March 1, 2012
On December 7th, oral argument was held in the Fifth Circuit in the NPR case before Judges Dennis, Clement, and Owen. You can find a detailed explanation of the issues here but in summary the questions involve whether, in the context of a Son of BOSS case: the gross valuation penalty applies when the basis producing transaction is not invalidated solely due to a bad valuation; whether other penalties apply; how the TEFRA jurisdictional rules function as to those penalties; and whether an FPAA issued after a non-TEFRA partnership no-change letter falls afoul of the no-second-FPAA rule.
Although both parties appealed, as the initial appellant DOJ began the argument. DOJ counsel argued that the Supreme Court’s decision in Nat’l Cable & Telecomm. Ass’n v. Brand X Internet Servs., 545 U.S. 967, 982 (2005), allowed Treas. Reg. § 1.6662-5(d) to override the Fifth Circuit’s position in Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990), that a valuation misstatement cannot apply where there are grounds for invalidating the transaction other than an incorrect valuation — such as where the transaction is totally disallowed under economic substance or on technical grounds. In this regard, DOJ requested that the court submit the matter for en banc review to address this issue and to consider the impact of Weiner v. United States, 389 F.3d 152 (5th Cir. 2004), which counsel characterized (as DOJ had in the brief) as calling the “total disallowance” rule into question.
As to the substantive application of penalties, DOJ argued that the complete concession by the taxpayer of the substance of the transaction compelled the conclusion that the position lacked substantial authority. Furthermore, counsel argued that there was no substantial authority at the time the transaction was reported on the taxpayer’s return. In this regard, DOJ posited that although Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975), had held that a contingent liability was not a liability for purposes of section 752, it did not address the questions of buying and selling offsetting options and of contributing them to a partnership only to arrange for a distribution and sale. As to these points, the only authority on point was Notice 2000-44, which stood for the proposition that the transaction did not work. This appears to be a repackaged version of the argument that there can never be substantial authority for transactions lacking economic substance.
Argument transitioned to the question of whether the district court had jurisdiction to consider a penalty defense put on by the partners and not by the partnership in this partnership action. For a prior discussion of this confusing question see our analysis here. Citing Klamath Strategic Inv. Fund, LLC v. United States, 568 F.3d 537 (5th Cir. 2009), DOJ counsel argued that the Fifth Circuit had already decided that an individual reasonable cause argument (such as one based on a legal opinion issued to the partner) cannot be raised in a TEFRA proceeding. The court seemed to recognize the impact of Klamath on this point. DOJ counsel then attempted to box the partnership in (as it had in the brief) on the question of whether the defense was raised by the partner or the partnership (several statements in the district court’s opinion seem to view the defense as a partner-level defense).
Moving on to the question of the merits of the reasonable cause position, DOJ argued that the district court erred in considering reliance on the tax opinion (which was written by R.J. Ruble) to be reasonable. Initially, counsel questioned whether the partners’ testimony that they did not believe Ruble had a conflict was reasonable in light of the partners’ knowledge of fee sharing and of the fact that Ruble had written opinions for other shelters for the same promoter. The court seemed to be honed in on this question. In closing, DOJ attempted to poison the well of partner good faith by reminding the Court that the partners in this case were repeat tax-shelter offenders and had attempted to hide the Son-of-BOSS losses as negative gross revenue from their law firm business.
Perhaps indicating a weakness on the penalty issues raised by DOJ, taxpayer’s counsel spent most of his time on the question of whether the second FPAA was invalid. The Court focused counsel on the fact that an error on the tax return (the Form 1065 did not check the TEFRA box although it did check the flow-through partner box (which would indicate a TEFRA partnership)) led the agent originally to pursue the case as non-TEFRA. Undeterred, counsel argued that this error was not material and that the agent had indicated in a deposition that he eventually learned that the partnership was TEFRA. Testimony was also offered in the district court that the reporting was an innocent mistake and not negligent or deceptive. The Court spent significant time questioning why the agent did not testify at trial (which appears to have been due to a mix-up on the part of DOJ). In summarizing his position, taxpayer’s counsel tried to focus the court on the language of the partnership no-change letter but to us it appears that the real question has to be whether the agent intended this to be a TEFRA audit. An FPAA simply cannot come out of a non-TEFRA audit. Based on the agent’s deposition transcript it seems clear that he did not believe he was involved in a TEFRA audit when he opened the audit and thus it is impossible that the initial notice was an FPAA.
Rebutting DOJ’s reasonable cause position, taxpayer’s counsel focused on the trial testimony and factual determinations by the district court that the taxpayers were acting reasonably and in good faith. On the question of jurisdiction, the taxpayer reverted to the tried and true (but not very strong) argument that requiring a later refund suit to address the reasonable cause question would be a waste of judicial resources and, in essence, a meaningless step. A cynic might say that the purpose of TEFRA is to waste judicial resources and create meaningless steps.
In rebuttal, DOJ counsel focused on the no-second-FPAA question and did a good job from our perspective. He noted that you have to have a TEFRA proceeding to have a TEFRA notice. Undermining the district court’s determination that the finality of the notice is relevant, counsel noted that all non-TEFRA notices are “final” but that doesn’t mean they are FPAAs. TEFRA is a parallel audit procedure and it is simply not enough that the IRS intended a final determination in a non-TEFRA partnership audit. The question is whether the IRS intended to issue a final notice in a TEFRA proceeding; since there was no “first” TEFRA proceeding, there was no “first” FPAA. We think this argument is right on target.
With limited questions coming from the Court it is difficult to see where this is headed. Our best guess is that the partnership will prevail on the reasonable cause position (it is difficult for an appellate court to overturn credibility determinations of witnesses) but lose on everything else including the no-second-FPAA issue.
Supreme Court Struggles With Confusing Criminal Tax and Deportation Interplay in Kawashima Oral Argument
January 6, 2012
We are finally getting around to updating Kawashima, the Supreme Court case involving the question of whether a conviction under section 7206 is a deportable offense under the immigration laws. The Court heard argument on the case back in November. A decision likely will be issued this spring. It’s hard to read which way the Court is leaning based on the arguments. Several Justices seemed to balk at petitioners’ technical argument that a false statement on a return (under section 7206) can be something less than intending to deceive the IRS (a crime involving “fraud or deceit” is deportable under the immigration laws — see our prior post).
The argument first focused on the Code’s “willfulness” concept and whether the requirement in section 7206 that the false statement be submitted willfully in fact turned an act that — without willfulness — might not be intended to deceive into something that showed intent to deceive. Petitioners’ counsel tried to focus the Court on the concept that intent to deceive required intent to induce an action or reliance and not merely intent to make a false statement. This position seemed to concern several Justices given that the false statement was on a document submitted to the government for a specific purpose (reporting taxes). The argument also briefly turned to the question of the case law — largely Tax Court case law — which historically held that a conviction under section 7206 did not automatically trigger the extended limitations period for fraud unless the IRS independently proved fraud. The Justices did not substantively comment on this point during petitioners’ time but came back to it during the government’s argument and it seemed to get some traction with the Chief Justice.
Petitioners’ counsel and Justice Scalia spent a substantial amount of time discussing whether the inclusion of both section 7201 and the “fraud or deceit” provision in the deportation law rendered the former superfluous if the government’s reading was adopted. This involved a discussion of the text of section 7201, which has long been textually framed as an attempt “to evade or defeat any tax” and does not specifically use the words fraud or deceit. While the Justices did not seem to be happy with the responses by petitioners’ counsel, an amicus brief submitted by Johnnie Walters — a former IRS Commissioner — deals with the history and meaning of section 7201 quite compellingly. And when questioning the government’s counsel, Justices Ginsburg and Kagan both seemed concerned that the government’s position could read one part of the deportation statute out of the law based on this historic reading of section 7201. This led Justice Breyer to introduce the idea that section 7206 does not seem to meet the common law definitions of fraud or deceit — a point not raised by counsel as best as we can tell — but something that could be relevant in determining Congressional intent.
Piercing through the government’s argument, Justice Kagan was able to get its counsel to admit that even the evasion-of-payment cases under section 7201 have to involve some sort of fraud in order to be prosecuted under that statute. Counsel also basically admitted that the IRS/DOJ has never prosecuted a section 7201 case that didn’t involve fraud. This triggered a question by Justice Breyer as to whether the government’s position would make every single perjury statute a deportable offense — something that would profoundly impact both defendants and the system. Justice Kagan then returned to the circularity of the government’s arguments regarding superfluity (a point we have made a few times previously).
As we said at the outset, it is difficult to see where all of this is going. Petitioners do seem to us to have the stronger case when you consider the historic meaning of section 7201 (which is fundamental to criminal tax practice) but the statutory text could be confusing when read outside of that context. We will update you as soon as we see a decision.
November 7, 2011
The NPR case (involving penalty application and TEFRA issues in the context of a Son of BOSS transaction: see latest substantive discussion here) has been calendared for argument in New Orleans on December 7th in the East Courtroom.
October 18, 2011
The petitioners’ and respondent’s briefs have been filed in Kawashima v. Holder, Sup. Ct. Docket No. 10-577, appealing 615 F.3d 1043 (9th Cir. 2010). As described in our original post, that case involves the question of whether pleas to section 7206 offenses (subscribing to false statements and assisting same) are “aggravated felonies” that result in deportation under the immigration laws. The case turns largely on the statutory interpretation of the relevant portion of 8 U.S.C. §1101(a)(43)(M).
The petitioners’ position is essentially the same as it was below (although more developed). The primary argument is based on the language of 8 U.S.C. §1101(a)(43)(M), which provides, in relevant part, that an aggravated felony includes an offense that:
(i) involves fraud or deceit in which the loss to the victim or victims exceeds $10,000; or
(ii) is described in section 7201 of the Internal Revenue Code of 1986 (relating to tax evasion) in which the revenue loss to the Government exceeds $10,000.
The crime to which petitioners pled is plainly not an aggravated felony under the second prong, because petitioner pled to section 7206 and not to section 7201. Petitioners argue that section 7206 offenses cannot be covered by the first prong either. They base this argument on ordinary principles of statutory construction.
First, petitioners argue that the use of the term “revenue loss” in the second prong of the statute indicates Congressional intent that the term “loss to the victim or victims” in the first prong does not include a revenue loss to the government. The purposeful use of different terms in each section seems to imply such an intent. Furthermore, the response that this difference simply reflects a different purpose for each prong (one that focuses on governmental loss and one that does not) ultimately supports petitioners’ overall argument that the first prong was not intended to reach losses to the government such as through non-section 7201 tax crimes.
Second, petitioners posit that interpreting tax crimes to fall into the first statutory prong would render the second superfluous. As we previously discussed, this seems to be a strong argument. At a minimum, it would be odd for Congress to place one tax crime in a specific statutory provision and all other tax crimes in a vague and broad provision that covers many other offenses. And the analysis in Leocal v. Ashcroft, 543 U.S. 1 (2004) (cited by petitioners) strongly implies that Congress should not be considered to have intended that meaning.
Finally, petitioners argue that the reference in the second prong to “tax evasion” helps to define (and limit) the scope of the term “fraud or deceit” in the first prong and that the sentencing guidelines support this view. Petitioners’ analysis in this respect is largely based on the application of the interpretative canon that the specific limits the more general. Because terms like “revenue loss” and “tax evasion” are used in the second prong, it is not appropriate — under petitioners’ application of this canon — to read those terms into the first prong. Petitioners’ reliance on the sentencing guidelines seems to be a stretch given that there is no direct support for the premise that Congress actually considered these guidelines when formulating the aggravated felony definition. (Petitioners argue that Congress “likely” considered same given the timeline of adoption of the various provisions.)
In the alternative, the Kawashimas argue that their pleas did not involve fraud or deceit (and thus could not be included in the first prong anyway) and that, even if they might be included in that prong, the whole scheme is so confusing that the rule of lenity should apply to exempt them from a strict application. The first argument relies on the elemental approach to the determination of whether a crime is an aggravated felony as applied by the Court in Nijhawan v. Holder, 555 U.S. 1131 (2009) and earlier rulings. Under that approach, courts are supposed to determine whether the relevant factors for aggravated felony purposes (here, among others, fraud or deceit) were necessarily elements of the crime for which the defendant was convicted and not to focus on the specific conduct committed by the specific defendant. See also Leocal, 543 U.S. at 7. Because the elements of section 7206 do not require a finding of fraud or deceit (petitioners characterize it, not altogether unfairly, as a tax perjury statute), under this “elements and nature” approach, a section 7206 offense cannot amount to an aggravated felony under the first prong of 8 U.S.C. §1101(a)(43)(M). This second argument is a Hail Mary and implicitly relies on the confusing state of the immigration law in this area as demonstrated in the rest of petitioners’ brief. While immigration rules are ludicrously complex in this area, so is much of criminal law. Unless the members of the Court are prepared to hold that any issue complex enough to find its way into their hands is necessarily unclear or confusing enough to give rise to the rule of lenity, it would seem an odd way to resolve the case (although a refusal by the Court to apply ludicrously complex rules might convince Congress to be more rational in drafting statutes).
The Solicitor General’s brief generally tracks the petitioners’ arguments in substance but not in order. The government takes issue with the petitioners’ assertion that section 7206 does not require an element of fraud or deceit by focusing more on the dictionary definition of deceit than the historic application of section 7206 in jurisprudential context. As to the question of fraud, the government attempts to equate material falsehoods (required for section 7206) with fraud (or at least deceit). This appears to be a difficult argument to sustain unless the Court is prepared to depart from principles that are fairly well settled in the lower courts. The Tax Court and several Circuit Courts of Appeals have held that a conviction under section 7206 does not necessarily trigger fraud penalties or the fraud period of limitations in the civil side of the Internal Revenue Code. See, e.g., Wright v. Commissioner, 84 T.C. 636 (1985). It is hard to reconcile the government’s argument with these authorities. Perhaps the best way to distinguish these authorities is on the basis that the material falsehoods at issue did not amount to a showing that the taxpayer intended to prepare a fraudulent return (i.e., to commit tax evasion) and that the aggravated felony test asks the (different) question of whether any fraud was conducted against a “victim.” The logical problem with this argument is that it assumes that there is some other way for the government to suffer a loss than the fraudulent return. If the fraud has to be linked to the loss, then the interpretation of section 7206 in cases like Wright seems inconsistent with the government’s argument in its brief.
The government attacks petitioners’ specific-over-general argument on the basis that the second prong does not by its terms encompass all tax offenses (it refers only to section 7201, the capstone tax offense). While this is true, it raises the question of why Congress would have isolated one tax offense from all of the others (assuming all of the others are included in the first prong). This, in turn, drives into petitioners’ superfluity argument. On that question (where much of the merit rests in our opinion), the government starts with the premise that Congress sometimes wishes to be superfluous. It then argues that the failure of the second prong to cover all tax offenses (as opposed to section 7201) would render that prong ambiguous. This argument seems baseless. The only way prong one is rendered ambiguous by petitioners’ argument is if you are predisposed to assume that all tax offenses are either in prong one or in prong two. If you come to the statutory interpretation exercise without that excess luggage, it is perfectly natural for prong two to deal with the sole exemplar of a tax offense that is an aggravated felony and for prong one to include no tax offenses at all. (This is arguably the most natural reading of the provision). The government’s efforts to force ambiguity into prong one by arguing that Congress might have wanted to make really, really, really sure that a tax statute — section 7201 — that for all time has stood as the capstone of tax fraud/evasion would be interpreted as involving fraud or deceit seem to us a bit of a stretch.
The government finishes by focusing on the legislative disconnect between the aggravated felony rules and the sentencing guidelines (fairly chastising petitioners for failing to prove a direct connection). It also dismisses the applicability of the rule of lenity on the ground that mere ambiguity is insufficient to trigger that rule (the case law indicates the ambiguity must be grievous). Finally, the government notes that the agency never formally addressed the question of whether non-section 7201 tax crimes can be aggravated felonies. In the government’s view the agency should be allowed to do so on any remand and any such decision should be accorded Chevron deference. As mentioned above, we doubt that the Court will resolve the case on either of these bases.
Petitioners’ reply brief is due October 31, and the case is scheduled for oral argument on November 7.
September 20, 2011
The Ninth Circuit issued its opinion in Samueli v. Commissioner, Nos. 09-72457 and 09-72458, on September 15, 2011, largely affirming the Tax Court (opinion linked below, and see our prior coverage here). In upholding the decision in favor of the IRS, the Ninth Circuit added a couple of wrinkles to the Tax Court’s rationale in responding to the taxpayers’ arguments on appeal.
The court first dispensed with the taxpayers’ argument that, contrary to the Tax Court’s finding, the transactions at issue did not reduce the purported lenders’ opportunity for gain (a statutory element of I.R.C. § 1058 non-recognition). The court found that not only did taxpayers have an extremely limited right to recall the securities (the interest strips were recallable on two days out of approximately 450), thereby limiting the opportunity to take advantage of potential short term swings in value, but also the lending agreement further constrained taxpayers by adding another layer of pricing risk that could have made recalling the securities economically infeasible. Accordingly, the Ninth Circuit ruled that section 1058 was inapplicable as a more or less routine matter of statutory interpretation.
But the court didn’t stop there. Responding to the taxpayers’ argument that section 1058 is merely a safe harbor and does not definitively delineate securities loans that should be afforded non-recognition treatment, the court held that taxpayers’ purported loan did not align with the policy animating section 1058 (the facilitation of liquidity for the securities markets), and therefore the transaction was not eligible for tax-favored treatment. The court was clearly exercised by its assessment that the taxpayers’ “loan, a tax shelter marketed as such for which the borrowing broker did not pay the lender any consideration, clearly was not ‘the thing which the statute intended.’” (quoting Gregory v. Helvering, 293 U.S at 469). The court reasoned that, because the taxpayers’ transaction was inconsistent with the purpose of the statutory provision at issue, taxpayers could not avail themselves of some sort of common law penumbra around the statute (assuming one exists in the first instance–a debatable proposition).
As we noted in our earlier post, the taxpayers argued in their reply brief that irrespective of section 1058, the transactions were in substance the purchase of a contractual right later terminated, and therefore eligible for capital gains treatment pursuant to I.R.C. § 1234A. Noting that the government had successfully argued application of substance-over-form, the court nonetheless opined that “[it] does not mean that [the taxpayers] therefore must have the right to call the transaction whatever they want after the fact.” Tacitly applying a version of what some practitioners refer to as the Danielson doctrine, the court held that the taxpayers were stuck with their form and could not recast the transactions to avoid the tax consequences of the Service’s recharacterization. See, e.g., Comm’r v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974) (“while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, . . .and may not enjoy the benefit of some other route he might have chosen to follow but did not”); Comm’r v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967) (“a party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.”).
August 24, 2011
The Federal Circuit’s en banc opinion is out. It affirms the Court of Federal Claims on the reasoning set out in our prior posts and rejects the harmless error analysis of the prior panel opinion. We are pleased to see the Federal Circuit safely emerge (albeit clutching map and compass) from the TEFRA forest.
August 18, 2011
As we mentioned in our last post, the only brief remaining to be filed in NPR was the taxpayer’s reply brief. That brief has now been filed and with it a DOJ motion to strike part of that reply as an inappropriate sur-reply. The motion concerns a section in the reply in which the taxpayer takes on DOJ for arguing (in its previously filed reply brief ) that the only relevant factor in determining the incidence of the valuation misstatement penalty (between partnership and partner) is whether there are partnership items involved and not where the specific misstatement results in a loss.
The taxpayer’s view is that DOJ is trying to have its cake and eat it too – arguing that the penalty applies at the partnership level because it is related to partnership items but refusing to allow section 6664 arguments to be heard on the grounds that those are specific to the partner. DOJ’s position is that it would be barred from raising the penalty outside of the context of a partnership proceeding because the penalty relates to a partnership item (or items) and that it is not inconsistent to require section 6664 intent to be evaluated at the partner level (and, in any event, it is required by the regulations). All of this, as we have extensively discussed, is intertwined in the silliness of trying to separate partner and partnership intent between TEFRA levels something the regulations perhaps should not have done but clearly do. It will be interesting to see how the Fifth Circuit handles the case.
August 12, 2011
It has been a while since we published an update on NPR (please no comments on Supreme Court Justices, schoolchildren, and bloggers taking summers off). Since our last post discussing the government’s opening brief, the taxpayer filed its brief responding to the government and opening the briefing on their cross-appeal. The government also filed its response/reply. All that remains now is the taxpayer’s reply brief on its cross-appeal, currently due on August 15. There are a slew of technical TEFRA issues that are raised by the parties. The taxpayer is appealing the district court’s rulings regarding whether a no change letter can ever be an FPAA and, if it can be, whether an erroneously checked box on the tax return (claiming that the partnership was not a TEFRA partnership) can constitute a misrepresentation of a material fact such that the no-second-FPAA rule of section 6223(f) is inapplicable. As we discussed last post, the parties are jointly briefing — in the government’s appeal — the application of the Heasley/Weiner line of cases to the taxpayer’s concession strategically made to circumvent the gross valuation misstatement penalty. Mayo is implicated by the application of Treasury Regulation section 1.6662-5(d) (DOJ relies on Brand X to argue that the regulation controls over the contrary rule previously announced in Heasley).
However, as we discussed in prior posts, the main issue here is good faith reliance on counsel — R.J. Ruble — by the taxpayer for purposes of the section 6664 reasonable cause defense and when, procedurally, that defense can be raised. The government continues to hew to the line that reliance is inappropriate (because of a technical conflict and because reliance was just not reasonable under the circumstances). DOJ also argues that the defense can be raised only in a partner-level proceeding pursuant to then Temporary Treasury Regulation section 301.6221-1T(d) (the judges may want to get a cholesterol test with all of this Mayo being spread around). For its part, the taxpayer argues that the district court already determined — after seeing the witness testimony — that the reliance was in good faith. Furthermore, since one of the partners is the TMP, the reasonable cause defense is being raised by the partnership as much as by the partners. Setting aside whether you believe the testimony (which the district court judge did), if we could decide cases based on the fact that section 301.6221-1T(d) of the TEFRA penalty regulations is stupid, this would be easy. As we have said before, separating partner and partnership intent in a transaction involving a partnership that was purposefully created by the partners to implement that very same transaction is like trying to dance on a headless pin. With deference under Mayo, however, “stupid is as stupid does” is not the test for striking down regulations. We will just have to wait and see how much patience the Fifth Circuit has for this Forrest Gump of a regulation.
June 29, 2011
The government filed its response brief in Anschutz Co., et al. v. Commissioner, Nos. 11-9001 & 11-9002 (10th Cir.), on June 22, 2011 (linked below). See our prior coverage here. Not surprisingly, the government argues that the Tax Court got it right in viewing the putatively separate variable prepaid forward contracts and stock loans as two parts of one overall arrangement, designed to monetize the value of the taxpayer’s low-basis stock at the outset of the deal. The Tax Court held that, in substance, the overall arrangement was a sale for tax purposes because the benefits and burdens of owning the stock had been passed to Anschutz’s counterparty. Based on the briefing, it appears that the key question in the case will be whether the IRS and the Tax Court were correct in viewing the transactions as an integrated whole, or whether they must be analyzed separately under the technical provisions applicable to stock loans and variable prepaid forwards.
May 17, 2011
As we’ve reported in the last few months, several securities lending cases are percolating in the appellate courts (see here and here). On April 29, 2011, Anschutz Company filed the opening brief in its appeal of the Tax Court’s decision for the government (opinion and brief linked below).
At issue in Anschutz is the appropriate tax treatment of a set of transactions between the taxpayer and Donaldson, Lufkin & Jenrette Securities Corp. (“DLJ”). The taxpayer sought to leverage long-held shares in publicly-traded railroad companies to obtain financing for other endeavors. In the taxpayer’s hands, the shares had a low basis relative to their fair market value at the time of the transactions in question. The transactions involved the use of prepaid variable forward contracts (“PVFCs”) and concurrent share lending agreements (“SLAs”). Under the PVFCs, DLJ paid the taxpayer a percentage of the current market value of the shares in exchange for the right to receive a number of shares or their cash equivalent at a point in the future. The number of shares to be delivered (or their cash equivalent) was to be determined by a formula agreed upon at the outset. In order to secure its obligation, the taxpayer pledged a number of shares sufficient to ensure consummation of the deal at maturity. In parallel, DLJ entered into an SLA with the taxpayer under which DLJ would take possession of the pledged shares to use them in short sale transactions. Although each of the two transactions, viewed in isolation, would have passed muster under relevant authorities as non-taxable open transactions, the government challenged the arrangement as constituting in substance a taxable sale of the shares at the inception of the deal. After a two-day trial, the Tax Court agreed.
On appeal, Anschutz argues that the Tax Court’s decision to view the transactions as two legs of one overall arrangement was error. Rather, the taxpayer contends that the two transactions should be respected as stand-alone occurrences to be analyzed separately. Under the taxpayer’s view, the PVFCs are non-taxable open transactions under Rev. Rul. 2003-7, and the SLAs fall within the ambit of I.R.C. section 1058 (stock loans not taxable provided certain conditions are met). For the Tax Court, the crux of the case was that the PVFCs had the effect of shifting to DLJ all risk of loss and most of the opportunity for gain on the shares. Under section 1058, a stock lending arrangement cannot reduce the risk of loss or opportunity for gain if it is to be considered non-taxable. The taxpayer contends, however, that in spite of a master agreement governing both legs of the arrangement, the facts properly construed require the two transactions to be analyzed separately as independent deals, each with their own tax consequences.
The government’s response is now due on June 24, 2011. We’ll keep you posted on this and other developments in the securities lending cases.
May 13, 2011
The en banc Federal Circuit heard oral argument in the Bush TEFRA case on Wednesday the 10th of May. For those still interested after reading this, you can listen to the argument here. As we indicated in our prior analysis, we think the resolution of this case is simple. Unfortunately, although the parties and the court almost escaped the weeds several times, with one of the judges asking a question very close to the mark, it was a dissatisfying oral argument (from our perspective). The point that needed to be made is that an agreement to “no change” a partnership item is “treatment” of a partnership item in and of itself — you have just treated it the same as it was originally treated. Thus, a change in tax liability that “reflects” a partnership no change is a computational adjustment.
To put some more meat on that, section 6221 illustrates the purpose of TEFRA to require “the tax treatment of any partnership item [to be] determined at the partnership level.” Section 6230(a) coordinates the Code’s deficiency proceedings with TEFRA and mandates that, aside from converted items, notices of deficiency are required only for “affected items which require partner level determinations.” Claims arising out of erroneous “computational adjustments” can be litigated but the underlying treatment of partnership items resolved in a TEFRA proceeding cannot be re-litigated. Section 6230(c). Section 6231(a)(6) defines a “computational adjustment” as a “change in the tax liability of a partner which properly reflects the treatment … of a partnership item.”
Where you have a change in tax liability of a partner that “reflects” the “treatment” (not the “change” in treatment, just the treatment) of a partnership item and no partner-level determinations are necessary, then no notice of deficiency is required. In Bush, the partners settled the “treatment” of the partnership items as a no change and agreed to all of the necessary partner level determinations so there was no need for a partner-level determination to determine tax consequences. Accordingly, no notice of deficiency was necessary. Contrary to the taxpayers’ position at oral argument (and in the briefs), the fact that there could be other (non-partnership) items contested in a notice of deficiency is irrelevant. Likewise, it is irrelevant that the partnership items or treatment of those items never changed. You don’t need a change in a partnership item or a change in the treatment of that item to have a computational adjustment. Instead, you need a change in tax liability that reflects the treatment of partnership items. Any TEFRA-based adjustment does that even if the partnership items stay as they are on the original return because their treatment is reflected in that tax liability. That is the whole point of TEFRA: partnership item treatment is relegated to TEFRA proceedings and everything flows out of that treatment. So a change in tax liability driven by a change in allowed partnership losses based on a change in a partner’s at-risk amount reflects the treatment of a partnership item (the losses, which are no-changed, which is a form of “treatment”) and thus is a computational adjustment.
Although the court asked several questions on the period of limitations and assessment issues and asked other questions to determine the scope of the problem, the rest of the taxpayers’ arguments are a sideshow. It is always tough to tell how a case will be decided based on the arguments, but, even though it was less than satisfying, the court’s questioning indicates to us that the government will prevail and the court will find its way out of this part of the TEFRA forest.
April 27, 2011
The Government has filed its brief in its Fifth Circuit appeal from the denial of penalties in the NPR Investments case (for prior discussion go here). There are no surprises. The Government takes the position that the district court’s reliance on Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990) (likely abrogated by Treas. Reg. § 1.6662-5(g) and certainly weakened on these facts by Weiner v. United States, 389 F.3d 152 (5th Cir. 2004)) is misplaced. Thus, the government argues that the mere fact that the taxpayer’s entire transaction (and not just a valuation or basis item) was concededly devoid of substance is not a bar to valuation misstatement penalties. The Government also takes issue with the alleged consideration by the district court of the partners’ (as opposed to the partnership’s) reasonable cause defenses in this TEFRA proceeding contrary to Temp. Treas. Reg. § 301.6662-1T(c)-(d). At a big picture level, the Government is still none-too-pleased with the district court’s open reliance on an R.J. Ruble opinion as contributing to such defenses, an act of reliance that it argues is contrary to case law prohibiting a taxpayer from relying on conflicted advisers for reasonable cause and also contrary to, among other things, the restriction on relying on a legal opinion that is based on representations the taxpayer knows are untrue. Treas. Reg. Sec. 1.6662-4(c)(1)(i).
This case has the potential to be another Mayo/Brand X battle-royale (what tax case doesn’t these days?) given that there are at least three regulations explicitly relied on by the Government some of which post-date contrary court opinions. But at bottom the case is just about a district court judge who looked into the eyes of the taxpayers and found not malice but, rather, an objectively good faith belief in the adviser who was hired to bring them safely past the landmines and snipers that fill the no-man’s land also known as the tax code. Although they didn’t make it across (the taxpayers abandoned defense of the claimed tax benefits and R.J. – metaphorically shot – is serving time), the district court apparently couldn’t fault them for trying. The government’s view is much harsher. In essence, it thinks that in trying to find a way to make it to the tax-free promised land, the taxpayers should have tried a little harder to explore the obstacles in their way before taking their guide’s word for it. At least their place shall never be with those cold and timid souls who know neither victory nor defeat.
The taxpayer’s brief is due May 17th. We will keep you posted.
March 31, 2011
On March 29, 2011, the Fourth Circuit rendered its opinion in Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, No. 10-1333 (opinion linked below). As described in our previous coverage, the case involved an IRS challenge to the taxpayer’s treatment of partnerships used as marketing vehicles for state tax credits derived from historic rehabilitation projects. Agreeing with the government’s disguised sale theory, the court reversed the Tax Court and ruled that the transactions at issue were taxable sales of state tax credits, as opposed to non-taxable capital contributions followed by partnership distributions.
After quickly dispensing with the taxpayer’s argument that the tax credits received by investors were not “property” under the statute, and skipping over the question of whether the funds’ investors were bona fide partners for federal tax purposes, the court took a decidedly statutory approach to resolving the case by focusing on the disguised sale regime under I.R.C. § 707(b). In applying the statute, the court largely relied on the guidance in Treas. Reg. § 1.707-3, which sets forth a presumption that reciprocal transfers between a partner and a partnership within a two-year period constitute a disguised sale unless facts and circumstances clearly establish otherwise. The regulation also lists ten factors to consider in determining whether the second transfer in a non-simultaneous pair of transfers is “dependent on the entrepreneurial risks of partnership operations.”
In addition to finding that the transfers-within-two-years presumption required the taxpayer to “clearly establish” that the transfers did not constitute a sale, the court focused on five of the Treas. Reg. § 1.707-3 factors. First, the court found the timing and amount of the second transfer (the allocation of tax credits to the investors) were determinable with reasonable certainty at the time of the first transfer (the alleged contributions to capital made by the investors), and each investor knew with specificity the size of the credits that he or she could expect. Second, the investors had legally enforceable rights to the credits per their subscription agreements; they had been promised state credits in exchange for their capital contributions. Third, the investors’ rights to the credits were secured through a promise of refunds if sufficient state credits were not delivered to the investors. Fourth, the transfers of credits to the investors were disproportionately large compared to the negligible (0.01 percent) interest that most investors held in the partnerships. Significantly, in this regard the court found that “the transfer of tax credits to each investor by the partnership had no correlation to each investor’s interest in partnership profits whatsoever.” Finally, the investors had no further obligations or relationship with the partnership after they received their credits. In light of the presumption, the court opined that these factors “strongly counsel for a finding that these transactions were sales.”
Further girding its rationale, the court noted that the taxpayer did not follow the form of the subscription agreements, assigning each investor a 0.01 percent interest regardless of their capital contributions. The Fourth Circuit further noted that the partnership status of the investors was transitory in nature, which echoed a concern expressed in the legislative history to section 707(b). Also, the court noted that the Tax Court did not analyze the factors in Treas. Reg. § 1.707-3 but rather relied on its own analysis of the investors’ level of entrepreneurial risk. As an interesting aside (from a regulatory deference point of view), the court opined that the Tax Court was not bound to “tick through [the factors] mechanically[,]” but was “free to” conduct its own evaluation of risk, because the regulation “simply reflects those characteristics the Department of the Treasury, given its experience and expertise, thinks significant.” Nonetheless, the court found the Tax Court’s independent analysis of entrepreneurial risk unconvincing, viewing the risks cited as “both speculative and circumscribed.” In the final analysis, the court held that the only risk borne by the investors was “that faced by any advance purchaser who pays for an item with a promise of later delivery. It is not the risk of the entrepreneur who puts money into a venture with the hope that it might grow in amount but with the knowledge that it may well shrink.”
March 21, 2011
A while ago we reported on a spate of IRS successes in cases involving purported securities loans (here). The Samueli case is fully briefed in the Ninth Circuit and is expected to be argued in the next couple of months. As we anticipated, two more of those cases, Anschutz and Calloway, have been appealed to the Tenth and Eleventh Circuits, respectively. The taxpayer in Calloway filed his opening brief on March 15, 2011 (linked below). Briefing has not yet begun in Anschutz.
In Calloway, the taxpayer was an IBM employee of many years who had acquired IBM stock during his employment. By the time of the transaction in question, the stock’s value was five times the taxpayer’s basis. Desiring to monetize the stock, and by his own admission, seeking to maximize his after-tax return, the taxpayer entered into an arrangement whereby he transferred his stock to a counterparty in return for a loan equal to 90% of the stock’s fair market value. This resulted in a 10% higher return than a straight sale subject to long-term capital gains tax. Under the arrangement, the taxpayer had no right to any dividends, no ability to reap any gains from appreciation of the stock, and no right to recall the stock during the loan period. The counterparty had the right to sell or otherwise dispose of the stock it purportedly held as collateral. At the close of the three-year loan period, the taxpayer had the option of repaying the principal with interest to redeem his collateral, refinancing the transaction for an additional term, or surrendering his collateral in exchange for extinguishment of the debt. As the stock had depreciated significantly, the taxpayer chose to surrender his collateral. Notably, not only did the taxpayer not report the transaction as a sale, he also did not report any cancellation of indebtedness income upon extinguishing the purported debt.
The IRS challenged the taxpayer’s treatment of the transaction as a loan, asserting that in substance the arrangement was a sale of the taxpayer’s securities. In a reviewed decision, the Tax Court agreed with the IRS that the transaction was indeed a sale, primarily because the benefits and burdens of ownership of the stock had in fact passed to the counterparty (under an application of the test articulated in Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981)). Of course, it didn’t help the taxpayer that the counterparty had been sued successfully for promoter penalties and for an injunction to cease all further shelter promotion activities.
On appeal, the taxpayer’s position centers around the arguments that (1) the Tax Court’s finding that the counterparty had the right to sell the stock immediately was clear error, and (2) the finding that the taxpayer could not demand the return of his stock during the three-year period was also clear error. These arguments apparently are based on the position that the counterparty did not have the right to sell the stock until a “legitimate” loan was already in place, and because the counterparty used the stock sale to finance the purported loan, no such right ever accrued. Thus, according to the taxpayer, he remained in control of the stock under the terms of the arrangement, and therefore the transaction is subject to the safe harbors under I.R.C. § 1058 and Rev. Rul. 57-451, and furthermore should not be deemed a sale under the applicable common law securities-loan authorities.
We’ll provide an update when the government files its response, and we’ll post on Anschutz when the briefing gets under way (the opening brief is due May 2). On a related note, the Tax Court recently held for the government in a case involving a transaction materially identical to the one in Calloway. See Kurata v. Commissioner, T.C. Memo 2011-64 (March 16, 2011).
February 22, 2011
We have added the taxpayer’s reply brief to the original post. We will update you as soon as we hear what the en banc court does.
February 10, 2011
We noted back in November that the taxpayer had filed a petition for certiorari in Kawashima v. Holder, 615 F.3d 1043 (9th Cir. 2010), on the question whether Code section 7206 offenses provide a basis for deportation — an issue on which the circuits are split. We stated that the Court could be expected to rule on the petition in early 2011, even if the government obtained a fairly routine 30-day extension of its December 2, 2010 response date.
There is no ruling yet because the government has now obtained three such extensions. That is fairly unusual and may indicate that the government’s lawyers are struggling with how to respond. In any case, it is unlikely that the Court would grant another extension. If a response is filed on the current due date of March 4, 2011, then the Court will likely issue its ruling on its April 4 order list.
February 2, 2011
We have added DOJ’s brief to the original post. Nothing much surprising in it; the arguments adopted reflect the same approach taken in our initial post (and in the Court of Federal Claims). A point of interest is that there are 30 related cases holding at the Court of Federal Claims that depend on its resolution. We will update you as soon as we hear what the en banc court does.
January 21, 2011
In our prior post on these cases, we compared the different factual findings made by the courts in analyzing penalty exposure under section 6664 and discussed the very factual nature of a reasonable cause and good faith penalty defense. Both cases were subsequently appealed. Canal Corp.looks like it is going to settle with the Fourth Circuit granting a motion to hold the appeal in abeyance pending finalization of that settlement (the company is in bankruptcy). Thus, those hoping for an appellate smack-down of the penalty supporting opinion from the Tax Court will be disappointed. NPR Investments is a different story. Briefs are due in that appeal (which lies in the Fifth Circuit) starting on February 19th. So Government hopes of another Son-of-Boss penalty success live on. If we see anything interesting, we will report on it.
January 19, 2011
On January 18, 2011, the taxpayers filed a Notice of Supplemental Authority, drawing the court’s attention to the Tax Court’s recent opinion in Historic Boardwalk Hall, LLC v. Commissioner, 136 T.C. 1 (Jan. 3, 2011). According to the taxpayers in Virginia Historic, the new Tax Court case involves many factual and legal issues similar to those in the instant case. We’ll have an analysis of the recent decision and its potential impact on the issues in Virginia Historic in the near future.
Oral argument is scheduled in Virginia Historic for January 25, 2011.
January 18, 2011
As can be seen by the sheer number of our posts that deal with it, the unified partnership audit procedures of the Tax Equity and Fiscal Responsibility Act (“TEFRA”) can cause confusion. In fact, they can be downright bewildering. It is particularly easy to get lost if one walks into the TEFRA wilderness without keeping one eye fixed at all times on the overarching purpose of TEFRA. The case of Bush v. United States, et. al., Fed Cir. Nos. 2009-5008 and 5009, is a textbook example of what happens when you lose sight of that landmark. An apparently innocuous TEFRA proceeding resulted in a startling panel opinion authored by Judge Dyk and joined by Judge Linn that has baffled TEFRA practitioners. (Judge Prost concurred in the result on a theory that comports with the common understanding of TEFRA.) Bush v. United States, et. al., 599 F.3d 1352 (Fed. Cir. 2010). Instead of ending the case, that opinion has triggered a flurry of activity that should eventually lead to an en banc decision by the full court. Thus far, the panel decision has generated two sets of petitions for rehearing and responses, a vacated panel opinion, an order from the en banc court identifying four sets of questions to be addressed in new briefs, and at least one new amicus brief. And the en banc briefing process is just getting started. In order to keep from drawing the reader too far into the wilds ourselves, we describe the issue and the law first and then explain what happened to get us to where we are.
The facts in Bush are relatively simple. The taxpayers had TEFRA partnerships. Those TEFRA partnerships were audited, and a TEFRA partnership proceeding was brought. That proceeding was settled by the taxpayers. The Internal Revenue Service sent notices of computational adjustment to the taxpayers to reflect the adjustments agreed in the settlement; no notices of deficiency were sent. The taxpayers paid the amounts reflected in the notices of computational adjustment. Later, the taxpayers filed claims for refund with respect to the amounts they paid pursuant to the settlement and eventually sued in the Court of Federal Claims seeking to recover those amounts.
Now for the law. The purpose of TEFRA is to determine the tax treatment of “any partnership item” at “the partnership level.” Section 6221. This ensures “consistent . . . treatment” among partners and between the partners and the partnership. Section 6222. Consistency and unity is so important that the Service is empowered to issue “computational adjustments” to make the partners’ individual returns consistent with the partnership return. Section 6222(c)(2). Section 6226 provides the sole mechanism to judicially challenge the Service’s proposed adjustment of a “partnership item” – namely, filing a petition in court in response to the notice of final partnership adjustment issued by the Service. The notice of deficiency process, found in subchapter B of Chapter 63 of the Code, is specifically integrated with the TEFRA process outlined above (which is found in subchapter C of Chapter 63 of the Code), by section 6230. As relevant here, section 6230(a) contains the rules for when the IRS is required to issue a notice of deficiency under subchapter B with respect to various items, and section 6230(c) contains rules that allow a taxpayer to challenge a computational adjustment.
Section 6230 leaves a relatively narrow gap within which the standard notice of deficiency process is to operate in TEFRA partner-level proceedings. Setting aside a very specific (and irrelevant for our purposes) innocent spouse rule, section 6230(a)(2) provides that a notice of deficiency must be issued with respect to “affected items which require partner level determinations” and “items which [although they had been partnership items] have become nonpartnership items.” For all other “computational adjustments” related to: (i) partnership items; or (ii) affected items that do not require partner level determinations “subchapter B of this chapter shall not apply.” Section 6230(a)(1). This limitation on the notice of deficiency requirement, however, does not leave the partner facing a computational adjustment without recourse. Section 6230(c) allows the partner to file a claim for refund in several cases including, among others: (i) to apply a partnership settlement; or (ii) to seek a credit or refund of an overpayment attributable to the application of such a settlement. Section 6230(c)(1)(A)(ii) and (B). Critically, under either of these refund claim provisions, substantive review of the “treatment of partnership items” resolved in the settlement is verboten. Section 6230(c)(4). This is necessarily the case because the whole unifying purpose of TEFRA would be undermined if a later proceeding could affect the treatment of items properly agreed in a settlement by the parties at the partnership level.
Readers that are still awake will see that there are really only two nuts to crack in order to resolve Bush. First, were the items subject to the settlement either partnership items or affected items that do not require partner level determinations (which would mean that there was no notice of deficiency requirement)? Second, assuming they were, did the questions raised in the claim attempt to substantively re-review the determination of those items (which, again, is a statutory no-no)? As to the first question, the item at issue in Bush was the section 465 “at-risk” amount (basically, the amount that the taxpayer has placed at risk in the venture and thus as to which deductions are allowed). At-risk amounts are affected items to the extent they are not partnership items. Treas. Reg. §301-6231(a)(5)-1(c). The settlement agreement set out that the taxpayers’ at-risk amounts were equal to their capital contributions to the partnership and actually specified the dollar amount. Thus, it is arguable that the affected item in Bush is actually a partnership item. See Treas. Reg. §301-6231(a)(3)-1(a)(4)(i) (considering capital contributions generally as partnership items). Regardless, it is certainly not an “affected item which require[s] partner level determinations” because it was finally resolved in the settlement agreement and the partner’s specific situation doesn’t affect it at all. Therefore, no notice of deficiency was required under section 6230. Having made it this far, even a blind squirrel in the dark TEFRA forest can find and crack the second nut; if the settlement agreement resolved the item, and if that item doesn’t require a partner-level determination, then a claim challenging the substantive application of that item is barred by section 6230(c)(4).
The foregoing analysis is consistent with Federal Circuit precedent. Olson v. United States, 172 F.3d 1311, 1318 (Fed. Cir. 1999) (no notice of deficiency required where the computational notices involved “nothing more than reviewing the taxpayers’ returns for the years in question, striking out the [items] that had been improperly claimed, and re-summing the remaining figures”). It is also essentially the analytical methodology applied by the Court of Federal Claims in denying the taxpayers’ refund claim. See Bush v. United States, 78 Fed. Cl. 76 (Fed. Cl. 2007). But someplace between here and there, the Federal Circuit majority got turned around over the definition of a computational adjustment vis-à-vis section 6230(a)(1). It affirmed the trial court, but only after a convoluted analysis that began with the conclusion that the Service had erred in failing to issue a notice of deficiency to the taxpayers as a prerequisite to assessing the amounts agreed to in the settlement.
Section 6231(a)(6) defines a computational adjustment as “the change in the tax liability of a partner which properly reflects the treatment under this subchapter of a partnership item.” Perhaps this language, like much in TEFRA, could be clearer, but it is hard to imagine that Congress intended to give it the construction adopted by the Federal Circuit majority. The majority read the statute as associating the term “change,” at the beginning of the subsection, with the term “partnership item,” at the end of the subsection; meaning that there always has to be a “change” in a “partnership item” in order for any adjustment to be “computational.” However, based on the language itself, the statute is better read as including all situations involving a change in tax liability driven by any “treatment of a partnership item,” and not just those involving a “change” in that treatment. The word “change” directly modifies only tax liability and the use of the word “treatment” (as opposed to “change”) to define the connection to a partnership item appears to be an intentional distinction. Furthermore, any computational adjustment “affect items,” and “affected item” is defined as an item “to the extent such item is affected [not necessarily “changed”] by a partnership item.” If the partner’s tax liability changed (which it did), and that change “properly reflect[ed] the treatment” of a partnership item (and didn’t require any partner-level determinations), it is a computational adjustment. This reading also harmonizes sections 6230 and 6231 and is consistent with the broader purpose of TEFRA in unifying partnership proceedings and making partners’ returns consistent with partnership returns. See generally section 6222 (which contemplates changes to partner returns by “computational adjustment” to make them consistent with partnership returns); see also Judge Prost’s concurrence, 599 F.3d at 1366.
But the majority disagreed. And having made it this far into the woods, it turned around only to find that all of its breadcrumbs had been eaten. Worse, it could see the right answer (the taxpayer loses), but couldn’t easily get there from its entanglement in the thicket of TEFRA. Creatively, the majority got to the desired destination by stepping out of the TEFRA forest to stand on the federal harmless error statute, 28 U.S.C. §2111 (a provision, it is fair to say, that is not regularly seen in tax cases). The Federal Circuit applied section 2111 to find that the Service’s failure to issue a notice of deficiency was harmless because the taxpayer had other methods to challenge the underlying issue including both their original proceeding and a hypothetical collection due process hearing. See section 6330. If you are not badly in need of a GPS at this point, you are doing very well.
The parties filed dueling petitions for rehearing. The taxpayers did their best to take advantage of the panel opinion’s vulnerabilities (vulnerabilities that were created by the majority getting so tangled up in TEFRA it had to reach out of the tax code to solve the problem). Positing that a valid assessment was a prerequisite for the Government to retain timely made payments, the taxpayer argued that section 6213 must be mechanically followed in order to legitimately assess taxes, and therefore the alternative methods suggested by the Federal Circuit would be ineffective and could not render the error harmless. For its part, the Government tried to reorient the court to the correct reading of “computational adjustment” and pointed to Lewis v. Reynolds, 284 U.S. 281 (1932), which might allow the taxpayers a refund (due to some of the payments apparently being made after the assessment statute had closed) in spite of the court’s harmless error analysis. (As an aside, on the valid assessment point, Judge Allegra’s recent opinion in Principal Life Ins. Co. v. United States, 2010 U.S. Claims LEXIS 856 (Fed. Cl. 2010), drawing from Lewis, nicely slays the chimera that is the “requirement” of “valid assessment” for non-time-barred years)
Thankfully, the Court vacated the panel opinion and granted rehearing en banc limited to the following four issues:
a) Under I.R.C. § 6213, were taxpayers in this case entitled to a pre-assessment deficiency notice? Were the assessments the results of a “computational adjustment” under § 6230 as the term “computational adjustment” is defined in § 6231(a)(6)?
b) If the IRS were required to issue a deficiency notice, does § 6213 require that a refund be made to the taxpayers for amounts not collected “by levy or through a proceeding in court”?
c) Are taxpayers entitled to a refund under any other section of the Internal Revenue Code? For example, what effect, if any, does an assessment without notice under § 6213 have on stopping the running of the statute of limitations?
d) Does the harmless error statute, 28 U.S.C. § 2111, apply to the government’s failure to issue a deficiency notice under I.R.C. § 6213? If so, should it apply to the taxpayers in this case?
The parties are in the process of briefing these issues. We are hopeful that the Court has found its compass and is diligently working its way out of the trees. Harmless error has nothing to do with the resolution of this case and neither do the technicalities of assessment. The taxpayers agreed to the treatment of various items in a partnership proceeding. There was no need for a partner-level determination in order to compute an adjustment with respect to those items. Therefore, no notice of deficiency was required. If the taxpayers had a complaint about how those calculations were performed that did not involve a substantive challenge to the agreed at-risk amount, they would have a claim. They don’t, so they lose.
December 6, 2010
Veritas Software Corp. v. Commissioner, 133 T.C. No. 14 (2009) was the first cost sharing buy-in case to go to trial. The question before the court was the value to place on the transfer by Veritas to its Irish subsidiary of the right to use technical and marketing intangibles related to software development. Veritas argued that the valuation should be based on an adjusted comparable uncontrolled transaction (CUT) analysis (involving licenses of the same or similar property). The IRS argued that it should be based on an aggregate discounted cash flow (DCF) analysis that valued the hypothetical transfer of a portion of Veritas’ business to the Irish sub; i.e., an “akin to a sale” theory.
The Tax Court held for the taxpayer in substantial part. Finding that the IRS’s “akin to a sale theory was akin to a surrender,” it rejected the IRS position that the “synergies” supposedly effectuated by considering as an aggregate various finite-lived intangibles (many of which were not even transferred) caused the whole to live forever. This is Gunnery Sergeant Hartman’s valuation method:
Marines die, that’s what we’re here for. But the Marine Corps lives forever. And that means you live forever. Full Metal Jacket (1987).
Rejecting this method, the Court dismantled the IRS’s DCF valuation which, through the application of unrealistic useful lives, growth rates, and discount rates, purported to value the transfer of assets as if it was valuing the sale of a business enterprise.
The Tax Court is correct. The Gunny’s method doesn’t work in IP valuation and, although it sounds good, it doesn’t really work with respect to the Marine Corps either. The whole doesn’t become everlasting simply because of the very important, historic sacrifices made by its earlier parts. Current and future success depends on the valor (or value) of the current parts as much as, and often more than, that of the former. Showing an understanding of this principle, the Tax Court found that a significant contributor to the anticipated future success of the Irish business was old-fashioned hard work by Veritas Ireland and its foreign affiliates. Accordingly, the Court held that the taxpayer’s CUT method, with certain adjustments, properly reflected the value of the transferred intangibles based on their expected useful lives.
In the ordinary course, one would expect the IRS to appeal a decision where it believed the factual and legal conclusions were fundamentally erroneous. However, like the schoolyard bully who gets beat up by the first nerdy kid he picks on, the IRS has kept its tactics but changed its victim. The IRS declined to appeal Veritas, while setting out its plan to take someone else’s lunch money in an Action on Decision that refuses to acquiesce in the Tax Court decision and indicates that it will challenge future transactions under the same aggregate value method rejected in Veritas. The AOD states that the IRS is not appealing Veritas because the Tax Court’s decision allegedly turns on erroneous factual findings that would be difficult to overturn on appeal.
This attempt by the IRS to use an AOD to continue to harass taxpayers should fail. The Tax Court’s opinion did not conclude that the useful life of the pre-existing IP could never survive later technology developments. And it did not exclude the possibility of future product value flowing from that original IP. Rather, it rejected the view that synergies allow the IRS to turn a specific asset valuation into a global business valuation and, while they are at it, include in that valuation non-compensable goodwill and going-concern value. The “head-start” IP provides is indeed valuable, but it is properly valued as part of a specific asset and not in some “synergistic” stew of assets, goodwill, going concern value and business opportunity. (While we are at it, Hospital Corp. of America v. Commissioner, 81 T.C. 520 (1983)) did not bless the valuation of a business opportunity; it held that while proprietary systems, methods and processes are compensable, the mere business opportunity to engage in R&D is not.) IP does give competitive advantages that do not necessarily disappear in next generation product developments. However, one cannot treat an IP transfer as the segmentation and transfer of an entire living, breathing business. This ignores the transaction that happened but, more importantly, the real and substantial risks assumed by the parties in developing the future IP, risks that drive the real value of those future products, products that are but one part of the value of that continuing business. Contra Litigating Treas. Reg. § 1.482-7T.
The AOD acknowledges that “[t]he facts found by the Court materially differed from the determinations made by the Service” but does not accept the consequences. The Tax Court disagreed with the IRS’s view of “the facts” because those “facts” were entirely inconsistent with the business realities of IP transfers. If it does not believe its position merits an appeal, the IRS should accept its loss. Instead, it is pushing around other taxpayers by foisting the same untenable “factual” story on them. As former British Prime Minister Benjamin Disraeli once said, “courage is fire and bullying is smoke.” The Veritas AOD is nothing but smoke.
December 4, 2010
We previously mentioned the IFA “Great Debate,” held on the campus of Stanford University on October 27, 2010, where the debaters squared off on the debatable utility of the Temporary Cost Sharing Regulations Income Method in valuing intangible transfers for transfer pricing purposes. As forecast, the debate was extremely well-attended (notwithstanding the conflicting start of the first game of the World Series just up the road in San Francisco). Bob Kirschenbaum and Clark Chandler drew the “pro” (i.e., you should never use the Income Method) while Jim O’Brien and Keith Reams drew the “con.” After the debate, Bob and I kicked around his presentation, how things went, and how he feels about the issue generally. The discussion seemed interesting enough to formalize and post.
Did you enjoy arguing the “pro” position? Would you have preferred to have the “con” position?
We were prepared for either and I think Clark and I did a good job advocating. However, I actually would have preferred the “con” position. It is more interesting analytically because you get to drill down on how the Code and Regulations might be read to permit an income method analysis that would fairly measure the value of the IP actually transferred.
With most taxpayers fighting the income method at Exam, wasn’t the “pro” position easier?
It is easier in the sense that the argument can be made very simply. That is true. The argument goes like this: The existing cost sharing regulatory construct already enabled the evaluation of rights to the anticipated income stream without essentially disregarding the transaction as actually structured by the parties. The “con” position, on the other hand, requires a more nuanced understanding of transfer pricing principles, what they are trying to achieve, and how one might go about constructing a set of variable inputs that could be used to indirectly derive the value of the IP transferred.
Personally, do you think the income method has a place in transfer pricing practice?
I think it does. However, Clark made a very persuasive argument that the Income Method as constituted in the Temporary Regs, while not to be discarded out of hand, becomes much more tenuous: (i) if the Regulations are read as mandating a counterfactual perpetual useful life of transferred IP (see Veritas v. Commissioner), and (ii) when coupled with the Periodic Trigger look-back provisions of the Temporary Regulations. If fairly applied, and in the right circumstances, the Income Method can be a powerful convergence tool for valuing IP. We have proven that in our dealings with Exam on cases where the IRS seeks to require CIP-compliant outcomes. Obviously, it will never be as good as a valid CUT, but it can be useful and does have a place in the practice.
What does the Tax Court’s recent decision in Veritas tell us about the viability of the Income Method?
At the end of the day, probably not much. Veritas was a gross overreach by the IRS; ultimately, the decision is just Bausch & Lomb revisited. Taxing a neutral transfer of business opportunity is not going to fly, nor is the imposition of a perpetual life for IP that produces premium profits for some limited number of years. That dog just will not hunt against a sophisticated and well-advised taxpayer. But it certainly doesn’t mean that the Income Method, properly applied, is never useful.
What do you see as the biggest errors the IRS makes in applying the Income Method?
(1) The perpetual useful life edict, and (2) the implicit presumption of unlimited sustention of competitive advantage. Technology progresses and, the fact is, legacy technology often doesn’t persist for multiple generations. You could not find too many people in Silicon Valley—where I do a fair amount of my work—who would take the other side of that proposition. Even where technology does persist for an extended period, the IRS at times contends that fundamentally new products, developed at great risk under Cost Sharing, owe their genesis entirely to foundational IP. You cannot assume large growth rates decades out and try to allocate all of that value to the original IP. At some point the competitive advantage associated with the pre-existing IP will dissipate. This is very basic finance theory. There are certainly other concerns but these are the most glaring weaknesses in the application of the Income Method.
November 16, 2010
As we expected, a petition for certiorari has been filed in Kawashima v. Holder, 615 F.3d 1043 (9th Cir. 2010). To review, that case involves the question of whether pleas by Mr. and Mrs. Kawashima to section 7206 offenses of subscribing to false statements (and assisting same) as to their corporation’s 1991 tax return could be “aggravated felonies” under the immigration laws. As noted in our initial blog post, the relevant section of 8 U.S.C. §1101(a)(43)(M), if read holistically, would seem to preclude that conclusion but a divided panel of the Ninth Circuit (after changing its mind a few times in the interim) ultimately held that section 7206 offenses do provide a basis for deportation.
In addition to pointing out the circuit split (the Third Circuit – in another divided panel – previously adopted the Kawashimas’ position), the petition cites myriad statutory construction cases for the premise that (M)(i), involving “fraud or deceit,” cannot encompass section 7206 when M(ii) specifically references only section 7201 (the crime of tax evasion). We were disappointed to see that our favorite case on this subject (United Savings Association of Texas v. Timbers of Inwood Forest Associates, 484 U.S. 365 (1988)) wasn’t cited:
Statutory construction . . . is a holistic endeavor. A provision that may seem ambiguous in isolation is often clarified by the remainder of the statutory scheme – because the same terminology is used elsewhere in a context that makes its meaning clear . . . or because only one of the permissible meanings produces a substantive effect that is compatible with the rest of the law.
Id. at 371. Perhaps that gem will make it into a merits brief if certiorari is granted.
The petition also takes on the question of whether a section 7206 crime necessarily involves fraud, citing Considine v. United States, 683 F.2d 1285 (9th Cir. 1982) for the proposition that it doesn’t. The petition also makes arguments based on rule of lenity as frequently applied in the immigration context. See generally INS v. St. Cyr, 533 U.S. 289 (2001).
Finally, the petition presents a second question – an interesting procedural question of whether the Ninth Circuit acted outside of its authority under Federal Rule of Appellate Procedure 41 by amending its second opinion as to Mrs. Kawashima (which found she had not committed an aggravated felony on grounds that the loss amount has not been proven) after the date the mandate allegedly was required to issue as to her, because the petition for rehearing was filed only as to Mr. Kawashima. This is a potential home-run argument for one of the petitioners, but the question lacks the broad applicability that would ordinarily interest the Supreme Court. The Court is free under its rules to grant certiorari limited to one of the questions presented in the petition if it so chooses. It will be interesting to see if it does so in this instance.
The government’s response is currently due on December 2, but the government routinely requests extensions of 30 days or more to respond to petitions for certiorari. The Court can be expected to rule on the petition early in 2011.
October 22, 2010
On October 15, 2010, the government filed its reply brief in TIFD III-E Inc. v. United States, No. 10-70 (2d Cir.) (“Castle Harbour”). The brief is linked below. For our prior coverage of the case, see here and here.
In its reply, the government contends that I.R.C. section 704(e)(1) is inapplicable to the facts of the case, and that the provision only applies in the family partnership context, where parties are related. The government asserts that section 704(e)(1) was not intended to apply, and indeed has never before been applied (and upheld) to an arm’s length transaction between two or more corporate entities.
Even assuming section 704(e)(1) applies, the government argues that the Dutch banks did not possess “capital interests” under the statute, because “capital interests” are legally equivalent to bona fide partnership interests, which the Second Circuit has already determined the Dutch banks did not possess. In essence, the government argues that the test under section 704(e)(1) is the same as the test under Commissioner v. Culbertson, 337 U.S. 733 (1949), and the Second Circuit having made its determination under that test, it is now law of the case that the Dutch banks did not have “capital interests.”
On a similar tack, the government also argues that under the facts of the case, the banks did not possess capital interests in the purported partnership. The government attempts to rebut the taxpayer’s fact arguments by arguing that a number of these fact issues were previously considered by the Second Circuit, with the court rejecting them as support for the conclusion that the banks had a meaningful equity participation in the partnership.
With respect to section 704(b), the government asserts that the taxpayer’s discussion of 704(c) is a red herring, and that the section 704(b) substantial economic effect test requires that tax results follow economic results; i.e., tax benefits and burdens must coincide with the related economic benefits and burdens. The government argues that the transaction at issue plainly fails that test: the taxpayer received $288 million of the partnership’s actual income, but only paid tax on $6 million. Meanwhile, the Dutch banks received $28 million of the partnership’s actual income, but were allocated $310 million of it.
The government also reiterates its position regarding penalties: the District Court’s misconstruction of the facts and misapplication of the law do nothing to abrogate asserted penalties, and that the taxpayer really did not have substantial authority for its return position.
September 17, 2010
On September 14, 2010, the tax matters partner (“TMP”) for Castle Harbour LLC filed its response brief in TIFD III-E Inc. v. United States, No. 10-70 (2nd Cir.) (brief linked below). For our prior coverage of this case, see here. As many readers are no doubt aware, this is the second time this case is before the Second Circuit.
In the response brief , the TMP frames the issues as: (1) whether the district court, upon remand, correctly determined the investment banks were partners under I.R.C. section 704(e)(1), (2) whether the IRS can reallocate income under I.R.C. section 704(b) despite the section 704(c) “ceiling rule,” and (3) whether the district court correctly decided that I.R.C. section 6662 accuracy-related penalties were not applicable.
First, the TMP argues that section 704(e)(1) creates an independent, objective alternative to the Culbertson test, with the critical issue being whether the purported partner holds a “capital interest.” The TMP contends that, because the banks’ interests were economically and legally equivalent to preferred stock, and because preferred stock is treated as equity for tax purposes even though it possesses many characteristics of debt, the banks held “capital interests” under section 704(e)(1). Accordingly, the TMP argues that the banks were bona fide partners in Castle Harbour, the Second Circuit’s application of Culbertson notwithstanding.
Second, the TMP contests the IRS’s ability to reallocate income under I.R.C. section 704(b) in spite of application of the section 704(c) ceiling rule (assuming the banks were bona fide partners). The regulations under section 704(c) were amended to allow such a reallocation for property contributions occurring after December 20, 1993, which is after the contributions at issue in the case. Accordingly, the TMP takes the position that the IRS is attempting an end-run around the effective date of the amended regulations.
Finally, the TMP also argues that victory at trial, based on the careful findings of fact by the district court, demonstrates that the transactions were primarily business-motivated, and furthermore, that substantial authority existed for the TMP’s return position. Accordingly, the TMP contends that accuracy-related penalties should not apply, even if the IRS’s adjustment is ultimately upheld.
September 13, 2010
We have been promising a post on the application of the section 6664 reasonable cause and good faith defense to tax penalties as it relates to reliance on tax advisers. Here it is.
There has been much activity in this area in the district courts and the Tax Court and not much winnowing or rule setting in the circuits. This is understandable; the application of the standards is highly factual and is well-placed in the hands of trial judges. We will analyze here some potential inconsistencies in two recent high-profile section 6664 decisions, Canal Corp. v. Commissioner, (Slip Op. attached) (August 5, 2010) (which found reasonable cause and good faith lacking) and NPR Invs., LLC v. United States, (E.D. Tex. Aug. 10, 2010) (which found reasonable cause and good faith met).
In Canal Corp., the Tax Court considered the application of section 6664 to a should-level PricewaterhouseCoopers opinion. (In the parlance, a “should-level” opinion means that the transaction “should” be upheld; it is a higher standard than more-likely-than-not, which means only that the transaction is more, perhaps only 51% more, likely to be upheld than not.) The Canal Corp. transaction emerged from the decision of a predecessor of Canal Corp., Chesapeake Corporation, to dispose of its tissue business, WISCO. After seeking advice from PwC and others, Chesapeake decided to dispose of the business by forming a partnership with Georgia Pacific to which WISCO would contribute its assets and liabilities and from which WISCO would receive a distribution of cash. The cash was funded by the new partnership borrowing money, and that debt was indemnified by WISCO. In essence, the substantive question presented to the court was whether the contribution/distribution amounted to the formation of a partnership (which would not trigger the built-in gain on the WISCO assets) or, rather, a sale of those assets to GP (which would).
In addition to helping structure and advise on the transaction, PwC was asked to prepare the aforementioned opinion. The partner writing the opinion was not the historic PwC engagement partner but rather an expert from the Washington National Tax group of PwC. PwC charged a flat fee of $800,000 for the opinion. Because the area of the law was relatively unclear, the opinion relied on analogy and analytics to reach its conclusions (including a withdrawn revenue procedure that set out tests to apply for advance rulings in a different area); there was apparently little direct authority available to cite. The parties effectuated the transaction on the day that PwC issued the opinion.
The Tax Court determined that the transaction was a disguised sale. This was based largely on the court’s conclusion that the indemnity by WISCO was illusory and thus that WISCO should not be allocated any amount of the partnership’s liabilities. If WISCO had been allocated these partnership liabilities then the transaction would be viewed as a financing transaction and not a sale. After all, you can’t call something a sale if the seller gets left holding the bag for the purchase price. But the court found WISCO’s bag empty and proceeded to penalties.
The Canal Corp. court began its analysis of section 6664 by recognizing that “[r]easonable cause has been found when a taxpayer selects a competent tax adviser, supplies the adviser with all relevant information and, in a manner consistent with ordinary business care and prudence, relies on the adviser’s professional judgment as to the taxpayer’s tax obligations.” Slip Op. at 31. However, the court noted that such advice “must not be based on unreasonable factual or legal assumptions” and cannot be relied upon when given by an advisor “tainted by an inherent conflict of interest.” Id. at 32. Citing Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993), a case involving promoters of master recording leasing programs, the Court concluded that a “professional tax adviser with a stake in the outcome has such a conflict of interest.” Id.
Applying these conceptual standards to the PwC opinion, the Tax Court found it lacking. At the outset, the court thought it incredible that significant time had been spent on an opinion so “littered with typographical errors, disorganized and incomplete.” Id. at 33. The Court’s confidence in the opinion was further undermined by the fact that only a draft could be found and the author (even after presumably being prepared for trial) did not recognize parts of the opinion when asked about them in court. On the question of assumptions generally, the lack of specific citation in support of the opinion’s premises and the frequent use of terms such as “it appears” in the place of hard analysis was also troubling for the court, which found it unreasonable that anyone would issue a should-level opinion on analogy and analytics with no direct support for the position. The Court found the author’s testimonial responses to challenges on these points unsettling and bluntly concluded that the only reason the opinion was issued at the should level was that “no lesser level of comfort would have commanded the $800,000 fixed fee that Chesapeake paid for the opinion.” Id. at 35.
On the question of a conflict of interest, the Court found a large one. Commenting that it “would be hard pressed to identify which of his hats” the author was wearing when he rendered the opinion, the Court concluded that the author’s work in developing, planning, structuring, and implementing the transaction took away too much of his independence (which the Court found to be “sacrosanct to good faith reliance”) to allow him to objectively analyze the merits of the transaction. Slip Op. at 36-38. Given that the only hurdle to closing the transaction was, in the end, the $800,000 flat fee opinion, the Court found that Chesapeake was attempting to buy “an insurance policy as to the taxability of the transaction.” Id. at 37. The Court voided the policy.
NPR involved a transaction the IRS characterized as a “Son of BOSS” transaction involving offsetting foreign currency options. As explained by the Court, the IRS’s view of a Son of BOSS transaction is “a series of contrived steps in a partnership interest to generate artificial tax losses designed to offset income from other transactions.” Slip Op. at 2 n.3. It is fair to say that Son of BOSS transactions are considered by the IRS to be one of the “worst of the worst,” so much so that they are the only transaction that is specifically barred from being considered by IRS Appeals. See Announcement 2004-46, Sec. 5 (May 24, 2004). Indeed, NPR conceded the merits of the transactions at issue prior to the decision. Accordingly, the only items considered by the district court were a period of limitations issue (which we will not discuss here) and the penalties.
After working through the background elements of section 6662, the district court in NPR began its analysis in a similar way to the Tax Court in Canal Corp., setting out both the restrictions on relying upon unreasonable assumptions and on a conflicted adviser. Slip Op. at 24-26. The conclusion, however, was quite different. Finding that the taxpayers were “not tax lawyers” and were not “learned in tax law” the court held that their reliance on the more-likely-than-not opinion of R.J. Ruble (who, at the time of the court’s ruling, had already been convicted of tax evasion associated with the rendering of tax opinions) was reasonable based on its findings that the opinion reached “objectively reasonable conclusions” and detailed a “reasonable interpretation of the law” (albeit one that the taxpayers conceded before trial). Id. at 27-28. Critically, the Court found persuasive the taxpayer’s plea that they, as unsophisticated men, sought out the advice of professionals who they did not know were conflicted and followed that advice; “what else could we have done except follow their advice?” Id. at *28.
As shown above, the differences between Canal Corp. and NPR are not differences in legal standards but differences in fact-finding. Both courts invoked and applied the same standards and prior interpretations of those standards; they just applied them to different facts as each judge found those facts. That is exactly what trial courts are supposed to do; take legal standards and do the hard work of applying them to the myriad fact patterns that arise. Viewed from that perspective, there is nothing in conflict between the two rulings; different facts support different results.
In a sense, the “inconsistencies” give a certain comfort in the decisions of both courts. Judges say what the law is, that is true. But more relevant to a trial lawyer, in a bench trial, they say what the facts are. In both Canal Corp. and NPR, the judges reached a conclusion based on their common-sense perceptions of what happened in the courtroom. While they can (and likely will) be second-guessed, that is their job. The NPR court was not swayed by all of the IRS’s anti-Son-of-BOSS rhetoric. Rather, the court evaluated the honesty and integrity of the specific taxpayers before it, their options (not the foreign currency kind) and their knowledge, and decided that no more could reasonably be asked of them. Similarly, the Canal Corp. court wasn’t swayed by the involvement of a major accounting firm in a business transaction between two large, sophisticated companies. Instead, the court looked at the analytics and thoroughness of the opinion, the involvement of the author in the transaction (including what he was paid), and his credibility on the stand, and concluded that it was unreasonable for a sophisticated consumer of tax advice to rely on his opinion. Whether you agree with the fact-finding (which is tough to do if you didn’t sit through both trials), the fact-finding has to be separated from the analytics; the analytics were sound (and consistent).
Viewed from the perspective of the tax planner, however, justifying the different outcomes on the basis of different fact-finding does not provide much comfort. Most tax planners would turn up their nose at a Son of BOSS opinion given to a group of individual investors to generate relatively large foreign currency options losses on a relatively minor investment. Yet a significant number have criticized the Tax Court’s opinion in Canal. Perhaps the distinction is just based on an “I know [a good transaction] when I see it” analysis, but many view what Canal Corp. did as “legitimate” tax planning and believe that a PwC advisor from the esteemed Washington National Tax group should have been viewed as more credible than a convicted felon. However, when a judge looks into the eyes of the adviser and doesn’t like what she sees, the taxpayer is at grave risk on penalties. Similarly, when the written product is capable of being analytically questioned, even undermined, based on sloppiness and lack of support or detail, a judge can be expected to have a negative reaction to that work product. That negative reaction will carry over to the credibility of its author, particularly where a substantial fee was received. On the flip side of the coin, if the judge finds the taxpayer honest and forthcoming about what he believed and what he tried to do to confirm that belief, the judge is likely to find reasonable cause and good faith. In short, the way the judge perceives the facts determines the outcome; that is why they call it a facts and circumstances based test.
Asking for “consistency” in such matters amounts to nothing less than the neutering of the trial court. “The ordinary lawsuit, civil or criminal, normally depends for its resolution on which version of the facts in dispute is accepted by the trier of fact.” NLRB v. Pittsburgh S.S. Co., 337 U.S. 656, 659 (1949). Indeed, rather than chasing the siren song of legal consistency, it is better to accept that fact-based tests like section 6664 belong to the trial lawyers to prove and to the trial judges to find. While that may appear to create a lack of consistency, it doesn’t. As we have shown, the inconsistency some see in Canal Corp. and NPR does not flow from an inconsistency in the law. Rather, there is always unpredictability as to how the facts will be perceived by different decision-makers. That is merely the uncertainty of litigation: the risk that a given judge on a given day may or may not believe your witnesses or your theory of the case. This is necessarily so; “[f]indings as to the design, motive and intent with which men act depend peculiarly upon the credit given to witnesses by those who see and hear them.” United States v. Yellow Cab Co., 338 U.S. 338, 341 (1949). Said differently, what a lawyer (or a client) thinks the facts are doesn’t matter if they can’t convince the judge they draw to perceive the facts as they see them. Making choices between “two permissible views of the weight of evidence” (id.) is precisely what trial judges are supposed to do and precisely what both of the judges in these cases did. Appeals in both cases, if they are filed, will have to take this into account.
September 12, 2010
Lately, the IRS has had a successful run of attacking transactions involving purported securities loans. See Anschutz Co. v. Commissioner, 135 T.C. 5 (July 2010); Calloway v. Commissioner, 135 T.C. 3 (July 2010); Samueli v. Commissioner, 132 T.C. 4 (March 2009). Two of the cases, Samueli and Anschutz, involve the construction of I.R.C. section 1058, which provides for non-recognition treatment of a loan of securities that meets the following criteria: (1) the loan agreement provides for the return of securities identical to the securities transferred; (2) the agreement provides for payments to the transferor of amounts equivalent to all interest, dividends, and other distributions which the owner of the securities is entitled to receive during the period of the loan; and (3) the agreement does not reduce the risk of loss or opportunity for gain of the transferor of the securities in the securities transferred.
In Samueli, the Tax Court held that a series of transactions between a taxpayer and a broker/dealer did not qualify for section 1058 treatment because the purported securities loan reduced the taxpayer’s opportunity for gain (the taxpayer was the lender of securities under the form of the transactions). The transactions consisted of: (1) taxpayer’s purchase of $1.7 billion in mortgage-backed interest strips on margin (the broker/dealer allowed the taxpayer to purchase the securities on credit); (2) a securities loan of the interest strips back to the broker/dealer, with a transfer of $1.7 billion in cash collateral to the taxpayer; and (3) the taxpayer paying interest on the cash collateral at a variable rate (with the broker/dealer paying a relatively small amount of interest on taxpayer’s funds deposited in its margin account). The arrangement further provided that taxpayer could recall the securities only on two specified dates during the term of the loan, or at maturity. Ordinarily, securities loans are callable at any time. The Tax Court determined that the limited ability of the taxpayer to retrieve its securities reduced the taxpayer’s opportunity for gain, because taxpayer did not have the right to take advantage of favorable swings in the price of the securities if they occurred at a time when taxpayer did not have the right to call the loan.
Interestingly, the Tax Court went a step further than merely holding that non-recognition treatment was improper under section 1058. Cursorily invoking the substance-over-form doctrine, the court also held that as a matter of economic reality there was no securities loan at all; rather, in the court’s view there was a wash sale at the outset (purchase of the securities by taxpayer immediately followed by a resale to the broker/dealer for no gain), and a subsequent purchase under a constructive forward contract followed by a resale to the broker/dealer, resulting in a modest short-term capital gain. Because there was no true indebtedness, the court held, taxpayer’s interest deductions were not allowable.
The taxpayer has appealed the Tax Court’s decision to the Ninth Circuit, and the case has been fully briefed. The Tax Court’s opinion and the appellate briefs are linked below. In the opening brief, the taxpayer argues that the Tax Court: (1) misinterpreted section 1058 by adding a “loan terminable upon demand” requirement, (2) erroneously construed the section 1058 requirements as the sine qua non of securities loans for federal tax purposes (cf. Provost v. United States, 269 U.S. 443 (1926) (for purposes of the stamp tax, the borrowing of stock and the return of identical stock to the lender are taxable exchanges)), (3) recharacterized the transactions in a manner inconsistent with their economic reality, and (4) even if the recharacterization stands, improperly treated the deemed disposition of the forward contract shares as short-term capital gain.
In its response, the government contends that the Tax Court correctly determined that the arrangement was not eligible for non-recognition treatment under section 1058 because it reduced the taxpayer’s opportunity for gain in the securities, contrary to section 1058(b)(3). Furthermore, the government argues, the court correctly held that the overall arrangement was not a loan in substance, and therefore the purported interest paid on the collateral is not deductible.
In the reply, the taxpayer changes tack somewhat and argues that the focus on section 1058 heretofore has been a mistake by all involved. The taxpayer contends that the tax treatment of the transactions should be the same regardless of the application of section 1058—long-term capital gain and deductible interest, based on the notion that taxpayer received basis in a contractual right at the outset, which was later disposed of at a gain, and that taxpayer’s payment of interest on the collateral was consideration for the broker/dealer’s forbearance of the use of the collateral.
We will continue to follow the case as it develops. According to news reports, the taxpayer in Anschutz intends to appeal the Tax Court’s decision as well, and we will post on that case as soon as the appeal is filed (which will likely be in the 10th Cir.).
September 8, 2010
Practitioners interested in the more interesting conceptual aspects of transfer pricing should mark October 27th on their calendars. On that day, the International Fiscal Association is sponsoring a debate on the usefulness of the income method to value intangibles in the transfer pricing context. Dubbed “The Great Debate” by IFA, this year’s event will pit the best transfer pricing practitioners in the world (including Miller & Chevalier’s Bob Kirschenbaum and Baker & McKenzie’s Jim O’Brien) against each other. Neither will know which position they are arguing prior to a coin toss. The gloves will surely come off and our current understanding is that the only thing missing will be a steel cage. Attendance is limited to IFA members and special guests (which you can become by being sponsored by an IFA member).
September 4, 2010
The government filed its reply brief in Virginia Historic Tax Credit Fund 2001, LLC v. Commissioner, No. 10-1333 (4th Cir.), on September 1, 2010. The brief is linked below.
In its reply, the government argues that the tax characterization of the investor transactions, i.e., whether the investments were equity contributions or merely the purchase of state tax credits, is subject to the de novo standard of review. Accordingly, the government contends that the Tax Court’s determination that the taxpayers were bona fide equity investors is a question of law not subject to the more deferential “clear error” standard of review, as argued by the taxpayers.
In addition to reiterating its positions presented in the opening brief, the government also contends that the IRS has the power to recharacterize, for tax purposes, a transaction according to its substance, in spite of the fact that the parties may have adopted the form of the transaction for purposes other than tax avoidance. The taxpayers argue that the form of the transactions was adopted in order to comply with state law limitations on the transfer of historic preservation tax credits, and therefore the form of the transactions should be respected for federal tax purposes.
The government also supplements its statutory disguised sale theory with the arguments that the transactions were “transfers” of “property” as those terms are employed in I.R.C. § 707 and the regulations thereunder, and that the taxpayers’ arguments regarding the existence of meaningful entrepreneurial risk are not supported by the record.
September 1, 2010
On August 30, 2010, the Ninth Circuit granted Petitioner’s Motion to Stay the Mandate in Kawashima. This stays the mandate in the case pending the filing of a petition for writ of certiorari and confirms our prior speculation that petitioner is going to try to make a run at the Supreme Court. We will be watching the case with interest and will post the petition when it appears.
August 18, 2010
On August 4, 2010, the Ninth Circuit denied panel and en banc rehearing in a case applying 8 U.S.C. § 1101(a)(43)(M)(i) to hold that a tax offense other than tax evasion is a crime involving fraud or deceit and thus an aggravated felony under the immigration laws (which allows for deportation). Kawashima v. Holder, 2010 U.S. App. LEXIS 16125 (9th Cir. Aug. 4, 2010). This is actually the fourth opinion issued by the Ninth Circuit in the case, appending a three-judge dissent from denial of en banc rehearing to the third panel opinion issued back in January 2010. Kawashima v. Holder, 593 F.3d 979 (9th Cir. 2010). (The first two panel opinions (Kawashima v. Mukasey, 530 F.3d 1111 (9th Cir. 2008), and Kawashima v. Gonzalez, 503 F.3d 997 (9th Cir. 2007)), were withdrawn so that the panel could reconsider the case in light of new Ninth Circuit and Supreme Court decisions.) The Ninth Circuit has now placed itself squarely in conflict with the decision of a divided panel of the Third Circuit (Ki Se Lee v. Ashcroft, 368 F.3d 218 (3d Cir. 2004), in which then Judge (now Justice) Alito was the dissenter. The Fifth Circuit, however, adopted the same basic reasoning as Kawashima in Arguelles-Olivares v. Mukasey, 526 F.3d 171 (5th Cir. 2008), cert. denied, 130 S. Ct. 736 (2009).
The primary question in these cases is one of statutory interpretation. 8 U.S.C. §1101(a)(43)(M) provides that an aggravated felony includes an offense that:
(i) involves fraud or deceit in which the loss to the victim or victims exceeds $ 10,000; or
(ii) is described in section 7201 of the Internal Revenue Code of 1986 (relating to tax evasion) in which the revenue loss to the Government exceeds $ 10,000;
Mr. Kawashima pled guilty to section 7206(1), a tax crime that involves subscribing to a false statement on a tax return; his wife pled to section 7206(2), a tax crime involving aiding and assisting in the preparation of a false tax return. Neither pled to section 7201, tax evasion.
The dispute between the circuits rests on how much the interpretation of (M)(i) should be guided by the existence of (M)(ii). As the Third Circuit and a strongly worded dissent in Kawashima both note, “statutory text must be read in context.” 2010 U.S. App. LEXIS 16125 at *28. When read in context, it appears that the only tax crime that was intended to be covered is tax evasion as set out in (M)(ii). This is so because if tax crimes are governed by (M)(i), then (M)(ii) would be superfluous. Superfluities are a red flag in statutory interpretation. See, e.g., Market Co. v. Hoffman, 101 U.S. 112, 115 (1879) (“We are not at liberty to construe any statute so as to deny effect to any part of its language. It is a cardinal rule of statutory construction that significance and effect shall, if possible, be accorded to every word.”).
The majority in Kawashima evaded this reasoning on the basis that if Congress had not wanted (M)(i) to apply to tax offenses “Congress surely would have included some language in that provision to signal that intention.” U.S. App. LEXIS 16125 at *13. Apparently, the language in the next clause, (M)(ii), doesn’t count. And the majority’s opinion does not convincingly address the problem of creating superfluities. Merely because the language of (M)(i) is broad enough to cover tax offenses other than tax evasion when that subsection is read in isolation, that doesn’t mean that one can divine Congressional intent to actually do so when the statute is read holistically. Regardless, two circuits have now adopted the view that a tax offense other than tax evasion can be an “aggravated felony.”
It is too early to tell if a petition for certiorari will be filed in Kawashima but given the split and the substantial number of amici involved in the circuit filings, one might reasonably expect one. That said, the same conflict was presented in Arguelles-Olivares yet the Court denied certiorari, apparently persuaded by the Solicitor General’s suggestion that the Court “should wait for further developments.” Having the Ninth Circuit join the Fifth Circuit in agreeing with the government may not be the kind of development the Supreme Court had in mind. A petition for certiorari would be due on November 2, 2010. The final Ninth Circuit opinion and the United States brief in opposition in Arguelles-Olivares are attached.
August 13, 2010
On July 28, 2010, the IRS released AOD 2010-33; 2010-33 IRB 1. The AOD acquiesces in the result but not the reasoning of Xilinx, Inc. v. Comm’r, 598 F.3d 1191, 1196 (9th Cir. 2010) which held that stock option costs are not required to be shared as “costs” for purposes of cost sharing agreements under old Treas. Reg. §1.482-7. For prior analysis of Xilinx see this. The AOD in and of itself is relatively unsurprising. New regulations (some might say “litigating regulations”) have been issued that explicitly address the issue, and those regulations will test the question of whether Treasury has the authority to require the inclusion of such costs. The IRS surely realized that from an administrative perspective it was smart to let this one go. The best move for most taxpayers is likely to grab a bucket of popcorn and watch the fireworks as a few brave souls test Treasury’s mettle by challenging the validity of the new regulations. Including a provision in your cost sharing agreements that allow adjustments in the event of a future invalidation of the regulations might go well with the popcorn.
The only really interesting item in the AOD is the gratuitous bootstrap of the Cost Sharing Buy-In Regs “realistic alternatives principle.” The still warm “realistic alternatives principle” – the IRS assertion that an uncontrolled taxpayer will not choose an alternative that is less economically rewarding than another available alternative – “applies not to restructure the actual transaction in which controlled taxpayers engage, but to adjust pricing to an arm’s length result.” AOD, 2010 TNT 145-18, pp.4-5. That assertion appears to ignore that “arm’s length” is not some obscure term of art cooked up by the IRS, but rather an established concept that lies at the heart of most countries’ approach to international taxation.
Still clinging to the withdrawn Ninth Circuit opinion, the AOD offers in support of this premise that “the Secretary of the Treasury is authorized to define terms adopted in regulations, especially when they are neither present nor compelled in statutory language (such as the arm’s length standard), that might differ from the definition others would place on those terms.” Xilinx, Inc. v. Comm’r, 567 F.3d 482, 491 (9th Cir. 2009).
In short, the IRS appears to have dusted off the rule book of the King in Alice and Wonderland:
The King: “Rule Forty-two. All persons more than a mile high to leave the court.”
“I’m not a mile high,” said Alice.
“You are,” said the King.
“Nearly two miles high,” added the Queen.
“Well, I shan’t go, at any rate,” said Alice: “besides, that’s not a regular rule: you invented it just now.”
“It’s the oldest rule in the book,” said the King.
“Then it ought to be Number One,” said Alice.
Alice’s Adventures in Wonderland at 125 (Giunti Classics ed. 2002). The IRS has often been disappointed with the real rule Number One (the arm’s length principle) when the results of real-world transactions do not coincide with the results the IRS desires. Now the IRS looks to magically transform that rule into one that replaces those real-world transactions with the IRS’s revenue-maximizing vision. Tax Wonderland is getting curiouser and curiouser.
August 12, 2010
The last post in this series discussed differences in procedural posture that cause differences in the application of penalties. Court splits in how the various and sundry penalty provisions in the Code are applied is an even more confusing area. The two principal confusions are in the areas of TEFRA and valuation misstatements. We will deal with TEFRA in this post.
Partnerships are not taxpaying entities. They flow income, losses, deductions, and credits through to their partners who pay the tax. Nevertheless, since Congress enacted the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, 96 Stat. 324, 648-71 (TEFRA), some partnerships have been subject to audit (and litigation of those audit adjustments in court) directly at the partnership level. Because individual partners still have tax issues that are not related to the partnership, tax items have to be divided between those that are handled in the partnership proceeding (so-called “partnership items”) and those that are handled at the level of the partners (so-called “non-partnership items”). (There is a third category of items that are affected by partnership items, appropriately named “affected items,” which we don’t need to address for purposes of this discussion.) As one can imagine, dividing the partnership tax world up into these two sorts of items is not always the easiest thing to do where you have items that are factually affected both by actions taken by the partnership and by actions taken by the partners.
In an apparent attempt to clarify this treatment in a small way, in 1997 Congress decreed that penalties that relate to partnership items are determined at the partnership level (i.e., the penalties themselves are partnership items). Seesection 6221. The difficulty implementing this provision is that, although partnerships are subject to audit, they are often owned and run by people and those people are often the partners. When one takes this fact into account in the context of the various penalty defense provisions, such as section 6664, which protects against penalties if a taxpayer has “reasonable cause and good faith,” you have a dilemma. Namely, if penalties are determined at the partnership (and not partner) level, whose conduct can you look at to determine if the partnership (and not the partners) had reasonable cause and good faith?
Regulations require that if an individual partner invokes section 6664 as a personal defense, that invocation has to be done in a partner level proceeding (generally, a refund action after the TEFRA proceeding is completed). Treas. Reg. § 301.6221-1(d). The IRS position as to how this applies in practice appears to be that the only conduct that is relevant for purposes of applying section 6664 in a TEFRA proceeding is what the partnership did through its own non-partner employees or, perhaps (it is unclear), the “tax matters partner” who manages the tax affairs of the partnership. From the IRS perspective, if a partner asserts conduct for purposes of section 6664, that assertion has to be parsed to see if the partner intended his or her conduct to be attributed to the partnership or, rather, asserted it on their own behalf. See Pet. for Rehearing at 8-10, Klamath Strategic Investment Fund v. United States, 568 F.3d 537 (5th Cir. 2009) (Docket No. 07-40861) (the petition was denied, it is included here to show the IRS position). Exactly how one is to conduct this hair-splitting (some might say hare-brained) analysis is hard to fathom. The best evidence of whether a partner’s conduct was on his or her behalf, or the partnership’s, will be the partner’s own statement. Presumably, any well-advised partner will say that he or she intended the conduct on behalf of the partnership if the desire is to raise the defense on behalf of the partnership, and only badly advised partners won’t. Surely, this is not a sustainable test.
Courts are split. The Fifth Circuit in Klamath rejected the IRS theory and looked to the actions of partners to impute reasonable cause and good faith to the partnership. 568 F.3d at 548. The Court of Federal Claims had at least two competing views. Stobie Creek Investments, LLC v. United States, 82 Fed. Cl. 636, 703 (2008) generally went the same way as Klamath, looking to the managing partners’ actions. But in what has to be the most thorough analysis of the issue, Judge Allegra in Clearmeadow Invs., LLC v. United States, 87 Fed. Cl. 509, 520 (2009) ruled for the Government giving deference to: (i) the regulatory edict that actions of the partners are only to be considered in the later refund proceeding and not in the TEFRA proceeding; and (ii) the language of section 6664 and regulations thereunder, which focuses on “taxpayers” and distinguishes partnerships from taxpayers. Based on the docket, Clearmeadow is not being appealed.
Regardless of your persuasion, at least Clearmeadow seemed to have debunked the idea that it could somehow matter (and, even more strangely, somehow be determined by the judge) whether the partner intended the conduct on his or her own behalf or on behalf of the partnership. Id. at 521. Relying on the discretion of a litigant to determine jurisdiction does seem off-base. Yet that is exactly what the Federal Circuit did on appeal in Stobie Creek, affirming on the basis that the Court had jurisdiction because the partnership “claim[ed] it had reasonable cause based on the actions of its managing partner.” Stobie Creek Invs. LLC v. United States, 608 F.3d 1366, 1381 (Fed. Cir. 2010). Given that the Court went on to find that there was no reasonable cause, a cynic might say that the Court was anxious to give itself jurisdiction so it could reject the penalty defense definitively and prevent the taxpayer from taking another bite at the apple in a later refund proceeding, perhaps in district court. In any event, Stobie Creek has reignited the debate about whether a self-serving statement about intent controls jurisdiction and doesn’t seem to resolve the questions of: (i) when a partner is acting on his or her own behalf versus the partnership’s or (ii) whether the rules apply differently to managing versus non-managing partners. The state of the law in this area of penalty application is indeed still schizophrenic.
The next post in the penalties series will skip past valuation allowances (where there is also a circuit split we will come back to) and deal with reasonable reliance on tax advisers (for which we will surely get some hate mail).
July 29, 2010
Based our recent post on the Sala decision here, we have had several comments inquiring about the varied application of penalties in the “tax shelter” cases. This is the first in a planned series of responses to those comments that will try to explain, iron out, or at least flag, some of the irregularities.
When looking at the application of penalties to “shelter” cases generally, procedural posture matters. A good example of this is Sala. Why did the 10th Circuit discussion in Sala omit penalties? Because it was a refund case in which the taxpayer appears to have filed a qualified amended return (“QAR”) prior to being “caught” by the IRS. See generally 26 C.F.R. § 1.6664-2(c)(2). There is a discussion of whether Sala’s amended return was qualified in the district court opinion and that ruling apparently was not a subject of the appeal. Sala v. United States, 552 F. Supp. 2d 1167, 1204 (D. Colo. 2008). Thus, in a refund suit posture, there may be procedural reasons why penalties are inapplicable.
The refund claim situation is contrasted for penalty purposes with either deficiency proceedings or TEFRA proceedings. In either of the latter, penalties cannot be abated by a QAR (at least as to the matter at issue) because the taxpayer must have a deficiency or adjustment (to income) in order to bring either action. See generally sections 6212 and 6225-6. Thus, in cases such as Gouveia v. Commissioner, T.C. Memo 2004-25 (2004), the Tax Court addressed (and imposed) penalties in a deficiency context. And, in Castle Harbor, the courts addressed (but did not impose) penalties in the context of a TEFRA proceeding. TIFD III-E Inc. v. United States, 2009 U.S. Dist. LEXIS 93853 (D. Conn 2009). (We previously discussed the pending appeal in Castle Harbour here.)
While there is nothing mysterious about the foregoing, the different routes tax cases take can often cause an illusion that there is inconsistency in the application of penalties when, in fact, the cases are just procedurally different. One other area in which this confusion is particularly common (and an area in which there is a bit of a dispute as to the correct application of the law) concerns whose behavior “counts” for purposes of the sections 6662 (reasonable basis) and 6664 (reasonable cause and good faith) defenses in the context of a TEFRA proceeding. We will address that issue in our next post on penalties.
July 27, 2010
The Appellees filed their response brief yesterday in Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, No. 10-1333 (4th Cir.) (linked below). Our previous discussion of the case is here.
The government has advanced two basic arguments. First, it argues that the partners of the state tax credit partnerships were not bona fide partners that made capital contributions; rather, the government contends, the alleged partners were, in substance, purchasers of state tax credits. As such, the proceeds of these sales transactions are gross income to the partnerships, not non-taxable contributions to capital. In making this argument, the government focuses on the fact that the alleged partners had no possibility of realizing any economic benefit from their purported investments other than the acquisition of state tax credits at a discount from their face value. Second, the government argues that even if the partners were bona fide partners, the disguised sale rules under I.R.C. § 707 apply to recharacterize the transactions as taxable sales of property by the partnership to the partners acting in non-partner capacities.
The Appellees (comprised of two of the tax credit funds at issue and their tax matters partner) contend that the investors in the tax credit funds were bona fide partners for federal income tax purposes because they pooled their capital with the intent of sharing in a pool of non-federal-tax economic benefits pursuant to partnership allocation provisions under state law. Relying on Frank Lyon Co. v. United States, 435 U.S. 561 (1978), Appellees further contend that the partnership form of the transactions at issue was compelled by state-law regulatory realities (Virginia law prohibits the direct transfer of historic preservation tax credits), and thus the form should be respected. With respect to the government’s I.R.C. § 707 argument, Appellees argue that the disguised sale rules do not apply where, as here, the partners were acting in their capacities as partners, the alleged consideration constitutes a contribution to capital, the partnership allocates tax attributes as opposed to transferring property (i.e., the state tax credits are not property), and there is a meaningful sharing of risk among partners.
Stay tuned—the Fourth Circuit’s decision could have a substantial impact on the question of the nature of a partner for federal income tax purposes and the scope of the disguised sale rules, as well as substance-over-form principles generally.
July 26, 2010
In a brief (and some might say terse) opinion, the Tenth Circuit has reversed the District Court in Sala v. United States, 552 F. Supp. 2d 1167 (D. Colo. 2008) (decision linked below). As many readers will recall, Sala was considered an outlier among the tax shelter cases litigated over the past few years, with the taxpayer winning at trial in a Son-of-BOSS case. See our prior discussion of the case here.
Citing to Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1356 (Fed. Cir. 2006), and Black & Decker Corp. v. United States, 436 F.3d 431, 441 (4th Cir. 2006), the Tenth Circuit focused narrowly on the specific transaction that gave rise to the claimed tax benefits, thus adding to the emerging trend of using a narrow definition of the transaction to defeat the efforts of tax planners. It remains to be seen whether the Tenth Circuit and other courts will embrace Coltec as closely when confronted with more traditional tax planning, rather than a Son-of-BOSS tax shelter.
Following its own precedent and a well-established approach to analyzing economic substance, the court concluded that the loss-generating transaction lacked economic substance. In making this determination, the court considered both the taxpayer’s subjective business motivation in entering into the transaction, as well as whether the transaction had “objective economic substance.” After engaging in a “common-sense examination of the evidence as a whole,” the court found it “clear that the transaction was designed primarily to create a reportable tax loss that would almost entirely offset Sala’s [tax year] 2000 income with little actual economic risk.” The court also held that the “existence of some potential profit” is insufficient to imbue a transaction with economic substance where the purported tax benefits substantially outweigh the potential economic gains. Holding for the government on the dispositive economic substance issue, the court declined to reach any of the other issues raised.
With this decision, Sala moves from being an interesting outlier to just another case in the mainstream of tax shelter decisions. It is very unlikely that the taxpayer will be able to interest the en banc court or the Supreme Court in further review. If he wants to try, a rehearing petition would be due on September 7 and a cert petition would be due on October 21.
July 23, 2010
The Tax Appellate Blog is a new blog dedicated to covering important tax cases pending before the various federal courts of appeals that are of interest to practitioners and others who follow the development of federal tax law. We will try to post regularly as developments warrant, and we welcome commentary from the broader tax law community. We also plan to provide links to the pleadings and other pertinent documents in those cases. So, welcome aboard.
July 23, 2010
In what is considered by many an anomaly among the so-called “Son-of-BOSS” cases, the IRS lost the trial of a refund claim before the United States District Court for the District of Colorado in 2008. See Sala v. United States, 552 F. Supp. 2d 1167 (D. Colo. 2008). As many readers are no doubt aware, “Son-of-BOSS” is the nickname given to a type of loss-generating transaction described in IRS Notice 2000-44 (“BOSS” stands for “Bond and Option Sales Strategy”). In one variation of such transactions, a taxpayer both buys and sells options on a given position and then contributes these options to an investment partnership. Relying on Helmer v. Commissioner, T.C. Memo 1975-160, which held that liabilities created by short option positions are too contingent to affect a partner’s basis in a partnership, the taxpayer takes a basis in its partnership interest equal to the value of the long options position (i.e., not offset by the short options position). Later, the investment partnership is liquidated and the assets sold, or the taxpayer’s interest is sold, with the taxpayer claiming substantial losses on what, economically speaking, was a pretty safe bet.
In Sala, the taxpayer invested in foreign currency options and contributed them to a partnership managed by renowned foreign currency trader, Andrew Krieger. The amount of losses generated by the transactions at issue coincidentally offset a huge slug of income the taxpayer had in 2000 (approximately $60 million). Despite the government’s best efforts, the court found for the taxpayer, holding that the transactions possessed economic substance. The court also rejected the government’s attempt to retroactively apply regulations that reject the Helmer decision mentioned above.
The government appealed the case to the Tenth Circuit (briefing is linked below). The government argues that the trial court erred in a number of respects, including: (1) determining that the transactions to be analyzed for economic substance are the entire array of transactions associated with a “legitimate” investment program, as opposed to the discrete options transactions giving rise to the claimed losses; (2) implicitly determining that the loss was a bona fide loss within the meaning of I.R.C. § 165; (3) invalidating or refusing to apply Treas. Reg. § 1.752-6 (which contains a basis-reduction rule designed to nullify “Son-of-BOSS” transactions); and (4) denying the government’s motion for a new trial after one of the taxpayer’s key witnesses (Krieger) recanted his testimony after accepting a plea agreement on criminal charges of promoting illegal tax shelters.
The taxpayer responded by arguing that: (1) the rule of Helmer was applicable law at the time of the contested transactions and should be followed; (2) the court blessed each phase of the contested transactions as having substance, not just the entirety; (3) the government did not adequately raise the § 165 argument at trial, and the provision nonetheless does not disallow the taxpayer’s loss; (4) Treas. Reg. § 1.752-6, as applied, is beyond the authority granted by the statute; and (5) the government did not meet its burden for obtaining a new trial.
Oral argument was held on November 16, 2009, and subsequently the government has directed the court’s attention pursuant to FRAP 28(j) to three of its recent wins in similar cases (supplemental submissions linked below). Given that the case has been fully submitted for several months now, a decision could be imminent. The length of deliberation also may indicate that the court will engage in a detailed analysis that could depart from the opinions of other courts. Should the taxpayer prevail, the case could be viewed as giving rise to a circuit split on the appropriate framework for analyzing alleged tax shelters, which could also have far-reaching implications for the recently codified economic substance doctrine.
June 28, 2010
As many if not most tax practitioners are aware, Castle Harbour is the nickname of a partnership taxation case that has been the subject of a great deal of attention in recent years. See TIFD III-E Inc. v. United States, 342 F. Supp. 2d 94 (D.Conn. 2004), rev’d, 459 F.3d 220 (2d Cir. 2006). The case involved a partnership arrangement that allocated 98% of the taxable income derived from fully depreciated aircraft leases to two foreign banks, even though the banks received only a relatively meager debt-like return on their partnership interests. The IRS attacked the structure on two basic grounds: (1) that the overall arrangement was a sham, and (2) that the foreign banks were not bona fide equity partners, but rather held interests economically in the nature of secured loans.
The district court decided the case in the taxpayer’s favor, holding that the partnership arrangement was not a sham because there were legitimate business purposes for the deal, and the arrangement did have appreciable economic effects, even though the partners had tax avoidance motives in entering into the deal. The Second Circuit reversed the district court on the IRS’ second argument, namely that the banks were not bona fide partners because they had no meaningful stake in the entrepreneurial success or failure of the venture. The court’s holding was based on an application of the Supreme Court’s facts and circumstances test for bona fide partner status set forth in Commissioner v. Culbertson, 337 U.S. 733 (1949). The Second Circuit remanded the case for further consideration of an alternative argument by the taxpayer—that the partnership was a “family partnership” under I.R.C. section 704(e).
In a somewhat surprising turn, the district court held that the banks were partners in a partnership under section 704(e), irrespective of the Second Circuit’s ruling applying Culbertson. The government, of course, has appealed to the Second CIrcuit, No. 10-70. The government’s brief is linked below. The taxapayer’s brief is due September 14, 2010.
June 20, 2010
The Tax Court and the U.S. District Court in New Jersey recently issued the first two opinions construing I.R.C. section 707(a)(2)(B), which is somewhat remarkable given that the partnership disguised sale rules have been on the books since 1984. See Va. Historic Tax Credit Fund 2001 LP v. Comm’r, T.C. Memo 2009-295; United States v. G-I Holdings Inc. (In re: G-I Holdings, Inc.), 2009 U.S. Dist. LEXIS 115850 (D.N.J. Dec. 14, 2009). The Government has appealed the Tax Court’s decision in Virginia Historic to the Fourth Circuit.
In Virginia Historic, the Tax Court rejected the IRS’s challenge to the use of partnerships as marketing vehicles for state tax credits. Under Virginia law, taxpayers can receive tax credits for investment in historical renovation projects. The tax credits are made available to stimulate investment in such projects because they are often unprofitable, and as a result, financing for the projects is often difficult to obtain. Because of restrictions on the direct transfer of the tax credits, the taxpayers in this case set up several investment partnerships that pooled funds from many investors and then contributed the funds to several lower-tier developer-partnerships. In exchange for investment in the developer-partnerships the upper-tier partnerships received partnership interests that entitled them to tax credits generated by specific projects. The tax credits would then be pooled by the upper-tier partnerships and distributed to the investors. The IRS took the position that the scheme was a disguised sale of tax credits in exchange for the investors’ cash.
In a memorandum opinion by Judge Kroupa, the Tax Court rejected the IRS’s disguised-sale contention largely on the basis that the investments were subject to the entrepreneurial risks of the enterprise. There was a possibility that developers would not complete the projects on time or in a manner acceptable to the state agency overseeing the projects, which placed receipt of the tax credits at risk. There was also the possibility that the upper-tier partnerships would not be able to pool sufficient credits to be able to make all of the promised distributions. Although distribution of the credits was guaranteed by the partnerships, there was no guarantee that the partnerships would have sufficient resources to make the investors whole. Accordingly, the court held that the investors’ capital was sufficiently at risk in order to avoid disguised sale treatment. Significantly, the degree of risk associated with the acquisition of state tax credits was relatively small, especially given that the investment partnerships spread risk through the pooling of resources and the dispersion of those resources over many developer-partnership projects.
The government has filed its opening brief. The taxpayer’s brief in response is due July 26, 2010. We will continue to monitor the case and post the briefs as soon as they are available.
The district court in GI-Holdings, by contrast, did apply the disguised-sale rule of Code section 707(b). The unpublished decision, linked below, contains a detailed discussion of the issue, but it is not yet an appealable order. Proceedings in the district court have been stayed until September 2010, but there is a strong possibility that the case will be appealed to the Third Circuit after the remaining issues are resolved in the district court.