DOJ Argues Partnerships Lacked Economic Substance

In 1989, Brunswick Corporation entered into two arrangements designed by Merrill Lynch to create substantial paper capital losses for itself that would allow it to shelter from tax the substantial capital gains it expected to report from the impending sales of certain of its businesses and the sale of its stock in a Japanese corporation. The partnerships would purchase short-term private placement notes (PPNs) and sell the PPNs several weeks later for 80 percent cash and 20 percent debt instruments that would pay out over several years (LIBOR-indexed installment notes). The partnerships would report a large gain in the first year, most of which would be allocated to the foreign partner.

The next year, Brunswick would acquire a majority interest in the partnerships and sell the LIBOR notes, creating a large tax loss because the basis available for recovery would exceed the notes' value. The primary foreign entity was Algemene Bank Netherlands N.V. (ABN), and the partnerships allegedly formed were Saba Partnership and Otrabanda Investerings Partnership. Brunswick ultimately used the paper losses created by the transactions (which approached $200 million) to shelter from tax the capital gains it reported in 1987, 1989, 1992, 1993, 1994 and 1995. The IRS determined that the transactions that gave rise to the paper gains and losses lacked economic substance, and therefore adjusted the partnership returns filed by Saba and Otrabanda to eliminate the gains and losses reported from the transactions. Saba and Otrabanda then filed Tax Court petitions contesting the proposed adjustments. The Tax Court upheld the IRS's determination that the tax-motivated transactions engaged in by Saba and Otrabanda lacked economic substance.

The Justice Department argues that the Tax Court properly refused to give effect to the tax avoidance scheme that Brunswick attempted to implement through the Saba and Otrabanda partnerships. The DOJ contends that this Court's decision in ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (D.C. Cir. 2000), cert. denied, 121 S.C. 171 (2000) (for the full text, see Doc 2000-3346 (20 original pages) or 2000 TNT 23-11 ), which involved the same tax avoidance scheme, establishes that Saba and Otrabanda are not genuine partnerships for federal tax purposes. The Justice Department insists that any argument that the facts of this case differ materially from the facts of ASA Investerings is entirely without merit.

It is uniformly recognized that taxpayers are entitled to

[2] 2. In our opening brief (at pages 38-41), we argued that the decision in ASA controls the outcome of this case and establishes that Saba and Otrabanda are not genuine partnerships for federal tax purposes. In this regard, we asserted (at page 38) that there was no material difference between this case and ASA because Saba and Otrabanda, like ASA, were formed to implement the same Merrill Lynch tax-avoidance scheme and because Brunswick, the intended beneficiary of the scheme in this case, like AlliedSignal, the intended beneficiary of the scheme in ASA, lacked a nontax business purpose for entering into the arrangements. We also noted (at pase 40 n.15) that ABN, the foreign "partner" in Saba, Otrabanda and ASA, entered into hedge transactions that eliminated all possibility of gain or loss for itself from the tax-avoidance scheme, and pointed out that Brunswick, like AlliedSignal, incurred millions of dollars of fees and transactions costs that it could have avoided if it had been motivated by genuine business purposes.

[3] 3. In their answering brief, Saba and Otrabanda acknowledge that "[t]here are obvious similarities between the facts of ASA and the facts of the present case." (Answering Brief at 38.) They nevertheless argue that this Court should not resolve the partnership issue in favor of the Commissioner on the basis of ASA, but rather should remand the case to the Tax Court to allow that court to address the issue in the first instance. In Saba's and Otrabanda's view, a remand to the Tax Court is warranted because there are "significant differences between the facts of this case and those of ASA" (Answering Brief at 43) that render "[t]he relationships and agreements among the partners in ASA * * * very different from the relationships among the partners in this case" (id. at 38).

[4] The notion that the facts of this case differ materially from the facts of ASA is entirely without merit. The Court in ASA concluded that the relationship between AlliedSignal and ABN was not a valid partnership because it was created solely to implement a blatant tax-avoidance scheme that attempted to "game" the federal tax system. 201 F.3d at 513. That holding applies with equal force to this case, where the Tax Court already has held that "there is overwhelming evidence in the record that Saba and Otrabanda were organized solely to generate tax benefits for Brunswick." Tax Court Opinion at 113. In particular, the court stressed that (id. at 116- 117):

the record contains little in the way of notes or documentation,

[6] 4. In an effort to escape the effect of ASA, Saba and Otrabanda assert that the Court in that case could not have held that a putative partnership must have a nontax business purpose to be respected for federal tax purposes, because "any such holding would be contrary to decades of established precedent, in every Circuit which has considered the issue." (Answering Brief at 46.) In particular, they contend that cases beginning with the Supreme Court's decision in Moline Properties v. Commissioner, 319 U.S. 436 (1943), consistently have adopted a two-part test for determining whether an entity should be recognized for federal tax purposes (whether the entity served a business purpose or engaged in business activity). ³

[7] Saba's and Otrabanda's reading of ASA is refuted by the Court's opinion. The Court in ASA stated on two occasions that the absence of a nontax business purpose was determinative. See 201 F.3d at 512 ("Thus, what the petitioner alleges to be a two-pronged inquiry is in fact a unitary test-whether the 'sham' be in the entity or the transaction-under which the absence of a nontax business purpose is fatal")(footnote omitted); id. at 513 ("Thus, the Tax Court was, we think, sound in its basic inquiry, trying to decide whether, all facts considered, the parties intended to join together as partners to conduct business activity for a purpose other than tax avoidance"). There is nothing new about that standard. The Supreme Court held more than sixty years ago that the appropriate standard for determining whether a partnership has been formed for federal tax purposes is whether "the parties IN GOOD FAITH AND ACTING WITH A BUSINESS PURPOSE intended to join together in the present conduct of the enterprise." Commissioner v. Culbertson, 337 U.S. 733, 749 (1949) (emphasis added).

[8] The cases cited by Saba and Otrabanda as standing for the proposition that a partnership formed solely for tax purposes will be respected so long as it engages in "business activity" do not support that proposition, since those cases involved corporations and not partnerships. The issue in Moline Properties was whether income from the sale of real property owned by a corporation was taxable to the corporation (as the Commissioner contended) or to the corporation's sole shareholder (as the taxpayer contended). The Supreme Court, relying on the corporation's status as a "separate taxable entity," ruled in favor of the Commissioner (319 U.S. at 438-439; footnotes omitted):

The doctrine of corporate entity fulfills a useful purpose

[10] MOLINE PROPERTIES -- and other cases involving corporations -- have no bearing on the question whether two parties have formed a genuine partnership for federal tax purposes. The decision in Moline Properties was based on the fact that a corporation is a "separate taxable entity," i.e., an entity that is subject to tax on the income it earns. See 26 U.S.C. section 11(a). Because a corporation is a separate taxable entity, the owners of the corporation (its shareholders) ordinarily are not subject to tax on the corporation's income. By contrast, a partnership is not a separate taxable entity for federal tax purposes. See 26 U.S.C. section 701 ("A partnership as such shall not be subject to the income tax imposed by this chapter"). Instead, the partnership's income, losses, and other tax items are attributed to its partners. See 26 U.S.C. section 702(a). Because partnerships are not separate taxable entities, the decision in Moline Properties, by its own terms, has no bearing on the question whether two parties have formed a genuine partnership for federal tax purposes. That issue must be resolved by applying the standard set forth by the Supreme Court in Culbertson. ⁴

[11] The Supreme Court's opinion in Culbertson -- which was issued a few years after Moline Properties, and did not even cite, much less rely on, that decision in determining whether the taxpayers in question had entered into a genuine partnership for federal tax purposes -- confirms that Moline Properties has nothing to do with partnerships. Indeed, if the business activity test set forth in Moline Properties had been relevant, Culbertson would have been resolved in favor of the taxpayers, since the putative partnership in that case (unlike Saba and Otrabanda) was unquestionably engaged in a legitimate business (breeding and selling cattle). See also Commissioner v. Tower, 327 U.S. 280 (1945) (post-Moline Properties decision holding that a husband and wife had not formed a valid partnership even though the entity engaged in legitimate business activity).

[12] There is also nothing in Moline Properties that validates blatant tax-avoidance schemes such as the scheme that Brunswick sought to implement in this case. Moline Properties stands for the straightforward proposition that a corporation that serves a legitimate business purpose or that is engaged in legitimate business activity is ordinarily taxed on the income it earns. The case, however, does not suggest that courts are required to treat a relationship that exists only to implement a tax-avoidance scheme for the benefit of one of the parties as a valid partnership for federal tax purposes. On the contrary, the Supreme Court stressed that its holding did not apply in cases involving attempts to perpetrate "frauds on the tax statute * * *." 319 U.S. at 439. That is precisely what Brunswick -- which claimed a $200 million tax loss from its participation in the Merrill Lynch tax-avoidance scheme even though its actual economic loss from the transactions was only $5 million -- is attempting to perpetrate here. This Court held in ASA that the putative partnership formed in that case to implement the Merrill Lynch scheme was a sham. The putative partnerships formed in the instant case were created under the same blueprints and for the identical tax avoidance motive that this Court considered inimical to a valid partnership in ASA. Moline Properties no more immunizes Saba and Otrabanda from scrutiny under the business purpose doctrine than it did the putative partnership in ASA.

[13] Saba's and Otrabanda's contention (Answering Brief at 48- 49) that ASA erroneously collapsed the "two-part test" established by Moline Properties into a unitary "business purpose" test also "attempts to create a distinction where none exists." Zmuda v. Commissioner, 731 F.2d 1417, 1420 (9th Cir. 1984). "Business purpose" and "business activity" are two sides of the same coin; both terms are directed at the question whether a corporation is serving a legitimate purpose. The Court in ASA never suggested that a corporation engaged in legitimate business activity would not be respected for federal tax purposes. On the contrary, it observed that "[i]t is uniformly recognized that taxpayers are entitled to structure their transactions in such a way to minimize tax." 201 F.3d at 513. The Court's point was that in some cases, purported business activity is nothing more than a facade for an abusive tax-avoidance scheme. Ibid. ("When the business purpose doctrine is violated, such structuring is deemed to have gotten out of hand, to have been carried to such extreme lengths that the business purpose is no more than a facade"). Neither Moline Properties nor any other case cited by Saba and Otrabanda suggests that courts are powerless to prevent such schemes from coming to fruition. On the contrary, the law of this Circuit, as established by the decision in ASA, is directly to the contrary.

[14] Saba's and Otrabanda's contention (Answering Brief at 49) that the decision in ASA is in "direct conflict" with Horn v. Commissioner, 968 F.2d 1229 (D.C. Cir. 1992), is frivolous.

[15] Horn did not address the question whether a purported partnership should be recognized for federal tax purposes. As discussed in our opening brief (Opening Brief at 41-43), the issue in that case was whether Section 108 of the Tax Reform Act of 1984 allowed a commodities dealer to deduct actual economic losses incurred in the dispositions of the legs of straddle transactions even though the transactions had no reasonable prospect of economic gain and were designed only to produce tax benefits. The Court's decision in favor of the taxpayer thus resolved an issue of statutory interpretation.

[16] 5. Saba and Otrabanda erroneously suggest (Answering Brief at 50-52) that Section 704(e) of the Internal Revenue Code (a provision that was not addressed by this Court in its opinion in ASA) may validate sham partnerships. Section 704(e) states that "[a] person shall be recognized as a partner * * * if he owns a capital interest in a partnership in which capital is a material income- producing factor, whether or not such interest was derived by purchase or gift from any other person." The statute thus provides an objective standard for determining whether a particular "person" is a "partner" in an extant partnership. Section 704(e), however, does not provide any standard for determining whether an arrangement constitutes a bona fide partnership, but rather assumes the existence of a genuine partnership engaged in a legitimate income-producing business. See Treas. Reg. 1.704-1(e)(1)(iv)("Capital is a material income-producing factor if a substantial portion of the gross income of the business is attributable to the employment of capital in the business conducted by the partnership"). The statute, therefore, does not apply to sham partnerships created to implement tax-avoidance schemes, since, if there is no genuine partnership, there can be no actual partners.

CONCLUSION

[17] For the reasons stated above and in our opening brief, the decisions of the Tax Court should be affirmed on the basis of this Court's decision in ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (2000), and the case should be remanded to the Tax Court for entry of new decisions in conformity with that decision. In the alternative, the decision of the Tax Court should be affirmed.

Respectfully submitted,

[18] Pursuant to Rule 32(a)(7)(C) of the Federal Rules of Appellate Procedure, I certify that this brief contains 3211 Words.

EDWARD T. PERELMUTER

[19] It is hereby certified that service of this reply brief has been made on the following counsel for the appellant-cross- appellee, by Federal Express, on this 13th day of July, 2001:

Joel V. Williamson, Esquire

² Because the Tax Court already has made the controlling determination that Saba and Otrabanda "were organized solely to generate tax benefits for Brunswick" -- there is no merit to their contention (Answering Brief at 42) that the Commissioner is "invit[ing] this Court to act as a trial court and to make findings of fact concerning the partnership issue."

³ We would point out noting that ASA filed a petition for rehearing with suggestion for rehearing en banc contending that the Court's holding on the business purpose doctrine in that case conflicted with Moline Properties and subsequent cases. This Court denied the petition on April 24, 2000.

⁴ The only case cited by Saba and Otrabanda that involved a partnership -- Bertoli v. Commissioner, 103 T.C. 501 (1994) -- did not resolve an issue comparable to the issue resolved in favor of the Commissioner in ASA. The issue in Bertoli was whether a partnership should be treated as an entity separate from an unrelated party -- a corporation owned by the partnership's general partner. As the Tax Court recognized in Campbell County State Bank, Inc. v. Commissioner, 37 T.C. 430, 442 (1961), rev'd on other grounds, 311 F.2d 374 (8th Cir. 1963), which was relied on by the court in Bertoli (see 103 T.C. at 511), there is a distinction between the question whether a partnership should be treated as an entity separate from an unrelated entity and the question whether two parties have formed a partnership. The latter question must be resolved by applying the standard set forth by the Supreme Court in Culbertson.