of the offsetting tax gains.
42
the type of "bona fide" losses that are deductible under the
Internal Revenue Code and regulations.
While ACM contends that "it would be absurd to
conclude that the application of the Commissioner's own
[ratable basis recovery] regulations results in gains or
losses that the Commissioner can then deem to be other
than ``bona fide,' " reply br. at 14, its argument confounds
a tax accounting regulation which merely prescribes a
method for reporting otherwise existing deductible losses
that are realized over several years with a substantive
deductibility provision authorizing the deduction of certain
losses. In order to be deductible, a loss must reflect actual
economic consequences sustained in an economically
substantive transaction and cannot result solely from the
application of a tax accounting rule to bifurcate a loss
component of a transaction from its offsetting gain
component to generate an artificial loss which, as the Tax
Court found, is "not economically inherent in" the
transaction. 73 T.C.M. at 2215.41 Based on our review of
the record regarding the objective economic consequences
of ACM's short-swing, offsetting investment in and
divestment from the Citicorp notes, we find ample support
for the Tax Court's determination that ACM's transactions
generated only "phantom losses" which cannot form the
basis of a capital loss deduction under the Internal
Revenue Code.42
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41. Because the ratable basis recovery rule simply provides a method for
reporting otherwise existing economically substantive losses, we find it
irrelevant that the rule recognizes that its application could
"inappropriately defer or accelerate recovery of the taxpayer's basis,"
resulting in " ``substantial distortion' " of the tax consequences realized
in
any particular year of a transaction. See ACM br. at 32-34 (quoting
Temp. Treas. Reg. SS 15a.453-1(c)(3), (c)(7)). While the rule contemplates
some distortion as to the timing of when actual gains or losses are
reported over the span of a contingent installment sale, it does not
contemplate the reporting of losses which are not the bona fide result of
an economically substantive transaction. Thus, contrary to ACM's
argument, the tax losses it reported are not "precisely what the
[regulations] intended." See br. at 33.
42. Having found ample support for the Tax Court's conclusion that
ACM's transactions lacked economic substance and thus cannot give rise
43
3. Subjective Aspects of the Economic Sham Analysis
In making its determination that it did "not find any
economic substance" in ACM's transactions, the Tax Court
relied extensively on evidence that the transactions were
not intended to serve any "useful non-tax purpose" and
were not reasonably expected to generate a pre-tax profit.
See 73 T.C.M. at 2215, 2229. ACM contends, br. at 34, that
the Tax Court improperly conducted a "generic tax-
independent" inquiry into the non-tax purposes and
potential pre-tax profitability of the transaction based on a
misapplication of Gregory, 293 U.S. at 469, 55 S.Ct. at 267.
According to ACM, the Tax Court mistook Gregory's
scrutiny of the "business or corporate purpose" behind the
transaction for a universally applicable aspect of the
economic substance analysis when in reality, ACM
contends, Gregory undertook this inquiry only because the
specific Internal Revenue Code provision there at issue
required that the transaction be effected "pursuant to a
plan of reorganization." See br. at 20-23 (citing Gregory,
293 U.S. at 469, 55 S.Ct. at 267). Thus, ACM argues, the
Tax Court erred in considering the intended purpose and
expected profitability of the transactions in this case where
the relevant provisions providing for the gain or loss on
sales or exchanges of property, I.R.C. S 1001, and for the
treatment of installment sales, I.R.C. S 453, do not require
a particular business purpose or profit motive. See id.
We disagree, and find that the Tax Court's analysis
properly rested on economic substance cases applying
provisions which, like those relevant in this case, do not by
their terms require a business purpose or profit motive. In
Goldstein v. Commissioner, 364 F.2d 734, 736 (2d Cir.
1966), the court analyzed the economic substance of a
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to taxable gains or deductible losses regardless of how those gains and
losses are allocated, we need not address the Commissioner's alternative
argument that the tax consequences of the transaction must be
disregarded because ACM's partnership structure artificially "bifurcat[ed]
the tax consequences of the transaction" by allocating taxable gains to
a foreign partner and offsetting tax losses to the taxpayer in a manner
which the relevant statute and regulations did not intend. See br. at 32-
34.
44
transaction under I.R.C. S 163(a), which provides, in purely
objective terms without reference to a business purpose or
profit motive, that "[t]here shall be allowed as a deduction
all interest paid or accrued within a taxable year on
indebtedness." The Goldstein court acknowledged that this
broad language did not require "that the deductible interest
serve a business purpose, that it be ordinary and
necessary, or even that it be reasonable," but found that
the language did not permit deductions arising from a
transaction that had "no substance or purpose aside from
the taxpayer's desire to obtain the tax benefit of an interest
deduction." Id. at 741-42. Thus, the court found, the
taxpayer was not entitled to deduct her substantial interest
charges, although they had accrued in an arms'-length
transaction, because she had incurred the underlying debt
for the sole purpose of generating a tax deduction to offset
other income.43
Likewise, in Wexler, 31 F.3d 117, we considered and
rejected the taxpayer's argument that a transaction need
not further any non-tax objectives or hold any profit
potential where the governing statutory provisions do not
"require that the deductions they provide for arise from
transactions having a business purpose or profit motive."
Id. at 122. Despite the broad statutory language allowing
the deduction of "all interest paid or accrued . . . on
indebtedness," I.R.C. S 163(a), we concluded that interest
charges were not deductible if they arose from a transaction
"entered into without expectation of economic profit and
[with] no purpose beyond creating tax deductions." Id. at
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43. ACM seeks to distinguish Goldstein on the grounds that it involved
a transaction which lacked objective economic effect because
"economically, [the taxpayer's] activities netted zero." However, contrary
to ACM's contention that it "bore all of the benefits and burdens of the
ownership of . . . the Citicorp Notes and then the cash and LIBOR Notes,
and stood to recognize true economic gain or loss from holding those
assets," reply br. at 5-6, we find that the critical parts of ACM's
transactions also "netted zero" because its acquisition and offsetting
disposition of the Citicorp notes had no net effect on its economic
position. Thus, we reject ACM's attempt to distinguish Goldstein which,
like the Tax Court opinion in this case, analyzed the taxpayer's intended
purposes as well as the transaction's economic effects.
45
123-24 (citations omitted). We emphasized that interest
payments "are not deductible where the underlying
transaction has no purpose other than tax avoidance" even
if the governing statutory language "had no express
business-purpose requirement." Id. at 124 (citations
omitted).44 Thus, we find no merit in ACM's argument that
the Tax Court erred as a matter of law by scrutinizing the
asserted business purposes and profit motives behind
ACM's transactions, and we turn to the question of whether
the court erred in finding that the transactions were not
intended to serve ACM's professed non-tax purposes and
were not reasonably expected to generate a pre-tax profit.
4. Intended Purposes and Anticipated Profitability of ACM's
Transactions
Before the Tax Court, ACM conceded that there were tax
objectives behind its transactions but contended that "tax-
independent considerations informed and justified each
step of the strategy." 73 T.C.M. at 2217. ACM asserted that
its transactions, in addition to presenting "a realistic
prospect that ACM would have made a profit" on a pre-tax
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44. Because the intended purposes behind a transaction are relevant in
assessing its economic substance even where the statute is drafted in
broad terms that do not require a particular intent or purpose, we are
unpersuaded by ACM's argument that its transactions must be
respected as economically substantive because I.R.C.S 1001, which
provides for the recognition of gain or loss "on the sale or exchange of
property" was intended to encompass "all exchanges." See br. at 23-25
(citing H.R. Rep. No. 179, 68th Cong., 1st Sess., at 13 (1924)). ACM
emphasizes, br. at 25-27, that the Supreme Court in Cottage Savings,
499 U.S. 554, 111 S.Ct. at 1503, recognized the tax effects of a
disposition that was motivated solely by tax considerations and was not
expected to generate a pre-tax profit. As discussed above, however, the
transaction in Cottage Savings had objective economic substance
because it resulted in the realization of actual economic losses arising
from a $2 million decline in market value of the property exchanged.
Where such objective economic effects are lacking, scrutiny of the
subjective intent behind the transactions becomes an important means
of determining whether the transactions constitute a scheme with "no
purpose other than tax avoidance" that may not give rise to deductible
losses even where the statute contains no express requirement that the
transaction serve a non-tax business purpose. Wexler, 31 F.3d at 124.
46
basis, also served the tax-independent purposes of
providing an interim investment until ACM needed its cash
to acquire Colgate debt and a hedge against interest rate
risk within the partnership. The Tax Court, however, found
that the record did not support ACM's assertions that the
transactions were designed either to serve these non-tax
objectives or to generate a pre-tax profit, see 73 T.C.M. at
2217-29, and for the following reasons, we agree.
a. Interim Investment
ACM contends that it invested in the Citicorp notes not
only because they qualified for treatment under the
contingent installment sale provisions and the ratable basis
recovery rule, but also because they served as an
appropriate interim investment until ACM could invest in
the Colgate debt whose acquisition, according to ACM, was
a central objective of the partnership. The Tax Court,
however, rejected this contention on the grounds that ACM
did not acquire the Citicorp notes as an interim investment
"to accommodate the timing of the acquisition of Colgate
debt; rather, it was the reverse: The acquisition of the
Colgate debt was timed so as to accommodate the
requirements of the section 453 investment strategy" which
required ACM to acquire and dispose of private placement
notes. 73 T.C.M. at 2227. This conclusion finds abundant
support in the record.
In May 1989, Merrill Lynch presented Colgate with an
initial proposal of partnership transactions intended to
generate capital losses which Colgate could use to offset
1988 capital gains. Although Merrill Lynch had not yet
incorporated the concept of using the partnership to
acquire Colgate debt issues as it did in its subsequent July
28 and August 17 proposals, its May proposal nonetheless
contemplated the acquisition and imminent disposition of
short-term securities, with no intervening change in their
economic value, in exchange for contingent installment
notes. See 73 T.C.M. at 2191; app. at 678-79, 275-77. The
fact that the acquisition and disposition of short-term notes
were central parts of the proposed partnership transactions
even before the formulation of non-tax partnership
objectives belies ACM's contention that its contingent
47
installment exchange of Citicorp notes was designed to
accommodate the timing of its debt acquisition strategy.
Moreover, as early as October 3, 1989, one month before
ACM was formed, Pohlschroeder reported that he had
identified the Met notes as targets for acquisition and that,
"pursuant to an inquiry to Metropolitan, we feel confident
that the partnership can purchase sufficient Colgate debt"
to serve the partnership's objectives. App. at 314. Yet,
despite this confidence that the debt was available for
purchase well in advance of ACM's formation,
Pohlschroeder did not recommend that the partnership
invest its funds directly in the identified debt issues or
finalize the terms of the anticipated debt purpose, but
rather identified as the "Next Steps" after formation of the
partnership "Short-term investment securities acquired. . . .
Disposition of short term investment securities to fund
acquisition of Colgate debt." App. at 321. In accordance
with this plan, ACM did not take any measures to pursue
the prompt purchase of these debt issues upon its receipt
of $205 million in cash contributions on November 2, 1989,
but rather, acting through Colgate, instructed Metropolitan
to attend a November 17 meeting to discuss the terms of
the sale. See 73 T.C.M. at 2227.45 Thus, we agree with the
Tax Court's finding that any delay preceding the
opportunity to acquire Colgate debt was of ACM's own
deliberate making and was intended so that ACM could
engage in the tax-motivated acquisition and disposition of
qualifying short-term notes in the contingent installment
sale that had been contemplated since before Merrill Lynch
and Colgate devised the concept of incorporating debt
acquisition objectives into Merrill Lynch's initial tax
reduction proposal.
Even if ACM had faced a delay before it could purchase
Colgate debt and thus needed to locate a suitable interim
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45. Pohlschroeder's handwritten memorandum of October 19 indicating
that the Met Note acquisition would proceed on November 17 and that
the Long Bond and Euro Note acquisitions would proceed after
acquisition of the Citicorp notes further supports the Tax Court's
determination that ACM delayed the acquisition of the debt issues to
accommodate its tax-driven strategy of acquiring and disposing of private
placement notes in a contingent installment sale. See 73 T.C.M. at 2200.
48
investment, the Citicorp notes ill served the professed
purpose of holding cash assets in anticipation of an
impending purchase. The notes, which in order to qualify
for treatment in a contingent installment sale could not be
traded on an established market, see I.R.C. S 453(k)(2)(A),
were highly illiquid and thus could not be converted back
into the cash needed to purchase Colgate debt without
significant transaction costs in the form of the bid-ask
spread which Merrill Lynch deemed necessary to market
the notes to third parties. These transaction costs rendered
the illiquid Citicorp notes paying 8.78% significantly less
advantageous as an interim investment than the fully liquid
cash deposit account paying 8.75%. Accordingly, wefind no
error in the Tax Court's conclusion that ACM's brief
investment in the Citicorp notes was motivated by the
pursuit of the tax advantages of a contingent installment
sale rather than by a need for an interim investment
pending its acquisition of Colgate debt. See 73 T.C.M. at
2227-29.
b. Hedge Against Interest Rate Risk
The Tax Court also rejected ACM's contention that it
invested in LIBOR notes not only because they generated
the contingent payments necessary to trigger the
application of the ratable basis recovery rule, but also
because they were an appropriate hedge against the
interest rate exposure brought about by ACM's investment
in Colgate debt issues. As the court explained, ACM's
asserted rationale of hedging against other assets within
the partnership would "defeat [the] very purpose" which
Colgate had advanced for pursuing a debt acquisition
partnership in the first instance. 73 T.C.M. at 2222. The
court accurately noted that Colgate had entered into the
partnership based on a prediction of falling interest rates
and had justified its plan to acquire fixed-rate Colgate debt
issues on the grounds that as interest rates declined, these
issues would appreciate in value to ACM as the obligee,
thus offsetting, through Colgate's share in ACM, the
increased burdens that Colgate effectively would sustain as
the obligor on those instruments if market interest rates fell
further below the fixed rate established on these
49
obligations. See 73 T.C.M. at 2192-93, 2221-25; app. at
311, 666-68, 880-82, 2762-63, 2765, 2769-70.
While the acquisition of Colgate debt furthered this
professed goal of decreasing the exposure associated with
Colgate's fixed rate long term debt structure outside of the
partnership, the acquisition of the LIBOR notes, whose
value would decline as interest rates declined, conversely
increased ACM's exposure to falling interest rates, offsetting
the desired effect of the debt acquisition program which
purportedly was a fundamental partnership objective. See
T.C.M. at 2221; app. at 311. Accordingly, the LIBOR notes,
by hedging against the Colgate debt issues acquired within
the partnership, negated the potential benefit of ACM's
acquisition of these issues as a hedge against Colgate's
interest rate exposure outside the partnership.
The fact that the interest rate exposure resulting from the
LIBOR notes undermined rather than furthered the
partnership's purported debt management objectives is also
evident from the fact that Colgate reserved the option under
the partnership agreement to elect to increase its share in
changes in the value of the Colgate debt issues attributable
to fluctuations in market interest rates, and exercised this
option on several occasions. See app. at 101. Because the
value of the fixed-rate Colgate debt issues increased in
inverse proportion to interest rates, Colgate's exercise of
this option reflects a prediction of falling interest rates
which would result in risk to Colgate through its liabilities
outside the partnership but would benefit Colgate through
its interest in the assets held within the partnership. The
acquisition of LIBOR notes, whose value depended in direct
proportion on interest rates, effectively would dilute the
benefits which the partnership was intended to yield and
which Colgate sought to maximize by exercising its options
under the partnership agreement. Thus, we find
considerable support in the record for the Tax Court's
conclusion that the acquisition of the LIBOR notes operated
to "defeat [the] very purpose" which ACM had advanced as
a tax-independent justification for its sequence of
investments.
Although ACM meticulously set forth, in
contemporaneously recorded documents, tax-independent
50
rationales for each of its transactions with respect to the
Citicorp notes and LIBOR notes,46 these stated rationales
cannot withstand scrutiny in light of the stated purposes
behind the partnership itself, because the investment in the
Citicorp notes impeded rather than advanced ACM's
professed goal of making its cash available to acquire
Colgate debt issues, just as the investment in the LIBOR
notes impeded rather than advanced the professed goal of
acquiring partnership assets that would hedge against
Colgate's exposure to declining interest rates outside the
partnership.47 Accordingly, wefind no error in the Tax
Court's determination that the transactions "served no
useful non-tax purpose," 73 T.C.M. at 2229, and thus
constituted the type of scheme with "no purpose other than
tax avoidance" that lacks the economic substance
necessary to give rise to a deductible loss. Wexler, 31 F.3d
at 124.48
_________________________________________________________________
46. See app. at 386-87 (authorizing investment in "private placement"
notes as an investment "pending the acquisition" of Colgate debt issues);
app. at 391 (recommending sale of Citicorp notes to generate cash
needed to acquire Colgate debt and acquisition of LIBOR notes to hedge
risks associated with Colgate debt); app. at 397 (advising reduction of
LIBOR note holdings in light of reduced need for hedging within
partnership); app. at 408-09 (recommending disposition of remaining
"highly volatile" LIBOR notes in light of Colgate's increased partnership
interest which eliminated need for hedge within partnership).
47. The rationales set forth in ACM's contemporaneous records are
particularly implausible in light of the documents prepared between May
and October 1989, before ACM's formation, which propose an identical
sequence of transactions far in advance of the events which, according
to memoranda and minutes recorded during the operation of the
partnership, prompted each ensuing step in the series of transactions.
See 71 T.C.M. at 2191; app. at 678-79, 275-79, 310-21, 296-308.
48. While ACM purported to combine the tax avoidance objectives of
Merrill Lynch's initial May 1989 proposal with the non-tax debt
acquisition objectives incorporated into subsequent proposals, ACM's
pursuit of these two distinct objectives within the same partnership
cannot obscure the fact that the contingent installment exchange, which
was solely responsible for the tax consequences at issue, was executed
independently of, did not further, and in fact impeded ACM's pursuit of
its non-tax debt acquisition objectives, because the Citicorp notes placed
the cash needed to acquire Colgate debt into illiquid instruments whose
51
c. Anticipated Profitability
In addition to rejecting ACM's asserted non-tax
justifications for its sequence of investments and
dispositions, the Tax Court also rejected ACM's contention
that its transactions were reasonably expected to yield a
pre-tax profit because the court found ACM had planned
and executed its transactions without regard to their pre-
tax economic consequences. See 73 T.C.M. at 2217-21. The
evidence in the record overwhelmingly supports this
conclusion.49 The documents outlining the proposed
transactions, while quite detailed in their explication of
expected tax consequences, are devoid of such detailed
projections as to the expected rate of return on the private
placement notes and contingent payment notes that were
essential components of each proposal. See 73 T.C.M. at
2191; app. at 678-79, 263-79, 296-308.50
Moreover, ACM's partners were aware before they entered
the partnership that the planned sequence of investments
would entail over $3 million in transaction costs. See app.
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disposition cost ACM several million dollars in transaction costs while
the purchase of the LIBOR notes increased exposure to falling interest
rates, diminishing the desired effects of the debt acquisition strategy.
Thus, the non-tax motivations behind ACM's debt purchase do not alter
the fact that the contingent installment sale was motivated only by tax
avoidance purposes.
49. ACM, citing Sacks v. Commissioner, 69 F.3d 982, 991 (9th Cir. 1995),
argues that a transaction need not be profitable in order to be respected
for tax purposes. See br. at 24 & n.30. Sacks, however, held that,
"[w]here a transaction has economic substance, it does not become a
sham merely because it is likely to be unprofitable on a pre-tax basis,"
and found that the transaction had economic substance because it
involved a sale and leaseback of equipment used for legitimate business
purposes and it resulted in concrete changes in the parties' economic
positions. See 69 F.3d at 990-92. Thus, Sacks is inapposite in this case
where the contingent installment exchange served no non-tax business
purposes and did not materially alter ACM's economic position.
50. According to these documents, the capital gains realized in the first
year of the transaction would equal the aggregate capital losses realized
in the ensuing years, reflecting no net economic change. See app. at 279,
300-301, 305-08.
52
at 294. Yet Colgate, which effectively bore virtually all of
these costs pursuant to the terms of the partnership
agreement, did not attempt to assess whether the
transactions would be profitable after accounting for these
significant transaction costs. See 73 T.C.M. at 2217-18,
2204. Furthermore, while ACM planned to dispose of the
Citicorp notes after a brief holding period for an amount
equal to their purchase price, see app. at 275-77, 300, 321,
its proposed transactions contemplated holding for two
years the LIBOR notes whose principal value would decline
in the event of the falling interest rates which ACM's
partners predicted. See app. at 311, 753-55.
Thus, while the Citicorp note investment which was
essential to structuring the transaction as a contingent
installment sale was economically inconsequential, the
LIBOR note investment which was equally essential to
achieving the desired tax structure was economically
disadvantageous under the market conditions which
Colgate predicted and which actually transpired. ACM's
lack of regard for the relative costs and benefits of the
contemplated transaction and its failure to conduct a
contemporaneous profitability analysis support the Tax
Court's conclusion that ACM's transactions were not
designed or reasonably anticipated to yield a pre-tax profit,
particularly in view of the significant transactions costs
involved in exchanging illiquid private placement
instruments. See Hines v. United States, 912 F.2d 736, 739
(4th Cir. 1990).51
_________________________________________________________________
51. ACM, citing its expert's opinion that ACM could have earned a profit
at market interest rates of 8%, see br. at 38 & n.47, contends that the
Tax Court erred in concluding that ACM could not have expected to earn
a profit from its transactions "under any reasonable forecast of future
interest rates." 73 T.C.M. at 2219. However, in assessing the anticipated
profitability of a transaction, tax courts properly may disregard
computations, such as those presented by ACM's expert, that were
prepared in the context of the litigation and which "had not entered into
[the taxpayer's] calculations at the outset" of the transaction.
Goldstein,
364 F.2d at 740. Because nothing in the record resembles a profitability
calculation conducted at the inception of the transaction, we find no
error in the Tax Court's determination that ACM's transactions were not
designed to generate a profit.
53
In light of the Tax Court's well-founded conclusion that
Colgate and ACM expected interest rates to decline,
rendering the proposed transactions unprofitable, we find it
immaterial whether, as ACM contends, the court overstated
the degree to which interest rates would have had to rise in
order for ACM to recover its transaction costs. See br. at
42-43. Even accepting ACM's assertion that it could have
recovered its costs upon a significantly smaller rise in
interest rates than that calculated by the Tax Court, this
assertion is immaterial in the event of falling interest rates
and at best demonstrates a prospect of a nominal,
incidental pre-tax profit which would not support a finding
that the transaction was designed to serve a non-tax profit
motive. See Sheldon v. Commissioner, 94 T.C. 738, 768
(1990).52
Furthermore, we find no merit in ACM's assertion that
the Tax Court improperly based its determination that the
transactions were unprofitable for Colgate on the erroneous
assumption that Colgate, directly and through
Southampton, "would continue to own only 17 percent of
ACM's assets," causing it to understate the profits Colgate
would receive toward the end of the transactions when it
would own 99.7% of the partnership. See br. at 39.53 As
_________________________________________________________________
52. Similarly, the evidence that neither Colgate nor ACM reasonably
expected to gain any pretax profit from the transaction or even
attempted to formulate a profitability projection compels us to reject
ACM's contention that the Tax Court's profitability analysis improperly
rested on a finding that ACM could have made greater profits with less
risk by pursuing alternative investments. See br. at 46. While Lemmen
v. Commissioner, 77 T.C. 1326, 1346 n.29 (1981), on which ACM relies,
emphasized that a business venture may constitute an activity engaged
in for profit within the meaning of I.R.C. S 183 even when other types of
ventures may have been more profitable, this proposition does not
preclude the Tax Court from considering, in its analysis of whether there
was a profit motive behind ACM's transactions, that the decision to
exchange Citicorp notes for LIBOR notes involved substantial transaction
costs, entailed significant risks given the anticipated falling interest
rates, and compared unfavorably to the higher profitability and lower
risk of the 8.75% cash deposit accounts which ACM affirmatively
relinquished to pursue this strategy.
53. ACM contends that the Tax Court erred by examining the
transactions' anticipated profitability from Colgate's perspective,
contrary
54
discussed above, however, neither ACM nor any of its
partners reasonably anticipated any profits resulting from
the relevant transactions, which entailed an economically
inconsequential investment in Citicorp notes and a
decidedly unprofitable investment in LIBOR notes whose
value would be expected to decline under
contemporaneously predicted market conditions. Because
the contingent installment exchange transaction, as
contemplated and as actually executed, yielded no
partnership profits in any amount, Colgate's percentage
share of those non-existent profits is immaterial.54
Even assuming, however, that ACM and its partners
expected to earn some measure of profits upon disposition
of the BOT LIBOR notes, any additional portion of these
profits that would redound to Colgate's benefit due to its
increased share in the partnership cannot be characterized
as an additional return on Colgate's investment in
_________________________________________________________________
to the principle that the expected profitability of partnership
transactions
must be determined "at the partnership level, rather than at the level of
the partners." Br. at 36. However, as we explained in Simon v.
Commissioner, 830 F.2d 499, 507 (3d Cir. 1987),
[a]lthough the existence of a profit objective of a partnership is
determined at the partnership level, . . . a partnership is merely
a
formal entity, and a determination of profit objective can only be
made with reference to the actions of those . . . who manage the
partnership affairs. . . . . [Therefore] the Tax Court did not
misapply
the profit objective test at the partnership level by looking to
the
motives and actions of those individuals that organized, structured
and conducted [partnership] operations.
In this case where ACM and its transactions were structured around
Colgate's objectives and where Colgate was to hold a 99.7% stake in any
eventual partnership profits, see 73 T.C.M. at 2190-97, 2217-19, 2221,
we find no error in the Tax Court's examination of Colgate's prospects for
profit as a means of analyzing ACM's prospects for profit.
54. ACM argues, br. at 9, that each of ACM's partners realized a positive
pre-tax return on its investment in ACM. However, we reject ACM's
attempt to equate net partnership profits with profits resulting from the
contingent installment exchange which gave rise to the tax consequences
at issue and which the Tax Court properly found, based on ample
evidence in the record, was not reasonably anticipated to generate a
profit. See 73 T.C.M. at 2218-19.
55
partnership assets because Colgate, directly and through
Southampton, paid well over $100 million to acquire its
increased partnership interest. See app. at 137, 769-70.55
These additional contributions far exceeded Colgate's initial
partnership investment of $35 million, undermining ACM's
assertion that any additional returns attributable to
Colgate's increased stake in the partnership properly may
be characterized as further returns on Colgate's interest in
the partnership's investments. Thus, we are unpersuaded
by ACM's contention that the Tax Court distorted its
profitability analysis by failing to account for Colgate's
increased partnership interest.
ACM also argues that the Tax Court's profitability
analysis was flawed because the court adjusted the income
expected to be generated by the LIBOR notes to its net
present value. See br. at 43. In support of its assertion that
this net present value adjustment constitutes reversible
error, ACM cites Estate of Thomas v. Commissioner, 84 T.C.
412 (1985), which noted that the issue of present value
adjustments was "not raised or briefed by the parties" and
held that absent some statutory guidance, it would not
discount the residual value of obsolete partnership assets
at the time of obsolescence to their equivalent present
values at the time the partnership was formed. The court
reasoned that discounting to present value effectively would
require that the taxpayer's investment yield a rate of return
exceeding the discount rate which, the court found, would
contravene the admonition in Treas. Reg. S 1.183-2(b)(9)
that "the availability of other investments which would yield
a higher return, or which would be more likely to be
profitable, is not evidence that an activity is not engaged in
for profit" within the meaning of I.R.C. S 183. See 84 T.C.
at 440 n.52.
We reject ACM's contention that Estate of Thomas, which
_________________________________________________________________
55. On June 25, 1991, Colgate paid Kannex $85,897,203 and
Southampton paid Kannex $15 million to purchase a portion of Kannex's
share in the partnership. On November 27, 1991, ACM redeemed
Kannex's remaining partnership interest at a cost of $100,775,915 which
Colgate borrowed against the partnership assets it was to acquire. See
app. at 137, 769-70.
56
construed Treasury Regulations under I.R.C. S 183,
precludes present value adjustments in the prospect-for-
profit analysis under the judicially created economic
substance doctrine.56 In transactions that are designed to
yield deferred rather than immediate returns, present value
adjustments are, as the courts have recognized, an
appropriate means of assessing the transaction's actual
and anticipated economic effects. See, e.g., Hilton v.
Commissioner, 671 F.2d 316, 317 (9th Cir. 1982) (affirming
economic substance determination based on present value
analysis of taxpayer's investments); Citizens & Southern
Corp. v. Commissioner, 91 T.C. 463, 498 (1988) (noting that
value of an acquired asset may be determined based on
future income likely to be generated that by that asset
discounted to present value), aff'd, 919 F.2d 1992 (11th
Cir. 1990); Gianaris v. Commissioner, 64 T.C.M. (CCH)
1229, 1234 (1992) ("we have consistently discounted . . .
income streams produced by [an investment] in
determining whether the taxpayer had a profit objective")
(citations omitted).
We find no basis in the law for precluding a tax court's
reliance on a present value adjustment where such an
adjustment, under the surrounding circumstances, will
serve as an accurate gauge of the reasonably expected
economic consequences of the transaction. In this case
where ACM's transactions essentially converted readily
available cash, with only a brief interim investment in the
Citicorp notes, into a stream of deferred payments, we find
that the present value adjustment played an appropriate
_________________________________________________________________
56. ACM also cites City of New York v. Commissioner, 103 T.C. 481, 487
(1994), aff 'd, 70 F.3d 142 (D.C. Cir. 1995), which analyzed whether
I.R.C. S 141, in setting forth statutory distinctions based on the amount
of bond proceeds forwarded to private parties, referred to these amounts
in absolute terms or as adjusted to present value. The court concluded
that "time value of money concepts can be applied only in the presence
of a legislative directive to do so" and found no indication that Congress
intended to refer to adjusted amounts. Id. (citation omitted). Because the
issue of whether to imply a net present value adjustment in an amount
specified in the Internal Revenue Code is distinct from the issue of
whether to consider net present value as a variable in a profitability
analysis under the economic substance doctrine, wefind City of New
York inapposite.
57
role in the Tax Court's analysis of the potential profitability
of the transactions. We accordingly find no error in this
aspect of the court's analysis.
ACM also avers that the Tax Court erred in excluding
from its profitability analysis "the pre-tax income resulting
from the investment of $140 million of cash received as
part of the consideration for the Citicorp Notes." Br. at 44.
We disagree. The Tax Court properly analyzed the
profitability of the transactions whose economic substance
is at issue, namely the contingent installment exchange of
Citicorp notes for LIBOR notes which gave rise to the
disputed tax consequences. Any profits arising from ACM's
investment of $140 million in cash into Colgate debt issues
did not result from the contingent installment exchange
whose economic substance is in issue. Because this sum of
cash in fact represents the portion of the proceeds from the
Citicorp notes which ACM did not invest in the contingent
installment exchange of the other $35 million in Citicorp
notes for contingent-payment LIBOR notes, any profits
derived from these funds cannot be characterized as profits
arising from the contingent installment exchange. Thus, the
Tax Court properly excluded these profits from its analysis
of the profitability of the contingent installment sale which
gave rise to the disputed capital losses.57 We find ample
_________________________________________________________________
57. For similar reasons, we reject ACM's contention, see br. at 45, that
the Tax Court erroneously excluded from its profitability analysis the
gains derived from the portion of the Citicorp notes which ACM held
until October 1991 instead of exchanging them for LIBOR notes. These
notes, like the $140 million cash proceeds of the Citicorp note
disposition, were not involved in the exchange for contingent-payment
notes. Thus, any profits generated thereby may not be considered to be
profits arising from the contingent installment sale. In fact, the
profitability of holding the Citicorp notes until 1991 when they could be
tendered to the issuer at par, ensuring recovery of their principal value,
only highlights the lack of reasonably anticipated profitability in
exchanging these notes for the LIBOR notes whose principal value was
at risk in the projected declining interest rate market. We also are
unpersuaded by ACM's contention, see id., that the Tax Court, having
excluded from its profitability analysis the gains from the Citicorp notes
held until 1991, erred by failing to exclude from its calculations a
portion of the transaction costs arising from the partnership transactions
58
support in the record for the Tax Court's conclusion that
ACM and its partners did not reasonably anticipate that its
contingent installment sale would generate a pre-tax profit.
Because ACM's acquisition and disposition of the Citicorp
notes in a contingent installment exchange was without
objective effect on ACM's net economic position or non-tax
objectives, and because its investments in the Citicorp
notes and LIBOR notes did not rationally serve ACM's
professed non-tax objectives or afford ACM or its partners
a reasonable prospect for pre-tax profit, we will affirm the
Tax Court's determination that the contingent installment
exchange transactions lacked economic substance and its
resulting decision providing that the capital gain and loss
at issue will not be recognized and thus disallowing
deductions arising from the application of the contingent
installment sale provisions and the ratable basis recovery
rule.
B. Actual Economic Losses
Following the entry of the Tax Court's opinion holding
that ACM's contingent installment sale did not have
sufficient economic substance to be recognized for tax
purposes, the parties submitted memoranda pursuant to
_________________________________________________________________
as a whole. See id. Even if we were to subtract the 15% pro rata portion
of the transaction costs that ACM suggests were attributable to the 15%
of ACM's $205 million in Citicorp notes which were not exchanged in the
contingent sale, the resulting increase in the net yield from ACM's
transactions, totaling under $0.5 million, would not support the
conclusion that these transactions portended a reasonable prospect for
profit, particularly in light of the evidence that ACM and its partners
made no attempt to assess the transactions' profitability after
transaction costs. In any event, the Tax Court properly declined to
allocate a pro rata portion of the overall transaction costs to the
portion
of the Citicorp notes which were put to Citicorp at par in 1991, because
the most significant portion of the transaction costs arose in the course
of negotiating the structured transaction and bid-ask spread required to
market the illiquid private placement notes to third parties in the
contingent installment exchange and to remarket the LIBOR notes, and
thus was not properly attributable to the notes which ACM retained and
put to Citicorp in 1991.
59
Tax Court Rule 155 regarding the proper computation of
tax liabilities to be allocated by ACM pursuant to that
opinion. ACM argued that even if it was not entitled to
deduct the entire $84,997,111 in tax losses it had reported,
it was entitled to deduct the approximately $6 million
"portion of its loss that is not attributable to the installment
sale accounting and that reflects the actual economics of
the transactions in issue." App. at 3386; see also app. at
3348-51, 3385-98. The court rejected ACM's argument and
entered a final decision disallowing all deductions arising
from ACM's transactions as well as the 1989 capital gain.
See app. at 3444. ACM contends that the Tax Court
erroneously failed to recognize that ACM's ownership of the
LIBOR notes had economic substance even if the
contingent installment sale did not, and thus improperly
disallowed deductions arising from its ownership of those
notes, resulting in inconsistent tax treatment in light of
ACM's reporting of the income generated by those notes.58
We agree.
In Lerman, 939 F.2d at 45, we held that a transaction
that lacks economic substance "simply is not recognized for
federal taxation purposes, for better or for worse," and we
are not aware of any cases applying the economic
substance doctrine selectively to recognize the
consequences of a taxpayer's actions for some tax purposes
but not others. Rather, the courts have applied economic
substance principles to "give effect either to both the cost
and the income functions [of a transaction], or to neither."
Seykota v. Commissioner, 62 T.C.M. (CCH) 1116, 1118
(1991); accord Sheldon, 94 T.C. at 762 (denying interest
deduction and accordingly holding that income items
should not be recognized); Arrowhead Mountain Getaway,
_________________________________________________________________
58. Contrary to the Commissioner's suggestion, br. at 49, ACM
adequately raised before the Tax Court its contention that, as gain from
the LIBOR notes was recognized, it was entitled to deduct the
corresponding economic losses on those notes. See app. at 3386
("[d]isallowing the loss from the sale of the LIBOR Notes would be
inconsistent with recognizing the income from the payments under the
Notes"); id. at 3390 (arguing that Commissioner "should not be permitted
to . . . cause the recognition of . . . income and then disregard the same
transactions in order to deny a loss").
60
Ltd. v. Commissioner, 69 T.C.M. (CCH) 1805, 1822 (1995)
(holding that because transactions were economic shams
that could not give rise to deductions, amounts received in
the course of those transactions could not be characterized
as taxable income), aff'd, 119 F.3d 80 (9th Cir. 1997)
(table). Thus, we must set aside the Tax Court's decision to
the extent that it disallowed the deduction of all losses,
including actual economic losses, associated with the
LIBOR notes without adjusting for the taxes paid on the
approximately $2.3 million of interest income generated by
the same notes. See app. at 3444, 3390.
While it is clear that the income and loss aspects of the
LIBOR notes must be treated consistently with one another,
this proposition does not resolve whether the consistency
should be achieved by disregarding the tax consequences of
the income generated by the notes or by permitting the
deduction of actual economic losses associated with the
notes. ACM urges us to adopt the latter position and in
support thereof invokes Wexler, 31 F.3d at 127, in which
we held that "in some circumstances, a sham transaction
may have separable, economically substantive, elements
that give rise to deductible interest obligations." According
to ACM, br. at 48, its ownership of the BOT LIBOR notes
and its 1991 disposition thereof for an actual economic loss
gave rise to a separable, economically substantive loss that
is properly deductible under Wexler because it is distinct
from the losses resulting from the ratable basis recovery
rule. The Commissioner, on the other hand, contends that
Wexler does not permit the deduction of ACM's economic
losses on the LIBOR notes because, according to the
Commissioner's interpretation of Wexler, a separable item
of loss is not deductible unless the underlying transaction
had a potential non-tax benefit. See br. at 48-49.
For the following reasons, we find ACM's contentions to
be more persuasive. In Wexler, the taxpayer invoked Rice's
Toyota, 752 F.2d at 95-96, which disallowed depreciation
and interest deductions arising from a transaction that was
a sham in that the taxpayer "subjectively lacked a business
purpose and the transaction objectively lacked economic
substance." The court found, however, that one discrete
portion of the transaction, which entailed the exchange of
61
a recourse note for "something of economic value," had
sufficient economic substance to give rise to an interest
deduction. Id. at 95-96. Distinguishing Rice's Toyota, we
found that the claimed deductions in Wexler did not
constitute such a "separable, economically substantive"
item that was distinct from the sham aspects of the
transaction, but rather constituted "the principal tax
benefits of the transaction." Wexler, 31 F.3d at 125. Thus,
we found, allowance of the deduction would have permitted
the taxpayer "to reap the entire benefit of its sham
transaction" by allowing him the deduction "that was the
centerpiece of the whole scheme." Id. at 127.
Such is not the case here. The actual economic losses
associated with ACM's ownership of the LIBOR notes are
both economically substantive and separable from the
sham aspects of the underlying transaction. Far from being
the "centerpiece" or "principal tax benefit" of the underlying
transaction, the approximately $6 million in economic
losses which ACM seeks to deduct were separate and
distinct from the $87 million tax loss that did not
correspond to any actual economic loss but rather was an
artifact of the ratable basis recovery rule which inflated the
tax basis of the LIBOR notes well above their actual cost
basis. In contrast to its economically inconsequential
acquisition and disposition of the Citicorp notes, ACM's
ownership of the BOT LIBOR notes, which extended over
two years under circumstances that posed an actual risk to
the principal value of that investment, had an economically
substantive impact on ACM's net financial position. In
these circumstances, recognition of both the income and
the loss aspects of ACM's investment in those notes will
result in consistent tax treatment which accurately reflects
the economic reality of ACM's transactions and will allow
deduction only of a "separable, economically substantive"
item that is not the "centerpiece" of the transactions,
consistently with our holding in Wexler.
While the Commissioner, br. at 48, urges us to read
Wexler more broadly to preclude any deductions associated
with an underlying transaction found to be a sham, we
decline to do so. We recognize that Wexler not only
distinguished Rice's Toyota on its facts, but also criticized
62
its reasoning. In doing so, however, Wexler did not criticize
Rice's Toyota's essential holding that "in some
circumstances, a sham transaction may have separable,
economically substantive elements that give rise to
deductible" liabilities, see 31 F.3d at 127, but rather
disagreed with the Rice's Toyota court'sfinding that the
recourse note portion of the transaction, which the court
had described as "a ``fee' for purchase of expected tax
benefits," had economic substance. As we explained in
Wexler, by the Rice's Toyota court's own description, that
transaction had no non-tax consequences and served no
non-tax purposes and thus could not be considered
economically substantive even if it was separable from the
central aspects of the underlying sham. See Wexler, 31
F.3d at 125 (quoting Rice's Toyota, 752 F.2d at 94).
ACM's possession of the LIBOR notes, although not
intended to serve non-tax purposes, had significant non-tax
economic effects, consisting of several million dollars in
actual economic losses. As we acknowledged in Wexler,
even where a transaction is not intended to serve business
purposes, it may give rise to a deduction to the extent that
it has objective economic consequences apart from tax
benefits. See 31 F.3d at 126 (citing Jacobson, 915 F.2d at
849); see also Gregory, 293 U.S. at 469, 55 S.Ct. at 267
(holding that if the transaction "in reality was effected" in
substance as well as in form, "the ulterior [tax avoidance]
purposes . . . will be disregarded); Northern Indiana Pub.
Serv. Co., 115 F.3d at 512 (holding that Gregory and its
progency "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"). Thus, we are unpersuaded by the
Commissioner's assertion that Wexler requires us to
disregard actual, objective economic losses merely because
they are incidental to a broader series of transactions that
are found to constitute an economic sham whose principal
tax benefits must be denied. See br. at 48-49. Because
ACM's possession and disposition of the LIBOR notes was
distinct from the contingent installment exchange which
constituted the underlying sham transaction and because
this distinct portion of the transaction had sufficient non-
tax economic effect to be recognized as economically
63
substantive, we find that this aspect of ACM's transactions
gave rise to the type of "separable, economically
substantive" loss that is deductible even when incurred in
the context of a broader transaction that constitutes an
economic sham. Wexler, 31 F.3d at 127. Accordingly, we
will reverse the Tax Court's decision to the extent that it
disallowed the deductions arising from the actual economic
losses which ACM sustained upon its disposition of the
LIBOR notes.
IV. CONCLUSION
For the foregoing reasons, we will affirm the Tax Court's
application of the economic substance doctrine and its
resulting decision eliminating the capital gains and losses
attributable to ACM's application of the contingent
installment sale provisions and the ratable basis recovery
rule. The Commissioner's cross appeal is moot and thus
will be dismissed. We will, however, reverse the Tax Court's
decision insofar as it disallowed the deductions arising from
the actual economic losses associated with ACM's
ownership of the LIBOR notes, and will remand to the Tax
Court for entry of a decision consistent with this opinion.
The parties will bear their own costs on this appeal.
64
McKEE, Circuit Judge, dissenting.
By finding that ACM's sales of the Citicorp notes for cash
and LIBOR Notes "satisfied each requirement of the
contingent installment sales provisions and the ratable
basis recovery rule," Maj. Op. at 28, yet, simultaneously
subjecting these transactions to an economic substance
and sham transaction analysis, the majority has ignored
the plain language of IRC S 1001, and controlling Supreme
Court precedent. We have injected the "economic
substance" analysis into an inquiry where it does not
belong. Therefore, I respectfully dissent.
ACM, like all taxpayers, has the absolute right to
decrease or to avoid the payment of taxes so long as that
goal is achieved legally. Gregory v. Helvering, 293 U.S. 465,
468 (1935). Id. In Gregory, the taxpayer wanted to transfer
stock from her wholly-owned corporation to herself, but
realized that a direct distribution of those shares would be
a taxable event. Therefore, in an attempt to avoid a taxable
event, the taxpayer created a new corporation, transferred
the stock to that new corporation, and then caused the new
corporation to distribute the stock to her in liquidation. The
taxpayer owned all of the stock of United Mortgage
Corporation, and that corporation owned 1000 shares of
the Monitor Securities Corporation that the taxpayer
wanted to obtain. In order to do so without paying the taxes
that would clearly be due on a direct transfer, she
engineered a purported reorganization of United Mortgage
Corporation. The Supreme Court described her scheme as
follows:
To that end, she caused the Averill Corporation to be
organized under the laws of Delaware on September
18, 1928. Three days later, the United Mortgage
Corporation transferred to the Averill Corporation the
1,000 shares of Monitor stock, for which all the shares
of the Averill Corporation were issued to the petitioner.
On September 24, the Averill Corporation was
dissolved, and liquidated by distributing all its assets,
namely, the Monitor shares, to the petitioner. No other
business was ever transacted, or intended to be
transacted, by that company. The petitioner
immediately sold the Monitor shares. . . .
65
Gregory, 293 U.S. at 467 (emphasis added). At the time, 26
USCA S 112 (g) exempted the gain realized from a corporate
reorganization "[i]f there is distributed, in pursuance of a
plan of reorganization, to a shareholder, . . . stock . . . in
such corporation." Id. at 468. Most significantly for our
purposes, the Court stated the issue as follows: "[b]ut the
question for determination is whether what was done, apart
from the tax motive, was the thing which the statute
intended." Id. at 469. The Court concluded that what was
done was not what the statute intended because the
liquidation was not a plan of reorganization at all, but "a
transfer of assets by one corporation to another in
pursuance of a plan having no relation to the business of
either. . . ." Id. Accordingly, the Court disregarded the
transaction, even though the form of the transaction
satisfied the literal requirements of the IRC's reorganization
provisions, because it found that the entire transaction was
nothing but "an elaborate and devious form of conveyance
masquerading as a corporate reorganization, and nothing
else." Id. at 470. In other words, the transaction was one
which "upon its face lies outside the plain intent of the
statute." Id. Consequently, "the rule which excludes from
consideration the motive of tax avoidance" did not apply. Id.Accordingly, I am not as persuaded as my colleagues that
Gregory should guide our inquiry into these transactions.
Here, the sales of the Citicorp Notes for cash and LIBOR
Notes were clearly "legitimate" sales in the nontax sense.
Under IRC S 1001, the tax consequences of a gain or loss in
the value of property are deferred until the taxpayer realizes
the gain or loss. Cottage Savings Assoc. v. Commissioner,
499 U.S. 554, 559 (1991). The concept of "realization" is
implicit in IRC S 1001(a), Id., and the realized gain is
recognized when the property is sold or exchanged. IRC
S 1001(c).1 In Cottage Savings, the Court held that a sale or
exchange of property is a realization event "so long as the
exchanged properties are ``materially different' -- that is, so
_________________________________________________________________
1. IRC S 1001(c) provides: "(c) Recognition of Gain or Loss. -- Except as
otherwise provided in this subtitle, the entire amount of the gain or
loss,
determined under this section, on the sale or exchange of property, shall
be recognized."
66
long as they embody legally distinct entitlements.' Id. at
566.
Cottage Savings sold 90% participation in 252
mortgages to four S&L's. It simultaneously purchased
90% participation interests in 305 mortgages held by
these S&L's. All of the loans involved in the transaction
were secured by single-family homes. . . .
On its 1980 federal income tax return, Cottage
Savings claimed a deduction . . . which represented the
adjusted difference between the face value of the
participation interests that it traded and the fair
market value of the participation interests it received.
. . .
Cottage Savings, 499 U.S. at 557. It was not disputed that
"[t]he . . . acknowledged purpose [of the transfers] was to
facilitate transactions that would generate tax losses but
that would not substantially affect the economic position of
the transacting S&L's". Id. at 556. In allowing the taxpayer
to deduct the resulting loss the Court reasoned that S 1001
did not recognize exchanges "commonly known as ``like
kind', and that Congress therefore intended to afford tax
recognition of gains and losses resulting from exchanges of
property that was materially different." Id., at 564. The
Court held "[u]nder our interpretation of S 1001(a), an
exchange of property gives rise to a realization event so long
as the exchanged properties are ``materially different' -- that
is, so long as they embody legally distinct entitlements." Id.That is what happened here, and I believe that, under
Cottage Savings, the tax loss here should have been
allowed.
ACM's sales of the Citicorp Notes for cash and LIBOR
Notes resulted in the exchange of materially different
property with "legally distinct entitlements.". Consequently,
the sales were substantive dispositions, and the tax effects
of those transactions should be recognized. Cottage
Savings, as well as the plain language of IRC S 1001,
demands that result.
Thus, I do not think that the many cases decided before
Cottage Savings that the majority relies upon are helpful.
e.g., Maj. Op. at 26-34. Similarly, I do not believe our
67
inquiry is furthered by discussing United States v. Wexler,
31 F.3d 117 (3rd Cir. 1994). See Maj. Op. at 45. There, we
were not addressing the issue of sham transactions in the
context presented here, nor did we cite Cottage Savings. We
did cite Lerman v. Commissioner, 939 F.2d 44, 45 (3d Cir.
1991), and we noted that, in Lerman, we said " ``economic
substance is a prerequisite to any Code provision allowing
deductions.' " 31 F.3d at 127 (quoting Lerman, 939 F.2d at48 & n. 6, 52). However, it is the definition of "economic
substance" that is the sticking point. Here, the "economic
substance" inquiry must be governed by the "material
difference requirement" of Cottage Savings, not by the tax
avoidance intent of the taxpayers.
In this regard, I believe the majority mischaracterizes the
appellant's argument. The majority states: "ACM
acknowledges that even where the ``form of the taxpayer's
activities indisputably satisfie[s] the literal requirements' of
the statutory language, the courts must examine ``whether
the substance of those transactions was consistent with
their form' ". Maj. Op. at 29 (quoting Appellant's Br. at 21).
However, ACM is referring to the issue as posed by Gregory
v. Helvering. In referring to the facts of that case, ACM
argues:
The form of the taxpayer's activities indisputably
satisfied the literal requirements of the Code's
reorganization provisions, but the question was
whether the substance of those transactions was
consistent with their form. As he does here, the
Commissioner argued in Gregory that the taxpayer's
ulterior purpose should be disregarded. . . .
In other words, the focus should be on the substance
of what was done, and not on why it was done. The
Supreme Court then analyzed the specific statutory
language concerning reorganizations and concluded
that the taxpayer's actions lay outside the plain intent
of the statute.
Appellant's Br. at 21.
As recited earlier, ACM's sales of the Citicorp Notes for
cash and LIBOR Notes resulted in the exchange of
materially different property. I believe our inquiry should
68
proceed no further, and reverse the holding of the Tax
Court eliminating the capital gains and losses attributable
to ACM's application of the contingent installment sale
provisions and the ratable basis recovery rule to its
disposition of the Citicorp Notes.
I can't help but suspect that the majority's conclusion to
the contrary is, in its essence, something akin to a"smell
test." If the scheme in question smells bad, the intent to
avoid taxes defines the result as we do not want the
taxpayer to "put one over." However, the issue clearly is not
whether ACM put one over on the Commissioner, or used
LIBOR notes to "pull the wool over his eyes." The issue is
whether what ACM did qualifies for the tax treatment it
seeks under S 1001. The fact that ACM may have"put one
over" in crafting these transactions ought not to influence
our inquiry. Our inquiry is cerebral, not visceral. To the
extent that the Commissioner is offended by these
transactions he should address Congress and/or the
rulemaking process, and not the courts.2
Accordingly I must dissent from what I admit is a very
finely crafted opinion by my colleague, Judge Greenberg.
A True Copy:
Teste:
Clerk of the United States Court of Appeals
for the Third Circuit
_________________________________________________________________
2. As the majority notes, the Commissioner apparently realized the
possible "loophole" in the regulations and enacted Treas. Reg. S 1.701-
2(a) in an apparent effort to curb such tax driven transactions as the
ones here. See Maj. Op. at 29-30, n. 29.
69