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 insists 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) (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. In the alternative, the Justice Department insists that the Tax Court correctly held that the Merrill Lynch transactions engaged in by Saba and Otrabanda lacked sufficient economic substance to give rise to recognizable gains and losses.

A. Parties and Amici. The parties in the Tax Court and in this Court are Saba Partnership, Brunswick Corporation, Tax Matters Partner, Otrabanda Investerings Partnership, Brunswick Corporation, Tax Matters Partner, and the Commissioner of Internal Revenue. There were no amici in the Tax Court and are no amici on appeal.

B. Rulings under Review. The rulings under review are the memorandum opinion of the Tax Court (Hon. Arthur L. Nims, III) issued October 27, 1999, and the Tax Court's subsequent decisions in conformity with its opinion entered on April 19, 2000.

C. Related Cases. This case was not previously before this Court or any other appellate court. This case involves the tax consequences of a transaction that is similar to the transaction involved in ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (D.C. Cir.), cert. denied, 121 S.Ct. 171 (2000). Another case that involves a similar transaction is pending in the District Court for the District of Columbia (Boca Investerings Partnership v. United States, No. 1:97-cv-602).

Jurisdictional statement

Statement of the issue

Statement of the case

Statement of the facts

Summary of argument

Argument:

Certificate of compliance with type volume limitation 53

Statutory Appendix

* ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998),

Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991)

Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966), cert. denied,

Gregory v. Helvering, 293 U.S. 465 (1935)

Higgins v. Smith, 308 U.S. 473 (1940)

* Horn v. Commissioner, 968 F.2d 1229 (D.C. Cir. 1992)

International Trading Co. v. Commissioner, 484 F.2d 707 (7th Cir.

Knight v. Commissioner, 115 T.C. No. 36 (2000)

Martin v. Commissioner, 61 F.2d 942 (2d Cir. 1932)

Masonry Masters, Inc. v. Nelson, 105 F.3d 708 (D.C. Cir. 1997)

Massey Motors v. United States, 364 U.S. 92 (1960)

Steen, In re, 509 F.2d 1398 (9th Cir. 1975)

Strangi v. Commissioner, 115 T.C. No. 35 (2000)

United States v. Wexler, 31 F.3d 117 (3d Cir. 1994)

Statutes:

1. Whether appellants Saba Partnership and Otrabanda Investerings Partnership are genuine partnerships for federal tax purposes.

2. Whether prearranged, tax-motivated transactions engaged in by appellants that were designed to create paper losses for Brunswick Corporation lacked economic substance, and therefore did not give rise to recognizable gains and losses for federal tax purposes.

STATEMENT OF THE CASE

[2] In 1990, Brunswick Corporation entered into two arrangements designed 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 arrangements, which featured "partnerships" (Saba and Otrabanda) between Brunswick, a Brunswick subsidiary, and foreign entities that were not subject to United States taxation, allocated most of the paper gain arising in the first year of the transaction to the foreign entities, while allocating most of the corresponding paper losses arising in the later years of the transaction to Brunswick and its subsidiary. 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.

[3] The Commissioner of Internal Revenue determined, inter alia, that the transactions that gave rise to the paper gains and paper 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 Commissioner's proposed adjustments. (Saba Petition; Otrabanda Petition.)

[4] On October 27, 1999, the Tax Court (Hon. Arthur L. Nims, III) filed a memorandum opinion, unofficially reported at 78 T.C.M. (CCH) 684, upholding the Commissioner's determination that the tax- motivated transactions engaged in by Saba and Otrabanda lacked economic substance. (Tax Court Opinion.) The Tax Court subsequently entered decisions in conformity with its opinion. (Saba Decision; Otrabanda Decision.)

STATEMENT OF THE FACTS

[5] In 1989, Merrill Lynch Company developed a tax avoidance scheme that was designed to generate large capital losses for a United States corporation that could be used to shelter from tax an equal amount of the corporation's capital gain. See ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (D.C. Cir.), cert. denied, 121 S.Ct. 171 (2000); ACM Partnership v. Commissioner, 157 F.3d 231, 233-234 (3d Cir. 1998), cert. denied, 119 S.Ct. 1251 (1999). The plan involved the formation of a "partnership" between the United States corporation and a foreign entity not subject to United States taxation, and a transaction that purported to comply with the terms of the ratable basis recovery regulation (Temp. Treas. Reg. section 15A.453-1(c)(3)(i)). That regulation provides a rule of tax accounting for "contingent installment sales" of property reportable under the installment method of accounting provided by Section 453 of the Internal Revenue Code. A contingent installment sale is a transaction that extends over a period of more than one year and has an indeterminate sales price on the date of sale. The Merrill Lynch transaction used the partnership structure and the ratable basis recovery regulation to create a large paper loss for the United States corporation while creating a large (nontaxable) gain for the foreign entity. The foreign entity received a fee for its participation in the scheme. ¹

[6] Brunswick Corporation is a United States corporation with headquarters in Skokie, Illinois. (First Stipulation of Facts at paragraph 8.) During the late 1980s, Brunswick's operations were organized among three lines of business: Marine, Recreation, and Technical. (Id. at paragraph 10.) Brunswick also owned over 3.1 million shares of Nireco Corporation, a Japanese corporation, as of January 1989. (Id. at paragraph 115.)

[7] In 1989, Brunswick decided to sell a number of businesses in its Technical group. (Id. at paragraph 69.) During that year, Brunswick also sold 400,000 of its Nireco shares and decided to sell its remaining interest in that corporation. (Id. at paragraphs 117, 118.) Brunswick retained Merrill Lynch to serve as its exclusive financial advisor in connection with the sale of a division in the Technical group and in connection with the sale of the Nireco stock. (Id. at paragraphs 73, 174; Exs. 21-J, 63-J.)

[8] In 1990, a Brunswick subsidiary sold 2,836,000 shares of Nireco stock. (First Stipulation of Facts at paragraph 145.) During that year, Brunswick also sold several of its businesses in the Technical group. (Id. at paragraphs 16, 69-110.) On its 1990 federal income tax return, Brunswick reported capital gains of $29,809,938 from the sale of the businesses in its Technical group (id. at paragraph 71), and reported capital gains of $100,782,182 from the sale of the Nireco shares (id. at paragraph 144).

[9] In December 1989, representatives of Brunswick met with representatives of Merrill Lynch to discuss a proposed transaction "to generate sufficient capital losses to offset the capital gain which will be generated on the sale of the Nireco shares." (Ex. 408- J.) The proposed transaction involved a partnership between Brunswick and a foreign entity that was similar to the arrangement that Merrill Lynch had marketed to other large United States corporations. According to a memorandum prepared by Judith P. Zelisko, Brunswick's assistant vice-president and Director of Taxes, the proposed transaction involved the following steps (Ex. 408-J):

[11] The foreign partner in the proposed partnership was to be Algemene Bank Nederland N.V. (ABN), a Netherlands financial institution that had played the role of the foreign partner in similar transactions that Merrill Lynch had marketed to other United States corporations. See ASA, 201 F.3d at 508; ACM, 157 F.3d at 235. Hans den Baas, the former head of the Financial Engineering Group at ABN's New York subsidiary (known as ABN New York), was intimately involved in the Merrill Lynch transactions with respect to Brunswick and other United States corporations. See ASA, 201 F.3d at 508-509. As part of the process of obtaining approval for the Brunswick venture from ABN's headquarters in the Netherlands, den Baas prepared a memorandum that discussed the proposed transaction. (Ex. 90-J.) The memorandum, which was entitled "New proposal for a $ 180 mm. facility for a Netherlands Antilles SPC to be managed by ABN Trust Curacao," stated as follows (Ex. 90-J):

[14] The "partnership," which was denominated Saba Partnership, was formed on February 23, 1990. The entity consisted of Brunswick, Skokie Investment Corporation (Skokie), a newly-created, wholly- owned subsidiary of Brunswick, and Sodbury Corporation, N.V. (Sodbury), a Netherlands Antilles corporation. (Ex. 108-J.) Sodbury was controlled by two foundations that were controlled in turn by ABN. (First Stipulation of Facts at paragraph 173.) The partners contributed a total of $200 million to the partnership on February 28, 1990. (Id. at paragraph 188.) Brunswick contributed $19 million in exchange for a 9.5% partnership interest; Skokie contributed $1 million in exchange for a .5% partnership interest; Sodbury contributed $180 million in exchange for a 90.0% partnership interest. (Id.) ² The partnership agreement recited that Saba (Ex. 107-J at Section 2.04):

[15] On March 23, 1990, Saba sold two of the private placement notes to Norinchukin Bank for $80 million in cash and two London Interbank Offering Rate ("LIBOR") Notes, ³ and sold the other two private placement notes to Fuji Bank for $80 million in cash and two other LIBOR notes. (Id. at paragraphs 222, 223.) LIBOR Notes are instruments that pay variable amounts at three-month periods on a fixed sum ("a notional amount"). (Id. at paragraph 220.) The variable amounts reflect adjustments in the LIBOR during the three-month period. The purchaser of a LIBOR Note makes a profit if the rate rises, and incurs a loss if the rate declines.

[16] The LIBOR Notes received by Saba from Norinchukin provided for twenty quarterly payments (commencing July 2, 1990) of an amount equal to 3-month LIBOR on a total notional principal amount of $51,530,000 (id. at paragraphs 220, 223), while the LIBOR Notes received by Saba from Fuji provided for twenty quarterly payments of 3-month LIBOR on a total notional principal amount of $51,440,000 (id. at paragraphs 224). Saba sold the four private placement notes at a discount of $1,500,000. (Id. at paragraph 233.) The origination value of the Norinchukin notes was $19,297,192, as was the origination value of the Fuji notes. (Id. at paragraph 235.) Saba invested the cash received from the sale of the private placement notes in time deposits and commercial paper. (Id. at paragraph 238.)

[17] On its partnership tax return for the 1990 taxable year (which ended on March 31, 1990), Saba treated the sale of the private placement notes as an "installment sale" within the meaning of Section 453(b) of the Code, reportable under the "contingent payment sale" provisions of Temp. Treas. Reg. section 15A.453-1(c). (Id. at paragraph 239.) Saba reported a short-term capital gain of $126,666,667 for 1990, reflecting the excess of the cash received from the sale of the private placement notes ($160,000,000) over the portion of the basis in the LIBOR Notes recovered during that year (computed by Saba to be $33,333,333). (Id. at paragraph 240.) The gain was allocated as follows: Brunswick: $12,033,334; Skokie: $633,333; Sodbury: $114,000,000 (Id. at paragraph 241.) Sodbury, which was not subject to United States taxation, did not pay any Netherlands Antilles tax on the capital gain allocated to it from the sale of the private placement notes.

[18] Sodbury entered into interest rate swaps with ABN and ABN entered into mirror swaps with a Merrill Lynch subsidiary (MLCS) to hedge the interest rate risk associated with the LIBOR Notes. (Id. at paragraph 305, Tax Court Trial Transcript at 1100.) Those swap transactions, which were mandated by ABN's main office in the Netherlands (Transcript at 1073), eliminated any possibility of gain or loss from the LIBOR Notes for Sodbury and ABN, since the correlation between the swaps and the LIBOR Notes was 99.999 percent (id. at 1100). As a result, they effectively "converted a very volatile investment into * * * a straight amortizing loan." (Id. at 1099). ABN entered into the swaps because it was "not in the business of gambling." (Id. at 1100.)

[19] On July 3, 1990, Brunswick entered into a consulting agreement with ABN. (First Stipulation of Facts at paragraph 274.) Under this agreement, Brunswick paid ABN $250,000 on or about July 10, 1990, $250,000 on or about February 27, 1991, and $250,000 on or about February 27, 1992. (Id. at paragraph 275.)

[20] On July 13, 1990, Brunswick purchased 50% of Sodbury's interest in Saba for $92,452,227 in cash. (Id. at paragraph 269.) The purchase left Brunswick with a 54.5% interest in Saba, left Skokie with a .5% interest in Saba, and left Sodbury with a 45% interest in Saba. (Id. at paragraph 270.) For purposes of computing the price of the purchase, the parties used a valuation prepared by Merrill Lynch. (Id. at paragraph 272.) Merrill Lynch valued the four LIBOR Notes at $36,215,000, and added $2,035,000 to that amount. (Id.) The additional amount consisted of a $1,500,000 private placement discount and a $535,000 "fee." (Ex. 136-J at BC010177.)

[21] On August 17, 1990, Saba distributed the two Fuji LIBOR Notes and one of the two Norinchukin LIBOR Notes to Brunswick. (First Stipulation of Facts at paragraph 280.) On that date, Saba also distributed $266,835 in cash to Skokie and $24,016,789 in cash to Sodbury. (Id.) The parties valued the four LIBOR Notes at $38,794,000, a figure that reflected the $1,500,000 private placement discount and the $535,000 fee. (Id. at paragraph 281.) Brunswick and Merrill Lynch entered into swap transactions with respect to the LIBOR Notes that had been distributed to Brunswick. (Id. at paragraph 293.)

[22] On September 6, 1990, Brunswick sold the two Fuji LIBOR Notes and the one Norinchukin LIBOR Note to the Bank of Tokyo for $26,601,451. (Id. at paragraph 321.) Brunswick computed its basis in those Notes as of that date as $125,000,000, (id. at paragraph 324), ⁴ and computed its basis in Saba as of that date as $123,613,031 (id. at paragraph 326).

[23] On its 1990 consolidated federal income tax return, Brunswick reported a net long-term capital loss of $84,978,246 from its participation in Saba. (Id. at paragraph 328.) This figure reflected the reported capital loss on the sale of the two Fuji LIBOR Notes and the one Norinchukin LIBOR Note ($97,011,580) less Brunswick's and Skokie's distributive share of the gain reported by Saba on the sale of the private placement notes ($12,033,334). (Id.) Brunswick's actual loss on the sale of the three LIBOR Notes was $2,485,549. (First Stipulation of Facts at paragraph 330.)

[24] On September 14, 1990, Saba reduced Sodbury's interest in the "partnership" from 45% to 10% by paying Sodbury $60,204,145 in cash. (Id. at paragraph 336.) The transaction left Brunswick with an 89.18% interest in Saba, left Skokie with .82% interest in Saba, and left Sodbury with a 10% interest in Saba. (Id. at paragraph 337.)

[25] On April 3, 1991, Saba formed SBC International Holdings, Inc. (SBC). (Id. at paragraph 340.) Saba received all of the outstanding stock in that corporation in exchange for cash, commercial paper and the second Norinchukin LIBOR Note, which was valued at $7,752,000. (Id.) On June 21, 1991, Saba was dissolved. (Id. at paragraph 349.) As part of the dissolution, Brunswick received the outstanding stock in SBC, while Skokie and Sodbury received cash. (Id. at paragraph 352.)

[26] On July 2, 1991, SBC transferred the Norinchukin LIBOR Note to Norinchukin for $7,040,954. (Id. at paragraph 379.) Brunswick computed its basis in that Note as $41,666,667. (Id. at paragraph 381.)

[27] On its 1991 consolidated federal income tax return, Brunswick reported a long-term capital loss of $32,631,287 from the disposition of the Norinchukin LIBOR Note. (Id. at paragraph 387.) Brunswick's actual loss on the transaction, however, was only $719,046. (Id. at paragraph 388.) Brunswick thus reported a net long- term capital loss of $117,609,533 (1990 loss of $84,978,246 plus 1991 loss of $32,631,287) from its involvement in the Merrill Lynch transaction through Saba even though its actual loss on the transaction was only $3,204,595 (1990 loss of $2,485,549 plus 1991 loss of $719,046).

[28] In June 1990, Brunswick approached ABN with a proposal to create a second partnership. (Ex. 98-J at BC009186.) ⁵ A credit proposal prepared by den Baas explained that (ibid.):

[29] The second "partnership," which was denominated Otrabanda Investerings Partnership, was formed on June 20, 1990. (First Stipulation of Facts at paragraph 423.) The entity consisted of Brunswick, Skokie, and Bartolo Corporation, N.V., a Netherlands Antilles corporation. The stock of Bartolo was owned by Clavicor Corporation, N.V., a corporation whose stock was owned by two foundations that had been created by ABN (Rocky Foundation and Jasper Foundation). (Id. at paragraphs 412-416.) This structure was used at Brunswick's behest. (Id. at paragraph 417.) Brunswick paid Merrill Lynch at least $250,000 for services provided to Otrabanda. (Tax Court Opinion at 123-124.)

[30] The parties contributed a total of $150,000,000 to the Otrabanda Partnership. (Id. at paragraph 426.) Brunswick contributed $13,500,000 in exchange for a 9.0% partnership interest, Skokie contributed $1,500,000 in exchange for a 1.0% partnership interest, and Bartolo contributed $135,000,000 in exchange for a 90% partnership interest. (Id.). ⁶

[31] On June 29, 1990, Otrabanda purchased four floating rate $25 million certificates of deposit from the Industrial Bank of Japan for $100,000,000. (Id. at paragraph 446.) The instruments, which were not registered under the Securities Act of 1933, and were not traded on an established securities market (id. at paragraph 451), had a maturity date of June 21, 1995 (id. at paragraph 448), and paid interest at monthly intervals (id. at paragraph 449).

[32] On July 27, 1990, Otrabanda sold the four certificates of deposit to Sumitomo Bank Capital Markets for $80,000,000 in cash and four LIBOR Notes. (Id. at paragraphs 460, 461.) The LIBOR Notes provided for twenty quarterly payments (commencing November 1, 1990) of 3-month LIBOR on a total notional principal amount of $53,396,000. (Id. at paragraphs 461, 464.) Otrabanda sold the certificates of deposit at a discount of $750,000. (Id. at paragraph 467.) The origination value of the instruments was $19,451,562. (Id. at paragraph 469.) Otrabanda invested the cash received from the sale of the instruments in time deposits and commercial paper. (Id. at paragraph 471.)

[33] On its partnership tax return for the 1990 taxable year (which ended on July 31, 1990), Otrabanda treated the sale of the certificates of deposit as an installment sale within the meaning of Section 453(b) of the Code reportable under the "contingent payment sale" provisions of Temp. Treas. Reg. section 15A.453-1(c). (Id. at paragraph 472.) Otrabanda reported a capital gain of $63,333,334 from the transaction, reflecting the excess of the cash received from Sumitomo ($80,000,000) over the portion of the basis in the LIBOR Notes recovered during that year ($16,666,666). (Id. at paragraph 473.) The gain was allocated as follows: Brunswick: $5,700,000; Skokie: $633,333; Bartolo: $57,000,001. (Id. at paragraph 474.) Bartolo did not pay any United States or Netherlands Antilles tax on the gain that was allocated to it.

[34] ABN entered into interest rate swaps with MLCS and Bartolo to hedge the interest rate risk on the LIBOR Notes. (Id. at paragraph 506.) Like the hedge transactions involving Saba, those transactions eliminated any possibility of gain loss from the LIBOR Notes for Bartolo and ABN. (Tax Court Trial Transcript at 1100.)

[35] On October 11, 1990, Brunswick purchased 50% of Bartolo's interest in Otrabanda for $69,239,696 in cash. (First Stipulation of Facts at paragraph 487.) The transaction left Brunswick with a 54% interest in Otrabanda, left Skokie with a 1% interest in Otrabanda, and left Bartolo with a 45% interest in Otrabanda. (Id. at paragraph 488.) For purposes of computing the price of the purchase, the parties used a valuation prepared by Merrill Lynch. (Id. at paragraph 490.) Merrill Lynch valued the four LIBOR Notes at $20,016,983, added to that amount the $750,000 private placement discount, and rounded that figure to $20,767,000. (Id.)

[36] On November 1, 1990, Otrabanda distributed the four Sumitomo LIBOR Notes to Brunswick. (Id. at paragraph 493.) ⁷ On that date, Otrabanda also distributed $354,523 in cash to Skokie and distributed $15,968,064 in cash to Bartolo. (Id.)

[37] On November 28, 1990, Brunswick sold the Sumitomo LIBOR Notes to Banque Francaise du Commerce Exterieur for $17,458,827. (Id. at paragraph 518.) Brunswick computed its basis in those Notes as $83,333,333. (Id. at paragraph 520.) ⁸

[38] On its 1990 consolidated federal income tax return, Brunswick reported net long-term capital loss attributable to Otrabanda of $60,174,506. (Id. at paragraph 522.) This figure reflected the reported capital loss on the sale of the LIBOR Notes (computed to be $65,874,506) less Brunswick's and Skokie's distributive share of the gain reported by Otrabanda on the sale of the certificates of deposit ($5,700,000). (Id.) ⁹ Brunswick's actual loss on the transaction was $1,703,173. (Id. at paragraph 523.)

[39] On December 4, 1990, Otrabanda redeemed a portion of Bartolo's remaining interest for $46,370,431 in cash. (Id. at paragraph 527.) The transaction left Brunswick with an 88.4% interest in Otrabanda, left Skokie with a 1.6% interest in Otrabanda, and left Bartolo with a 10% interest in Otrabanda. (Id. at paragraph 529.) On December 10, 1990, Brunswick paid Bartolo $645,000 in cash in a transaction that a Brunswick document described as "fees due to ABN for Otrabanda Partnership." (Id. at paragraph 530.)

[40] On April 3, 1991, Otrabanda formed OBC International Holdings, Inc. (OBC). (Id. at paragraph 535.) Otrabanda received all of the outstanding stock in OBC in exchange for cash and commercial paper. (Id.) On June 21, 1991, Otrabanda was dissolved. (Id. at paragraph 542.) As part of the dissolution, Brunswick and Skokie collectively received 100% of the stock of OBC, while Bartolo received cash. (Id. at paragraph 544.)

[41] On its 1990 consolidated federal income tax return, Brunswick reported a short term net capital loss of $142,953,624. (Id. at paragraph 583.) This figure included an aggregate capital loss of $162,886,086 from the sale of the four Sumitomo LIBOR Notes ($65,874,506), the sale of the two Fuji LIBOR Notes, and the sale of one of the Norinchukin LIBOR Notes ($97,011,580) during that year. (Id.) Brunswick used $116,135,453 of the claimed loss in 1990, carried back $27,588,222 of the loss to 1988, and carried back $162,411 of the loss to 1987. (Id. at paragraph 584.)

[42] On its 1991 consolidated federal income tax return, Brunswick reported a net capital loss of $31,784,542, a figure that reflected a claimed loss of $32,631,287 from the sale of the remaining Norinchukin LIBOR Note during that year. (Id. at paragraph 585.) Brunswick used $846,745 of the claimed loss in 1991, carried back $16,580,600 of the loss to 1989, and carried back $6,362,009 of the loss to 1988. (Id. at paragraph 586.) Brunswick thus claimed tax losses from the Merrill Lynch transactions totaling $194,517,373 ($162,886,086 for 1990 plus $32,631,287 for 1991). Brunswick's actual economic loss on the transactions was approximately $5 million. ¹⁰

[43] The Commissioner of Internal Revenue audited the partnership returns filed by Saba and Otrabanda for 1990 and 1991, and proposed different adjustments based on alternative theories. One theory was that the ABN affiliates had not in fact entered into valid partnerships with Brunswick (and Skokie). Under this theory, the Commissioner recognized the Merrill Lynch transactions for tax purposes, but allocated all of the gains and losses reported from the transactions, as well as the interest earned on Saba's and Otrabanda's investments in commercial paper and other instruments, to Brunswick and Skokie. An alternative theory was that the Merrill Lynch transactions were economic shams. Under this theory, the Commissioner eliminated the gains and losses from the transactions from the partnership returns filed by Saba and Otrabanda. A third theory was that Saba's allocation of almost all of the gain from its Merrill Lynch transaction to Sodbury, and Otrabanda's allocation of almost all of the gain from its Merrill Lynch transaction to Bartolo, lacked substantial economic effect for purposes of Section 704(b) of the Code, and should be disregarded. Saba and Otrabanda then filed Tax Court petitions contesting the proposed adjustments.

[44] After consolidating the cases for disposition, and conducting a trial, the Tax Court issued a memorandum opinion in which it determined that the Merrill Lynch transactions engaged in by Saba and Otrabanda lacked economic substance and should not be recognized for federal tax purposes. (Tax Court Opinion at 93-130.) The Tax Court rejected the contention advanced by Saba and Otrabanda that, under the Supreme Court's decision in Gregory v. Helvering, 293 U.S. 465 (1935), and this Court's decision in Horn v. Commissioner, 968 F.2d 1229 (1992), the lack of a business purpose for a transaction and the absence of a prospect for profit from the transaction are irrelevant unless the relevant Code provisions require the presence of those elements. (Id. at 96-103.) The court held that Gregory v. Helvering "stands for the principle that a court is not obliged to respect the form of a transaction for tax purposes where the record shows that the transaction was in fact a contrivance designed to obtain an unintended tax benefit." (Id. at 101.) The court held that, under Horn, "the relevant inquiry is not whether business purpose or the prospect of a profit are required elements under the controlling provision, but rather whether Congress enacted the provision with the intention of sanctioning a particular transaction regardless of its economic substance." (Id. at 102.) The Tax Court therefore held that "an analysis of the economic substance of the [Merrill Lynch] transactions is appropriate in the absence of an indication in the controlling statutory provisions that Congress intended to favor such transactions regardless of their economic substance." (Id. at 102-103.)

[45] The Tax Court next rejected Saba's and Otrabanda's contention that an economic substance analysis was unwarranted under Section 1001 of the Internal Revenue Code and the Supreme Court's decision in Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991). (Id. at 103-110.) As far as Section 1001 was concerned, the court held that "neither the plain language of section 1001 nor its legislative history lends any support to the proposition that Congress intended to respect the tax consequences of sales or exchanges of property that lack economic substance." (Id. at 105.)

[46] The Tax Court held that Saba's and Otrabanda's reliance on Cottage Savings was misplaced for two reasons: (1) the Supreme Court in that case had not applied the economic substance test that had been applied in other cases, and (2) the taxpayer in Cottage Savings sought to close out a real economic loss while Brunswick was attempting to use fictional losses to offset its capital gains. (Id. at 108-109.) In support of its interpretation of Cottage Savings, the Tax Court cited to the Third Circuit's decision in ACM, where the court of appeals expressly rejected a similar argument in another case involving the Merrill Lynch tax-avoidance scheme. (Id. at 109- 110.)

[47] The Tax Court then evaluated the economic substance of the Merrill Lynch transactions that had been engaged in by Saba and Otrabanda. (Id. at 110-130.) The court observed that "[a]n evaluation of the economic substance of the * * * transactions requires: (1) A subjective inquiry whether the partnerships carried out the transactions for a valid business purpose other than to obtain tax benefits; and (2) an objective inquiry whether the * * * transactions had practical economic effects other than the creation of tax benefits." (Id. at 110-111.) On the first point, the court held that "there is overwhelming evidence in the record that Saba and Otrabanda were organized solely to generate tax benefits for Brunswick." (Id. at 113.) In particular, the court stressed that (id. at 116-117):

[49] Due to its disposition of the economic substance issue, the Tax Court did not address the Commissioner's alternative arguments, including the argument that Saba and Otrabanda were not valid partnerships for federal tax purposes. (Id. at 88.) Shortly after the Tax Court issued its opinion, this Court issued an opinion in ASA, another case involving the Merrill Lynch tax avoidance scheme. In ASA, this Court affirmed a Tax Court determination that the relationship between the United States corporation involved in that case (AlliedSignal) and ABN (the putative foreign partner) was not a genuine partnership for federal tax purposes.

[50] Saba and Otrabanda now appeal. ¹¹

SUMMARY OF ARGUMENT

[51] This case involves the same tax avoidance scheme that was at issue in ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (D.C. Cir. 2000), and ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998). In ASA, this Court affirmed the Tax Court's decision that a purported partnership between AlliedSignal and a foreign entity should be disregarded for federal tax purposes, with the result that AlliedSignal was required to recognize all of the income and losses reported by ASA. In ACM, the Third Circuit affirmed the Tax Court's determination that the entire scheme should be disregarded as lacking economic substance, so that none of the paper gains or offsetting losses created by the scheme would be recognized.

[52] In this case, the Tax Court determined that the transactions entered into by appellants should be disregarded in their entirety for federal tax purposes. As a result, the court did not address the Commissioner's alternative contention that the two partnerships should be disregarded.

[53] 1. Because there is no meaningful distinction between this case and ASA, we submit that this Court should affirm the Tax Court's decision on the basis of ASA. A disposition on that basis would render moot the appellants' contention that the Tax Court erred in applying the economic sham transaction doctrine to frustrate their tax avoidance scheme.

[54] 2. In the event this Court decides not to apply its decision in ASA here, it should affirm the Tax Court's decision for the same reason that the Third Circuit affirmed the Tax Court's decision in ACM. The scheme that gave rise to this case, as well as ASA and ACM, is an economic sham that seeks to manufacture paper losses to offset the real party in interest's capital gains from other transactions. Thus, in this case, Brunswick (the real party in interest) claimed losses approaching $200 million from two transactions even though it is undisputed that its actual economic loss from the transactions was a small fraction of that amount. The Tax Court here (like the Third Circuit in ACM) applied well established principles of tax law in refusing to give effect to the blatant tax avoidance scheme. This Court similarly should refuse to sanction Brunswick's attempt to manipulate the tax laws to produce phantom losses for itself.

ARGUMENT

A. Introduction

[56] The Internal Revenue Code contains numerous rules of tax accounting that are designed to provide an accurate measure of a taxpayer's actual gain or loss from a specific transaction. See Massey Motors v. United States, 364 U.S. 92, 106 (1960) ("accounting for federal income tax purposes * * * focus[es] on the need for an accurate determination of the net income from operations of a given business for a fiscal period"). Section 1001 of the Code generally provides that gain or loss from the sale or exchange of property is to be reported in the year the transaction occurs. In the event the taxpayer has a "gain" from the transaction, defined as the sum by which the amount received exceeds the taxpayer's "adjusted basis" in the property, ¹² that amount is included in the taxpayer's gross income under Code Section 61(a)(3). In the event the taxpayer has a "loss" from the transaction, defined as the sum by which the taxpayer's adjusted basis in the property exceeds the amount received, that amount is generally deductible under Code Section 165(a). Section 165(a) allows a deduction for "any loss sustained during the taxable year and not compensated for by insurance or otherwise." Treas. Reg. section 1.165-1(b) provides in pertinent part that:

To be allowable as a deduction under section 165(a), a loss must

[58] Prior to 1980, the installment method of accounting was available only to a taxpayer who had a "gain" from an installment sale; accordingly, a taxpayer who incurred a loss from such a transaction (because the sales price was less than the property's adjusted basis) could not report the loss on the installment method. Martin v. Commissioner, 61 F.2d 942 (2d Cir. 1932). The installment method was also unavailable in situations where more than a de minimis portion of the sales price was unascertainable. In re Steen, 509 F.2d 1398, 1403-1404 (9th Cir. 1975); Gralapp v. United States, 458 F.2d 1158, 1160 (10th Cir. 1972).

[59] In 1980, Congress determined that "a taxpayer should be permitted to report gain from a deferred payment sale under the installment method even if the selling price may be subject to some contingency." S. Rep. No. 96-1000, 96th Cong. 2d Sess. 23 (1980-2 C.B. 494, 506). Accordingly, in the Installment Sales Revision Act of 1980, Pub. L. No. 96-471, section 2, 96 Stat. 2247, 2251, Congress added Code Section 453(i)(2) (now Section 453(j)(2)), Statutory Appendix, infra, which directs the Secretary of the Treasury to issue "regulations providing for ratable basis recovery in transactions where the gross profit or the total contract price (or both) cannot be readily ascertained." The accompanying Senate Report (S. Rep. No. 96-1000, supra, at 23-24, 1980-2 C.B. at 506) explains this provision as follows:

In cases where the sales price is indefinite and no maximum

(3) Fixed period -- (i) In general. When a stated maximum

[61] The ratable basis recovery regulation thus provides a means for accounting for the basis of an asset that is recovered over a period of more than one year in a contingent sales transaction. See ACM Partnership v. Commissioner, 157 F.3d 231, 252 (3d Cir. 1998), cert. denied, 119 S.Ct. 1251 (1999). The regulation, however, is not intended to create deductions not otherwise authorized by the Code. Id.

[62] The following two examples illustrate the operation of the ratable basis recovery rule. The first example involves a situation where the seller makes a profit on the transaction:

Assume that a taxpayer sells property with a basis of $1500 for

[63] The second example demonstrates how the ratable basis recovery rule operates for a taxpayer who incurs a loss on a contingent installment sale:

Assume that a taxpayer sells property with a basis of $1500 for

[64] The ratable basis recovery rule also applies where the seller receives cash in addition to an instrument lacking a readily ascertainable market value. The following example illustrates the rule's operation in that situation:

Assume that a taxpayer sells property with a basis of $100 for

[65] Absent some additional factor, no rational taxpayer would ever report the transaction described in the last example as an installment sale under the ratable basis recovery regulation. ¹⁴ Although the transaction appears to be a "wash" for tax purposes, because the "taxable" gain is offset by an equivalent "loss," the arrangement, in reality, is quite unfavorable to the taxpayer, who must pay an immediate tax on the gain while deferring the loss to a subsequent year.

[66] In 1989, Merrill Lynch designed a transaction using the model in the last example that would create for Brunswick a large paper, i.e., noneconomic, loss that would shelter from tax the large capital gain Brunswick expected to report from the impending sale of certain of its businesses and the sale of its stock in a Japanese corporation. The key to the scheme was the formation of a "partnership" between Brunswick and a foreign entity not subject to United States taxation. See ASA Investerings Partnership v. Commissioner, 201 F.3d 505, 507-508 (D.C. Cir.), cert. denied, 121 S.Ct. 171 (2000); ACM, 157 F.3d at 252 n.40. The scheme required, at its inception, that the foreign entity would have an overwhelming majority interest in the "partnership" while Brunswick would have a small minority interest. In order to qualify for the treatment provided by the ratable basis recovery regulation, the partnership would purchase instruments that were not traded on an established securities market (see supra n.13), then sell the assets within a few weeks for a large amount of cash and a comparatively small amount of debt instruments whose yield over a fixed period of time was not ascertainable at the time of the sale.

[67] The proposed transaction contemplated that under Temp. Treas. Reg. section 15A.453-1(c)(3)(i), the "partnership" would acquire a large "basis" in the debt instruments. In the first taxable year of the transaction for the partnership (1990), the partnership would report a large "gain" representing the excess of the cash received over the comparatively minor amount of basis recovered for that year. Because the foreign partner would own a large majority interest at that time, most of the paper gain would be allocated to it, and thereby not be subject to United States taxation. In the next taxable year, after Brunswick had acquired a majority interest in the partnership, the partnership would distribute the debt instruments to Brunswick and Brunswick would then dispose of the instruments. Because the assigned basis in the debt instruments would greatly exceed the value of those instruments, Brunswick would report a large paper loss from the disposition. In the final step of the plan, Brunswick would use the loss to offset the capital gain it had realized from its other activities. Brunswick sought to receive $200 million in tax benefits from the arrangement, and agreed to pay multimillion dollar fees to Merrill Lynch and the foreign partner for their assistance in implementing the scheme.

[68] Brunswick participated in two separate "partnerships" (Saba and Otrabanda) after determining that the tax benefits it would receive from the first arrangement were not sufficient to shelter from tax all of its anticipated capital gains. In both arrangements, Brunswick and ABN, a Dutch bank, created subsidiary corporations that, along with Brunswick, collectively comprised the purported partnerships. The ABN entities were incorporated in the Netherlands Antilles, a well-known tax haven. At the beginning of the transaction, the ABN entities had a majority interest in each "partnership" while Brunswick and its subsidiary collectively had a minority interest in the "partnership."

[69] Saba and Otrabanda used the funds that had been contributed by the putative partners to purchase private placement notes and certificates of deposits, respectively. Shortly after purchasing those instruments, Saba and Otrabanda sold the instruments for cash, and LIBOR Notes whose yield over a 5-year period was unascertainable on the date of purchase.

[70] On their 1990 partnership returns, Saba and Otrabanda reported large capital gains from the sales of the private placement notes and certificates of deposit that were allocated mostly to the ABN entities. After the close of Saba's and Otrabanda's 1990 taxable years, Brunswick acquired majority interests in the "partnerships." The "partnerships" then distributed the LIBOR Notes with the large remaining basis to Brunswick. Brunswick disposed of those Notes in 1990 and 1991, and ultimately reported a total tax loss approaching $200 million from the dispositions even though its actual loss on the transactions was only approximately $5 million.

B. This Court's decision in ASA Investerings Partnership v.

[72] In ASA, the Tax Court focused on the nature of the relationship between the United States corporation involved in that case (AlliedSignal) and the foreign corporation (ABN), and implicitly assumed (without deciding the issue) that the Merrill Lynch transaction had sufficient economic substance to give rise to gains and losses that would be recognized for federal tax purposes. The court determined, however, that ASA was not a genuine partnership, and therefore allocated all of the income and losses reported by ASA to AlliedSignal and its subsidiary. This Court affirmed the Tax Court's determination that ASA was not a genuine partnership. 201 F.3d at 516.

[73] The Tax Court here issued its opinion after the Third Circuit issued its opinion in ACM but before this Court issued its opinion in ASA. Like the Third Circuit in ACM, the Tax Court concluded that the Merrill Lynch transaction lacked sufficient economic substance to give rise to paper gains and paper losses for federal tax purposes. The court did not address the Commissioner's alternative contention that the partnerships should not be recognized for federal tax purposes -the contention that was subsequently resolved in favor of the Commissioner in ASA.

[74] 2. Although the Tax Court did not address the partnership issue, the issue should be addressed by this Court and resolved in favor of the Commissioner on the basis of the Court's decision in ASA. See American Telephone and Telegraph Company v. F.C.C., 978 F.2d 727, 734 (D.C. Cir. 1992) ("a remand seems especially unnecessary in light of our prior opinion * * * which * * * virtually settles the issue in this court"). There is no material difference between the "partnership" at issue in ASA and Saba and Otrabanda. It is undisputed that all three "partnerships" were formed to implement the Merrill Lynch tax-avoidance scheme under which the ratable basis recovery regulation is manipulated to produce a large paper loss for a United States corporation. Brunswick, like AlliedSignal in the ASA case, lacked a nontax business purpose for entering into the arrangements. See Tax Court Opinion at 116-117 ("the proffered business purposes amount to little more than window dressing for transactions that were designed and implemented solely to generate tax benefits for Brunswick); ASA, 201 F.3d at 515 ("AlliedSignal focused on tax minimization to the virtual exclusion of ordinary business goals").

[75] Appellants state (Br. 9) that they do not challenge on appeal the Tax Court's finding that Brunswick lacked a nontax business purpose for participating in the Merrill Lynch scheme. In ASA, this Court held that the absence of a nontax business purpose provided the Tax Court with an appropriate basis for concluding that the partnership should not be respected for federal tax purposes (201 F.3d at 513):

It is uniformly recognized that taxpayers are entitled to

[77] In this case, Brunswick adopted the same tax avoidance blueprint that was used by AlliedSignal in ASA. ¹⁵ Because appellants do not challenge the Tax Court's finding that Brunswick formed its purported partnerships with ABN as part of a scheme to manufacture large paper losses to offset the capital gains it expected to receive from other transactions, this Court's decision in ASA is dispositive of the entire appeal and renders moot appellants' contention that the Tax Court erred in relying on the economic sham transaction doctrine to frustrate the scheme. ¹⁶

C. In the alternative, the Tax Court correctly held that the

[79] The issue in Horn was whether Section 108 of the Tax Reform Act of 1984 allowed commodities dealers 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. Section 108(a) of the Act provided that certain losses resulting from the disposition of one leg of a straddle transaction were to be allowed for the taxable year of the disposition if the loss was incurred in a trade or business or in a transaction entered into for profit, while Section 108(b) provided that straddle losses incurred by a commodities dealer were to be treated as incurred in a trade or business. This Court, after examining the text and legislative history of the statute, concluded that Section 108(b) created an irrebuttable presumption that a loss arising from a straddle transaction entered into by a commodities dealer was incurred in a trade or business, and therefore was to be allowed under Section 108(a). 968 F.2d at 1238-1240. As a result, the Court determined that the economic sham transaction doctrine had no role to play in the case. In particular, the Court noted that because the structure of Section 108(a) closely paralleled the sham transaction doctrine, it was "inconceivable that Congress intended that the 'sham' transaction doctrine be laid over the statute." 968 F.2d at 1238 (emphasis in original; footnote omitted.)

[80] On appeal, Saba and Otrabanda do not contend that their Merrill Lynch transactions had reasonable prospects for profit, or served nontax business purposes. As a result, it is undisputed that the transactions were economic shams. The ultimate issue here, therefore, is whether Congress (and the Treasury), in Code Section 453 and the ratable basis recovery regulation, intended to allow corporations to use such transactions to create large paper (i.e., noneconomic) loss deductions for themselves.

[81] 2. The transactions at issue are blatant abuses of the ratable basis recovery regulation, and, therefore, are plainly "not the type of transaction[s] Congress [and the Treasury] intended to favor." Horn, 968 F.2d at 1236. The ratable basis recovery regulation is "a tax accounting regulation that merely prescribes a method for reporting otherwise existing deductible losses that are realized over several years * * *." ACM, 157 F.3d at 252. The regulation obviously contemplates that the "real party in interest" in a bona fide contingent installment sale will report the gain at the beginning of the transaction and will claim the loss, if any, at the end of the transaction so that any reported net loss from the transaction will be an actual, economic loss. See ACM, 157 F.3d at 252 n.41 ("the ratable basis recovery rule simply provides a method for reporting otherwise existing economically substantive losses * * *"). The regulation, however, never contemplated (much less authorized) the bifurcation of the tax consequences of an installment sale between a party not subject to United States taxation (ABN) and a United States taxpayer (Brunswick) so as to provide the United States taxpayer with a completely artificial tax loss. The creation of such a phantom loss "distorts the liability of [Brunswick] to the detriment * * * of the entire tax-paying group, Higgins v. Smith, 308 U.S. 473, 476-477 (1940), and thus stands the tax accounting rule in the regulation on its head. The Third Circuit in ACM properly refused to sanction the same Merrill Lynch scheme that was adopted by the appellants here and its decision should be followed by this Court. A contrary decision would effectively allow corporations to exempt themselves from tax on their capital gains, since the scheme allows corporations to manufacture unlimited paper capital losses.

[82] The phantom loss created by the Merrill Lynch scheme also flies in the face of Treas. Reg. section 1.165-1(b), which provides that only a bona fide loss is deductible from gross income. As the Third Circuit aptly observed in ACM (157 F.3d at 252):

Tax losses such as these, which are purely an artifact of tax

[83] 3. Appellants' primary argument is that the Tax Court was required to give effect to their Merrill Lynch transactions because the transactions in which they exchanged private placement notes and certificates of deposit for LIBOR notes and cash constituted "sales" under Section 1001 of the Internal Revenue Code. In essence, appellants assert that, because they transferred the benefits and burdens of ownership of the private placement notes and certificates of deposits in those transactions, the Tax Court had no authority to employ the economic sham transaction doctrine to frustrate their tax avoidance scheme. The Third Circuit rejected essentially the same argument in ACM, as should this Court. In Knetsch v. United States, 364 U.S. 361 (1960), the taxpayer borrowed funds to purchase certain Treasury obligations and, as a consequence, incurred substantial interest expenses. The transaction, however, made no economic sense, and was implemented solely to create interest deductions for the taxpayer. The Supreme Court, relying on the economic substance doctrine, sustained the Commissioner's disallowance of the claimed deductions, even though the statute allowed a deduction for any interest paid or incurred by a taxpayer. The instant case, if anything, involves a more abusive situation than Knetsch, since the deductions claimed in that case reflected actual, out-of-pocket expenditures by the taxpayer, while the losses claimed by Brunswick are artificial paper losses.

[84] Moreover, appellants' focus on Section 1001 is entirely misdirected, since that provision was not the basis for the Merrill Lynch transaction. The Merrill Lynch scheme required manipulation of the ratable basis recovery regulation accompanying Section 453 of the Code. Accordingly, in determining whether the economic sham transaction doctrine applies in this case, the proper focus is on that regulation, not Section 1001. As demonstrated above, the Tax Court properly applied the doctrine because the regulation did not intend to sanction the abusive scheme that gave rise to this case.

[85] In any event, there is nothing in the language or legislative history of Section 1001 that requires courts to give effect to transactions that serve no purpose other than the creation of phony losses. Section 1001 addresses the timing of the recognition of gains and losses from the sale or other disposition of property. The statute says nothing about whether a particular transaction should be given effect for federal tax purposes, and it most certainly does not require a court to allow the deduction of wholly artificial losses that are created through an abusive scheme. As the Tax Court properly recognized (Tax Court Opinion at 105), there is nothing in the text or legislative history of Section 1001 that precludes a court from stepping in when a taxpayer (like Brunswick) is attempting to manufacture a result that is demonstrably at odds with the purpose of a particular Code provision or regulation. The Third Circuit came to the same conclusion in ACM.

[86] 4. Appellants err in suggesting (Br. 38) that the decision in Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991), supports their position. As the Third Circuit correctly recognized in ACM, 157 F.3d at 251-252, Cottage Savings did not involve a transaction that created artificial paper losses, but rather concerned the timing of the recognition of actual economic losses. The issue in that case was whether a taxable "disposition of property" within the meaning of Code Section 1001(a) occurred when the taxpayer exchanged its interests in a group of residential mortgage loans whose fair market value had declined over time for another group of residential mortgage loans of equivalent value. ¹⁸ The Court held that the transaction involved "materially different" properties within the meaning of Treas. Reg. section 1.1001-1 and therefore constituted a "disposition of property" for purposes of Code Section 1001(a). Because the taxpayer in that case had suffered an actual economic loss from the transaction, the Court concluded that the loss was deductible at the time that the transaction occurred. 499 U.S. at 567.

[87] Cottage Savings therefore provides no support for the anomalous notion that a court must give effect to a transaction that creates a paper loss. Nothing in that opinion abrogates the well- established requirement that, to be deductible, losses must be bona fide and actually sustained during the taxable year. Indeed, in Cottage Savings, the Court expressly confirmed the fundamental rule that "[o]nly a bona fide loss is allowable." 499 U.S. at 567 (quoting Treas. Reg. section 1.165-1(b)). ¹⁹

[88] 5. Appellants' reliance (Br. 44) on this Court's decision in Horn is misplaced on two counts. First, the Court in Horn emphasized that the taxpayer in that case had incurred an actual economic loss. See 968 F.2d at 1239 ("The taxpayer has taken an economic position (purchased an asset) that has decreased in value between the time he acquires it and the time he disposes of it"); id. ("Of course, where a taxpayer claims a "loss" which did not exist * * * no 'loss' within the meaning of those sections occurs. But * * * that emphatically is not the posture of this case"). By contrast, this case involves a scheme to create paper losses for Brunswick. Brunswick claimed almost $200 million in losses from the Merrill Lynch transactions it implemented through Saba and Otrabanda even though it is undisputed that its actual economic loss from the transactions was a small fraction of its claimed loss. Second, the Court in Horn concluded that the relevant provisions of the Tax Reform Act of 1984 mandated that the taxpayer receive the tax treatment he sought. By contrast, there is nothing in Section 453, the ratable basis recovery regulation, or Section 1001 that mandates that the Merrill Lynch scheme be given effect for federal tax purposes.

[89] 6. The other cases cited by appellants in which courts upheld transactions against challenges by the Commissioner (Br. 40) are similarly inapposite. None of those cases involved an abusive transaction in which a party sought to manipulate a Code provision or regulation to create a paper loss for itself. Appellants have not cited a single case where a court gave effect to such a transaction. ²⁰

[90] 7. Appellants observe (Br. 42-43) that Section 165 of the Code limits an individual taxpayer's loss deduction to losses incurred in a trade or business or losses incurred in a transaction entered for profit but does not explicitly impose any such restriction on a corporation. Building upon this fact, they contend (Br. 44) that application of the economic sham transaction doctrine to corporate transactions "is, at best, unnecessary and at worst will contradict Congress' intent as spelled out in section 165." That statement is plainly misconceived. First, application of the doctrine here is necessary to protect the integrity of the ratable basis recovery regulation. Second, the loss deduction provided by Section 165(a) to both corporate and individual taxpayers is limited to a bona fide economic loss. Treas. Reg. section 1.165-1(b). Accordingly, a decision that applies the economic sham transaction doctrine to preclude the deduction of paper losses is consistent with the underlying intent of Section 165.

[91] 8. Appellants' reliance (Br. 44-45) on International Trading Co. v. Commissioner, 484 F.2d 707 (7th Cir. 1973), is also misplaced. The issue in that case was whether a corporate taxpayer was entitled to a loss deduction for its actual economic loss on the sale of certain real estate even though the property was not used in a trade or business or held for the production of income. The court of appeals noted that, although Code Section 165 limited an individual's loss deduction to losses incurred in a trade or business or losses incurred in any transaction entered into for profit, it did not explicitly impose similar limitations on a corporation's deduction. The court declined to read those limitations into the statute.

[92] International Trading Co. held that a corporation is entitled to deduct the actual economic loss it incurred on a transaction. It did not hold, or even suggest, that a corporation is entitled to manipulate an accounting provision of the Code to create a paper loss deduction for itself in contravention of the rule embodied in Treas. Reg. section 1.165-1(b). The Seventh Circuit's decision, therefore, does not support the notion that courts are powerless to prevent such a scheme from coming to fruition. Nor is there any other authority that would allow Brunswick to claim loss deductions totaling almost $200 million from transactions that were basically washes. Indeed, even if Brunswick would have had a business purpose for participating in the Merrill Lynch scheme, it still would not be entitled to deduct noneconomic paper losses. Treas. Reg. section 1.165-1(b).

[93] 9. The Tax Court assigned Brunswick a basis in the LIBOR Notes it received from appellants that effectively precluded it from receiving any loss deduction from their dispositions. The court, however, also held that Saba and Otrabanda were not required to report interest income from those Notes. In their brief (Br. 54-55), appellants appear to contend that the Tax Court should have included the interest in the income reported by Saba and Otrabanda, but should have assigned Brunswick a basis in the LIBOR notes that would allow it to receive a deduction for its actual economic loss from their disposition. ²¹ The claimed loss consists in large part of transaction costs that Brunswick incurred in implementing the Merrill Lynch scheme. The Third Circuit adopted appellants' approach in ACM. See 157 F.3d at 260-263.

[94] In our view, the best approach is to eliminate all the income and losses from the Merrill Lynch transactions that were reported by Saba and Otrabanda. ²² Although there is no clear consensus on the matter, courts have sometimes held that a taxpayer is not entitled to any deduction from a transaction lacking in economic substance even when the taxpayer suffered some economic loss on the transaction. See Knetsch, 364 U.S. at 366 (1960); Goldstein v. Commissioner, 364 F.2d 734, 738-742 (2d Cir. 1966), cert. denied, 385 U.S. 1005 (1967). See also United States v. Wexler, 31 F.3d 117, 122 (3d Cir. 1994) ("Deductions for expenses resulting from [sham] transactions are not permitted"), cert. denied, 513 U.S. 1190 (1995). That result is appropriate here in order to deny Brunswick any tax benefit from its participation in the Merrill Lynch tax avoidance scheme. A contrary result would effectively force the public fisc to subsidize Brunswick's illegitimate activities, and, therefore, would undermine the efficacy of the economic sham transaction doctrine.

CONCLUSION

[95] For the reasons stated above, 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 decisions of the Tax Court should be affirmed.

Respectfully submitted,

EDWARD T. PERELMUTER

Internal Revenue Code of 1986 (26 U.S.C.):

Sec. 453. INSTALLMENT METHOD.

(a) General Rule. -- Except as otherwise provided in this section, income from an installment sale shall be taken into account for purposes of this title under the installment method.

(b) Installment Sale Defined. -- For purposes of this section-

(1) In general. -- The term "installment sale" means a disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs.

* * * * *

(c) Installment Method Defined. -- For purposes of this section, the term "installment method" means a method under which the income recognized for any taxable year from a disposition is that proportion of the payments received in that year which the gross profit (realized or to be realized when payment is completed) bears to the total contract price.

(d) Election Out. --

(1) In General. -- Subsection (a) shall not apply to any disposition if the taxpayer elects to have subsection (a) not apply to such disposition.

(2) Time and Manner For Making Election. -- Except as otherwise provided by regulations, an election under paragraph (1) with respect to a disposition may be made only on or before the due date prescribed by law (including extensions) for filing the taxpayer's return of the tax imposed by this chapter for the taxable year in which the disposition occurs. Such as election shall be made in the manner prescribed by regulations.

(3) Election revocable only with consent. -- An election under paragraph(1) with respect to any dispositon may be revoked only with the consent of the Secretary.

* * * * *

(j) Regulations. --

(1) In General. -- The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the provisions of this section.

(2) Selling Price Not Readily Ascertainable. -- The regulations prescribed under paragraph (1) shall include regulations providing for ratable basis recovery in transactions where the gross profit or the total contract price (or both) cannot be readily ascertained.

(k) Current Inclusion In Case of Revolving Credit Plans,ETC. -- In the case of --

(1) any disposition of personal property under a revolving credit plan, or

(2) any installment obligation arising out of a sale of -- (A) stock or securities which are traded on an established securities market, or

(B) to the extent provided in regulations, property (other than stock or securities) of a kind regularly traded on an established market, subsection (a) shall not apply, and, for purposes of this title, all payments to be received shall be treated as received in the year of disposition. The Secretary may provide for the application of this subsection in whole or in part for transactions in which the rules of this subsection otherwise would be avoided through the use of related parties, pass-thru entities, or intermediaries.

* * * * *

TEMPORARY TREASURY REGULATIONS ON INCOME TAX (26 C.F.R.):

Section 15A.453-1. Installment method reporting for sales of real property and casual sales of personal property (Temporary). - -

(a) In general. Unless the taxpayer otherwise elects in the manner prescribed in paragraph (d)(3) of this section, income from a sale of real property or a casual sale of personal property, where any payment is to be received in a taxable year after the year of sale, is to be reported on the installment method.

* * * * *

(c) Contingent payment sales -- (1) In general. Unless the taxpayer otherwise elects in the manner prescribed in paragraph (d)(3) of this section, contingent payment sales are to be reported on the installment method. As used in this section, the term "contingent payment sale" means a sale or other disposition of property in which the aggregate selling price cannot be determined by the close of the taxable year in which such sale or other disposition occurs.

The term "contingent payment sale" does not include tranactions with respect to which the installment obligation represents, under applicable principles of tax law, a retained interest in the property which is the subject of the transaction, an interest in a joint venture or a partnership, an equity interest in a corporation or similar transactions, regardless of the existence of a stated maximum selling price or a fixed payment term. See pargraph (c)(8) of this section, describing the extent to which the regulations under section 385 apply to the determination of whether an installment obligation represents an equity interest in a corporation.

This paragraph prescribes the rules to be applied in allocating the taxpayer's basis (including selling expenses except for selling expenses of dealers in real estate) to payments received and to be received in a contingent payment sale for which a maximum selling price is determinable, sales for which a maximum selling price is not determinable but the time over which payments will be received is determinable and sales for which neither a maximum selling price nor a definite payment term is determinable. In addition, rules are prescribed under which, in appropriate circumstances, the taxpayer will be permitted to recover basis under an income forecast computation. . . . .

(3) Fixed period -- (i) In general. When a stated maximum selling price cannot be determined as of the close of the taxable year in which the sale or other disposition occurs, but the maximum period over which payments may be received under the contingent sale price agreement is fixed, the taxpayer's basis (inclusive of selling expenses) shall be allocated to the taxable years in which payment may be received under the agreement in equal annual increments. In making the allocation it is not relevant whether the buyer is required to pay adequate stated interest. However, if the terms of the agreement incorporate an arithmetic component that is not identical for all taxable years basis shall be allocated among the taxable years to accord with that component unless, taking into account all of the payment terms of the agreeement, it is inappropriate to presume that payments under the contract are likely to accord with the variable component. If in any taxable year no payment is received or the amount of payment received (exclusive of interest) is less than the basis allocated to that taxable year, no loss shall be allowed unless the taxable year is the final payment year under the agreement or unless it is otherwise determined in accordance with the rules generally applicable to worthless debts that the future payment obligation under the agreement has become worthless. When no loss is allowed, the unrecovered portion of the basis allocated to the taxable year shall be carried forward to the next succeeding taxable year. If application of the foregoing rules to a particular case would substantially and inappropriately defer or accelerate recovery of the taxpayer's basis, a special rule will apply. See paragraph (c)(7) of this section.

(ii) Examples. The following examples illustrate the rules for recovery of basis in a contingent payment sale in which the stated maximum selling price cannot be determined but the period over which payments are to be received under the agreement is fixed. In each case, it is assumed that application of the described rules will not substantially and inappropriately defer or accelerate recovery of the taxpayer's basis.

Example (1). A sells Blackacre to B for 10 percent of Blackacre's gross yield for each of the next 5 years. A's basis in Blackacre is $5 million. Since the sales price is indefinite and the maximum selling price is not ascertainable from the terms of the contract, basis is recovered ratably over the period during which payment may be received under the contract. Thus, assuming A receives the payments (exclusive of interest) listed in the following table, A will report the following:

                                             Gain

                                              Gain

Example (4). The facts are the same as in example (3), but the agreement also requires that D make fixed installment payments in accordance with the following schedule: no payment in year 1, $100,000 in year 2, $200,00 in year 3, $300,000 in year 4, and 400,000 in year 5. Thus, while it is reasonable to project that the contingent component of the payments will decrease each year, the fixed component of the payments will increase each year. Accordingly, C is required to allocate $20,000 of basis to each of the taxable years 1 through 5. . . . .

² Skokie obtained its funds through a loan from Brunswick. (First Stipulation of Facts at 189.) Sodbury obtained its funds through loans from ABN. (Id. at 191.)

³ "LIBOR," the acronym for London International Bank Offering Rate, is the primary fixed income index reference rate used in European financial markets. See ACM, 157 F.3d at 234 n.2.

⁴ The parties stipulated that Brunswick erred in computing its basis in the LIBOR Notes, and should have computed the basis as $123,365,892. (First Stipulation of Facts at 325.)

⁵ Brunswick's Board of Directors had approved the corporation's participation in the second partnership at a meeting held on April 3, 1990. (Ex. J-9(25).)

⁶ Skokie obtained its funds through a loan from Brunswick. (First Stipulation of Facts at 427.) Bartolo obtained its funds through a capital contribution from Clavicor. (Id. at 429.) Clavicor obtained that amount through a loan from ABN. (Id. at 430.)

⁷ The four LIBOR Notes were valued at $19,162,000, a figure that included the $750,000 private placement discount. (First Stipulation of Facts at 493.)

⁸ The parties stipulated that Brunswick erred in computing its basis in the LIBOR Notes, and should have computed the basis as $82,271,984. (First Stipulation of Facts at 521.)

⁹ The $142,953,624 net figure also included capital gains of $12,033,334 attributable to Brunswick's allocated gain on the sale of the Chase private placement notes and $5,700,000 attributable to Brunswick's allocated gain on the sale of the Industrial Bank of Japan certificates of deposit. (First Stipulation of Facts at 583.)

¹⁰ Brunswick also incurred at least $6 million in expenses from its participation in Saba and Otrabanda. (Tax Court Opinion at 123.)

¹¹ The Commissioner has filed a protective cross-appeal to preserve his alternative arguments in the event this Court were to reverse the Tax Court's determination that the Merrill Lynch transactions engaged in by Saba and Otrabanda were economic shams. See ACM, 157 F.3d at 245. Although an appellee may defend a lower court's decision on grounds not addressed by the trial court, the Commissioner filed a protective cross-appeal in this case because his alternative theories would produce adjustments to the returns filed by Saba and Otrabanda that are not identical to the adjustments resulting from the Tax Court's decisions.

¹² Code Section 1011(a) provides generally that the adjusted basis for determining the gain or loss from the sale of property equals the basis determined under Code Section 1012 adjusted pursuant to Section 1016. Section 1012 provides generally that the basis of property equals the cost of the property.

¹³ The installment method is not available on sales of certain types of property, including stock or securities traded on an established securities market. See I.R.C. 453(k)(2)(A).

¹⁴ Section 453(d) allows any taxpayer to elect out of the installment method of accounting otherwise required by Section 453(a).

¹⁵ As in ASA, ABN entered into hedge transactions that eliminated all possibility of gain or loss for itself from the Merrill Lynch transactions. See Tax Court Trial Transcript at 1099- 1100 (testimony of Hans den Baas). Similarly, Brunswick incurred millions of dollars of fees and transactions costs that could have been avoided if it had been motivated by genuine business purposes.

¹⁶ It would be pointless to remand the case to the Tax Court for an initial determination whether Saba and Otrabanda should be disregarded, since the decision in ASA would compel the Tax Court to rule in favor of the Commissioner. As noted in the text, under the decision in ASA, all the income and losses from Saba and Otrabanda would be attributed entirely to Brunswick and its subsidiaries. Because that outcome would result in adjustments to the partnership returns that differ from the adjustments resulting from the Tax Court's decision, it would be necessary to remand the case to the Tax Court for entry of new decisions in the event this Court were to rule for the Commissioner on the basis of the decision in ASA.

¹⁷ The Court need consider appellants' argument that the Tax Court erred in relying on the economic sham transaction doctrine only if it concludes that its prior decision in ASA is not dispositive of this case.

¹⁸ The face value of the interests relinquished by the taxpayer in the transaction was approximately $6.9 million. 499 U.S. at 558. The fair market value of the interests it received in exchange was approximately $4.5 million. Ibid.

¹⁹ Appellants' attempt to analogize the Merrill Lynch transaction to a year-end sale of stock that has declined in value (Br. 51) misses the mark. In appellants' example the posited taxpayer has suffered (and is seeking to deduct) an actual economic loss. In the Merrill Lynch scheme, the ojbect is to create paper, capital losses that can be used to shelter the participant's capital gains from tax.

²⁰ Appellants err in suggesting (Br. 45) that the decisions in Strangi v. Commissioner, 115 T.C. No. 35 (2000) and Knight v. Commissioner, 115 T.C. No. 36 (2000) are inconsistent with the Tax Court's decision in this case. The issue in those cases was whether family partnerships should be recognized for federal tax purposes, not whether a particular transaction was an economic sham.

²¹ Under appellants' approach, Brunswick would not pay tax on the entire interest income, since most of the income would be allocated to the ABN affiliates that were its putative partners. Appellants' approach, therefore, would allow a large portion of the interest income to escape United States taxation.

²² Like the economic substance issue, this matter would be rendered moot in the event this Court were to affirm the Tax Court's decisions on the basis of its decision in ASA.