August 30, 2012
[Note: Miller & Chevalier filed a brief in this case on behalf of National Trust for Historic Preservation]
In a detailed 85-page opinion, the Third Circuit has reversed the Tax Court’s opinion that upheld a claim for historic rehabilitation tax credits by the private partner in a public/private partnership that rehabilitated a historic property on the Atlantic City boardwalk. See our earlier report here. The government had argued both that the transaction lacked economic substance and that the private partner, Pitney Bowes, was not a bona fide partner in the enterprise. The Third Circuit agreed with the government’s second argument and therefore found it unnecessary to decide whether there was economic substance. Given that approach, the court stated that it would “not opine on the parties’ dispute” on whether the Ninth Circuit was correct in Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995), in stating that the policy of providing a rehabilitation credit as a tax incentive is relevant “in evaluating whether a transaction has economic substance.” Slip op. 54 n.50. The court did make some general observations on economic substance, however, noting its agreement with amicus that the government’s position had inappropriately blurred the line between economic substance and the substance-over-form doctrine, which are “distinct” doctrines. Slip op. 52 n.50. Citing Southgate Master Fund, L.L.C. v. United States, 659 F.3d 466, 484 (5th Cir. 2011), the court added that “even if a transaction has economic substance, the tax treatment of those engaged in the transaction is still subject to a substance-over-form inquiry to determine whether a party was a bona fide partner in the business engaged in the transaction.” Slip op. 53 n.50.
Turning to the issue that it found dispositive, the court concluded that Pitney Bowes was not a bona fide partner because it “lacked a meaningful stake in either the success or failure of [the partnership].” Slip op. 85. In reaching that conclusion, the court relied heavily on two recent court of appeals’ decisions, the Second Circuit’s analysis of bona fide equity partnership participation in TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006) (“Castle Harbour”) and the Fourth Circuit’s analysis of “disguised sales” in Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011). Although the taxpayer had objected that the latter case was irrelevant because no disguised sale issue was present, the court agreed with the government’s argument in its reply brief that “the disguised-sale analysis in that case ‘touches on the same risk-reward analysis that lies at the heart of the bona fide-partner determination.’” Slip op. 67 n.54 (quoting U.S. Reply Br. 9). See our previous report here. The court elaborated on this point as follows: “Although we are not suggesting that a disguised-sale determination and a bona fide-partner inquiry are interchangeable, the analysis pertinent to each look to whether the putative partner is subject to meaningful risks of partnership operations before that partner receives the benefits which may flow from that enterprise.” Id. at 69 n.54.
The taxpayer had relied heavily on the Tax Court’s findings regarding the essentially factbound question of bona fide partnership, but the Third Circuit found that the deferential standard of review of factual findings was not an obstacle to reversal. The court first stated that “the record belies” the Tax Court’s conclusion that Pitney Bowes faced a risk that the rehabilitation would not be completed. Id. at 73. To deal with the standard of review, the court of appeals drew a hair-splitting distinction between the factual issue of “the existence of a risk” and what the court believed to be a “purely . . . legal question of how the parties agreed to divide that risk,” which “depends on the . . . documents and hence is a question of law.” Id. at 73 n.57. The court of appeals directly rejected other Tax Court findings regarding risk as “clearly erroneous.” Id. at 76.
The court did not dwell on the policy implications of its decision. It stated that it was “mindful of Congress’s goal of encouraging rehabilitation of historic buildings” and had not ignored the concerns expressed by the amici that a ruling for the government could “jeopardize the viability of future historic rehabilitation projects.” Id. at 84. But the court brushed aside those concerns, taking comfort in the response of the government’s reply brief that “[i]t is the prohibited sale of tax credits, not the tax credit provision itself, that the IRS has challenged.” Id. at 85. Be that as it may, decisions like this are likely to diminish the practical effectiveness of the credit as an incentive and thus to frustrate to some extent Congress’s desire to encourage historic rehabilitation projects.
A petition for rehearing would be due on October 11.
February 2, 2012
[Note: Miller and Chevalier represents amicus National Trust for Historic Preservation in this case]
The government has filed its reply brief in the Historic Boardwalk case in the Third Circuit. (See our prior report and the other briefs here.) The brief mostly goes over the same ground as the opening brief in seeking to deny section 47 historic rehabilitation credits to the private investor partner in the partnership that rehabilitated East Hall on the Atlantic City boardwalk. It attempts to side-step the Ninth Circuit’s economic substance analysis in Sacks by arguing that the Third Circuit did not explicitly endorse Sacks when it distinguished that case in other decisions. The brief urges the court instead to follow the Fourth Circuit’s Virginia Historic decision (see our coverage here), even though that case involved the disguised sale provisions, arguing that the case “touches on the same risk-reward analysis that lies at the heart of the bona-fide partner determination.” The government also argues that Congress’s intent in passing section 47 would not be thwarted because the private investor allegedly “made no investment in the Hall.”
Indeed, the reply brief includes a special “postscript” “in response to the amicus brief” filed for the National Trust for Historic Preservation that seeks to deflect the charge that the government’s position would undermine Congress’s purpose to facilitate historic rehabilitation. Not so, says the government. It is only “the prohibited sale of federal tax credits — not the rehabilitation tax credit provision itself — that is under attack here.”
Oral argument in the case has been tentatively scheduled for April 20.
January 12, 2012
[Note: Miller and Chevalier represents amicus National Trust for Historic Preservation in this case]
We present here a guest post by our colleague David Blair who has considerable experience in this area and authored the amicus brief in this case on behalf of the National Trust for Historic Preservation.
The government has appealed to the Third Circuit its loss before the Tax Court in Historic Boardwalk Hall, LLC v. Comm’r, which involves a public/private partnership that earned historic rehabilitation tax credits under Code section 47. The partnership rehabilitated East Hall, which is located on the boardwalk in Atlantic City. East Hall was completed in 1929, hosted the Miss America Pageant for many years, and is listed on the National Register of Historic Places. The IRS sought to prevent the private partner, Pitney Bowes, from claiming the historic rehabilitation tax credits, but the Tax Court upheld the taxpayer’s position after a four-day trial.
In its opening brief, the government advances the same three arguments in support of its disallowance that it made in the Tax Court. First, it asserts that Pitney Bowes was not in substance a partner because it did not have a meaningful stake in the partnership under the Culbertson-Tower line of cases. Second, it argues that the partnership was a sham for tax purposes under sham partnership and economic substance cases. Third, it argues that the partnership did not own the historic building for tax purposes and thus was not eligible for the section 47 credits for rehabilitating the building. In making the first two arguments, the government relies heavily on its recent victory in Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, where the Fourth Circuit overturned the Tax Court and found a disguised sale of state tax credits. (See our previous reports on that case here.) Similarly, the government’s brief places heavy reliance on its first-round victory before the Second Circuit in TIFD III-E, Inc. v. Comm’r (Castle Harbor), which is now back up on appeal. (See our previous reports on that case here.) In support of its sham partnership theory, the government cites provisions in the partnership agreement that protect investors from unnecessary risks, including environmental risks. On the third argument, the government asserts that the partnership never owned the building for tax purposes because the benefits and burdens of ownership never transferred.
Having won at trial, the taxpayer’s brief emphasizes the Tax Court’s factual findings in its favor. It also emphasizes the historic character of the building and the Congressional policy of using the tax laws to encourage private investment to preserve this type of historic structure. The taxpayer argues that the partnership was bona fide because the partners joined together with a business purpose of rehabilitating East Hall and earning profits going forward. The taxpayer also argues that the partnership has economic substance. In this regard, the taxpayer argues that the Ninth Circuit’s decision in Sacks v. Comm’r, 69 F.3d 982 (9th Cir. 1995), requires a modification of the normal economic substance analysis where Congress has offered tax credits to change taxpayers’ incentives. The taxpayer also argues that the partnership owned East Hall for tax purposes and therefore was eligible for the section 47 credits.
The National Trust for Historic Preservation filed an amicus brief in support of the taxpayer. That brief sets out the longstanding Congressional policy of offering the section 47 credit to encourage taxpayers to invest in historic rehabilitation projects that would not otherwise make economic sense. It further explains that historic rehabilitation projects typically involve partnerships between developers and investors that are motivated in part by the availability of the credit. It also is typical for these partnership agreements to protect the investors from unnecessarily taking on business risks. The amicus brief argues that, in applying the economic substance doctrine, courts should not override the narrowly focused Congressional policy of encouraging rehabilitation projects through the section 47 credit. Thus, courts should not simply review the non-tax business purpose and pre-tax profitability of investments in historic rehabilitation projects, but should acknowledge that the taxpayer can properly take into account the credits that Congress provides for historic rehabilitation projects. To do otherwise, as the Ninth Circuit observed in Sacks, “takes away with the executive hand what [the government] gives with the legislative.” The amicus argues that, at any rate, the transaction met the economic substance doctrine under Third Circuit precedent and that the partnership and Pitney Bowes interests were bona fide. It also points out that the Virginia Historic case is inapplicable because it involved a disguised sale, which the government has not alleged in this case. Similarly, the Castle Harbor case is distinguished on its facts due to the differences in the partnership agreements in the two cases.
The Real Estate Roundtable also filed an amicus brief, which highlights to the court that the recent codification of the economic substance doctrine in Code section 7701(o) places significant pressure on the distinction between, on the one hand, the economic substance doctrine, and on the other hand, substance-over-form and other “soft doctrine” attacks on transactions. This is due to the strict liability penalty that can apply to transactions that violate the economic substance doctrine. As the IRS has recognized in recent guidance under section 7701(o), it is necessary for the IRS and courts to carefully distinguish between cases where the economic substance doctrine is “relevant” and those where other judicial doctrines apply. The Real Estate Round Table then argues that the transaction at issue had economic substance.
The government’s reply brief is due January 31.
December 27, 2011
As we have previously reported (see here, here, and here), in Anschutz the Tax Court collapsed two transactions and held that they amounted to a taxable sale of stock. The Tenth Circuit was unmoved by the taxpayer’s appeal and has now affirmed, barely five weeks after hearing oral argument. In its decision, the court of appeals analyzes the transaction through the lens of the eight factors for determining a sale listed in Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981). With respect to the factor that assesses whether an equity interest was acquired in the property, the court quotes at length from the IRS’s Feb. 6, 2008, Coordinated Issues Paper on the topic, finding its analysis “compelling and applicable to the case before us.”
The court also rejects the taxpayer’s efforts to analogize its transactions to other approved transactions. The court explains that the transaction addressed in Rev. Rul. 2003-7 is distinguishable, in part because there was no borrowing of pledged shares. And the court holds that the taxpayers’ transactions in this case did not fall within the “safe harbor” of Code section 1058 because they “effectively eliminated [the] risk of loss and substantially reduced [the] opportunity for gain.”
December 13, 2011
In our earlier discussion of the disguised sale cases, we noted that the federal district court in New Jersey had issued an unpublished opinion in the GI Holdings case that applied the disguised sale rule of 26 U.S.C. § 707(a)(2)(B) to undo a transaction. We noted that there was not yet an appealable order in that case, but at some point an appeal to the Third Circuit was possible. It now appears that the case has been settled and will be formally dismissed in the coming weeks. Thus, there will be no appeal to the Third Circuit, and the Fourth Circuit’s recent decision in Virginia Historic (see our report here) remains as the sole appellate ruling on disguised sales.
November 17, 2011
On November 16, the Tenth Circuit heard oral argument in the Anschutz case, involving the taxpayers’ appeal from the Tax Court’s decision to collapse two transactions involving the use of prepaid variable forward contracts (“PVFCs”) and concurrent share lending agreements (“SLAs”), and treat them as a taxable sale of stock. A fuller description of the case and the parties’ briefs can be found in our prior reports here and here.
The panel hearing oral argument was Chief Judge Briscoe (a Clinton appointee and former Kansas state court judge and Assistant U.S. Attorney), Senior Judge McKay (a Carter appointee who was previously in private practice), and Judge O’Brien (a Bush II appointee who served for many years as a Wyoming state judge).
There is no specific date by which the court must decide the case, but a decision is most likely in the spring of 2012.
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.
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).
March 18, 2011
The Second Circuit has announced a May 16 oral argument date in TIFD III-E, Inc. v. United States, which is the second go-round for the case better known as Castle Harbour after the district court ruled again for the taxpayer on remand from the Second Circuit’s previous reversal. (See our prior reports and the briefs here, here, and here.) The identity of the three-judge panel will not be revealed until a later date.
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.
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 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 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.
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).
August 11, 2010
Virginia has filed an amicus brief in the Fourth Circuit in support of the taxpayers in the Virginia Historic case. (See here and here for previous coverage of the appeal). The brief focuses primarily on policy, arguing that Virginia created these tax credits to facilitate historic preservation and expected that partnership vehicles might be necessary for businesses and individuals to make use of the credits. According to the Commonwealth, “the IRS’s aggressive position threatens the effectiveness of the program and its benefits for all Virginians.” Although the amicus brief is light on analysis of the federal tax issues, it may well help persuade the Fourth Circuit that this is not a case where it needs to step in to prevent some kind of taxpayer “hanky-panky,” but rather that going along with the Tax Court would be “doing the right thing.”
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
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.