Government Argues Disallowance of POPS Shelter Losses Was Proper

 

ENDEAVOR PARTNERS FUND, LLC, and
DELTA CURRENCY TRADING, LLC, TAX MATTERS PARTNER,
Petitioners-Appellants
v.
COMMISSIONER OF INTERNAL REVENUE SERVICE,
Respondent-Appellee

NOT YET SCHEDULED FOR ORAL ARGUMENT

IN THE UNITED STATES COURT OF APPEALS
FOR THE DISTRICT OF COLUMBIA CIRCUIT

ON APPEAL FROM THE DECISIONS OF
THE UNITED STATES TAX COURT

BRIEF FOR THE APPELLEE

RICHARD E. ZUCKERMAN
Principal Deputy Assistant Attorney General

FRANCESCA UGOLINI (202) 514-1882
JUDITH A. HAGLEY (202) 514-8126
Attorneys
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044

CERTIFICATE AS TO PARTIES, RULINGS, AND RELATED CASES

A. Parties and Amici. The parties to the above-captioned consolidated appeal are (i) appellants Endeavor Partners Fund, LLC, Delta Currency Trading, LLC, Alligator Partners Fund, LLC, Cabrini Partners Fund, LLC, and Satellite Partners Fund, LLC, and (ii) appellee Commissioner of Internal Revenue. No amici or intervenors appeared before the Tax Court, nor have any amici or intervenors appeared in this Court.

B. Rulings Under Review. The rulings under review are the Tax Court Memorandum Findings of Fact and Opinion entered by Judge Lauber on June 28, 2018 (JA1886-1951), and the orders and decisions entered by Judge Lauber on July 11, 2018 (JA1952-1955). The Tax Court's Memorandum Opinion is published at 115 T.C.M. (CCH) 1540.

C. Related Cases. This case was not previously before this Court or any other appellate court. A related case is pending in the Tax Court and is being held in abeyance until the final disposition of this appeal. See Fermium II Partners Fund, LLC v. Commissioner,

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TABLE OF CONTENTS

Certificate as to parties, rulings, and related cases

Table of contents

Table of authorities

Glossary

Statement of jurisdiction

Statement of the issue

Statutes and regulations

Statement of the case

Summary of argument

Argument

The Tax Court correctly determined that the Partnerships' POPS tax shelter should be disregarded for tax purposes under the economic-substance doctrine

Standard of review

Conclusion

Certificate of compliance

Certificate of service

TABLE OF AUTHORITIES

Cases:

106 Ltd. v. Commissioner, 684 F.3d 84 (D.C. Cir. 2012)

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

Anderson v. City of Bessemer, 470 U.S. 564 (1985)

ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (D.C. Cir. 2000)

Baxter v. Commissioner, 910 F.3d 150 (4th Cir. 2018)

Blum v. Commissioner, 737 F.3d 1303 (10th Cir. 2013)

Boca Investerings Partnership v. United States, 314 F.3d 625 (D.C. Cir. 2003)

Cemco Investors, LLC v. United States, 515 F.3d 749 (7th Cir. 2008)

Chai v. Commissioner, 851 F.3d 190 (2d Cir. 2017)

Coltec Indus., Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006)

Crispin v. Commissioner, 708 F.3d 507 (3d Cir. 2013)

Dewees v. Commissioner, 870 F.2d 21 (1st Cir. 1989)

Doe v. U.S. Postal Serv., 317 F.3d 339 (D.C. Cir. 2003)

Frank Lyon Co. v. United States, 435 U.S. 561 (1978)

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

Hawk v. Commissioner, __ F.3d __, 2019 WL 2120170 (6th Cir. 2019)

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

Humboldt Shelby Holding Co. v. Commissioner, 107 T.C.M. (CCH) 1242 (2014), aff'd, 606 F. App'x 20 (2d Cir. 2015)

Huthnance v. District of Columbia, 722 F.3d 371 (D.C. Cir. 2013)

Jade Trading, LLC v. United States, 598 F.3d 1372 (Fed. Cir. 2010)

Kearney Partners Fund, LLC v. United States, 803 F.3d 1280 (11th Cir. 2015)

Kearney Partners Fund, LLC v. United States, No. 2:10-cv-153, 2014 WL 905459 (M.D. Fla. 2014), aff'd, 803 F.3d 1280 (11th Cir. 2015)

Kerman v. Commissioner, 713 F.3d 849 (6th Cir. 2013)

Knetsch v. United States, 364 U.S. 361 (1960)

Lane v. Deutsche Bank, AG, 44 N.E.3d 548 (Ill. App. Ct. 2015)

Nevada Partners Fund, LLC v. United States, 714 F. Supp. 2d 598 (S.D. Miss. 2010), aff'd, 720 F.3d 594 (5th Cir. 2013), vacated, 571 U.S. 1119, remanded to 556 F. App'x 371 (5th Cir. 2014)

Nevada Partners Fund, LLC v. United States, 720 F.3d 594 (5th Cir. 2013) vacated, 571 U.S. 1119, remanded to 556 F. App'x 371 (5th Cir. 2014)

Palm Canyon X Investments, LLC v. Commissioner, No. 16-1334, 2018 WL 1326394 (D.C. Cir. 2018)

Reddam v. Commissioner, 755 F.3d 1051 (9th Cir. 2014)

Sala v. United States, 613 F.3d 1249 (10th Cir. 2010)

Sochin v. Commissioner, 843 F.2d 351 (9th Cir. 1988)

Stobie Creek Invs. LLC v. United States, 608 F.3d 1366 (Fed. Cir. 2010)

Sugarloaf Fund, LLC v. Commissioner, 911 F.3d 854 (7th Cir. 2018)

United States v. Vega, 826 F.3d 514 (D.C. Cir. 2016)

United States v. Woods, 571 U.S. 31 (2013)

United States v. Young, 463 F.2d 934 (D.C. Cir. 1972)

WFC Holdings Corp. v. United States, 728 F.3d 736 (8th Cir. 2013)

Statutes:

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

Miscellaneous:

Notice 2002-50, 2002-2 C.B. 98

Notice 2002-65, 2002-2 C.B. 690

Tax Court Rule 142(a)(1)

GLOSSARY
Br.	opening brief filed by appellants
EURDKK	euro/krone exchange rate
IRS	Internal Revenue Service
JA	Joint Appendix
LIBOR	London Inter-Bank Offered Rate
Op/JA	Tax Court's opinion as paginated in Joint Appendix
Partnerships	the four appellants in this consolidated appeal: Endeavor Partners Fund, LLC; Alligator Partners Fund, LLC; Cabrini Partners Fund, LLC; and Satellite Partners Fund, LLC
PICO	Personal Investment Corp. tax shelter
POPS	Partnership Option Portfolio Securities tax shelter

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STATEMENT OF JURISDICTION

The Commissioner agrees with appellants' statement of jurisdiction.

STATEMENT OF THE ISSUE

Whether the Tax Court correctly determined that appellants' tax-avoidance scheme lacked economic substance where the scheme (i) purported to generate $144 million in wholly artificial tax losses, (ii) was structured to eliminate any potential for economic gain or loss, and (iii) depended on contrived and pre-planned steps that have no business purpose.

STATUTES AND REGULATIONS

Statutes and regulations are reproduced in the Addendum to appellants' opening brief.

STATEMENT OF THE CASE

A. Procedural overview

This consolidated partnership proceeding involves a marketed tax-avoidance scheme designed to generate large artificial (noneconomic) losses that could be utilized to shelter from taxation a like amount of income. The variation of the scheme in this case utilized offsetting foreign-currency options that in substance resulted in an economic wash but in form generated over $140 million in artificial losses. After a trial, the Tax Court held that the tax losses were properly disallowed by the IRS under the economic-substance doctrine, a long-standing judicial doctrine that evaluates whether a transaction has any real economic effect or business purpose. The Partnerships now appeal.

B. Background: POPS tax shelter

During the late 1990s and early 2000s, several firms widely marketed to wealthy individuals various tax-avoidance schemes that utilized offsetting options to generate large artificial tax losses and other tax benefits. See United States v. Woods, 571 U.S. 31, 33-35 (2013) (describing “offsetting-option tax shelter” that utilized Deutsche Bank's “currency-option spreads” that were designed to “generate large paper losses” and only “modest gains”). The scheme at issue in this case — referred to by its promoters as POPS (Partnership Option Portfolio Securities) — relied on a tiered-partnership structure, a transitory partner, and the tax rules related to option straddles and partnerships to generate artificial losses.¹ (Op/JA1892-1894.) To create the artificial tax loss, the shelter involves a series of prearranged steps whereby (i) a partnership enters into paired-options trades whereby one option in the pair “wins” a certain sum and the other option in the pair “loses” an equivalent sum, (ii) the gain from the winning option is recognized in year one and is allocated to an affiliate of the tax-shelter promoter, and (iii) the loss from the losing option is suspended in the partnership until its maturity date when the shelter-seeking taxpayer can recognize the loss.² (JA2064-2065, JA4885.) See JA488-492, JA5404-5412 (promotional materials outlining steps of POPS transaction).

To illustrate the strategy of the POPS scheme, Partnership purchases two options in 2001, paying $25.05 million for each option, and finances the purchase with a $50 million loan and $100,000 in cash. The options are designed to be offsetting so that one option will win a certain amount and the other option will lose a like amount, creating an economic wash. Later in 2001, the winning option pays $50 million, which is used to repay the loan for both options, and creates a $25 million paper gain for Partnership. That gain is allocated to a transitory partner (an affiliate of the tax-shelter promoter who has a strategy for avoiding tax on that gain). The losing option pays $100,000, creating a $25 million paper loss for Partnership that is not recognized in 2001 but is suspended (by delaying payment thereof) until a later tax year (2002). (The small payout from the losing option essentially returns the trivial cash component of the paired-options trade.) In 2002, Taxpayer purchases an interest in Partnership from the tax-shelter promoter and is allocated the $25 million loss, which Taxpayer utilizes to avoid taxation on a like amount of income.

By 2002, the promotion of POPS and related tax-avoidance schemes had become so widespread, and the resulting harm to the public fisc so severe, that the IRS classified the transaction (and similar transactions) as an abusive tax shelter, and warned taxpayers that it would disallow the resulting tax benefits and impose penalties. Notice 2002-50, 2002-2 C.B. 98; see also Notice 2002-65, 2002-2 C.B. 690 (disallowing tax benefits from transaction similar to POPS (marketed under the name PICO (Op/JA1894-1897)) that utilized an S corporation rather than a partnership). In the notices, the IRS advised that it will challenge these transactions on several different grounds, including (as relevant here) under the economic-substance doctrine. Under the economic-substance doctrine, transactions that satisfy the literal terms of the Internal Revenue Code or Treasury regulations are nevertheless disregarded for tax purposes if they lack any real “'economic effects'” and “are not the type of transaction Congress intended to favor.”³ Horn v. Commissioner, 968 F.2d 1229, 1236-1237 (D.C. Cir. 1992) (citation omitted).

Taxpayers who chose to litigate their POPS shelter have not fared well. Three tax cases (including this case) have addressed the POPS shelter. In each case, the shelter was rejected under the economic-substance doctrine. See Kearney Partners Fund, LLC v. United States, No. 2:10-cv-153, 2014 WL 905459 (M.D. Fla. 2014), aff'd, 803 F.3d 1280 (11th Cir. 2015); Nevada Partners Fund, LLC v. United States, 714 F. Supp. 2d 598 (S.D. Miss. 2010), aff'd, 720 F.3d 594 (5th Cir. 2013), vacated on other grounds, 571 U.S. 1119 (2014).⁴

C. The Partnerships' POPS tax shelter

The POPS tax shelter utilized in this case was engineered and implemented by Andrew Beer and his firm, Bricolage. (Op/JA1889.) During the late 1990s and early 2000s, Beer was in the business of designing and marketing tax-shelter transactions to high-wealth taxpayers. (Op/JA1890-1892; JA1007, JA2391, JA2473.) Beer began his tax-shelter business by developing trades for the Son-of-BOSS tax-avoidance scheme. (Op/JA1891-1892.) See generally 106 Ltd. v. Commissioner, 684 F.3d 84, 93 (D.C. Cir. 2012) (describing Son-of-BOSS tax shelter and its “too good to be true” artificial tax benefits). He later marketed POPS and PICO, two tax shelters that (as described above) were designed to generate gains in one tax period and offsetting losses in another. (Op/JA1892-1898; JA2113.) The transactions at issue in this case involved a variation of the POPS shelter. (JA4953-4954.)

In 2000, Beer sold the POPS transaction to numerous tax-shelter purchasers. (JA2070-2071.) Those transactions, however, generated tax losses larger than the shelter purchasers could utilize in 2000. (Op/JA1898.) Accordingly, Beer designed “POPS roll funds” that purported to transfer the excess losses into subsequent tax years. (Op/JA1898; JA5516.) To facilitate that tax strategy, Beer created several partnerships (including the four Partnerships involved in the appeal) to serve as “roll funds” for the sole purpose of deferring (rolling) into a later year excess losses from POPS transactions. (Op/JA1890, Op/JA1942-1943; JA2248, JA2266-2267, JA6813.)

To implement this strategy, each Partnership engaged in foreign-currency trades that allowed the Partnership to recognize income in the first year of trading while deferring an unrealized loss to a later year. (Op/JA1899-1907; JA2071.) The income was allocated to a Bricolage affiliate that then utilized another tax-avoidance strategy to eliminate the income. (Op/JA1924-1925; JA2253-2254, JA2392, JA2476-2477, JA7074, JA7118.)

In each trade, Bricolage worked closely with Deutsche Bank AG. (Op/JA1891; JA2254-2255.) During the late 1990s and early 2000s, Deutsche Bank participated in over 1,200 abusive tax shelters, including those marketed by Beer. (Op/JA1891; JA4757-4758.) In POPS, Deutsche Bank served as both the counterparty to Bricolage's offsetting-options trades and lender of the funds used to finance those trades. (Op/JA1902-1921; JA2105-2112.) The fees paid to Bricolage and Deutsche Bank for their roles in these transactions were computed as a percentage of the resulting tax losses, not as a percentage of any resulting economic gain. (Op/JA1891; JA2254-2255.)

The Partnerships entered into a series of offsetting foreign-currency option trades in 2000 and again in 2001. (Op/JA1898-1926 (detailing each of these trades).) This appeal concerns the 2001 trades.

1. Summary of offsetting-options trades

In late 2001, the Partnerships entered into three rounds of foreign-currency option trading with Deutsche Bank, on November 26, December 7, and December 18.⁵ (Op/JA1907-1926.) The options in each round expired after one week. (Op/JA1908.) Each option was a bet on the relationship of the euro to a different currency (the British pound, Japanese yen, or Swiss franc)⁶ on the settlement date, which was one week after the trade was entered into. (Op/JA1909-1921.)

In each of the three rounds of trades, the foreign-currency options were executed in offsetting pairs. (Op/JA1938-1939; JA204-205.) The options in each pair had identical contract specifications: same currency pair, same “trigger” price, and same expiration and settlement dates. (JA204.) The individual options in each pair differed only in their payouts: one option would realize its primary (winning) payout under one exchange-rate contingency (e.g., the euro would increase in value in relation to the pound), and its smaller residual (losing) payout under the other exchange-rate contingency (e.g., the euro would decrease in value in relation to the pound). The other option would mirror that result, providing the smaller residual payout under the first exchange-rate contingency (e.g., the euro would increase in value in relation to the pound) and the larger primary payout under the second exchange-rate contingency (e.g., the euro would decrease in value in relation to the pound). (JA205.) In other words, if one option “won,” receiving the large, primary payout, its paired option necessarily “lost,” receiving its small, residual payout. (Id.)

Almost all of the premiums for the options (over 99% of each premium) were paid with a 7-day loan from Deutsche Bank, with the Partnerships providing only a small amount of cash (.25%-.5% of the premium). (Op/JA1909-1921.) In each paired-options trade, the premium for one option was paid in euros and the premium for the other option was paid in Danish kroner. (Id.) The loan for each premium was in the same currency (e.g., euro loan for euro premium). (Id.) The dollar value of each premium in the pair was equal. (JA208-209.) For example, on November 26, 2001, the Partnerships entered into a block of trades where one option cost 47,693,350 euros and the other cost 354,849,300 kroner; the dollar value of each was $41,994,000. (Op/JA1909.) Almost all of the premiums were funded by a 7-day Deutsche Bank loan ($41,784,030 worth of euros and $41,784,030 worth of kroner), with the participating partnerships making a trivial cash payment of $209,970. (Op/JA1910.)

Each option had two potential payouts. (Op/JA1937-1938.) If the option won, the payout (“large payout”) was approximately equal to the sum of the two loans that funded the options pair, plus interest, and was in the currency of the winning-option premium (euro or krone). (Op/JA1910; JA205.) The large payout occurred in late 2001 (a week after the trade date) and was used to repay the loans that funded the option pair. (JA220-221, JA492.) The nominal sums representing the premium payments, loans, and winning payouts were all very large, but the sums never left Deutsche Bank, because the bank was both the lender of the financing for, and the counterparty to, the option trades. (JA221.)

If the option lost, the payout (“small payout”) was equal to the Partnerships' initial cash investment in the option pair, plus interest. (Op/JA1910; JA205, JA209.) The small payout was retained by Deutsche Bank, where it earned interest at LIBOR, and was payable to the Partnerships in a subsequent tax year (either at maturity in December 2003 or on an earlier termination date if the Partnerships so chose). (Op/JA1910-1913; JA209.) The deferral of the small payout until a subsequent tax year allowed the Partnerships to allocate the gain to one party (the Bricolage accommodating party) in 2001 and suspend the offsetting loss to be utilized in a subsequent tax year by another party (such as Beer himself or a tax-shelter client). (Op/JA1922-1927.)

Whether an option won or not depended on currency fluctuations between the payment-trigger currencies (for example, euros and pounds, see, above, n.6). (Op/JA1910-1911, Op/JA1937-1939.) But that currency fluctuation had no net economic effect on the Partnerships because, if the fluctuation triggered a large payout on the winning option in the pair, it would also trigger the small payout in the losing option in the pair. (Id.; JA209-225.) In other words, the option pairs were designed to be offsetting so that the Partnerships were guaranteed to receive a large payout and a small payout for each option pair, no matter the movement of the euro and the pound (or yen or franc) in relation to each other. (Id.)

Although the option pairing created an economic wash, it allowed Bricolage to generate artificial losses that could be used to shelter income from taxation. (Op/JA1926-1927; JA2185.) As noted above, the winning, large payout was received in 2001 and thus “gain” on the winning option was recognized in 2001. But the offsetting loss from the losing option would be suspended (and thus embedded in the Partnerships) until the small payout was received in a subsequent tax year. By separating the offsetting payouts in two different tax years, Bricolage was able to sever the gain from the winning option from the offsetting loss of the losing option. Pursuant to the POPS tax-avoidance strategy, the gain from the option trades was allocated to a Bricolage affiliate in 2001, and the losses remained embedded in the Partnerships to be realized at a future date. (Op/JA1924-1927.)

The large payout was designed to pay off the 7-day loans that the Partnerships had used to finance the premiums for the option pair. (Op/JA1938; JA202, JA205, JA452-454, JA492.) Although the large payout would be in one foreign currency (euros or kroner, depending on which option won) and the loans had to be repaid in both foreign currencies (the loan for the euro premium had to be repaid in euros and the loan for the krone premium had to be repaid in kroner), there was no real risk that one currency could not be converted to an amount sufficient to cover both loans because euros and kroner were “pegged” to each other and were expected to remain pegged during the 7-day trade. (Op/JA1908, Op/JA1944.) As pegged currencies, the price of euros and kroner “correlated almost perfectly.” (Op/JA1908.) Any movement between the two currencies during the 7-day period was expected to be minimal, capable of producing only negligible foreign-currency gain or loss. (JA186-187, JA209-210.)

The offsetting nature of the paired options, coupled with the use of pegged currencies, ensured that any return from the option trades would be de minimis relative to the amount of the purported premiums paid for the trades and the tax losses generated by the trades. (JA209.) For example, on November 26, 2001, the Partnerships purchased an option pair that was designed to generate an artificial tax loss of over $40 million and an economic wash on the winning option. (Op/JA1911-1912.) They paid $41,593,000 worth of euros for one option in the pair and $41,593,000 worth of kroner for the other option. (JA1181.) A few days later, the option trades were settled, and the Partnerships received the winning payout in kroner and used it to pay off the loans for both options. (Op/JA1913.) If the euro/krone exchange rate applicable on the settlement date (the spot rate) had been utilized to settle the trades, the Partnerships claim that they would have realized a $486 foreign-currency gain based on the minor fluctuation between the krone and the euro that occurred during the 7-day period of the trade. (JA1183.) But, as explained in the following section, the Partnerships did not realize that de minimis gain because Deutsche Bank utilized pre-agreed 7-day forward exchange rates⁷ to settle the option trades, rather than the settlement-date spot rates, and the use of the forward rates ensured that the amount of the large payout exactly equaled the amount due on the loans, resulting in zero foreign-currency gain or loss on the trades. (Op/JA1912-1913, Op/JA1939.)

2. Applicable exchange rates fixed in advance

Bricolage's promotional materials for the POPS shelter categorically provided that the “[o]ption payoff of winning position will pay off loan.” (JA454, JA492.) To ensure that the winning payout was exactly equal to the loan amount (plus accrued interest), the parties agreed that Deutsche Bank would utilize currency exchange rates designed to produce that result — 7-day forward rates — rather than the actual (spot) exchange rates prevailing on the date of settlement. (Op/JA1908-1909, Op/JA1939-1941; JA2300, JA2358.)

Consistent with Bricolage's promotional materials, Deutsche Bank and Bricolage exchanged spreadsheets that incorporated the forward rate that Deutsche Bank would use to settle the trades. (Op/JA1939.) Deutsche Bank's spreadsheets illustrated how using the forward rates would allow the Partnerships to pay off the loan to Deutsche Bank without any resulting foreign-currency gain or loss.⁸ (JA6840, JA6919, JA6957.) For example, on December 7, 2001, Deutsche Bank sent Bricolage an email, attaching spreadsheets that set out the cash flows for the December 7 trades. (JA2349-2350, 2385-2386, 6898-6933.) The spreadsheets reflected that, after seven days, the large payout that Deutsche Bank owed the Partnerships would exactly equal the amount of the loan (with interest) that the Partnerships would owe Deutsche Bank, thus netting to zero all cash flows except the small payout due in subsequent tax years. (JA2386, JA6463, JA6597, JA6910, JA6914, JA6919.) To ensure that the large payout and the loan repayment netted to zero, the spreadsheets included the euro/krone 7-day forward exchange rate (7.4457) that Deutsche Bank would use when converting the large payout in one currency so that it would cover exactly the loan in both currencies when the trades settled 7 days later. (JA2350-2351, JA6909 (line 22), JA6913 (line 22), JA6917.) Bricolage's internal spreadsheets prepared in advance of settling the December 7 trade contained the same 7-day forward rate (7.4457) as set out in the spreadsheets that Deutsche Bank sent it on the day of the trade. (JA2171-2172, JA6596 (line 28).)

A week after exchanging spreadsheets, Deutsche Bank utilized the 7-day forward rate to settle the trades. (Op/JA1912-1913, Op/JA1917, Op/JA1921; see charts depicting exact numbers at JA1463, JA1465, JA1467, JA1469.) By using the forward rate, Deutsche Bank calculated the large payout due to the Partnerships to exactly equal the amount that the Partnerships owed on the loans, with no gain or loss remaining for the Partnerships, as it had previously indicated would be the case (in the spreadsheets sent to Bricolage when the trades were entered into). (JA2250-2251, JA6910-6957.)

Consistent with Deutsche Bank's spreadsheets, the Partnerships' books recorded zero foreign-currency gain or loss from the trades. (Op/JA1899; JA2617.) Each Partnership recorded in its general ledger that it received the large payout from the paired-options trades and used that amount to pay the principal and interest that it owed to Deutsche Bank, with no funds remaining. (JA1597-1599, JA1613-1616, JA1627-1630.) Although the Partnerships engaged in numerous foreign-currency transactions, they did not record a single dollar of foreign-currency gain or loss on their books. (Op/JA1899; JA2358.) Rather, each trade proceeded as promoted — the large payout was exactly equal to the two amounts due (with interest) on the 7-day loans in the pair. (JA492, JA1597-1599, JA1613-1616, JA1627-1630, JA2351.)

During the trial, Beer admitted that Deutsche Bank had settled the trades using the 7-day forward rates reflected in the trade summary spreadsheets rather than the spot rates prevailing when the trades closed, thus causing the offsetting trades to “net out” without any gain or loss. (Op/JA1940; JA2251, JA2299-2300.) But he denied that there had been an agreement for Deutsche Bank to do so; he claimed that Deutsche Bank used the “wrong” conversion rates every time it settled trades with Bricolage but that he simply had overlooked the repeated error until it became apparent in the litigation. (Op/JA1940; JA2299-2301.) The Partnerships, however, did not call any Deutsche Bank witnesses to testify about their alleged repeated error. (Op/JA1940.) Beer further acknowledged that the Partnerships booked zero gain or loss from the trades on their own internal books but claimed that they did so due to a “clerical error between two junior employees.” (JA2583, JA2617.) The Partnerships, however, did not call those employees as witnesses to testify about their alleged errors in this regard.

The Tax Court found Beer's testimony to be “self-serving” and not “credible.” (Op/JA1940.) As the court noted, his testimony presupposed that Deutsche Bank erred in this way, not once, but every single time it closed an option trade with Bricolage. (Id.) The court further noted that Beer was unable to explain why the 7-day forward rate was included in the parties' spreadsheets to begin with, unless it was part of an agreement to fix the settlement exchange rates in advance. (Id.) The court found that the most logical witness to testify about Deutsche Bank's trading practice would have been a Deutsche Bank witness. (Id.) The court inferred from the Partnerships' failure to call such a witness that such testimony would not have been helpful to them. (Id.)

D. Bricolage terminates Partnerships

As noted above, the Partnerships recorded no economic gains or losses from their foreign-currency option trades on their books. (Op/JA1899.) On the Partnerships' 2001 tax returns, tax gains from the winning options were allocated to Bricolage affiliates, which utilized tax strategies to avoid paying tax on their gains. (Op/JA1924-1925.) The offsetting tax losses from those trades were rolled forward to 2002. (Op/JA1922.)

In mid-2002, the IRS published Notice 2002-50 and Notice 2002-65, which described Bricolage's POPS and PICO transactions and announced the IRS's intention to challenge the transactions as (among other things) lacking economic substance. (Op/JA1925; JA4787-4790.) The publication of these notices effectively eliminated demand for Bricolage's tax-shelter products. (Op/JA1925; JA2179, JA2184, JA5523.) Bricolage accordingly began to wind down its activities, including closing the loss legs of the November and December 2001 trades early, in October 2002, and then terminating the Partnerships. (Op/JA1925-1926; JA2184, JA2268-2269.)

When the loss legs closed in 2002, Deutsche Bank paid the Partnerships the deferred small payouts on the 2001 losing options. (Op/JA1938-1941; JA187; see charts JA1440-1448, JA1631-1632.) This payment returned the cash portion of the Partnerships' option-premium payments, with interest set at a pre-determined LIBOR interest rate. (Op/JA1941; JA209, JA468-469, JA2315, JA2356.)

On their final, 2002 partnership tax returns, the Partnerships reported losses from the 2001 trades calculated as the difference between the purchase price for each losing option and that option's deferred small payout. (Op/JA1926.) The total reported losses were approximately $144 million. (Id.) Those losses flowed through to Beer, who utilized approximately $40 million in 2002 to offset gains from fees earned that year from his tax-shelter business. (Op/JA1927 & n.17; JA2185, JA2597.)

E. Proceedings in the Tax Court

1. Parties' arguments

The Partnerships commenced this consolidated partnership proceeding after the IRS disallowed the losses related to the Partnerships' 2001 foreign-currency trades. The IRS disallowed the losses because (among other reasons) they were generated by a pre-arranged series of option trades that lacked economic substance and had no legitimate business purpose. (Op/JA1927; JA2920-2921.) Under the economic-substance doctrine, a transaction will not be respected for tax purposes unless it is reasonably expected to “appreciably” affect the taxpayer's beneficial interest in a manner other than reducing its tax. (Op/JA1937 (citing Knetsch v. United States, 364 U.S. 361, 366 (1960)).)

During the Tax Court proceedings, the Commissioner argued that the option trades lacked economic substance for two reasons. The Commissioner first argued that the use of paired, offsetting options ensured that only a de minimis economic gain or loss could be expected from the trades and that nominal pre-tax profit was insufficient to give the transaction economic substance. (JA665, JA1477, JA1480-1481, JA1493-1495, JA2634-2635.) The Commissioner further argued that the parties' prearranged use of forward exchange rates designed to ensure that the large payout was sufficient to pay off the loans eliminated the opportunity for that de minimis gain or loss from the large payout on each offsetting-options pair. (JA667, JA1502-1503.) The Partnerships, for their part, argued that “a dollar profit” was sufficient to give a transaction economic substance (JA2583), and that their evidence would prove that they did not agree in advance with Deutsche Bank to eliminate any risk or profit potential from the option trades (JA603).

2. Expert evidence

During the trial, the parties introduced expert evidence concerning the foreign-currency option trades and their potential profitability. The Partnerships submitted the testimony of Don Chance, an expert who previously had testified (unsuccessfully) for other taxpayers in tax-shelter cases. (Op/JA1928 n.18.) Chance testified that the option trades could be profitable if the krone and euro were to “depeg” during the 7-day period of the trade but did not estimate the likelihood of that “theoretical possibility.” (Op/JA1928.) (A “depeg” occurs when a government disconnects its currency rate from that of another currency. (JA2313.)) He acknowledged that there would have been more direct ways to place such an unlikely bet. (JA2313-2314.) He further testified that the options could generate a profit if you compared the potential return from the trades to only the cash invested in the transaction instead of the entire investment (the bulk of which was financed by the Deutsche Bank loan). (JA361-369, JA455-458, JA466.) He acknowledged, however, that, once the winning payout was used to retire the Deutsche Bank loan, the only remaining source of profit is the small payout, which was in essence a certificate of deposit in a foreign currency. (JA2315.)

The Tax Court concluded that Chance's testimony had “no probative value” because it was “premised on a contrary-to-fact assumption” about the trades. (Op/JA1929.) In this regard, his conclusions about the profitability of the option trades assumed that the trades would settle at whatever the spot rates were on the date of settlement, instead of the 7-day forward rates for the various currencies that prevailed when the parties entered into the trades. (Id.)

The Partnerships also submitted the testimony of Jack Yeager, who opined that Bricolage/Beer could generate a large profit by selling the Partnerships' tax shelter losses in 2003-2005. (Op/JA1929.) The Commissioner moved to exclude his testimony, arguing that it relied on several unproven assumptions and was, in any event, irrelevant to the legal issues in the case. (JA1496-1497, JA1811-1813, JA2489-2490, JA2521.) The Tax Court granted that motion, agreeing with the Commissioner (i) that Yeager failed to provide any basis for his assumptions, including the marketability of the tax-shelter losses, and (ii) that his testimony regarding Beer's desire to profit from his tax-shelter business was irrelevant to the distinct and separate question regarding the profitability of the trades. (Op/JA1929-1930.)

The Commissioner's expert (Timothy Weithers) concluded that the Partnerships had no reasonable expectation of profiting from the option trades. (Op/JA1931; JA186-187, JA204-209.) As Weithers explained, the “potential investment exposure inherent in each individual option is abrogated by the ubiquitous pairing with an effectively offsetting option,” and the “economics of the net result is negligible.”⁹ (JA209.) He concluded that the paired-options trades effectively involved a “Heads I win and Heads I lose” strategy. (JA224.) He further opined that the negligible exchange-rate risk that might otherwise attend the 7-day trades was eliminated by the parties' agreement that Deutsche Bank would calculate the option payouts using the forward rates reflected in Deutsche Bank's spreadsheets, so that the Partnerships could repay the loans without any gain or loss on the trades. (Op/JA1931; JA216, JA220-221, JA452-453, JA2349-2350, JA2358.) In Weithers' view, the purported investments in foreign-currency options were in substance cash deposits by the Partnerships that were returned with interest when the loss legs closed. (Op/JA1931; JA209.)

The Tax Court found that Weithers was a “knowledgeable and credible witness.” (Op/JA1931.)

3. Tax Court decision

The Tax Court concluded that the Commissioner correctly disallowed the artificial losses reported by the Partnerships because the paired foreign-currency options had no economic substance. (Op/JA1934.) The court observed that the transactions were designed to appear “complicated” but were in essence “remarkably simple and vapid.” (Op/JA1937.) As the court found, the purchase of the paired options generated a circular flow of funds: (i) for each option pair, the Partnerships were guaranteed to receive the large payout on the winning option and a small deferred payout on the losing option; (ii) the large payout was roughly equal to the sum of the two option premiums and was used to repay the Deutsche Bank loan that had financed the premiums; and (iii) once the large payout was offset against the loan, the transaction appears in its “true economic form” as a “modest deposit of cash” that is returned to the Partnerships one year later (with interest) in the form of the small deferred payout. (Op/JA1937-1938.)

Given that economic reality, the Tax Court determined that the paired options did not provide the Partnerships a “'reasonable possibility of profit.'” (Op/JA1937 (quoting Horn, 968 F.2d at 1237).) The court so ruled for multiple “reasons.” (Op/JA1940.) The court found that the “offsetting” nature of the paired-options trades precluded any reasonable expectation of profit from the trades. (Op/JA1938.) As the court explained, although each option was tremendously risky when viewed in isolation — in one week, it would roughly double in value or become almost worthless, depending on the exchange rate between the euro and a different currency (pound, yen, or franc) — that risk and related possibility for profit was “eliminated by the offsetting option, which precisely reversed the payout conditions.” (Id.) In other words, the court further explained, by entering into paired options that “precisely” offset each other, the Partnerships were guaranteed to win the large payout on one option and get the losing deferred payout on the other option, with the sum of the two payouts equaling the sum of the two option premiums (with interest). (Op/JA1938-1939.) Thus, the court concluded, by entering into offsetting options, the Partnerships could not profit from their supposed bet on the exchange rate between the euro and the pound, yen, or franc. (Op/JA1939.)

The Tax Court also addressed the minimal, “theoretical” risk that the Partnerships faced from “exchange rate swings” between the payout currencies (euro and krone) during the 7-day option period. (Op/JA1939.) In this regard, the large option payout would be in either euros or kroner but the Partnerships would need to pay off loans in both currencies. (Op/JA1909-1910.) Although the two currencies were pegged to each other, minor fluctuations in their exchange rates during the 7-day period could produce small foreign-currency gains or losses for the Partnerships. (Op/JA1908-1909; JA2617.) The court found that that “theoretical risk,” and potential for some profit, was “eliminated” altogether because Deutsche Bank and Bricolage “fixed the applicable exchange rates in advance,” as evidenced by the Deutsche Bank spreadsheets exchanged between the parties before the trades settled. (Op/JA1939.) The court further found that the Partnerships' consistent “track record” of recording zero gains and zero losses “clearly shows that the exchange rates were all fixed in advance,” and “that the roll funds thus bore no foreign-exchange risk of any kind.” (Op/JA1945-1946.) The court concluded that, “[w]hen the dust cleared, the roll funds simply made a bank deposit and got their money back one year later, with interest at LIBOR as agreed in advance.” (Op/JA1941.)

The Tax Court rejected the Partnerships' reliance on the remote possibility that the krone and euro could depeg as a source of profitability for the transaction, citing three reasons for doing so. (Op/JA1944.) First, the court found that such a depeg was “extremely unlikely.” (Id.) Second, the court observed that, if one really wished to place a “long-shot bet” on such an unlikely event, one would be “ill-advised to select an option period of just seven days.” (Id.) Finally, the court found that the parties' advance agreement not to calculate the option payouts using the settlement-date spot rates precluded any profit from a depeg occurring at settlement. (Id.)

The Tax Court next determined that the Partnerships, as a subjective matter, did not have a non-tax business purpose for engaging in the option trades. (Op/JA1941.) In support of that ruling, the court found (i) that the transactions at issue were outgrowths of prepackaged tax shelters marketed to other taxpayers, (ii) that those taxpayers had been charged a fee determined solely as a percentage of anticipated tax losses, (iii) that the transactions were designed to generate artificial losses, and (iv) that the Partnerships had executed numerous foreign-currency option trades over the course of two years and had not recorded a single dollar of foreign-exchange gain or loss. (Op/JA1942-1945.)

The Tax Court rejected the Partnerships' argument that the option trades had a business purpose because Bricolage intended to profit by selling the artificial tax losses that the option trades were designed to generate, holding that the argument was “misdirected.” (Op/JA1947.) As the court explained, that Bricolage hoped to profit from selling the losses did not demonstrate that the underlying option trades were designed to be profitable — they were not, given that they were structured with “precisely offsetting option payout terms and settlement exchange rates fixed in advance.” (Id.)

Finally, the Tax Court determined that accuracy-related penalties did not apply to the resulting underpayments of tax. (Op/JA1948-1950.) The court found that “the partnerships' conduct is plainly deserving of penalty” but that the Commissioner had imposed penalties without first obtaining the written supervisory approval required by I.R.C. § 6751.¹⁰ (Op/JA1888.)

SUMMARY OF ARGUMENT

This case involves the POPS tax shelter, a transaction that generated $144 million in artificial tax losses — $40 million of which were utilized by the shelter's promoter (Beer) — but nothing of substance (other than a small foreign-currency deposit). The Tax Court properly thwarted this attempted raid on the Treasury by holding that the transaction was invalid under the economic-substance doctrine, the same conclusion reached by the Fifth and Eleventh Circuits in rejecting another version of Beer's POPS shelter.

Applying this Court's economic-substance precedent to the record evidence, the Tax Court correctly found that the Partnerships' POPS transaction lacked economic substance, because the parties (i) utilized foreign-currency option trades that were designed to be offsetting, and (ii) agreed that the Partnerships' counterparty on the trades (Deutsche Bank) should settle the trades using forward exchange rates that eliminated all foreign-currency risk and profit potential. The court further correctly found that the Partnerships were motivated to enter into the option trades solely to generate the $144 million artificial tax loss.

The Partnerships' central contention is that the Tax Court clearly erred in finding that the parties agreed in advance about the forward rates. That contention is unavailing. The court's finding is fully supported by the record and by the court's well-founded credibility and evidentiary determinations. Moreover, even without the agreement about the rates, the potential to make any profit from the offsetting options was insignificant relative to the transaction's tax benefits, as the Fifth and Eleventh Circuits held in rejecting Beer's POPS scheme.

Equally unavailing is the Partnerships' attempt to disturb the Tax Court's well-supported finding that there was no business purpose for the offsetting-options trades. They ignore Beer's testimony that the options were designed to generate tax losses, as illustrated by his POPS marketing materials. And they conflate Beer's desire to profit from selling tax losses with the Partnerships' motivation for the option trades themselves. Only the latter is relevant here.

In short, the Partnerships have failed to provide any plausible basis for this Court to bless the phony losses generated by the abusive POPS scheme and thereby go into conflict with its sister circuits.

ARGUMENT
The Tax Court correctly determined that the Partnerships' POPS tax shelter should be disregarded for tax purposes under the economic-substance doctrine

Standard of review

This Court reviews Tax Court decisions in the same manner as it reviews district court decisions — questions of law are reviewed “de novo” and factual findings “for clear error.” ASA Investerings Partnership v. Commissioner, 201 F.3d 505, 511 (D.C. Cir. 2000). “[E]videntiary rulings” are reviewed for “abuse of discretion.” Huthnance v. District of Columbia, 722 F.3d 371, 377 (D.C. Cir. 2013).

A. Introduction

Taxpayers are entitled to structure their genuine business transactions “in such a way as to minimize tax.” ASA Investerings, 201 F.3d at 513. But they are not entitled to claim tax benefits from transactions where the purported “business purpose” for the transaction “is no more than a façade.” Id. To be respected for tax purposes, a transaction generally must have “economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached.” Frank Lyon Co. v. United States, 435 U.S. 561, 583-584 (1978). This well-established principle — now codified for transactions occurring after March 2010, see I.R.C. § 7701(o) — is referred to as the economic-substance doctrine. This doctrine permits Treasury and the courts to disregard transactions that satisfy the “literal terms” of the Code and Treasury regulations but subvert their “purpose.” Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1352-1354 (Fed. Cir. 2006).

This case involves the application of the economic-substance doctrine to a mass-marketed tax shelter (POPS) that has been rejected by two other circuits. (JA598, JA4991-4992.) To implement the tax scheme, the Partnerships entered into a series of paired-options trades. Each pair consisted of options that were mirror images of each other: if one option won, its mirror option would lose, creating an economic wash. The “winning” option would approximately double in value and its mirror — the “losing” option — necessarily lost its entire value aside from a small payout. By doubling in value, the winning option generated proceeds designed to pay off the loan that financed both options in the pair. And the losing option's small payout returned the Partnerships' de minimis equity investment in the pair, with interest. The economics of the net result of these circular cash flows was negligible, and in substance represented a foreign-currency bank deposit earning interest tied to LIBOR. (Op/JA1941; JA2145.)

The transaction was designed to manufacture enormous tax losses that were wholly artificial. These losses were engineered by allocating the gain from the winning option to an accommodating party (who ultimately paid no tax on the gain) in one year and then allocating the offsetting loss from the losing option to a shelter-seeking taxpayer in another year. In this case, the artificial loss was allocated to Beer, who utilized the loss to shelter $40 million in fees that he earned by peddling POPS and similar tax shelters to other taxpayers. (Op/JA1889-1898.)

The POPS shelter has not fared well in court. In Nevada Partners and Kearney, the trial courts rejected a version of the POPS shelter (marketed by Beer under the name “FOCus”) because the underlying foreign-currency trades “lack[ed] economic substance” and were “structured to create artificial losses for tax purposes.” Nevada Partners, 714 F. Supp. 2d at 633; accord Kearney, 2014 WL 905459, at *5. As the courts explained, the offsetting foreign-currency trades were structured so that the partnerships “end up with virtually equal gains and losses, with the gains cash-settled and the losses locked in for future realization” by shelter purchasers. Id. at *5-6 & n.13 (describing how these artificial tax “gains” were allotted to “Bricolage-affiliated entities” and then “washed away through the manipulation of the tax system”); accord Nevada Partners, 714 F. Supp. 2d at 607, 633. Both courts held that the option trades lacked economic substance, even though they were expected to generate some gains from foreign-currency exchange movements, because the gains were relatively “de minimis” and “modest profits relative to substantial tax benefits are insufficient to imbue an otherwise dubious transaction with economic substance.” Id. at 631-632; accord Kearney, 2014 WL 905459, at *9, 12-13 (describing how transaction that generated a $78 million tax loss lacked economic substance even though it had a “potential profit” between “$300,000 and $400,000”). Both economic-substance rulings were affirmed on appeal. Nevada Partners Fund, LLC v. United States, 720 F.3d 594 (5th Cir. 2013); Kearney Partners Fund, LLC v. United States, 803 F.3d 1280 (11th Cir. 2015).

These courts correctly recognized that the sole purpose of the POPS transaction is to “generate artificial, noneconomic tax losses.” Kearney, 803 F.3d at 1281. As the Second Circuit aptly summarized (in a case concerning the tax liability of one of Beer's accommodating parties), although there theoretically may have been “an opportunity to profit on the underlying investments,” the “whole point of [Beer's] shelter scheme was to neutralize any purported returns on investment by generating offsetting losses.” Chai v. Commissioner, 851 F.3d 190, 211 (2d Cir. 2017); see also Lane v. Deutsche Bank, AG, 44 N.E.3d 548, 551 (Ill. App. Ct. 2015) (finding that “the POPS transactions, rather than conveying a reasonable probability of profit, were rigged to result in a loss”).

The hallmark of an economic sham is a “generated loss [that] was designed to be entirely artificial.”¹¹ Sala v. United States, 613 F.3d 1249, 1253 (10th Cir. 2010). In ruling that the offsetting options utilized in POPS/FOCus lacked economic substance, the courts in Nevada Partners and Kearney emphasized that the losses generated by the options were wholly “artificial.” Kearney, 803 F.3d at 1294, 1296 n.25; Nevada Partners, 720 F.3d at 611-612. The same is true with the $144 million loss here. The Partnerships' option trades did not decline in value by $144 million during the brief duration of the trades. Rather, the Partnerships invested approximately $144 million over three trade dates in late 2001 and made approximately $144 million 7 days later, the vast bulk of which was used to retire the 7-day loans from Deutsche Bank that funded over 99% of the investment. The embedded $144 million tax loss rolled over to 2002 was not created by actual economic events. Rather, it was engineered by separating the gain and offsetting loss from each other through triggering the gain when one entity held the partnership interests (Bricolage-related accommodating parties) and suspending the loss until Beer (or anyone else desiring a tax shelter) could purchase the partnership interest.

The Tax Court correctly disallowed this abusive tax scheme under the economic-substance doctrine. The Partnerships' arguments to the contrary are predicated on challenging the Tax Court's well-supported findings and credibility determinations. As demonstrated below, those arguments cannot withstand scrutiny and provide no basis for this Court to go into conflict with the Fifth and Eleventh Circuits.¹²

B. The Tax Court correctly determined that the Partnerships' POPS transaction was an economic sham

To determine whether a transaction is an economic sham that should be disregarded for tax purposes, courts undertake a fact-intensive inquiry that evaluates (i) whether, from an objective standpoint, the transaction provided a reasonable possibility of profit or other indicia of “'economic substance,'” and (ii) whether, as a subjective matter, the taxpayer was motivated by a “'business purpose'” to engage in the transaction. Horn, 968 F.2d at 1237 (quoting Sochin v. Commissioner, 843 F.2d 351, 354 (9th Cir. 1988)). The objective and subjective inquiries are not wholly separate but are “'directed to the same question: whether the transaction contained economic substance aside from the tax consequences.'” Baxter, 910 F.3d at 158 (citation and emphasis omitted).

The Partnerships' suggestion (Br. 8-9 & n.5) that this Court's economic-substance analysis deviates in any material way from that applied by other circuits and codified by Congress in 2010 is incorrect.¹³ This Court, like the “majority” of the courts that have addressed the issue, has recognized that a “lack of economic substance is sufficient to invalidate the transaction regardless of whether the taxpayer has motives other than tax avoidance.”¹⁴ Nevada Partners, 720 F.3d at 608 & n.36 (citing Boca Investerings Partnership v. United States, 314 F.3d 625, 631 (D.C. Cir. 2003)). For example, in ASA Investerings, this Court held that, under the economic-substance doctrine, “a transaction will be disregarded if it did 'not appreciably affect [taxpayer's] beneficial interest except to reduce his tax.'” 201 F.3d at 514 (quoting Knetsch). The Court also held that “the absence of a nontax business purpose is fatal.”¹⁵ Id. at 512. Horn is not to the contrary. There, this Court described the economic-substance doctrine in multiple ways, Horn, 968 F.2d at 1237, and then determined that the doctrine did not apply because the unique statutory provision at issue there evidenced legislative intent to allow a specific deduction for commodity dealers even if generated in a transaction lacking economic substance or business purpose, id. at 1238, 1241-1243.¹⁶

Applying the economic-substance doctrine to the record evidence, the Tax Court found that the Partnerships' paired foreign-currency options (i) objectively were not expected to “appreciably” benefit the Partnerships' business, non-tax interests (Op/JA1937), and (ii) subjectively lacked “any business purpose” (Op/JA1948). The Partnerships have not identified any error — let alone clear error — in either finding, both of which are fully supported by the record.

1. The Tax Court did not clearly err in finding that the offsetting options lacked economic substance

Consistent with the Nevada Partners and Kearney decisions, the Tax Court found that the Partnerships' paired-options trades could not appreciably affect their economic (non-tax) interests because each option pair consisted of “offsetting” bets on foreign currency. (Op/JA1937-1939.) For each pair, the Partnerships were “guaranteed” to win the large payout on one option and receive the losing deferred payout on the other option. (Op/JA1938.) The sum of these two payouts equaled the sum of the two option premiums (with interest). (Op/JA1939.) As the Commissioner's expert aptly described the transaction, it involved a “Heads I win and Heads I lose” strategy. (JA224.) In other words, each option pair created an economic wash and in substance was nothing more than a “modest deposit of cash” that would be returned to the Partnership “one year later with interest.” (Op/JA1938.) Notably, the Partnerships do not challenge this finding in their opening brief.

Moreover, the offsetting trades in this case were even more of a sham than the offsetting trades utilized in Nevada Partners and Kearney. Here, unlike the situation there (where the options could generate de minimis gains or losses), Bricolage and Deutsche Bank eliminated even the de minimis gains or losses that offsetting options could generate (based on minor currency fluctuations during the 7-day trades) by allowing Deutsche Bank to use the forward exchange rates to settle the trades. (Op/JA1939.)

Ignoring the Tax Court's finding that the offsetting nature of the option pairs eliminated any substantial risk or potential for profit for the Partnerships, the Partnerships instead narrowly focus their challenge on the court's supplementary “finding” (Br. 3) that the parties agreed in advance to eliminate all risk and opportunity for profit — no matter how small — from the option trades.¹⁷ As demonstrated below, that finding is fully supported by (i) the record (§ B.1.a), (ii) the court's credibility determination regarding Beer's purported explanation as to why Deutsche Bank settled every single trade using the forward rates (§ B.1.b), and (iii) a properly drawn adverse inference regarding the Partnerships' failure to call witnesses that could support Beer's purported explanation (§ B.1.c). Moreover, even without that finding, the offsetting-options trades could not appreciably benefit the Partnerships' economic interests because any reasonably expected gain or loss based on using the actual spot exchange rates to settle the trades would be de minimis (§ B.1.d), as was the case in Kearney and Nevada Partners.

Before turning to those arguments, we briefly address the Partnerships' threshold contention (Br. 38-39) that the Tax Court should have shifted the burden of proof to the Commissioner on the prearranged-rate issue. That contention is unfounded and irrelevant.

To support its burden-of-proof argument, the Partnerships first rely on the Tax Court's “ruling” (Br. 39) regarding the Deutsche Bank spreadsheets. That reliance is misplaced. Although the court ruled that it was the Commissioner's “burden to tie these [spreadsheet] numbers in” to the “relevant” issues (JA2217, JA2220), it did not dictate how the Commissioner should satisfy that burden or require the Commissioner to do so through “witnesses,” as the Partnerships inaccurately suggest (Br. 28). Nor did the Commissioner make “clear” that he would utilize Deutsche Bank and Bricolage employees to explain the spreadsheets (Br. 15). To the contrary, the Commissioner specifically informed the Court that it would not be calling those employees as witnesses because it determined during the trial that it was not “necessary” to do so. (JA2221.) That such employees were included on the Commissioner's pre-trial list of potential witnesses in no way precluded the Commissioner from making its arguments through other means. Indeed, the Partnerships recognized that the Commissioner might not call every potential witness included on his pre-trial list and therefore incorporated those witnesses into their own pre-trial witness list. (JA584.)

The Commissioner ultimately tied the spreadsheet numbers to the issues in the case through painstaking analysis in his post-trial briefs and through his expert witness. See, above, n.8. The court evidently was satisfied with the Commissioner's efforts in this regard.

Similarly misplaced is the Partnerships' reliance (Br. 39-40) on Tax Court Rule 142(a)(1), which shifts the burden of proof to the Commissioner with respect to any “new matter.” The prearranged-rate issue was not a new matter. The Commissioner's original determinations (issued to the Partnerships in 2011) expressly provide that the POPS transaction was nothing more than a “prearranged” scheme designed to generate large artificial tax losses without any real risk or opportunity for gain. (JA2920, JA3110, JA3307, JA3503.) As the IRS explained when it disallowed the losses, the “prearranged” foreign-currency trades were designed to “look[ ] like an investment,” but were, in reality, “planned in such a way to generate a loss for the Tax Shelter Customer or Promoter and eliminate the financial exposure to the other participants.” (JA4906, JA4974, JA5011-5012, JA5049.) That the parties eliminated financial exposure by agreeing to Deutsche Bank's use of the forward exchange rates was merely a new fact uncovered during litigation that supported the Commissioner's original theory, not an “entirely new theory” (Br. 8).

In any event, the burden of proof is irrelevant here because the Tax Court's findings are supported by a preponderance of the evidence, as the court properly concluded. (Op/JA1934.)

a. The finding that the parties agreed to Deutsche Bank's use of the 7-day forward rates to settle the trades is not clearly erroneous

The Partnerships' appeal is quite narrow. There is no dispute that if Deutsche Bank calculated the payouts “at the forward rates, those funds are going to precisely cancel the amount of option premium borrowed plus interest on both the two currencies, Danish Krone and Euro,” and return the Partnerships' small “equity investment” with interest, as the Commissioner's expert testified and counsel for the Partnerships agreed. (JA2351-2353.) There is also no dispute that Deutsche Bank in fact calculated the payouts using the forward rates, thus eliminating all potential for gain or loss (no matter how de minimis) on the option trades, as Beer conceded and the Tax Court found. (Op/JA1940; JA2250-2251, JA2299-2300.) See Br. 41 (conceding Deutsche Bank's “use” of forward rates to settle all of the trades). And there is no evidence that Bricolage ever complained about the fact that Deutsche Bank settled every single option trade in a manner that generated “zero gain or loss.”¹⁸ (JA2579.) Rather, the only dispute is whether the Tax Court's “finding” that Bricolage and Deutsche Bank prearranged that result was “clearly erroneous” (Br. 38). As demonstrated below, that finding is fully supported by the evidence, including Deutsche Bank spreadsheets exchanged by the parties on the day of the December 7 and 18 trades, emails exchanged by the parties, Bricolage's spreadsheets and promotional materials, the Partnerships' ledgers, the Commissioner's expert evidence, and other circumstantial evidence.

First, there is direct evidence of the parties' agreement with regard to the December 7 and 18 trades. On December 7, 2001, the day the second block trade was entered into and a week before it settled, Deutsche Bank (Thomas Chin) sent an email to Bricolage (Clayton McDonald and Michael Braun¹⁹) stating, “As we confirmed over the phone, here are the details of today's trade,” and attaching spreadsheets reflecting the details of the December 7 trade. (JA6898-6916.) The first spreadsheet (JA6899-6908) was the spreadsheet that Bricolage had sent Deutsche Bank earlier in the day and the second spreadsheet (JA6909-6916) was Deutsche Bank's spreadsheet. Deutsche Bank's spreadsheet included the “EURDKK [euro/krone] Forward Exchange Rate 7.4457” that it ultimately used a week later to settle the trades and net out the large payouts and the loans for the option premiums. (JA2353, JA6909 (line 22).) The spreadsheet also illustrated that the large payouts would exactly pay off the loans, leaving “0” gain or loss (JA6910 (lines 15, 24), calculated using the forward exchange rates included in the spreadsheet (JA6909 (lines 22-24)). On December 17, 2001, Deutsche Bank sent a follow-up email to Bricolage (McDonald and Braun) regarding the December 7 trade, stating “as previously agreed, the EURDKK spot conversion rate is 7.4457” (JA6917), the exact same 7-day forward rate included in the spreadsheet exchanged between the parties on December 7, a week before the trades were settled using that rate (JA6909 (line 22)).

There are similar documents for the December 18 trades. On December 18, 2001, the day the third block trade was entered into and a week before it settled, Deutsche Bank (Chin) sent an email to Bricolage (McDonald) stating, “Attached is the spreadsheet containing the market rates and other details of the third tranche,” and attaching spreadsheets reflecting the details of the December 18 trade. (JA6941-6963.) Again, the first spreadsheet (JA6942-6955) was the spreadsheet that Bricolage had sent Deutsche Bank earlier in the day and the second spreadsheet (JA6956-6963) was Deutsche Bank's spreadsheet. Deutsche Bank's spreadsheet included the “EURDKK Forward Exchange Rate 7.4415” that it ultimately used a week later to settle the trades and net out the large payouts and the loans for the option premiums. (JA2353, JA6956 (line 22).) Like the spreadsheet exchanged on December 7, this spreadsheet also illustrated that the large payouts would exactly pay off the loans, leaving “0” gain or loss (JA6957 (lines 15, 24)), calculated using the forward exchange rates included in the spreadsheet (JA6956 (lines 22-24)). On December 26, 2001, Deutsche Bank sent a follow-up email to Bricolage regarding the December 18 trades, stating “as previously agreed, the EURDKK spot conversion rate is 7.4415” (JA6997), the exact same 7-day forward rate included in the spreadsheet exchanged between the parties on December 18, a week before the trades were settled using that rate (JA6956 (line 22)).

Whether or not the December 7 and December 18 trades were entered into “before” (Br. 42) Deutsche Bank sent the spreadsheets to Bricolage on those dates is irrelevant. The relevant fact is that the spreadsheets were sent before those trades settled, thus evidencing a pre-settlement agreement regarding how the trades would be settled a week later, as the Tax Court emphasized (Op/JA1939).

There is no email evidencing the exchange of spreadsheets related to the November 26, 2001, trades, as the Partnerships observe (Br. 41-42). But there is other evidence, which the Partnerships ignore, reflecting that the parties understood that Deutsche Bank would be using the forward rate to settle the trades. First, the Deutsche Bank spreadsheet for those trades (like the Deutsche Bank spreadsheets for the December 7 and 18 trades) includes 7-day forward rates, including the forward rate for euro-krone conversion (7.4406). (JA6839 (line 22).) Bricolage, for its part, included that exact same forward rate for the euro-krone conversion (7.4406) on its internal spreadsheet for the November 26 trade. (JA6462 (line 28).) In addition, Bricolage's spreadsheet for each of the trades — including the November 26 trades — expressly notes that Deutsche Bank would be using the “7 day forward rate” when calculating the small payout related to the Partnerships' cash investment. E.g., JA6464 (lines 92-93), JA6544 (lines 94-95), JA6640 (line 94). Bricolage sent Deutsche Bank a copy of its spreadsheets recording its acceptance of Deutsche Bank's use of the 7-day forward rate. (JA7038, JA7046 (line 94) (copy from Deutsche Bank's files of Bricolage's spreadsheet for December 18 trade).)

Tellingly, Bricolage never complained that Deutsche Bank calculated the November 26 large payouts to exactly equal the loan repayments, thus precluding Bricolage from receiving any gain whatsoever from the winning options. In this regard, on December 10, 2001, Deutsche Bank sent Bricolage an email summarizing the “payouts made by Deutsche Bank” for the “option trades executed on 26-Nov-01” and those payouts related only to the small payouts from the losing options that Deutsche Bank would retain until the maturity date in 2003.²⁰ (JA6836.) In response, Bricolage did not question why there was not a single payment from any of the winning options for the November 26 block of trades. According to the Partnerships, if the correct spot exchange rate had been used to settle the November 26 trades, rather than the 7-day forward rate, the Partnerships should have received almost $9,000 from the winning options' large payouts after the loans for the option premiums had been repaid. (JA1180,JA1183.) But, consistent with Deutsche Bank's spreadsheet for the November 26 trades indicating that the 7-day forward rate would be used to settle the trades (JA6839) and that doing so would provide Bricolage “0” from the winning options (JA6840 (lines 15, 24)), Bricolage in fact received $0 from the winning options because the 7-day forward rate was used to settle the trades, causing the large payout to exactly equal the amount of the euro and krone loans (JA2579).

Given this evidence of coordination between the parties, the absence in the record of an email exchange between Deutsche Bank and Bricolage actually exchanging the spreadsheets for the November 26 trades is of no moment. Indeed, in its promotional materials, Bricolage asserted that the “Option payoff of winning position will pay off loan” (JA492); that declarative statement could only be true if the parties had agreed in advance to the rates to be used on the settlement date, as the Commissioner's expert explained (JA454). And, again, there is no dispute (Op/JA1940; JA2353, JA2579) that Deutsche Bank in fact utilized the 7-day forward rate on the November 26 trade — without any complaint by Bricolage — to eliminate any gain or loss with regard to the large payouts and repayment of the loans. In light of this compelling circumstantial evidence, it was more than reasonable for the Tax Court to conclude that the parties had exchanged spreadsheets for the first trade as they had done with the latter two trades. See Doe v. U.S. Postal Serv., 317 F.3d 339, 343 (D.C. Cir. 2003) (explaining that the Court “generally draw[s] no distinction between the probative value of direct and circumstantial evidence”).

Further supporting the Tax Court's finding is the undisputed fact that the Partnerships' own books recorded that the option trades were settled without generating any gain or loss. In this regard, the Partnerships' general ledgers evidenced that “all of the binary trades came out with zero gain or loss for each partnership” when the 7-day trades settled, as Beer conceded at trial. (JA2579, JA2617.) To zero out the trades, the Partnerships' internal calculations used the spot rates in place the day the trades were entered into, rather than the spot rates prevailing on the day the trades were settled. (JA696, JA2174, JA2579, JA2617.) That Deutsche Bank used the 7-day forward rates to settle the trades with zero gain or loss, and the Partnerships used a different rate (the spot rates from the original trade dates) to record that the trades were settled with zero gain or loss, does not undermine the Tax Court's finding that the parties agreed to eliminate all risk or profit potential, as the Partnerships suggest (Br. 17). To the contrary, the calculations of both parties confirm that the parties agreed that the trades would not be settled by using the settlement date spot rates, which would have produced some gain or loss on the trades, as the Commissioner explained to the Tax Court (JA696). See JA2299 (Beer concedes that using the “forward price or the initial spot price” produces equivalent outcomes).

Likewise, that there were discrepancies in Deutsche Bank's calculations and in Bricolage's calculations regarding the dollar value of the large payouts (Br. 49-50 n.27) is irrelevant. It is undisputed that, under both parties' calculations, the Partnerships received zero dollars from the large payouts. That is, both Deutsche Bank and Bricolage calculated the large payouts on the settlement date so that they resulted in zero gain and zero loss on the option trades. And, again, those calculations were able to net out to zero because neither party used the actual spot (market) rate applicable for the settlement date. That is the relevant point. The transaction was designed so that Deutsche Bank never had to actually pay the large payout amounts to the Partnerships, and the Partnerships never took possession of any physical currencies from the winning options — the payouts were merely bookkeeping entries. Accordingly, exactly how Bricolage calculated the U.S. dollar amount of the large payouts on the Partnerships' general ledgers for purposes of zeroing out its obligations on the loan is wholly irrelevant.

Finally, the parties agree (i) that Deutsche Bank settled every single option trade using the 7-day forward rates set out in the exchanged spreadsheets rather than the “actual spot rates in effect on the settlement dates” (Br. 47), and (ii) that the Partnerships never complained to Deutsche Bank in any way about that behavior. This “pattern” evidence — standing alone — is compelling evidence that the parties understood that the trades would be settled in a way that eliminated all gain or loss on the trades. Dewees v. Commissioner, 870 F.2d 21, 31 (1st Cir. 1989) (holding that the “Tax Court was free to draw reasonable conclusions from the general pattern of transactions before it”). But the Tax Court's ruling was not based solely on that pattern evidence. Rather, the court's finding that the parties agreed that Deutsche Bank would use forward rates to settle the trades is supported by other evidence in the record, as detailed above. Given that abundant evidence, the Tax Court was not required to resort to a “species of res ipsa loquitur,” as the Partnerships contend (Br. 47).

b. The Tax Court's credibility determination regarding Beer's purported explanation for the 7-day forward rates is not clearly erroneous

The Partnerships' attempt to explain away the evidence of the parties' agreement through Beer's discredited testimony is unavailing. In this regard, the Partnerships contend (Br. 42-43) that the parties included 7-day forward rates in their spreadsheets “to ensure that the trades were properly priced” and that Deutsche Bank's use of the 7-day forward rates to settle the trades was merely an error, citing Beer's testimony to that effect. The Tax Court properly dismissed Beer's testimony as “self-serving” and not “credible.” (Op/JA1940.) The Partnerships have provided this Court no reason to reweigh the evidence in this regard or second-guess the trial court's “'credibility determinations,'” which are “'entitled to the greatest deference from this court on appeal.'” United States v. Vega, 826 F.3d 514, 543 (D.C. Cir. 2016) (citation omitted).

To begin with, Beer's testimony “presupposes that Deutsche Bank erred in this way, not once, but every time it closed a [Bricolage] options trade,” as the Tax Court explained. (Op/JA1940.) Repeating the exact same “error” over and over again for dozens of trades in and of itself strains plausibility. But Beer's testimony also conflicts with other evidence in the record. It conflicts with his promotional materials assuring potential shelter purchasers that the large payout “will” be sufficient to “pay off [the] loan” for the option premiums, an assurance that would only be true if the conversion rates were fixed in advance. (JA492.) It conflicts with Deutsche Bank's spreadsheets spelling out how the 7-day forward rates would be used to settle the trades in a way that would allow the large payout to zero out the loan and leave no foreign-currency gain or loss. (E.g., JA6840 (lines 15, 24).) It conflicts with Bricolage's spreadsheets, which expressly noted that Deutsche Bank would be utilizing the 7-day forward rate in its settlement calculations. (E.g., JA6464 (lines 92-93).) And it conflicts with the parties' emails concerning the “agreed” upon settlement “conversion rate” (JA6917, JA6997), which was the same as the forward rate (JA6909 (line 22), JA6956 (line 22)).

Beer's testimony also conflicts with his concession that the Partnerships' general ledgers did not book any gain or loss on the trades but simply applied the large payout received on each option pair to offset the loan owed for the premiums on each option pair. (JA2579, JA2617.) He further acknowledged that the trades zeroed out on the ledgers because the rates used to convert krone to euro and vice versa on the settlement date “was inconsistent with the actual range of spot rates on that day.” (JA2580; see also JA2299.) He speculated that the Partnerships calculated the trade settlements to net to zero as “a clerical error between two junior employees.” (JA2583.) The Partnerships did not, however, call those “junior employees” to testify about their purported error and therefore provided no support for Beer's self-serving, implausible testimony.

Importantly, the Partnerships never once questioned why the option trades generated not a single dollar of foreign-currency gain or loss during the 7-day period of the trades. Beer's post-hoc explanation (Br. 48) — properly rejected by the Tax Court as lacking credibility — does not serve the Partnerships' cause here. Either the expected amount of gain or loss due to currency fluctuations during the 7-day period was so de minimis as to negate any reason for Bricolage to question why the actual payouts produced no gain or loss. Or (as the Tax Court found) the parties understood that Deutsche Bank would settle the option trades using the 7-day euro/krone forward rates reflected in the trade summary spreadsheets, and that such agreed-upon rates eliminated any gain or loss. Both scenarios support the Tax Court's determination that there was no reasonable expectation of profit when the parties entered into the trades. See, below, § B.1.d.

In any event, the Partnerships' contention (Br. 42-43) that this Court should adopt its “explanation” of the evidence misapprehends the Court's function in reviewing the Tax Court's factual findings. As the Supreme Court has explained: “If the [trial] court's account of the evidence is plausible in light of the record viewed in its entirety, the court of appeals may not reverse it even though convinced that had it been sitting as the trier of fact, it would have weighed the evidence differently.” Anderson v. City of Bessemer, 470 U.S. 564, 573-574 (1985). As detailed above, the Tax Court's factual findings are more than plausible in light of the entire record.

c. The Tax Court correctly drew a negative inference from the Partnerships' failure to call any Deutsche Bank witness to support Beer's story as to why Deutsche Bank used the 7-day forward rates

In addition to lacking credibility, Beer's testimony regarding the “likely” reasons (Br. 17-18) that Deutsche Bank included a 7-day forward rate in its spreadsheets, and then used that rate when settling the trades, was based on pure speculation. In this regard, the Partnerships did not call any Deutsche Bank witnesses, even though they reserved the right to do so on their pre-trial witness list. (JA584.) That litigation strategy prompted the Tax Court to conclude that Deutsche Bank's testimony on this point would have been unfavorable to the Partnerships' theory of the case. (Op/JA1940.)

The Partnerships contend (Br. 43) that the Tax Court abused its discretion in drawing a negative inference (Op/JA1940) from their failure to call those witnesses. That contention lacks merit. Given that Deutsche Bank was the counterparty and calculation agent on each of the trades at issue (JA2306), and earned millions in fees from Bricolage's tax-shelter business (JA2112), the two entities had a special relationship, and “an adverse inference is 'natural and reasonable'” from the Partnerships' failure to call those witnesses. Huthnance, 722 F.3d at 379 (citation omitted).

That the Commissioner also had the ability to call the Deutsche Bank witnesses (Br. 44) does not preclude the fact finder from drawing an adverse inference from the Partnerships' failure to do so. See United States v. Young, 463 F.2d 934, 943 (D.C. Cir. 1972) (recognizing that “where each side has the physical capacity to locate and produce the witness, and it is debatable which side might more naturally have been expected to call the witness, there may be latitude for the judge to leave the matter to debate without an instruction, simply permitting each counsel to argue to the jury concerning the 'natural' inference of fact to be drawn”). Nor does the Government's non-prosecution agreement with Deutsche Bank (Br. 29, 44) change the fact that Bricolage had a special relationship with Deutsche Bank. See JA188-189 (Commissioner's expert describes highly “unusual” “intimate relationships” between Bricolage and Deutsche Bank in the offsetting-options trades). Because the Partnerships relied on Deutsche Bank's purported motives in executing the trades, they had every “reason” (Br. 46) to call Deutsche Bank to explain why the transaction was executed in a manner that eliminated all gain or loss on every single trade that the parties engaged in.

The Partnerships' suggestion (Br. 43-44) that Deutsche Bank was “entirely within the IRS's control” is baseless. The Partnerships had the ability to subpoena Deutsche Bank and its current and former employees pursuant to I.R.C. § 7456. Indeed, as noted above, the Partnerships expressly reserved the right to call those witnesses in the event that the Commissioner chose not to call them. (JA584.) Nothing in the non-prosecution agreement prevented Deutsche Bank from cooperating with the Partnerships or its employees (current or former) from testifying truthfully in court.

But, in any event, any error in this regard would have been harmless. See Huthnance, 722 F.3d at 381-382 (holding that adverse-inference instruction was harmless). The Tax Court did not rely on any single “fact standing alone” (Br. 46), but instead relied on a preponderance of all of the evidence (Op/JA1934). As detailed above, the Commissioner's contention that the parties had agreed to calculate the large payouts so that they would net out against the loans is supported by other evidence in the record including:

• Deutsche Bank's spreadsheets containing 7-day forward rates and calculations using those conversion rates to produce zero gain or loss (JA6839-6840, JA6909-6910, JA6956-6957);

• Deutsche Bank's emails to Bricolage regarding the spreadsheets (JA6898, JA6941) and “agreed” upon “conversion rate” (JA6917, JA6937, JA6997);

• notations on Bricolage's spreadsheets that Deutsche Bank is “using the 7 day forward rate” in its settlement calculations (JA6464, JA6476);

• Bricolage's promotional materials promising that the large payout “will” cover the loan (JA492);

• the Commissioner's expert's analysis of Bricolage's promotional materials and Deutsche Bank's spreadsheets (JA220-225, JA452-455, JA2349-2350, JA2385-2386);

• the undisputed fact that Deutsche Bank utilized the 7-day forward rates to net out the large payouts and the loans without any resulting gain or loss in any of the offsetting-options trades (JA2251, JA2358);

• Deutsche Bank's emails to Bricolage computing payouts to the Partnerships on only the losing options (JA6836, JA6917, JA6997-6998);

• the undisputed fact that Bricolage never complained to Deutsche Bank about the complete absence of gain or loss with regard to the large payouts on each trade; and

• the undisputed fact that the Partnerships' general ledgers booked no gain or loss on the large payouts (JA2579-2580).

Given this ample evidence, the Tax Court had more than enough reason — even without the adverse inference — to conclude that Bricolage and Deutsche Bank engineered the offsetting-options trades to avoid any risk or gain and that the transactions lacked economic substance.

The Partnerships' alternative suggestion that the Tax Court should have drawn an adverse inference against the Commissioner for not calling a Deutsche Bank witness (Br. 44-46) is unfounded. As the Tax Court ruled during the trial, the Commissioner was required to explain the Deutsche Bank spreadsheets, and demonstrate their relevance to the issues in the case, but did not need to call a Deutsche Bank “witness” to meet that burden. (JA2210, JA2216.) The Partnerships' assertion that the “Tax Court expressly told the parties that it would be the IRS's burden to call such witnesses to 'tie the numbers in'” (Br. 45) ignores the court's contrary ruling. The court expressly rejected the Partnerships' argument that the Commissioner could not meet its burden “without a witness” (JA2210). After the court rejected the Partnerships' argument, the Commissioner made clear that it did not need to call a Deutsche Bank witness to explain the documents or demonstrate their relevance and therefore did not intend to call such a witness. (JA2221, JA2246.) Evidently, the court ultimately agreed and was satisfied with the Commissioner's detailed analysis of the spreadsheets in its post-trial briefing. See, above, n.8.

d. Even without the parties' agreement to fix the exchange rates, the offsetting-options trades lacked economic substance

Even if the parties had not agreed that Deutsche Bank would settle the trades using the 7-day forward rates, the trades would nevertheless lack economic substance because (as the Tax Court found) they were designed to be “offsetting” (Op/JA1938) and could therefore be expected to produce only negligible economic results. By design, each option pair would have a winning and a losing option that — taken together — produced an economic wash. (JA209, JA2266.) As the Commissioner explained, even ignoring the use of forward rates, the “structure of the trades alone” as offsetting mirror transactions eliminated any possibility of real profit with respect to the large payout (JA2634-2635), and any expected “profit was de minimis compared to the tax benefits” (JA1493). Therefore, even if the record did not support the Tax Court's finding regarding the prearranged rates — which it does — the Partnerships nevertheless are unable to demonstrate that the offsetting-options trades should be respected for tax purposes.

Simply having some “profit potential” — no matter how remote or insignificant — does not immunize a transaction from analysis under the economic-substance doctrine, as the Partnerships contend (JA1659-1665). Indeed, the courts in Kearney and Nevada Partners emphasized this well-settled principle when rejecting the POPS tax shelter. See Kearney, 803 F.3d at 1296 n.25 (holding that the option trades had no meaningful profit potential, even though they “made some actual profits,” because (among other reasons) they were “de minimis compared to the amount invested”); Nevada Partners, 720 F.3d at 612-613 (holding that potential profit of $77,000 was “relatively insignificant” when compared to “the $18 million tax benefit”).

Several other courts of appeals have reached the same conclusion and have compared the amount of expected profit potential with the amount of the expected tax benefit. For example, in Sala, the Tenth Circuit rejected another tax-loss-generating transaction that (unlike the Partnerships' transaction) actually generated a $100,000 profit and had the potential to generate $500,000 more, holding that the “existence of some potential profit is 'insufficient to impute substance into an otherwise sham transaction' where a 'common-sense examination of the evidence as a whole' indicates the transaction lacks economic substance.” 613 F.3d at 1254 (citation omitted). As the court explained, even though the transaction had the potential to generate over $500,000 in economic profit, that profit was “negligible in comparison to the $24 million tax benefit” that the transaction was specifically designed to generate. Id.; accord Reddam v. Commissioner, 755 F.3d 1051, 1061 (9th Cir. 2014) (rejecting transaction even though it “could have created a sizeable economic gain,” because that gain “pales in comparison to the expectation that it would always create a tax loss of $42,000,000 to $50,000,000”); Blum v. Commissioner, 737 F.3d 1303, 1307 (10th Cir. 2013) (rejecting tax shelter even though the transaction “presented the possibility of profit”); WFC Holdings Corp. v. United States, 728 F.3d 736, 746 (8th Cir. 2013) (holding that “'[m]odest profits relative to substantial tax benefits are insufficient to imbue an otherwise dubious transaction with economic substance'”) (citation omitted); Crispin v. Commissioner, 708 F.3d 507, 514 (3d Cir. 2013) (same); Jade Trading, 598 F.3d at 1377 (same). As these courts correctly recognize, that a transaction has the potential to make a relatively minor profit does not necessarily mean that the transaction has sufficient economic substance to be recognized for federal tax purposes.²¹

The decisions of this Court are not to the contrary. Rather, this Court (citing binding precedent) has recognized that, to be respected for tax purposes, a transaction must “'appreciably affect'” a taxpayer's economic interests. ASA Investerings, 201 F.3d at 514 (quoting Knetsch, 364 U.S. at 366). This Court has also held that “de minimis” economic “risk” is insufficient to give a tax-motivated transaction economic substance. Id. Indeed, this Court apparently concurs with the reasoning of its sister circuits, stating (in the context of affirming accuracy-related penalties imposed on an artificial tax loss) that “the improbable tax advantages offered by the tax shelter — a $1 million dollar loss from a transaction that earned [the taxpayer] $10,000” should have alerted the taxpayer “to the shelter's illegitimacy.” 106 Ltd., 684 F.3d at 93; see also Horn, 968 F.2d at 1237 n.10, 1238 n.13 (observing that the Court had not yet decided exactly “how much profit potential or economic risk, relative to the expected tax benefit, is sufficient to take the transaction outside the economic transaction doctrine”).

To be clear, the Partnerships did not reasonably expect any pre-tax profit at all, given that the parties agreed to settle the option trades using rates that eliminated all potential gain or loss, as demonstrated above. But even if those agreed-upon rates had not been used, the admittedly “small” amount of expected profit (JA2617) — “tens of thousands” in Beer's estimation (JA2580) — pales in comparison to the guaranteed $144 million tax loss (Op/JA1926).

Finally, the Partnerships' remaining profitability arguments lack merit. Their contention that “half” of the Partnerships could have made “a substantial amount of money” if the krone depegged from the euro (Br. 25 & n.16) fails to evince that the transactions had economic substance. As the Tax Court found — and the Partnerships do not dispute (Br. 14; JA2148) — such a “depeg was extremely unlikely.” (Op/JA1944.) See JA472-473 (Commissioner's expert explained that possibility of the currencies decoupling was “remote” and that there were far simpler, less costly ways to bet on such an unlikely event). A transaction's economic substance is evaluated on the basis of a party's reasonable expectations, not on extremely “unlikely” or remote events. ASA Investerings, 201 F.3d at 514-515; accord Blum, 737 F.3d at 1312 (holding that the “mere possibility” of profit did not provide a “reasonable expectation of profit” for purposes of the economic-substance doctrine); Stobie Creek Invs. LLC v. United States, 608 F.3d 1366, 1376-1378 (Fed. Cir. 2010) (holding that option trades with Deutsche Bank lacked economic substance where (among other things) the profit potential was predicated on the unlikely event of certain foreign “currencies decoupling”).

Nor does the $128,000 net payment that the Partnerships received in October 2002 (representing the sum of the small payouts minus the sum of the Partnerships' cash investment (Br. 26)) demonstrate that the offsetting-options trades had economic substance. As the Tax Court found, that amount, in substance, was not the result of an option trade but was nothing more than the Partnerships' making a “bank deposit” in a foreign currency that was returned “one year later, with interest at LIBOR as agreed in advance.”²² (Op/JA1941.) Indeed, the Partnerships' own expert conceded as much, referring to the small payout as “essentially” a “certificate of deposit denominated in either euros or kroner” that matures two years later with interest. (JA350.)

2. The Tax Court did not clearly err in finding that the offsetting options lacked any business purpose

The Tax Court found that the Partnerships engaged in the paired foreign-currency options solely to generate tax losses. (Op/JA1941-1948.) That finding, too, is well supported by the record.

a. The evidence amply supports the Tax Court's finding

A finding that a transaction was not motivated by business reasons can be supported by evidence that it was part of a “prepackaged strategy marketed to shelter taxable gain.” Stobie Creek, 608 F.3d at 1379; accord Crispin, 708 F.3d at 515. Here, the Partnerships' option trades were part of a prepackaged tax-avoidance strategy that Beer and his Bricolage affiliates had sold to dozens of other taxpayers, as Beer conceded at trial and the Tax Court found. (Op/JA1942-1943; JA2071.) Formed in 2000, the Partnerships were designed as vehicles to carry losses for Bricolage's tax-shelter-purchasing clients, and, after serving that function, engaged in the trades at issue in 2001 to create embedded tax losses that could be utilized in subsequent years. (JA2071-2073, JA2248, JA2429, JA2621.) The prearranged steps of the Partnerships' transactions — whereby the Partnerships purchased offsetting options, allocated initial gains to one entity, and then allocated the related offsetting losses to a different entity — paralleled the generic option trades outlined in Bricolage's tax-shelter marketing materials and were in all material respects identical to the steps followed in every other POPS transaction implemented by Beer and Bricolage. (Op/JA1892-1894, Op/JA1902-1926; JA454, JA488-492, JA2064-2066; JA6707.) See also JA5412 (POPS marketing material illustrating how a “$25 million Realized Loss Leg” recognized in 2001 was an “offsetting position” to the $25 million “Gain 'leg' recognized in December 2000”).

The design of the POPS transaction further supports the Tax Court's finding that the Partnerships were motivated solely by tax purposes. “Evidence that a transaction was designed to 'produce a massive tax loss' indicates the transaction lacks economic substance.” Blum, 737 F.3d at 1311 (quoting Sala, 613 F.3d at 1255); accord Stobie Creek, 608 F.3d at 1379. Here, as Beer conceded, the transaction was designed to produce “large losses” (JA2147-2149, JA2248) — a massive $144 million loss that was wholly artificial. And he further conceded that the offsetting trades were “tax advantaged” (JA2180) and failed to demonstrate that they provided any economic advantage whatsoever.

The structure of the trades themselves confirms the Partnerships' tax motivation. The size of the options' nominal premiums had absolutely nothing to do with any investment strategy; each option pair — by design — had a winning payout and a losing payout and each winning payout — by design — exactly equaled the amount of the loan for both options in the pair. (JA204-211, JA224, JA453-454.) The ultimate economics of the winning option would not have changed if the Partnerships won $1 billion, $1 million, or $1 — in each instance, the Partnerships would receive $0 after repaying the loan. Only the tax result would have changed. There was no business reason for engaging in these offsetting transactions rather than simply making a foreign-currency deposit equal to the amount of the losing payout, as the Commissioner's expert testified. (JA218-221, JA225, JA468-469, JA2356.)

That the option trades were designed to generate tax losses is further confirmed by Beer's claimed indifference regarding whether Deutsche Bank used the “correct” rates to settle the trades. (Op/JA1940; JA2299-2301.) E.g., Reddam, 755 F.3d at 1058 (observing that taxpayer's “indifference” to Deutsche Bank's “mispricing” of financial instruments evidences lack of business purpose); Stobie Creek, 608 F.3d at 1378-1379 (same). As the Tax Court astutely observed, “nobody cared” about business results because the Partnerships were motivated only by tax results. (JA2301.)

Further supporting the Tax Court's no-business-purpose finding is the fact that the POPS transactions were priced as a tax shelter, not a business investment. In this regard, Beer conceded that Bricolage computed its fees for the original POPS transactions engaged in by the Partnerships as a “percentage” of the “tax losses” generated by the trades (Op/JA1891, Op/JA1943; JA2254-2255), rather than “typical economic considerations” — a hallmark of an abusive tax shelter. Stobie Creek, 608 F.3d at 1380.

b. The Partnerships' business-purpose arguments lack merit

The Partnerships have failed to demonstrate any error, let alone clear error, in the Tax Court's finding that there was no business purpose for the offsetting options. See Br. 53-61. In arguing that the court erred in this regard, the Partnerships have misconstrued the court's decision. The court did not simply conclude — with no further analysis — that “its finding that the transactions could not have produced a direct profit precluded any finding of business purpose” (Br. 54). Rather, the court examined multiple factors, including how the POPS transaction was “structure[d],” “pric[ed],” and “marketed to investors.” (Op/JA1941-1942.) As explained above, the court correctly found that the transaction was an extension of earlier POPS transactions that had been structured, priced, and marketed to taxpayers as a “tax” — not a business — opportunity.

The Partnerships' contention (Br. 24-25) that it was against the interests of Deutsche Bank and Bricolage to design the option trades in a way that eliminated any risk or profit potential misses the mark. The parties had an interest in ensuring that the transactions had “the appearance of investment activity,” not actual investment activity, as Deutsche Bank acknowledged in its non-prosecution agreement with the United States. (JA4765 (emphasis added).) Rather, as Deutsche Bank further acknowledged, the “POPS” shelter and related transactions “utilized straddles to generate non-economic losses that were used by customers to offset income” and were not “designed to achieve investment objectives” but “were motivated solely by the desire to avoid tax obligations.” (JA4773 (emphasis added).) As in other cases concerning a Deutsche Bank or Bricolage tax shelter (such as Stobie Creek, Kearney, and Nevada Partners), the underlying financial transactions were engineered to generate artificial tax benefits, not real economic gains.

Similarly lacking merit is the Partnerships' challenge (Br. 55) to the Tax Court's finding that there was “no evidence” — other than Beer's discredited testimony — that Bricolage intended to transform the Partnerships into “conventional investment vehicles” (Op/JA1946). The documents cited by the Partnerships (Br. 30, 55) are not to the contrary. Rather, those documents evidence only that Bricolage hoped to continue selling tax “losses” (JA5532) to taxpayers seeking to “shelter ordinary income” (JA6089), not any purported plan to begin selling conventional business investments. The testimony cited by the Partnerships (Br. 30) likewise discusses potential clients with a “tax situation” (JA2430) and potential transactions with a “tax advantage” (JA2431), such as the “PICO” tax shelter (JA2433). And those potential clients admittedly evaporated after the IRS issued Notice 2002-65 identifying the PICO transaction as an abusive tax shelter. (JA2432, JA5384.)

That Bricolage and Beer hoped to continue their lucrative tax-shelter business by marketing the “embedded losses” held by the Partnerships after the option trades were settled (Br. 29-30, 55) does not provide the Partnerships a business purpose for the trades themselves. Almost every tax shelter generates fees for the promoters, advisors, and accommodating parties. Such fees do not give the underlying purported “investments” business purpose. The purpose of the offsetting-options trades was to spread tax losses from one year to the next, as Beer conceded (JA2248) and other record evidence confirms (JA488, JA2391, JA2473). And, as noted above, the fees that Beer hoped to earn from peddling the Partnerships' losses would be calculated as a percentage of the tax losses, not as a percentage of the purportedly expected economic profit. (Op/JA1943; JA2254-2255.)

Indeed, to hold otherwise would allow every tax-shelter promoter to engage in his own abusive transactions with impunity. That anomalous result has been rejected by other courts, which have uniformly held that shelters engaged in by the shelter's promoter lacked economic substance and business purpose. E.g., Sugarloaf Fund, LLC v. Commissioner, 911 F.3d 854, 856 (7th Cir. 2018) (disregarding as a “sham” a tax shelter utilized by the “architect of [the] tax structure” to shelter his own gains from selling the shelter); Cemco Investors, LLC v. United States, 515 F.3d 749 (7th Cir. 2008) (same); Humboldt Shelby Holding Co. v. Commissioner, 107 T.C.M. (CCH) 1242 (2014) (same), aff'd, 606 F. App'x 20 (2d Cir. 2015).

What the Tax Court correctly recognized — and what the Partnerships would have this Court ignore — is that, when applying the economic-substance doctrine, the “transaction to be analyzed is the one that gave rise to the alleged tax benefit,” not some related transaction. Coltec, 454 F.3d at 1356-1357; accord Baxter, 910 F.3d at 162-163 (collecting cases); Nevada Partners, 720 F.3d at 613. Here, the alleged tax benefit — the $144 million artificial loss — was generated by the option trades, not by Bricolage's ability to market tax losses to tax-shelter purchasers. (Op/JA1947.) That Beer and Bricolage were able to profit from fees paid by POPS-shelter purchasers does not mean that the underlying POPS investments — designed to generate large artificial losses — had any real profit potential or business purpose.

The Partnerships' remaining business-purpose arguments are similarly off-base. The fact that the $144 million artificial loss generated by the offsetting-options scheme exceeded the amount of gain ($40 million) that Beer ultimately tried to shelter from taxation does not evidence a business purpose for the underlying trades (Br. 32, 55). The Partnerships reported the full amount of the artificial loss on their tax returns and, because the loss arose from a transaction that lacked economic substance, the Commissioner properly disallowed the entire amount in adjusting the Partnerships' tax returns. Moreover, the “$40 million in gains” realized by Beer and the $144 million in losses reported by the Partnerships were in fact “unrelated” (Br. 32) in that the losses were generated by the offsetting-options trades and the gains were generated by the fees that Beer charged for selling other tax losses to tax-shelter purchasers. And the fact that Beer may not have paid Deutsche Bank a fee for utilizing the artificial losses generated here (Br. 32-33, 55) is irrelevant. As Deutsche Bank acknowledged in the non-prosecution agreement, it was often the case that promoters and other tax-shelter facilitators would utilize the tax shelter to eliminate gains generated by the tax-shelter business and that no fees would be charged for such use. (JA4771.)

CONCLUSION

The decisions of the Tax Court should be affirmed.

Respectfully submitted,

RICHARD E. ZUCKERMAN
Principal Deputy Assistant Attorney General

FRANCESCA UGOLINI (202) 514-1882
JUDITH A. HAGLEY (202) 514-8126
Attorneys
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044

MAY 2019