Partnerships Insist They Have 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 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, and 1992-1995. 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 partnerships argue that the Tax Court erred in holding that the sales of the PPNs lacked economic substance for purposes of section 1001. They insist that the IRS's interpretation of economic substance is erroneous as a matter of law because it improperly focused on Brunswick's motive instead of "what actually occurred". The partnerships further argue that the plain meaning, the purpose, and the legislative history of section 453 and the regs support their calculations of gain and loss. Finally, the partnerships maintain that there is no basis in the record to conclude that the partnerships are not partnerships for federal income tax purposes.

[2] In the FPAAs issued to the Partnerships, one of the Commissioner's determinations was that the transfers of the PPNs (Saba) and CDs (Otrabanda) in exchange for cash and LIBOR Notes should be disregarded as lacking in economic substance. Although the Tax Court agreed the Partnerships had "sold" the PPNs and CDs (Opinion 118), the Tax Court rejected the Partnerships' arguments that the transfers of the PPNs and CDs qualified as "sales" as defined in section 1001 ¹ and therefore held that the transfers should be disregarded as lacking in economic substance. Accordingly, the Tax Court held that "no gains or losses will be recognized on the sales of the PPNs and CDs." (Opinion 130) Consistent with its determination that the purchase and sale of the PPNs and CDs lacked economic substance, the Tax Court also held that the Partnerships were not required to report interest income from the PPNs, CDs, and LIBOR Notes. As a result of its holding that the transfers of the PPNs and CDs did not qualify as "sales" for tax purposes, the Tax Court did not consider two alternative issues raised by the Commissioner: (1) whether the Partnerships qualified as partnerships for federal tax purposes, and (2) whether the section 453 regulations applied to the sales of the PPNs and CDs. (Opinion 88, 96)

[3] In this appeal, the Commissioner does not defend the Tax Court's conclusion that the transfers of the PPNs and CDs do not qualify as "sales" as defined in section 1001. The Commissioner instead argues as his primary position that this Court should rule on the Commissioner's cross-appeal and should hold, based on its decision in ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (D.C. Cir.), cert. denied, 121 S.Ct. 171 (2000), that the Partnerships should not be treated as partnerships for federal income tax purposes. The Commissioner makes this argument even though the Tax Court did not make any findings of fact concerning the partnership issue. As a result, this Court has no factual basis on which to rule on the Commissioner's cross-appeal. See, e.g., American Federal Group, Ltd. v. Rothenberg, 136 F.3d 897, 912 (2d Cir. 1998).

[4] The Commissioner is correct in characterizing his cross- appeal as a "protective cross-appeal to preserve his alternative arguments in the event this Court were to reverse the Tax Court's determination." (Com. Br. 26 n.11) See Michael E. Tigar, Federal Appeals Jurisdiction & Practice section 6.10, at 369 (3d ed. 1999) ("A protective cross-appeal will also be necessary to obtain review of an issue that will arise, if at all, only if the judgment or order appealed from is reversed or modified."). The Commissioner recognizes that his cross-appeal would produce a result different from the Tax Court's judgment. (Com. Br. 26 n.11) Since the Commissioner's cross- appeal requests a result different from the Tax Court's judgment, the alternative arguments on his cross-appeal do not come into play unless "this Court were to reverse the Tax Court's determination." ² (Com. Br. 26 n.11) For this reason, as a matter of logical presentation, we believe it is first necessary to address whether the Tax Court's decision should be affirmed before addressing the Commissioner's cross-appeal. For the reasons set forth in Part I of this brief, the Tax Court's decision should be reversed.

[5] As an alternative to his primary argument, the Commissioner argues that this Court should uphold the Tax Court's judgment. The Commissioner does not, however, defend the Tax Court's judgment that the sales of the PPNs and CDs should be disregarded as lacking in economic substance for purposes of section 1001. Instead, the Commissioner bases his economic substance argument on section 453 and argues that this Court should not apply the plain meaning of the section 453 regulations. The Tax Court expressly declined to consider this issue. (Opinion 96) In Part II, below, we demonstrate that the operation of the section 453 regulations as applied to the facts of this case is perfectly consistent with the plain meaning, purpose, and legislative history of the section 453 regulations.

[6] Finally, we next address the Commissioner's primary claim, i.e., his cross-appeal, which argues that the Partnerships should not be treated as partnerships for federal income tax purposes. Since the Tax Court did not make any factual findings regarding the partnership issue, this Court cannot rule on the Commissioner's cross-appeal. Therefore, for the reasons stated in Part III, this case should be remanded to the Tax Court for consideration of the Commissioner's cross-appeal in the event the Tax Court's judgment is reversed.

I. THE TAX COURT ERRED IN HOLDING THAT THE SALES OF THE PPNs AND CDs

[8] In his defense of the Tax Court's opinion, the Commissioner attempts to obscure the exact nature of the Tax Court's holding. In particular, the Commissioner claims that "the proper focus" of the "economic sham transaction doctrine is on that regulation [i.e., the section 453 regulation], not Section 1001." (Com. Br. 46) The Commissioner is clearly mistaken. The Tax Court's opinion was based on section 1001, and it expressly declined to consider the application of the section 453 regulations to the Partnerships' transactions.

[9] In its briefs in the Tax Court, the Partnerships argued that the sales of the PPNs and CDs had economic substance for purposes of section 1001 because the Partnerships actually transferred ownership, dominion, and control over the PPNs and CDs to third parties -- a fact the Tax Court and the Commissioner do not dispute. (Opinion 118-19) Thus, the Partnerships argued that a "nontax business purpose" and a "possibility of profit" were not required by section 1001. The Tax Court disagreed, stating that -- in its view -- the Partnerships' arguments were not consistent with "the plain language of section 1001 [or] its legislative history" and that Congress did not intend "to respect the tax consequences of sales or exchanges of property that lack economic substance." (Opinion 105) Since the Tax Court concluded that the sales of the PPNs and CDs did not qualify as "sales" within the meaning of section 1001, it held "no gains or losses will be recognized on the sales of the PPNs and CDs." (Opinion 130)

[10] It should be obvious that if a transaction does not qualify as a "sale" within the meaning of section 1001, and therefore does not produce gain or loss, the installment sale regulations do not come into play -- if there is no "sale" for purposes of section 1001, by definition there can be no "installment sale" for purposes of section 453. Indeed, that is exactly what the Tax Court held. The Tax Court noted the Partnerships' arguments "that the disputed transactions satisfy the requirements of the contingent installment sale provisions and the ratable basis recovery rules." (Opinion 95) The Tax Court stated, however, that "[i]n light of our holding in these cases, we need not consider" the parties' arguments on the section 453 regulations. (Opinion 96)

[11] Therefore, the Commissioner is clearly misguided in arguing that "Section 1001 . . . was not the basis for" the Partnerships' transactions. (Com. Br. 46) While the Partnerships' transactions depend on both section 1001 and section 453, the Tax Court did not reach the section 453 issue because it ruled against the Partnerships on the basis of section 1001. Thus, in reviewing the Tax Court's decision, we must first consider whether the Tax Court was correct in holding that a nontax business purpose and the possibility of profit are required under section 1001.

B. THE COMMISSIONER'S INTERPRETATION OF ECONOMIC SUBSTANCE IS

[13] The Commissioner, on the other hand, views issues of economic substance as anodynes for the pain of reasoning." Commissioner v. Sansome, 60 F.2d 931, 933 (2d Cir.), cert. denied, 287 U.S. 667 (1934). The bulk of the Commissioner's argument consists of attacks upon Brunswick's motives, despite longstanding authority that the motive to reduce tax must be "put aside." Gregory, 293 U.S. at 469. ³ Thus, any discussion of "what actually occurred," see id., and the legal consequences of those events under the relevant Code sections, is largely absent from the Commissioner's brief.

[14] Since the Commissioner focuses upon Brunswick's motive as the test for economic substance, the Commissioner is less than clear on exactly WHICH part of the Partnerships' transactions lacks economic substance. As we shall see below, the Commissioner does not dispute the Partnerships' claims that the sales of the PPNs and CDs had all the characteristics which can possibly be required of a "sale" as defined in section 1001. While the exact nature of the Commissioner's argument is unclear, the Commissioner appears to claim that the operation of his own regulations produces a result which lacks economic substance. (Com. Br. 46) ("the proper focus" of the economic substance doctrine "is on that [the section 453] regulation") The Commissioner's lack of specificity is consistent with his view that economic substance applies "independently" of the Code -- if economic substance is "independent" of the Code, and not a rule of statutory interpretation, there is (at least in the Commissioner's view) no need to link his analysis to any particular Code section. Cf. Horn, 968 F.2d at 1238.

[15] Consistent with this approach, the Commissioner does not analyze the purpose of sections 1001 and 453, other than to provide bland assurances -- without citation to authority or support-that the Partnerships' tax avoidance motive is not consistent with the statutory purpose. ⁴

2. THE COMMISSIONER IS MISTAKEN IN ASSUMING THAT A

[17] The Commissioner therefore misstates the Partnerships' arguments when he claims the Partnerships do not dispute "that the transactions were economic shams" (Com. Br. 43), and also misstates the Partnerships' arguments when he claims that the Partnerships have argued that "the Tax Court had no authority to employ the economic sham transaction doctrine." (Com. Br. 45)

[18] These claims simply are not true. The Partnerships have never denied that the Partnerships' transactions must have economic substance. When, however, as in this case, a challenged sale transaction actually conveys the benefits and burdens of ownership to a third party, the transaction has all of the economic substance which can possibly be required of a sale transaction.

[19] The Commissioner relies on the "reasonable prospect for profit" and "nontax business purpose" tests as the exclusive tests for economic substance. The error in this formulation is plain: if the Commissioner were correct, a different result would have been required in Horn, Cottage Savings, and many other cases. ⁵ The Commissioner's argument is contrary to the law of this Circuit, which holds that these two "tests" are only "general factors." Horn, 968 F.2d at 1237.

3. THE COMMISSIONER HAS NOT DEFENDED THE TAX COURT'S

[21] The Commissioner does not dispute the Partnerships' claims (and the Tax Court's factual finding (Opinion 118-19)) that they actually transferred ownership of the PPNs and CDs in exchange for cash and LIBOR Notes, and therefore he does not dispute that " what actually occurred," see Gregory, 293 U.S. at 469, constitutes a "sale" as that term is understood for federal income tax purposes. Commissioner v. Brown, 380 U.S. 563, 570-72 (1965).

[22] Similarly, the Commissioner does not dispute the Partnerships' claim that the sale of the PPNs and CDs had "practical economic effects" other than the creation of tax benefits. See Horn, 968 F.2d at 1237 (quoting Sochin v. Commissioner, 843 F.2d 351, 354 (9th Cir.), cert. denied, 488 U.S. 824 (1988)). When the Partnerships purchased the PPNs and CDs, they owned relatively stable investments designed to maintain their principal value in response to changes in interest rates. When the Partnerships sold the PPNs and CDs, they acquired volatile instruments ⁶ (the LIBOR Notes) which fluctuated significantly in response to changes in interest rates. The Commissioner's expert witness agreed that the LIBOR Notes had economic attributes "materially different" from the PPNs and CDs. (Tr. 1696-97). When Brunswick sold the LIBOR Notes, it suffered a significant economic loss, which was in part attributable to the effect of declining interest rates on the volatile LIBOR Notes. This loss could have been over $19 million had Brunswick held the Notes to term. (Opinion 125)

[23] The Commissioner offers no response to the Partnerships' claims that the transfer of the PPNs and CDs had "practical economic effects" and resulted in an exchange of property with "materially different characteristics." ⁷ See Cottage Savings, 499 U.S. at 566; Horn, 968 F.2d at 1237. Significantly, the Commissioner does not defend the Tax Court's claim that the sales of the PPNs and CDs "did not meaningfully change Brunswick's economic position." (Opinion 129) In view of the Tax Court's determination that Brunswick and SBC "lost nearly $5 million on the sale of the LIBOR Notes" (Opinion 122), the Tax Court's determination is impossible to defend.

[24] The type of practical "economic effects" which entitle a transaction to respect "include the creation of genuine obligations enforceable by an unrelated party." See United Parcel Service, No. 00-12720, slip op. at 7. ⁸ When the Partnerships purchased the PPNs and CDs, they acquired legally enforceable claims against Chase and IBJ. As the Commissioner's expert acknowledged, they also become exposed to a wide variety of risks. (Tr. 1532-52). When the Partnerships sold the PPNs and CDs to Fuji, Norinchukin, and Sumitomo, these purchasers acquired the risks and benefits which had previously belonged to the Partnerships. The purchasers became acutely aware of the " practical economic effects" of their purchase when the Chase Notes plunged in value and Fuji was unable to sell those notes. (Tr. 1168, 1241; Exs. 146-J(2), (3), (5), (6), (8)) These "practical economic effects" arising from the purchase and sale of property with " materially different characteristics" are the essence of a sale as defined in section 1001. Cottage Savings, 499 U.S. at 566.

[25] In the opening brief the Partnerships demonstrated that the purpose and legislative history of section 1001 require an objective test, which must be applied without regard to the taxpayer's intent. See Cottage Savings, 499 U.S. at 565-66. Thus, in a wide variety of circumstances, the Courts have rejected the Commissioner's economic substance arguments when a challenged transfer actually resulted in a transfer of the benefits and burdens of ownership. The cases on this point are described on pages 40-41 of the Partnerships' opening brief. The Commissioner does not dispute the Partnerships' claim, confirmed in Cottage Savings, that section 1001 requires neither a nontax business purpose nor a possibility of profit.

[26] In its opening brief, the Partnerships stated that, with the exceptions of the decisions in ACM Partnership v. Commissioner, 157 F.3d 231 (3rd Cir. 1998), and the Tax Court's opinion below, they were "not aware of any case which holds that a transfer of property which results in a transfer of beneficial ownership, and therefore qualifies as a 'sale' under the normal meaning of the term, nonetheless lacks economic substance due to the motive to reduce tax." (Ptshp. Br. 45) The Commissioner's brief bears out the Partnerships' claim, since the Commissioner was apparently unable to locate any other cases contrary to the Partnerships' argument.

[27] The Commissioner does, of course, rely heavily on ACM which (along with the Tax Court's decision below) is apparently the only case which has ever held that a genuine transfer of ownership may be disregarded for tax purposes. In its opening brief, however, the Partnerships demonstrated that the Third Circuit's approach to economic substance issues, as exemplified in Lerman, Wexler, and ACM, ⁹ is in direct conflict with this Court's decision in Horn. (Ptshp. Br. 34-35) Lerman, Wexler, and ACM all hold that the "sham transaction doctrine applies independently" of the provisions of the Code, which is contrary to the law of this Circuit. See Horn, 968 F.2d at 1238. Despite this clear conflict, the Commissioner relies on ACM without attempting to reconcile (or even acknowledge) the discrepancies between the Third Circuit's precedent and Horn.

[28] Since ACM applies economic substance as an independent requirement, it does not take into account the purpose of section 453. In Part II, below, we demonstrate that section 453 authorizes the deduction of noneconomic losses, and thus ACM is in error in disallowing losses which are specifically authorized by section 453 simply because those losses are noneconomic.

[29] Since the Commissioner has not been able to locate any cases which support his interpretation of section 1001, ¹⁰ he relies heavily on Knetsch v. United States, 364 U.S. 361 (1960). Knetsch involved an interest deduction under section 163, not a sale under section 1001. In accordance with "congressional policy," section 163 permits interest deductions only for "purposive activity." Goldstein v. Commissioner, 364 F.2d 734, 741 (2d Cir. 1966). As this Court observed in Horn, Knetsch turned upon questions of Congress' intent as expressed in section 163. Horn, 968 F.2d at 1236-37. Congress' intent as expressed in section 163 obviously has no value in construing section 1001.

[30] In contrast, Congress did not intend to include a "purposive activity" requirement in section 1001. Cottage Savings, 499 U.S. at 564-66. The Congressional intent underlying section 1001 was discussed in detail in the Partnerships' opening brief (Ptshp. Br. 36-39), and the Commissioner has not questioned the Partnerships' analysis.

[31] If the taxpayer in Cottage Savings had been required to pass the standards set forth in Knetsch, it seems clear the outcome would have been different, since the transaction in Cottage Savings had no business purpose and no potential for profit. See Cottage Savings Assoc. v. Commissioner, 90 T.C. 372, 385 (1988), rev'd, 890 F.2d 848 (6th Cir. 1989), rev'd, 499 U.S. 554 (1991). The different outcomes in these two cases show that different standards apply. Since this case is governed by the standard set forth in Cottage Savings, and not that set forth in Knetsch, the Commissioner's reliance on Knetsch is misplaced.

[32] The Commissioner also heavily relies on Treas. Reg. section 1.165-1(b), which the Commissioner claims limits loss deductions to "bona fide" losses. As the Commissioner recognizes, however, the rules of section 453 provide an "exception" to the general rules for recognizing gain or loss. (Com. Br. 29) The Code explicitly provides that installment sales are subject to the "special rules" of section 453. Treas. Reg. section 1.1001-1(d); see also section 1001(d). Therefore, to the extent that the normal rules of sections 1001 and 165 are inconsistent with the rules of section 453, the rules of section 453 control. See section 1001(d).

[33] The Commissioner's argument concerning "bona fide" losses is apparently based on his claim that the rules of section 453 produce "noneconomic losses" (and, as we shall see, noneconomic gains) when a single year is viewed in isolation. As the Commissioner recognizes, however, whether a loss is "bona fide" can only be measured by the economic reality of the entire transaction." (Corn. Br. 33) In the following section (Part II), we will demonstrate that Congress understood that the section 453 regulations would produce noneconomic gains and noneconomic losses when any given year is viewed in isolation. Indeed, that understanding is explicitly embedded in the text of the regulations and the legislative history of section 453. We will also demonstrate that the application of the section 453 regulations to the Partnerships' transactions, when those transactions are viewed in their entirety, produces a result which exactly matches economic reality.

[34] Similarly, the Commissioner's remaining arguments attempt to distinguish Cottage Savings, Horn, and International Trading Co. v. Commissioner, 57 T.C. 455 (1971), rev'd, 484 F.2d 707 (7th Cir. 1973), on the grounds that those cases involved "actual 453 does indeed authorize the deduction of noneconomic losses.

4. THE COMMISSIONER'S CLAIM THAT THE PARTNERSHIPS HAVE

[36] Thus, the Commissioner is simply wrong in jumping to the conclusion that the Partnerships' acquiescence in the Tax Court's "factual findings" includes an admission that the Partnerships' transactions lacked "business purpose." The determination of "business purpose" is a legal issue, subject to de novo review, even when the Tax Court's findings of fact go unchallenged. United Parcel Service, No.00-12720, slip op . at 5;IES Industries, Nos. 00-1221 and 00-1535, slip op. at 2.

[37] While the Partnerships' value as a takeover defense and a countercyclical investment may have been a "derivative or by product of its desire to reduce taxes," these aims nevertheless had value to Brunswick's business. The record contains an enormous amount of evidence substantiating Brunswick's concern with hostile takeovers. (Stip. paragraphs 23-55; Tr. 165-74, 180-81, 243-44, 386-87, 435-38, 914-16, 921-25, 929-39, 945, 1002; Exs. 503-J, 518-J, 527-R). Mr. Reichert, Brunswick's CEO, was concerned about holding a large amount of cash and he genuinely believed the investment in the Partnerships would make Brunswick less susceptible to a takeover. (Tr. 964-66)

[38] The Tax Court claimed that Brunswick "had already taken far more meaningful and effective steps to counter any takeover attempt." (Opinion 115) Whether the Partnerships were a "meaningful and effective step," however, is a matter for Brunswick's business judgment, not the Tax Court's. See, e.g., Boyd Gaming Corp. v. Commissioner, 177 F.3d 1096, 1101 (9th Cir. 1999). It is certainly not unreasonable to assume that having previously adopted at least five takeover defenses (Opinion 9-10), Brunswick may have wanted to add a sixth.

[39] Brunswick also managed the Partnerships' investments in an effort to maximize income. Brunswick rejected suggested investments over concerns in credit quality. (Tr. 482) It carefully studied the characteristics of the LIBOR Notes and created models to study their profitability. (Tr. 440-43, 469-75; Exs. 362-J(1), 362-J(2), 490-J, 491-J) When interest rates did not go the way Brunswick had expected, it did what any prudent business person would do -- it hedged the LIBOR Notes against downturns in interest rates and sold the LIBOR Notes when interest rates continued their decline. Brunswick's careful management of its risk represents "good business judgment" consistent with an intent to maximize profit and minimize risk from the LIBOR Notes. See IES Industries, Nos. 00-1221 and 00-1535, slip op. at 9. The Partnerships' and the Commissioner's expert witnesses both agreed that the LIBOR Notes were likely to produce a profit of in excess of $ 10 million at forecasted interest rates. (Tr. 1526-27; Ex. 539-P at 27) While the Tax Court held that these "modest profits" were "insufficient" for purposes of economic substance (Opinion 126), potential profits of this magnitude would have certainly had value.

[40] While the Partnerships did lose money on the LIBOR Notes, both Partnerships operated at a profit despite these losses. Saba's tax returns reported profits of over $11 million, while Otrabanda reported profits of over $6.5 million (not including the losses on the LIBOR Notes). (Exs.3-J(1-3),4-J(1-2)). These profits, even though only a "derivative or by product" of the motive to avoid tax, nevertheless represent profits which inured to and had value in the partners' respective businesses.

[41] As stated above, we do not contest the Tax Court's finding that Brunswick's business objectives were "derivative" of its tax motive. As the decisions in UPS and IES indicate, however, the Tax Court was wrong to ignore these business objectives simply because they may have been less important than Brunswick's tax motive.

[42] As the Partnerships stated in their opening brief, the issue of "business purpose" is largely irrelevant to the legal issue presented by this appeal, since section 1001 does not require a business purpose. Similarly, since the sale of the PPNs and CDs produced "practical legal effects," a business purpose is not required (at least in this Circuit). ¹² We believe it is important, however, to correct the Commissioner's mistaken understanding that the Partnerships have agreed with the Commissioner's "narrow notion" of business purpose. See United Parcel Service, No. 00-12720, slip op. at 9.

II. THE PARTNERSHIP'S CALCULATIONS OF GAIN AND LOSS ARE REQUIRED BY

[44] Therefore, the question which must be addressed is this: "Does section 453 authorize the deduction of noneconomic losses in specific years as part of the overall taxation of a multi-year installment sale?" Put another way, the issue is whether Congress had the power to authorize the deduction of noneconomic losses as part of the installment sale rules. See Horn, 968 F.2d at 1236-37. As we shall demonstrate below, the plain meaning, purpose, and legislative history of section 453 and its regulations "makes it clear that that is exactly what Congress intended to do." See Horn, 968 F.2d at 1236.

A. THE PARTNERSHIPS METICULOUSLY APPLIED THE PLAIN MEANING OF

[46] On March 23, 1990, Saba ¹³ sold the Chase PPNs to Norinchukin and Fuji in exchange for $160,000,000 and four LIBOR Notes, which provided for payments to be received after the taxable year of the sale. The Commissioner does not dispute that this transaction qualified as an "installment sale" as defined in section 453(b)(1). (Ptshp. Br. Addendum 1)

[47] Since the LIBOR Notes provided for a series of payments the amount of which could not be determined in advance, the sale of the PPNs qualified as a "contingent payment sale" as that term is defined in Temp. Treas. Reg. section 15A.453-1(c)(1). (Ptshp. Br. Addendum 3) The Commissioner does not dispute that the sale of the PPNs was a "contingent payment sale."

[48] The agreement for the sale of the PPNs did not contain a "stated maximum selling price": ¹⁴ as interest rates increased, the sales price of the PPNs (i.e., payments on the LIBOR Notes) would increase, and there was no limit to this potential increase. The sales agreement did, however, contain a "maximum period over which payments may be received," since the LIBOR Notes provided for a series of payment over five years. Id. at (c)(3)(i). Under the terms of the regulations, Saba was therefore required to allocate its basis in the PPNs to the "taxable years in which payment may be received under the agreement in equal annual increments." Id. Saba did so; since the sale agreement provided for a series of payments over six years (including the initial cash payment), Saba allocated one-sixth of its basis in the PPNs to the year of sale. Saba calculated this "annual increment" as $33,333,333 (1/6 of $200,000,000). The Commissioner has not disputed that Saba correctly applied the plain words of the regulation in allocating its basis in the PPNs to the taxable years in question.

[49] Having calculated its basis in the PPNs, Saba was required to report a gain for 1990 equal to cash received ($160,000,000) less its basis allocated to 1990 ($33,333,333). Saba reported this gain -- $126,666,667 -- on its tax return. Once again, the Commissioner has not disputed that Saba correctly performed the calculations required by the section 453 regulations. This gain of $126,666,667 is noneconomic, i.e., it does not represent an actual economic gain on the sale of the PPNs. Nevertheless, the rules of section 453 require that it be included in income.

[50] On August 17, 1990, Saba distributed three of the LIBOR Notes to Brunswick. Brunswick was required to report its basis in these three Notes in an amount equal to Saba's basis in the Notes (but not to exceed Brunswick's adjusted basis in the Partnership). Section 732(a). Thus, Brunswick calculated its basis in the three LIBOR Notes as $123,613,031, ¹⁵ or five-sixths of the original basis (i.e., the basis remaining after the allocation of basis to the partnership's taxable year ended March 31, 1990). During trial preparation the Commissioner correctly pointed out that Brunswick had erred by not reducing its basis to take into account payments on the LIBOR Notes allocated as a return of principal. Thus, the parties agreed that the basis in the three LIBOR Notes was $123,365,892, instead of $123,613,031. (Stip. paragraph 325) Since the Commissioner has actively assisted in making this calculation, the Commissioner plainly does not dispute that this calculation is in accordance with section 453.

[51] On August 17, 1990, Brunswick sold the three LIBOR Notes for $26,601,451 and calculated a tax loss of $96,764,441. ¹⁶ As the Commissioner recognizes, a "'loss' is defined as the sum by which the taxpayer's adjusted basis in the property exceeds the amount received." (Com[.] Br. 29) Brunswick's calculation exactly followed the Commissioner's statement of the rule: it calculated its loss as the excess of basis ($123,365,892) over the amount received ($26,601,451). When SBC sold the fourth LIBOR Note for $6,621,692, it used identical methods to calculate a basis of $39,252,979 in this Note. On the sale of this Note, SBC recorded a loss of $32,631,287.

[52] Therefore, we can calculate the net loss on the installment sale of the PPNs by totaling up the various gains and losses calculated by reference to the installment sale regulations. The net loss on the sale of the PPNs so calculated is $2,729,061:

          $126,666,667        Gain (March 23, 1990)

[54] Therefore, the end result of the Partnership's transactions, i.e., the net loss, calculated by reference to the section 453 regulations is precisely in accord with economic reality. To quote and paraphrase from the Commissioner's brief, "[t]his result reflects the economic reality of the entire transaction" since the purchase and sale of the PPNs and LIBOR Notes produced an economic loss of $2,729,061. (Com. Br. 33)

[55] The Commissioner apparently does not deny that the section 453 regulations as applied to the Partnerships' transactions produced the "correct result over the period of the transaction." ¹⁸ (Com[.] Br. 34) The Commissioner's objection, rather, is that, viewed in isolation, in any given year the section 453 regulations may create "paper (i.e., noneconomic) losses." (Com. Br. 43) (The regulations will, of course, also create large noneconomic gains, as they did in this case. It would appear, however, that the Commissioner is not concerned with taxpayers paying taxes on noneconomic gains, but is concerned only with taxpayers claiming noneconomic losses.)

[56] Given the application of the section 453 regulations to the facts of this case, the issue which must be addressed is this -- should this Court uphold the Commissioner in refusing to apply those regulations simply because those regulations may produce a noneconomic result in a given year?

[57] There is no authority to support the Commissioner's claim -- in fact, the legislative history and the regulations themselves explicitly recognize that the section 453 regulations WILL produce noneconomic gains and losses when a given year is viewed in isolation. Thus, the result in this case is absolutely consistent with the statutory and regulatory purpose.

[58] Before examining the purpose of the regulations, however, we must first determine whether the Commissioner is entitled to resort to the purpose of the regulations when his arguments are contrary to the plain meaning of the regulations.

B. THE COMMISSIONER MAY NOT DISREGARD THE PLAIN MEANING OF HIS

[60] In these circumstances, the plain meaning of the regulations must be followed, without resorting to an inquiry into Congressional intent. See, e.g., Exxon Corp. v. Commissioner, 102 T.C. 721, 726 (1994) ("[T]he plain words of a regulation should be followed where those words are clear and unambiguous, without resort to legislative intent or legislative history."). This is so even when adherence to the plain meaning of the regulations produces what may appear to be an unintended result. Brown Group, Inc. v. Commissioner, 77 F.3d 217, 222 (8th Cir. 1996); Woods Investment Co. v. Commissioner, 85 T.C. 274, 281-82 (1985).

[61] This result is even more clear when, as is the case here, the regulation in question is a legislative regulation of the agency's own making. ¹⁹ Transco Exploration Co. v. Commissioner, 95 T.C. 373, 387 (1990), aff'd, 949 F.2d 837 (5th Cir. 1992); Woods Investment, 85 T.C. at 282; see also United Dominion Industries, Inc. v. Commissioner, ___ U.S. ___, 121 S.Ct. 1934, 1943 (2001).

[62] After the Commissioner became aware of the facts of this case and other similar cases, he announced plans to amend the section 453 regulations to prevent the result he complains of here. Notice 90-56, 1990-2 C.B. 344. To date, however, the Commissioner has not proposed any changes to the section 453 regulations relevant to this case. The failure to amend the regulations further supports the Partnerships' claim that this Court should not tamper with the regulations as written. Transco Exploration, 95 T.C. at 387; Woods Investment, 85 T.C. at 282.

[63] The Commissioner's argument that the section 453 regulation is the "proper focus" of the economic substance doctrine would make more sense if the parties offered competing interpretations of the regulation; in that event, the Commissioner would certainly be entitled to argue that his interpretation was more in keeping with the underlying purpose of section 453. The Commissioner does not argue, however, that the Partnerships have misinterpreted or misapplied the regulations. Principles of economic substance act as rules of statutory interpretation, and since there is no genuine dispute over section 453's interpretation, there is no role for the economic substance doctrine in this case. Horn, 968 F.2d at 1238-39; see Higgins v. Marshall, 584 F.2d 1035, 1037-38 (D.C. Cir. 1978), cert. denied, 441 U.S. 931 (1979) (noting that there is no need to resort to tools of statutory construction or to rely on legislative history when language of statute is clear and unambiguous).

[64] The gist of the Commissioner's economic substance argument seems to be that the regulation should have been drafted differently. While the Commissioner may well be experiencing drafter's remorse, his regrets are not a proper foundation for the application of the economic substance doctrine.

C. CONGRESS UNDERSTOOD THAT THE SECTION 453 REGULATIONS WOULD

[66] The application of the section 453 regulations to the sales of the PPNs and CDs produced large gains. Those gains were offset by large losses when the LIBOR Notes were sold. This pattern -- noneconomic gains followed by offsetting noneconomic losses -- was expressly intended by Congress and is explicitly set forth in the text of the regulations. Indeed, in his brief, the Commissioner acknowledges that the section 453 regulations were designed to create "gain at the beginning of the transaction" and "loss, if any, at the end of the transaction so that any reported net loss from the transactions will be an ACTUAL, economic loss." (Com. Br. 43) ²⁰ As demonstrated above, that is exactly what happened in this case. If the Commissioner has a problem with this result, he should change the section 453 regulations or find another solution to his problem.

[67] When the amount of income produced by a sale is uncertain, i.e., the sale involves a contingent purchase price, Congress intended to err on the side of overstating the taxpayer's income by calculating income by reference to the "maximum selling price." S. Rep. No. 96-1000, 96th Cong., 2d Sess. 23 (1980), reprinted in 1980 U.S.C.C.A.N. 4696, 4718. (Addendum C) The regulations carry out this intent by "maximiz[ing] the selling price." Temp. Treas. Reg. section 15A.453-1(c)(2)(i)(A). The regulations also err on the side of accelerating the taxation of income to the maximum extent possible. The regulations expressly "accelerate payments to the earliest date or dates permitted under the [sale] agreement." Id.

[68] Conversely, the ratable basis recovery rule defers the recovery of basis in "equal annual increments" over the term of an installment sale agreement which does not include a maximum selling price. Temp. Treas. Reg. section 15A.453-1(c)(3)(i). Thus, while the taxation of income is accelerated to reflect cash received, the recovery of basis is not accelerated to match the receipt of cash. Moreover, the recovery of basis is even further deferred when the cash received in any given year is less than the basis allocated to that year, i.e., basis is further deferred when cash is deferred. Temp. Treas. Reg. section 15A.453-1(c)(3)(i). Since the regulations accelerate the taxation of cash but defer the recovery of basis, the regulations will necessarily produce noneconomic results whenever cash is not received in exactly the same "equal annual increments" as basis is recovered.

[69] The combination of accelerating income and deferring deductions virtually guarantees that section 453 will produce temporary distortions of a taxpayer's economic income. These temporary distortions of income, while undesirable, are the inevitable result of crafting a set of rules which may be applied to contingent income. When Congress created the rules for contingent installment sales, it was completely aware that these rules would create temporary distortions in a taxpayer's economic income. For example, as mentioned above, the legislative history and regulations require that profit be calculated by reference to the maximum selling price. In calculating the maximum selling price, all contingencies must be resolved in favor of the highest possible sales price. S. Rep. No. 96-1000, supra at 4718. (Addendum C) If it is later determined that the contingencies will not be satisfied, thus reducing the selling price, the taxpayer will then report a reduced amount of income. If the taxpayer had previously reported more income than the total income as recomputed, the taxpayer would deduct the excess as a loss in the year of adjustment. Id.

[70] In the example set forth in the legislative history, Congress clearly understood that, as a result of the regulations, in some instances taxpayers would report excess income in the early years of an installment sale. To eliminate this excess income, the taxpayer would be allowed a loss in a later year. This loss would obviously not be an economic loss; in fact, the loss would be allowable even if the transaction resulted in an overall gain. See Temp. Treas. Reg. section 15A.453-1(c)(2)(iii) (Example 5) (taxpayer entitled to claim a loss of $5 million in a subsequent year even though the transaction produced a profit of $25 million).

[71] The loss described above, even though explicitly authorized in the legislative history, would not pass the Commissioner's test for deductibility, as the loss does not reflect actual economic consequences. This loss is obviously not an "economic loss," since the taxpayer reported an overall gain.

[72] The example set forth in the legislative history has exactly the same effect as the Partnerships' transactions. The plain words of the statute and regulations required the Partnerships to report a substantial gain, which was later offset by loss deductions, resulting in a net loss which was exactly equal to the overall economic loss.

[73] The regulations explicitly recognize that the installment sale rules, including the ratable basis recovery rule, could "substantially and inappropriately defer or accelerate recovery" of basis, thereby producing a "SUBSTANTIAL DISTORTION" of a taxpayer's income. Temp. Treas. Reg. section 15A.453-1(c)(7) (emphasis added). (Addendum D) The regulations provide a remedy for this distortion in only two circumstances: (1) a taxpayer MAY REQUEST from the Commissioner an alternative method if basis recovery is substantially and inappropriately deferred (thus resulting in the acceleration of income, as occurred in connection with the Partnerships' sale of the PPNs); and (2) the Commissioner may require an alternative method if basis recovery is substantially and inappropriately accelerated (thus resulting in the deferral of taxable income). Id. The regulations do not provide the Commissioner a remedy in this situation, where income is accelerated and basis recovery is deferred. Since Congress delegated to the Commissioner the authority to promulgate the ratable basis recovery rule, and since the Partnerships followed the clear mandate of the legislative regulations, the result here cannot be other than precisely what the statute intended.

D. THE RULES OF THE SECTION 453 REGULATIONS ARE CONSISTENT WITH

[75] In particular, the goal of tax accounting is the "collection of revenue." Id. Since the principal purpose of tax accounting is the protection of the revenue, tax accounting emphasizes the immediate taxation of all revenue but defers the allowance of deductions:

The entire process of government depends upon the expeditious

[76] Thus, while financial accounting principles generally require a matching of expenses and deductions, tax accounting principles generally emphasize the acceleration of income and the deferral of deductions. Thor Power, 439 U.S. at 543; RCA, 664 F.2d at 888. Financial accounting, while it "doubtless presents a rather accurate image of the total financial structure . . . [it] fails to respect the criteria of annual tax accounting." American Automobile Ass'n v. United States, 367 U.S. 687, 692 (1961).

[77] Since tax accounting rules require the acceleration of income and the deferral of deductions, any transaction viewed in isolation will necessarily produce both "noneconomic gains" and "noneconomic losses." For example, in the well-known trilogy of Automobile Club of Michigan, American Automobile Ass'n, and Schlude, the Supreme Court held that taxpayers were subject to tax on pre-paid income, even though they had not yet been required to incur the expenses of providing the services related to the pre-paid income. These cases require taxpayers to report "noneconomic gain" when they receive cash, even though this gain does not reflect economic income, since it does not take into account associated deductions which will follow in later years. These "noneconomic gains" will be offset by "noneconomic losses" when the taxpayers incur expenses to provide the required services. The netting of these "gains" and "losses" over a period of years will accurately reflect the taxpayer's economic income, but in any given year tax accounting rules will necessarily mismatch the taxpayer's income and expenses in that year. See generally, Schlude v. Commissioner, 372 U.S. 128 (1963); American Automobile Ass'n, 367 U.S. 687; Automobile Club of Michigan v. Commissioner, 353 U.S. 180 (1957).

E. CONCLUSION: THE COMMISSIONER'S REMEDY DOES NOT LIE WITH

[79] The Commissioner's complaint lies not with section 453 and the CALCULATION of gain and loss; it lies with the ALLOCATION of gain and loss as calculated under section 453. A simple example will make this point clear. If ABN were subject to U.S. taxation, can there be any doubt that the Commissioner would insist on the taxation of the noneconomic gain allocated to ABN? ²¹

[80] The Commissioner has other tools at his disposal better suited to the task at hand. Most importantly, the facts of this case have been known to the Commissioner since August of 1990, when the Commissioner announced that he would change the section 453 regulations. He has not done so.

[81] The Commissioner has also put into place the so-called "anti-abuse rules," which are designed to remedy what the Commissioner views as potential problems in the operation of the partnership rules. Treas. Reg. section 1.701-2. These rules, however, are not effective for the taxable years involved in this case. Id. at (g).

III. THIS COURT HAS NO FACTUAL BASIS FOR RULING ON THE COMMISSIONER'S

whether, considering all the facts -- the agreement, the conduct

[83] Since the test for partnership status is inherently factual, this Court may not decide the Commissioner's cross-appeal in the first instance unless the Tax Court has made findings of fact on the partnership issue. ²² American Federal Group, 136 F.3d at 912 ("[E]ven partial affirmance on this alternative basis would require an improper incursion by this court into first-instance fact-finding of trial courts"); Transport Mfg. & Equip. Co. of Delaware v. Commissioner, 374 F.2d 173, 177 (8th Cir. 1967) ("Where the Tax Court has failed to make adequate fact findings, the appropriate remedy is to remand to the Tax Court for such findings."); see also United Parcel Service, No. 00-12720, slip op. at 12 (remanding to Tax Court to consider IRS's alternative arguments in support of deficiency determination).

B. THE COMMISSIONER MAY NOT RELY ON ASA AS ESTABLISHING THE

[85] There are obvious similarities between the facts of ASA and the facts of the present case: both cases involved the sale of private placement notes in exchange for cash and contingent notes. The Commissioner's argument depends, however, upon the relationships between the parties, and the facts of the two cases are remarkably different on this score. The relationships and agreements among the partners in ASA were very different from the relationships among the partners in this case. Since the partnership issue is inherently factual, the decision in ASA cannot be used as precedent in this case, ²⁴ particularly in the complete absence of any factual findings by the Tax Court on the partnership issue. Mendenhall, 5 F.3d at 1566-70.

[86] The Tax Court's decision in ASA was based on a series of detailed factual findings concerning the parties' relationships. First, and perhaps most importantly, the Tax Court found that the purported partners in ASA had no intent of living up to their written partnership agreement. The purported partners negotiated an unwritten agreement, called the "Bermuda Agreement" by the Tax Court, which actually governed their conduct. Their written agreement was a "facade." The key provisions of the Bermuda Agreement were:

that Allied Signal would pay all of the partnership's expenses

[87] Second, the Tax Court made extensive findings of fact indicating that, as part of the Bermuda Agreement, AlliedSignal had promised ABN a "specified return" equal to a 75 basis point return on funds advanced to the partnership, "no more and no less." 76 T.C.M. at 334. As a result of this "specified return," ABN's return was "independent of the performance of ASA's investments . . . . ABN did not have any profit potential beyond its specified return." Id. at 333.

[88] The agreement to pay ABN a "specified return" controlled the relationship between the parties. The parties carefully calculated the shortfall between the income allocated to the ABN partners and the specified return, and AlliedSignal recorded the shortfall as a liability on its books. In 1991, Allied Signal made a payment directly to ABN in accordance with the Bermuda Agreement. As the Tax Court held, this payment was calculated to provide ABN a specified return on its capital contribution, and thus violated the provisions of the partnership agreement which prohibited the payment of interest on capital contributions. When the parties later determined that AlliedSignal had overpaid ABN, AlliedSignal demanded and received a refund. Id. at 334.

[89] Third, the Tax Court held that, as a result of the Bermuda Agreement and contrary to the partnership agreement, ABN "did not intend to share in ASA's losses" and that the risk of any such losses was "de minimis." Id. at 335.

[90] Fourth, although the partnership agreement in ASA provided that the partners would bear expenses in accordance with their respective interests, pursuant to the terms of the Bermuda Agreement, "AlliedSignal was obligated to, and did in fact, pay all of ASA's expenses." Id.

[91] Fifth, the Tax Court found that AlliedSignal "made all of the critical decisions." ASA, 76 T.C.M. at 335.

[92] Based on the totality of these facts, the Tax Court concluded that AlliedSignal and ABN "did not share in the venture's profits and losses and did not comply with their partnership agreement when it conflicted with the Bermuda Agreement." Id. "AlliedSignal and ABN had a debtor-creditor relationship" since, under the terms of the Bermuda Agreement, AlliedSignal agreed to pay ABN a specified return without regard to the success or failure of ASA's operations. Id.

[93] On appeal, this Court reviewed the Tax Court's findings of fact under a "clear error" standard. ASA, 201 F.3d at 513 ("no clear error in the finding" that ABN's participation was not substantive). Most importantly, this Court found "no clear error in [the Tax Court's] findings that the direct payments made to ABN were to compensate it merely for its funding costs." Id. at 514. Thus, in ASA, ABN had no stake in the success or failure of the venture, which is obviously one of the critical aspects of partnership status. The Tax Court's conclusion that ABN had no stake in the success or failure of ASA certainly justified its ultimate conclusion that the parties had no intent to form a real partnership.

C. THERE IS NO BASIS IN THE RECORD OF THIS CASE TO CONCLUDE THAT

[95] As described above, see Part III.B., in ASA the Tax Court made a series of findings of fact in support of its conclusion that ASA should not be treated as a partnership. In contrast, in the present case, the Tax Court expressly declined to decide the partnership issue. (Opinion 88) As a result, the Tax Court did not make any findings of fact on the partnership issue. Significantly, on this appeal the Commissioner does not claim that the Tax Court made any findings of fact of the type it made in ASA.

[96] The Commissioner's argument on his cross-appeal invites this Court to act as a trial court and to make findings of fact concerning the partnership issue. The Commissioner's invitation is misdirected and is particularly inappropriate since, in response to the Tax Court's decision in ASA, at trial the Partnerships submitted substantial evidence to illustrate that the facts of this case are significantly different from the facts of ASA. Unlike the Commissioner, we do not believe it is appropriate for this Court to make findings of fact on the partnership issue. We briefly summarize this evidence below, however, simply to demonstrate the significant differences between the facts of this case and those of ASA.

o The relationships between Brunswick and ABN were governed by

[98] To understand the significance of the Tax Court's findings of fact, it is important to keep in mind exactly what the Partnerships argued and the Tax Court decided in the decision below. The Tax Court succinctly phrased the issue as follows:

[P]etitioner maintains that section 1001 (a) and Cottage

[99] Thus, the legal issue before the Tax Court was whether the transfer of the PPNs and CDs in exchange for the LIBOR Notes and cash required a "business purpose" or "potential for profit" in order to qualify as a sale for purposes of section 1001. The Tax Court decided this legal issue against the Partnerships. Since the Partnerships believe the Tax Court's interpretation of 1001 is wrong as a matter of law, solely for purposes of appealing the Tax Court's decision on this "legal issue," i.e., the 1001 issue, the Partnerships did not challenge the Tax Court's factual findings.

[100] As described above, the Tax Court did not reach the partnership issue, and did not make any findings of fact on this issue. The Commissioner's claim that the Partnerships have acquiesced in findings of fact the Tax Court did not make on issues the Court expressly declined to decide is obviously misguided.

[101] The Tax Court's opinion focused upon the purchase and sale of the CDs and PPNs and the profit to be derived from these transactions in deciding the application of 1001. The Tax Court did not examine the Partnerships' operations in their entirety. In particular, the Tax Court's opinion does not reflect that both Partnerships operated at a profit, even after the losses from the LIBOR Notes. See page 20, above.

[102] The Commissioner's cross-appeal raises a plethora of issues which have never been addressed by any court. How should ABN's investment be characterized? How should the amounts which ABN received be characterized? Should Brunswick be allowed interest deductions for the income received by ABN? The Commissioner does not address how these issues arising from his cross-appeal are to be resolved. Since these issues have never been reviewed by any court, the partnership issue is not ready for resolution.

D. THE COMMISSIONER'S SUGGESTION THAT ASA CREATED A NEW TEST FOR

[104] The Commissioner seems to suggest, however, that ASA created a new legal standard, under which a partnership will not be respected if it lacks a nontax business purpose. Such a standard would obviously have been unnecessary to the decision in ASA, since that decision is amply supported by the Tax Court's factual findings. In addition, any such holding would be contrary to decades of established precedent, in every Circuit which has considered the issue. Therefore, this Court should resist the Commissioner's attempt to rewrite the law -- particularly since the absence of factual findings on the issue would require this Court to rewrite the law in a vacuum.

[105] In Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943), the Supreme Court established a test under which a corporation must be respected for tax purposes if (1) it is formed for a business purpose or (2) it conducts business activity:

The doctrine of corporate entity fills a useful purpose in

[106] The two-part test as set forth in Moline Properties has been extended to partnerships. See, e.g., Bertoli v. Commissioner, 103 T.C. 501, 511-12 (1994).

[107] Under the two-part test set forth in Moline, an entity must be respected for federal income tax purposes if it actually engages in business activity, even if the entity was formed for the purpose of tax avoidance. Thus, the purpose for forming a corporation or partnership is irrelevant so long as the corporation or partnership engages in business activity.

[108] Thus, in Keller v. Commissioner, 723 F.2d 58 (10th Cir. 1983), aff'g, 77 T.C. 1014 (1981), the Commissioner argued that a physician's professional corporation should be disregarded because it was created for a tax avoidance purpose. The Tax Court did not agree that there was such a purpose, but would have respected the corporation in any event:

Similarly, even if petitioner's desire to obtain the benefits of

[109] The level of activity necessary to sustain a[n] entity's separate existence is minimal. In The Gregg Company of Delaware v. Commissioner, 239 F.2d 498 (2d Cir. 1956), cert. denied, 353 U.S. 946 (1957), the taxpayer argued that a corporation formed as part of a plan to avoid U.S. tax should be disregarded because it "was not engaged in any business activity." Id. at 502. The Second Circuit disagreed, holding that the receipt of dividends was sufficient business activity under Moline Properties:

The petitioner was originally formed in order to effectuate a

[110] In ASA, this Court suggested that National Investors Corp. v. Hoey, 144 F.2d 466 (2d Cir. 1944) imposed a unitary test for entity status. ASA, 201 F.3d at 512-13. In The Gregg Company, however, which was decided after National Investors, the Second Circuit affirmed the two-part test and upheld the status of a corporation created for the elimination of tax, so long as the corporation engaged in business activity.

[111] Every Circuit which has considered the issue has agreed that Moline Properties established a two-part test under which a[n] entity must be respected if it engages in business activity. ²⁷ Therefore, this Circuit's suggestion that Moline Properties does not require "a two-pronged inquiry [but] is in fact a unitary test . . . under which the absence of a nontax business purpose is fatal," ASA, 201 F.3d at 512, would appear to be in conflict with every other Circuit which has ever considered the issue.

[112] In addition, such a reading of ASA would be in direct conflict with this Circuit's opinion in Horn. The taxpayer in Horn quite plainly had no "nontax business purpose," and thus a different result would have been required in Horn had ASA's "nontax business purpose" test been applied in Horn. The Commissioner interprets ASA as imposing a "nontax business purpose" as a requirement which applies independently of the Code. To the extent ASA imposes such a requirement, it is in direct conflict with the decision in Horn.

[113] ASA's emphasis on tax motivation is also difficult to reconcile with both Gregory and Horn. In the Partnerships' opening brief, we argued in detail that questions of economic substance must be determined by "what actually occurred." Gregory, 239 U.S. at 469. Issues of economic substance must be decided by detailed examination of the facts, and cannot be determined by reference to the taxpayer's intent. See United Parcel Service, No. 00-12720, slip op. at 9-10; IES Industries, Nos. 00-1221 and 00-1535, slip op. at 8.

[114] When we examine the facts in ASA, i.e., "what actually occurred," this Circuit's conclusion in ASA is fully justified. The parties did not intend to share in the profits of the partnership; they instead agreed that AlliedSignal would pay ABN a "specified return," and thus they created a debtor-credit relationship.

2. ASA DOES NOT TAKE INTO ACCOUNT THE LEGISLATIVE HISTORY OF

[116] Following the decision in Commissioner v. Culbertson, some cases held that the participation of a partner in a partnership would not be respected if the partner's participation lacked business purpose. See H.R. Rep. No. 586, 82d Cong., 1st Sess. (1951), reprinted in 1951 U.S.C.C.A.N. 1781, 1814 (reviewing case law subsequent to Culbertson). (Addendum E)

[117] In response to these decisions, Congress enacted 704(e)(1) to eliminate any requirement that participation in a partnership be motivated by a business purpose:

The test is no longer whether the parties acted in good faith

[118] Section 704(e)(1) provides 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. (Addendum F) The legislative history makes clear that the purpose for bringing the partner into the partnership is irrelevant so long as the "ownership is real." H.R. Rep. No. 586, supra at 1814.

[119] While 704(e)(1) was primarily aimed at certain decisions involving family partnerships, Congress did not intend to limit 704(e)(1) to family partnerships. Evans, 447 F.2d at 551. Indeed, the legislative history of 704(e)(1) explicitly states that the rules for family partnerships were to be the same as for other forms of business. H.R. Rep. No. 586, supra at 1814.

[120] Thus, to paraphrase Horn, we must again ask whether Congress could have approved the formation of partnerships which lack a business purpose. The legislative history of 704(e)(1) "makes it clear that that is exactly what Congress intended to do." See Horn, 968 F.2d at 1236.

[121] Two recent cases in the Tax Court, while not relying on 704(e)(1), hold that partnerships must be respected for federal income tax purposes even when the formation of the partnerships is motivated solely by tax considerations. See Estate of Strangi v. Commissioner, 115 T.C. No. 35 (2000); Knight v. Commissioner, 115 T.C. No. 36 (2000). These cases are consistent with 704(e)(1) and are inconsistent with the Commissioner's expansive reading of ASA.

[122] Finally, we note that 704(e)(1) is consistent with the result in ASA. Since ABN had a creditor-debtor relationship with AlliedSignal, ABN did not contribute capital to the partnership; ABN in effect made a loan to AlliedSignal. As Congress stated in enacting section 704(e)(1), "the Commissioner and the courts [are] free to inquire" whether the purported partner "actually owns the interest in the partnership." H.R. Rep. No. 586, supra at 1814. Since ABN merely made a loan to AlliedSignal, and did not participate in the profits of the venture, it owned no interest in the partnership.

CONCLUSION

[123] WHEREFORE, the Partnerships respectfully request that the decision of the Tax Court be reversed and that this case be remanded to the Tax Court for consideration of the Commissioner's cross- appeal.

Dated: June 28, 2001

² The logical import of the Commissioner's decision to press his cross-appeal as his primary argument is that he believes the Tax Court's decision on section 10001 cannot be sustained on appeal. This conclusion is consistent with the Commissioner's minimal defense of the Tax Court's holding on section 1001.

³ "Nor do we think a dog is to be hanged simply by giving him a bad name." Fabreeka Products Co. v. Commissioner, 294 F.2d 876, 878 n.2 (1st Cir. 1961). In recent days, two Circuit Courts have confirmed that tax avoidance motives play a minimal role in questions of economic substance. United Parcel Service of America, Inc. v. Commissioner, No. 00-12720 (11th Cir. filed June 20, 2001); IES Industries, Inc. v. Commissioner, Nos. 00-1221 and 00-1535 (8th Cir. filed June 14, 2001). The slip opinions in these two cases are included in the Addendum of legal authorities attached to this brief.

⁴ For example, the Commissioner claims that the section 453 regulation "obviously contemplates" that the same person "will report the gain at the beginning of the transaction and will claim the loss, if any, at the end of the transaction." (Com. Br. 43) Despite the Commissioner's claim that this principle is "obvious," the Commissioner does not provide any citations to section 453, the regulations, or legislative history for his claim. The purpose of section 453 is to calculate gain or loss in the context of an installment sale. There is nothing in section 453 which controls TO WHOM gain or loss is allocated; other sections of the Code, see, e.g., section 704(b), control this issue. The Commissioner made an argument based on section 704(b) in the Tax Court, but he does not renew that argument on this appeal.

⁵ See, e.g., Kraft Foods Co. v. Commissioner, 232 F.2d 118 (2d Cir. 1956) and other cases cited on pages 29-30 and 40 of the Partnerships' opening brief.

⁶ The Partnerships also acquired cash, which also has economic characteristics significantly different from the PPNs and CDs.

⁷ As described in the Partnerships' opening brief, a transfer of property in exchange for property with materially different characteristics, which therefore qualifies as a " sale" for purposes of section 1001, will, by definition, produce "practical economic effects."

⁸ Since UPS was decided under 11th Circuit law, that case required the presence of both "practical economic effects" as well as a "nontax business purpose." United Parcel Service, No. 00-12720, slip. op. at 6-7 n.2. The law in this Circuit requires either "practical economic effects" or a "nontax business purpose." See Horn, 968 F.2d at 1237-38. In Del Commercial Properties, Inc. v. Commissioner, No. 00- 1313, slip op. at 4 (D.C. Cir. filed June 8, 2001), this Court held against a transaction which lacked both a "business purpose" and "actual, non-tax related changes in economic position" (quoting Northern Ind. Pub. Serv. Co. v. Commissioner, 115 F.3d 506, 512 (7th Cir. 1997)).

⁹ See generally ACM Partnership, 157 F.3d 231; United States v. Wexler, 31 F.3d 117 (3d Cir. 1994), cert. denied, 513 U.S. 1190 (1995); Lerman v. Commissioner, 939 F.2d 44 (3d Cir.), cert. denied, 502 U.S. 984 (1991).

¹⁰ The Commissioner refers briefly to Higgins v. Smith, 308 U.S. 473 (1940). The Commissioner does not question, however, the Partnership's reading of that case as one in which the purported transfer failed to shift dominion and control over the property in question. Since the Commissioner does not question the Tax Court's factual finding that the Partnerships transferred control and ownership of the PPNs and CDs to third parties, Higgins does not help the Commissioner.

¹¹ The Eighth Circuit also has recently weighed in on the issue of business purpose and found that a transaction does not lack business purpose merely because it was motivated by tax considerations. See IES Industries, Nos. 00-1221 and 00-1535, slip op. at 7-8.

¹² See n.8, above.

¹³ Since the calculation for Otrabanda is similar in nature, for purposes of simplicity we have included only the Saba calculation.

¹⁴ Id. at (c)(3)(i). (Ptshp. Br. Addendum 3).

¹⁵ In Brunswick's original calculations, its basis in the LIBOR Notes was limited by its adjusted basis in Saba. (Stip. paragraph 326-27)

¹⁶ This is the amount which Brunswick should have recorded, taking into account the corrected basis of $123,365,892.

¹⁷ The original value of the LIBOR Notes, including transaction costs, was $40,000,000. Over the life of the Notes, Saba and SBC received payments allocated to principal, i.e., a return of their investment, in the following amounts, leaving remaining principal of $35,952,202.97:

                                   $40,000,000.00

¹⁸ On pages 33 and 34 of his brief, the Commissioner posits an example which he claims is the "model" for the Merrill Lynch transaction. The Commissioner agrees that this example "produced the correct result OVER THE PERIOD OF THE TRANSACTION." (Com. Br. 34)

¹⁹ Congress delegated authority over the section 453 regulations to the Secretary of the Treasury. Section 453(j)(1).

²⁰ On pages 32-34 of his brief, the Commissioner sets forth two examples which confirm this rule. In the first example, involving a profit of $1,500, gain is reported in each year. In the second example, involving a loss of $1,500, the loss (unlike the gain in the prior example) is deferred until the end of the transaction. The Tax Court's opinion also acknowledges that section 453 "may have the effect" of accelerating income and deferring losses. (Opinion 94)

²¹ See Kenneth W. Gideon, Assessing the Income Tax: Transparency, Simplicity, Fairness, 98 TNT 225-71 , Nov. 23, 1998 ("Could, for example, another taxpayer with a problem opposite that of ACM invoke the ACM decision to avoid the creation of inappropriate 'artificial' income by the ratable basis recovery regulations?").

²² The Commissioner relies on American Tel. & Tel. Co. v. Federal Communications Comm'n., 978 F.2d 727 (D.C. Cir. 1992) for his claim that a remand is not required. The AT&T case did not involve any findings of fact, but was limited to issues of "statutory construction" on which this Circuit had previously ruled. Id. at 735. AT&T is accordingly irrelevant to issues, such as the partnership issue, which are inherently factual.

²³ The Commissioner's claim to "affirm the Tax Court's decision on the basis of ASA" is misleading, as the Commissioner concedes that a decision based on ASA would produce a different outcome from the Tax Court's decision. (Com. Br. 26 n.11)

²⁴ In his response to ASA's Petition for Rehearing, the Commissioner described ASA as a "fact-specific decision." Appellee's Response, April 4, 2000, p. 2.

²⁵ The Commissioner places emphasis on certain documents prepared by ABN which indicate that ABN wanted to obtain a fixed return for its investment in Saba. (Com. Br. 8-9) These documents were prepared by ABN before it ever met anyone from Brunswick. While ABN may have wanted to negotiate a fixed return with Brunswick, it obviously was not successful in doing so. The Commissioner has not alleged that Brunswick paid ABN a "specified return" in the manner paid by AlliedSignal.

²⁶ As described above, the Commissioner is incorrect when he states that the Partnerships "do not challenge on appeal" the Tax Court's resolution of the business purpose issue. See Part I.B.4.

²⁷ See, e.g., Sargent v. Commissioner, 929 F.2d 1252, 1259 (8th Cir. 1991); Gulf Oil Corp. v. Commissioner, 914 F.2d 396, 411 (3d Cir. 1990); Humana, Inc. v. Commissioner, 881 F.2d 247, 252 (6th Cir. 1989); Vaughn v. United States, 740 F.2d 941, 943 (Fed. Cir. 1984); Taylor v. Commissioner, 445 F.2d 455, 457 (1st Cir. 1971); Kimbrell v. Commissioner, 371 F.2d 897, 901 (5th Cir. 1967); Dodd v. Commissioner, 298 F.2d 570, 577 (4th Cir. 1962).