Partnerships Argue Tax Court Erred in Economic Substance Decision

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

United States Court of Appeals
for the District of Columbia Circuit

(Consolidated with 18-1276, -1277, -1278)

On Appeal from the Decisions of the U.S. Tax Court,
in Nos. USTC-8721-12, USTC-8846-12, USTC-8698-12, USTC-8710-12

REPLY BRIEF FOR PETITIONERS-APPELLANTS

ADRIENNE B. KOCH
DAVID L. KATSKY
ELIAS M. ZUCKERMAN
HALEY E. ADAMS
KATSKY KORINS LLP
605 Third Avenue
New York, New York 10158
(212) 953-6000
akoch@katskykorins.com
dkatsky@katskykorins.com
ezuckerman@katskykorins.com
hadams@katskykorins.com

Counsel for Petitioners-Appellants

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TABLE OF CONTENTS

TABLE OF AUTHORITIES 

GLOSSARY 

PRELIMINARY STATEMENT 

STATUTES AND REGULATIONS 

SUMMARY OF ARGUMENT 

ARGUMENT

CONCLUSION 

TABLE OF AUTHORITIES

Cases:

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

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

Bowyer v. District of Columbia, 793 F.3d 49 (D.C. Cir. 2015)

Bufco Corp. v. N.L.R.B., 147 F.3d 964 (D.C. Cir. 1998)

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

Christian Legal Soc. Chapter of the Univ. of Calif. v. Martinez, 561 U.S. 661 (2010) 

Czekalski v. LaHood, 589 F.3d 449 (D.C. Cir. 2009)

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

Estate of Parsons v. Palestinian Auth., 715 F. Supp. 2d 27 (D.D.C. 2010), aff'd in part, rev'd in part on other grounds, 651 F.3d 118 (D.C. Cir. 2011) 

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

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

In re Papst Licensing GmbH & Co. KG Litigation, 767 F. Supp. 2d 1 (D.D.C. 2011) 

McCormick v. District of Columbia, 752 F.3d 980 (D.C. Cir. 2014) 

Moses v. Howard Univ. Hosp., 567 F. Supp. 2d 62 (D.D.C. 2008), aff'd, 606 F.3d 789 (D.C. Cir. 2010) 

Muhammed v. Close, 540 U.S. 749 (2004) 

Oscanyan v. Arms Co., 103 U.S. 261 (1880)

Queen v. Schultz, 671 Fed. App'x 812 (D.C. Cir. 2016)

Radtke v. Caschetta, 822 F.3d 571 (D.C. Cir. 2016)

Skinner v. U.S. Dept. of Justice and Bureau of Prisons, 584 F.3d 1093 (D.C. Cir. 2009) 

U.S. v. Coughlin, 610 F.3d 89 (D.C. Cir. 2010) 

U.S. v. Glenn, 64 F.3d 706 (D.C. Cir. 1995) 

United States v. Davis, 596 F.3d 852 (D.C. Cir. 2010) 

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

Washington Regional Medicorp. v. Burwell, 813 F.3d 357 (D.C. Cir. 2015) Williams v. Illinois, 567 U.S. 50 (2012) 

Statutes & Other Authorities:

Federal Trial Handbook Civil § 63.2

Fed. R. Evid. 803(6)

Fed. R. Evid. 901(a) 

GLOSSARY

App Br.	appellants’ opening brief on appeal
Bricolage	Bricolage Capital, LLC, one of the entities in the Delta Group (sometimes also used by the IRS to refer to the Delta Group as a whole)
Delta	Delta Currency Trading, LLC, one of the entities in the Delta Group
Delta Group	Bricolage, Delta, and Counterpoint Capital, LLC together with their affiliates (including the Partnerships)
DOJ	United States Department of Justice
DKK	Danish krone
Eur	Euro
FPAA	Final Partnership Administrative Adjustment
FX options or FX binary option pair trades	trades consisting of two options, one priced in Eur and the other in DKK, each option representing, in the first instance, a bet on the exchange rate between two foreign currencies as of a date seven (7) days following the date of the trade, and, as result of the financing of the purchase of the two options, also representing a bet on currency fluctuations between the Eur and DKK, and between each of those currencies and the U.S. dollar by virtue of the dollar-based investment by each Partnership
IRS	United States Internal Revenue Service
IRS Br.	appellee’s responsive brief on appeal
JA	Joint Appendix
LIBOR	London Inter-Bank Offered Rate
Non-Prosecution Agreement	the agreement entered into in or about December 2010 between Deutsche Bank and the DOJ (reproduced at JA 4757-86)
Memorandum	the Memorandum Findings of Fact and Opinion filed on June 28, 2018 in the US Tax Court (Lauber, J.) (reproduced at JA1886-1951)
Partnerships	Endeavor Partners Fund, LLC, Alligator Partners Fund, LLC, Cabrini Partners Fund, LLC, and Satellite Partners Fund, LLC
Petitioners	the Partnerships and Delta
PICO	Personal Investment Corporation
POPS	Partnership Option Portfolio Securities

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PRELIMINARY STATEMENT

This appeal is not about tax shelters; it is about procedural fairness and the rules of evidence. The IRS represented below that it would prove through the testimony of five witnesses that the parties agreed to rig the exchange rates at which certain transactions would be settled, but after hearing Petitioners' evidence the IRS withdrew those witnesses — including the three Deutsche Bank witnesses it controlled — one after the other until none testified. The Tax Court repeatedly and consistently ruled that the IRS bore the burden of proving that the documents at the heart of its case were what it said they were and established rigging, but when it came time to impose that burden the Tax Court instead shifted it to Petitioners. In doing so, the Tax Court reached the pivotal conclusion on which its ruling is based by holding the IRS to a relaxed evidentiary standard that tilted the field in a way the rules do not allow.

The IRS's brief is an effort to wish away this history. Unable to find support for the Tax Court's rulings in the trial record or its arguments below, the IRS attempts on appeal to rewrite that record and retry the case on a different theory. The most glaring example of this is the central premise of the IRS's brief: that the transactions at issue must fail because they are “POPS” transactions of a type that has already repeatedly been found to lack economic substance. (See, e.g., IRS Br. at 1-8, 13, 15-16, 31-32, 35-40, 43-45, 69-70, 76, 78-80, 82). But in the Tax Court, the IRS conceded — and the Tax Court held — that these transactions are not POPS transactions. As the Tax Court explained:

While the POPS, PICO and related tax shelters are not directly involved in these cases, the facts flowing from their implementation are inevitably part of the factual narrative leading up to the transactions involved here. Respondent may put on any relevant evidence concerning this factual narrative. That said, the transactions involved in these cases will be fairly evaluated on their own merits, without any prejudicial thumb on the scale attributable to transactions in which these entities may previously have engaged.

(JA1007-1008, emphasis added). The Tax Court repeated during trial that information about other transactions (including POPS) would not “color [its] view of what happened” in the transactions at issue, and the IRS accepted that caveat as a condition to the admission of evidence concerning those other transactions. (See JA1960). The IRS cannot now escape the failure of its proof below through incessant incantations of POPS.¹

In the Tax Court the IRS also repeatedly conceded that absent an agreement to rig the exchange rates these transactions (unlike POPS transactions) would have involved “tremendous risk.” (See infra at 22-24). The IRS argued that this “risk” demonstrated that the exchange rates must have been rigged because otherwise Deutsche Bank would not have undertaken the transactions. (See JA1355; JA1492-3; JA1504; JA1828). Although it has abandoned that argument on appeal, the effect of the concession — and of the rulings the Tax Court made in light of it — remains: the transactions here were not POPS transactions; if the exchange rates were not rigged they would have involved “tremendous risk”; and the principal question on appeal is whether the Tax Court erred in finding they were rigged.

As detailed below, the answer to that question is yes. And while the IRS argues at length that this does not require reversal, all of those arguments are either (a) inconsistent with the record, or (b) based on purported “evidence” that is not evidence at all. We respectfully submit that to affirm on any of these grounds would compound the procedural and evidentiary infirmities from which the Tax Court's decision suffers.

As a result, the Tax Court's finding that the transactions lacked economic substance should be reversed, and the case should be remanded so that the Tax Court may address the IRS's “alternative arguments” that the “[P]artnerships were shams and that the transactions violated subchapter K's antiabuse provisions.” (See JA1934; accord IRS Br. at 40, n.12).

STATUTES AND REGULATIONS

See opening brief.

SUMMARY OF ARGUMENT

The Tax Court's finding that the transactions lacked economic substance because the parties deprived them of profit potential by rigging the exchange rates is infected with a legal error that requires its reversal: an adverse inference improperly drawn against Petitioners because of the absence of certain witnesses from Deutsche Bank. Contrary to the IRS's arguments, that inference was improper as a matter of law because those witnesses were at least as available to the IRS as they were to Petitioners and in fact were under the IRS's direct control. (Point I.A.1).

This improper adverse inference requires reversal because it “substantially affected the outcome of the case.” Huthnance v. District of Columbia, 722 F.3d 371, 381 (D.C. Cir. 2013). That the inference had such an effect is clear on the face of the Tax Court's Memorandum, which cites the inference as a basis for its conclusion. But if there could be any doubt, none of the alternative “evidence” the IRS cites could constitute a basis for affirmance, both because the Tax Court did not actually rely on any of it (and most of it was not even argued below) and because none of it qualifies as evidence in any event. (Point I.A.2). We respectfully submit that the IRS had the burden of proof and failed to carry it (Point I.B), but regardless of burden of proof the finding that the transactions were rigged cannot stand.

The IRS is incorrect when it asserts that this Court can affirm without upholding that finding. Contrary to the IRS's characterization, the Tax Court did not find that the transactions would lack profit potential even if the exchange rates were not rigged. Quite the opposite: it expressly found that absent such rigging the transactions would have had a potential for profit. While under other circumstances that might not preclude this Court from affirming on the alternative grounds the IRS now argues, here it may not do so because the IRS affirmatively asked the Tax Court to find that absent such rigging the transactions would have involved “tremendous risk.” Moreover, the IRS's current claim would be unavailing even if its arguments below did not preclude that claim: this Court may affirm on alternative grounds only on de novo review, and in any event may not do so on grounds not argued below absent “exceptional circumstances” that the IRS does not even argue are present here. For all of these reasons, the Court should decline to find that the transactions lacked profit potential on the alternative grounds the IRS now argues. (Point II).

If the Court does find that the transactions lacked profit potential, it should nevertheless reverse the finding that they lacked economic substance because their business purpose — to position the Partnerships to serve as components of investment products that were being developed to be sold for a profit — independently gave them economic substance within the meaning of this Court's jurisprudence. The IRS's argument on business purpose fails to engage with the arguments Petitioners actually made in their opening brief, instead falsely characterizing the transactions as “POPS transactions” and arguing that POPS transactions lack a business purpose. POPS, however, is beside the point. The transactions that are actually at issue were unquestionably intended to make money for the business that ultimately claimed their losses. That is enough to imbue them with a business purpose, which in turn gives them economic substance. (Point III).

ARGUMENT

I. THE TAX COURT'S FINDING THAT THE TRANSACTIONS WERE RIGGED WAS CLEARLY ERRONEOUS

A. The Record Does Not Support The Tax Court's Finding That The Transactions Were Rigged

1. The Tax Court Erred As A Matter Of Law In Drawing An Adverse Inference Against Petitioners

It is undisputed that, to find that the transactions were rigged to eliminate profits (and therefore lacked economic substance), the Tax Court drew an adverse inference against Petitioners based on the absence of any testimony from the Deutsche Bank witnesses. (See IRS Br. at 63-68). It is also undisputed that those witnesses were at least as available to the IRS as they were to Petitioners. (Id. at 64). The IRS's argument that this “does not preclude” an adverse inference against Petitioners (id.) is contrary to law.

“[T]he law permits” an adverse inference only where a missing witness is “peculiarly” within the power of the party against whom the inference is sought. U.S. v. Glenn, 64 F.3d 706, 709 (D.C. Cir. 1995) (collecting cases; citations and internal quotations omitted); accord Bufco Corp. v. N.L.R.B., 147 F.3d 964, 971 (D.C. Cir. 1998) (where party seeking adverse inference “could have called” the witnesses in question, adverse inference “unwarranted”). The inference is not available unless that prerequisite is met, and the burden of showing the opposing party's “peculiar[ ]” control lies with the party seeking the adverse inference. Czekalski v. LaHood, 589 F.3d 449, 455 (D.C. Cir. 2009). Since Petitioners undisputedly did not have such control over the Deutsche Bank witnesses, as a matter of law there could be no adverse inference against Petitioners.

United States v. Young, 463 F.2d 934 (D.C. Cir. 1972), on which the IRS exclusively relies for its contrary argument (see IRS Br. at 64), does not support the IRS's position. In Young, the prosecutor commented during summation on the absence of certain witnesses. 463 F.2d at 939. Although the defendant did not object at trial (see id. at 941-42), he argued on appeal that his conviction should be reversed because the prosecutor failed to obtain advance permission from the trial court before commenting on the defendant's failure to call those witnesses. Id. at 941.

Noting that any error was procedural, this Court held that it could not form a basis for reversal unless the Court concluded that “if the correct procedure had been followed the comment would not have been permitted.” Id. In affirming, the Court noted that because it was “most unlikely” that the defendant would have been able to persuade the lower court that the witnesses in question were equally available to the prosecutor, the comment would likely have been allowed if advance permission had been sought. Id. at 942.

The Court in Young also reaffirmed the settled rule that “in criminal as well as civil cases, . . . [b]oth comment by counsel and instruction by the judge as to absent witnesses is prohibited” unless “the witness is peculiarly within the power of the party to produce.” Young, 463 F.2d at 939-40 (collecting cases; emphasis added). Indeed, although it noted that “[t]here is a difference between an instruction, which has the weight of law, and argument of counsel, which is only that,” it emphasized that even an argument of counsel “must not be in conflict with the law.” Id. at 943. If a witness is “not peculiarly available to a party,” an argument of counsel asking the jury for an adverse inference “is contrary to law” and “cannot be permitted.” Id. The Court nevertheless affirmed based on the defendant's failure to preserve his objections in the lower court and the Court's conclusion that on the facts before it any error was not prejudicial.

Young does not support the proposition that it could ever be appropriate for a judge sitting as trier of fact to decide a case based on an adverse inference where the relevant witness was equally available to the other side. The adverse inference against Petitioners was improper as a matter of law, and the Tax Court committed clear error in drawing one.

Although the adverse inference analysis could stop there, the IRS is also incorrect when it asserts (at 65) that the Deutsche Bank witnesses were not in fact “peculiarly” available to the IRS. To the extent that the IRS's expert testimony that the Delta Group appeared to have an “unusual” or “intimate” relationship with Deutsche Bank (see IRS Br. at 64) could actually constitute evidence of such a relationship (but see infra at 13, n.4), at best it describes a relationship that existed in 2001 — over a decade before the trial of these cases. In the interim, Deutsche Bank had signed the Non-Prosecution Agreement in which it agreed — under penalty of criminal prosecution — to cooperate with and assist the IRS (and not Petitioners) in connection with matters that undisputedly included the very trial here. (See App. Br. at 21-22). That agreement constituted a current relationship between Deutsche Bank and the IRS that made the Deutsche Bank witnesses “peculiarly available” to the IRS within the meaning of the adverse inference jurisprudence, regardless of Petitioners' theoretical ability to subpoena them. See generally Federal Trial Handbook Civil § 63.2 (“A witness's availability is not determined solely from his physical presence at the trial or his accessibility to subpoena. Rather, availability also will turn on the witness's relationship to the nonproducing party.”) (collecting cases; citations and internal quotations omitted).

If there could have been any inference based on the absence of the Deutsche Bank witnesses, it should have been against the IRS. But in all events, as a matter of law it should not have been against Petitioners.

2. The Adverse Inference Requires Reversal

a. The Tax Court's Memorandum Makes Clear That The Adverse Inference Substantially Affected The Outcome

The Tax Court's error requires reversal because it “substantially affected the outcome of the case.” Huthnance, 722 F.3d at 381. Unlike the situation in an appeal from a jury verdict following an erroneous adverse inference instruction (where the Court must speculate about whether the jury actually made an adverse inference),² here the Court knows that the trier of fact relied on an adverse inference because the trier of fact said so. (JA1940). The Court therefore “cannot say with fair assurance that the error was harmless,” and accordingly “must conclude that the error was not.” Huthnance, 722 F.3d at 381

b. In All Events, None Of The Alternative Evidence The IRS Cites Could Support The Result The Tax Court Reached

We submit that the fact that the Tax Court expressly relied on the adverse inference in reaching its conclusion should end the inquiry. But none of the material to which the IRS now points on appeal could change the analysis in any event because none of it is actually evidence. In particular:

• The IRS argues that emails to Delta from Thomas Chin of Deutsche Bank referring to an “'agreed' upon 'conversion rate'” and to details “confirmed over the phone” show that Deutsche Bank and Delta agreed in advance on the conversion rates that would be used to close out the transactions. (IRS Br. at 66; id. at 50-51). But these out-of-court statements by a Deutsche Bank witness who was on the IRS's witness list (see JA717-18) but whom the IRS chose not to call to testify are hearsay; they cannot be used to prove the truth of their assertions. See, e.g., United States v. Davis, 596 F.3d 852, 857-58 (D.C. Cir. 2010).³ The Tax Court recognized as much when it admitted the emails into evidence: it (a) noted that Mr. Chin was slated to testify, and (b) stated that his emails themselves did “not prove that Delta agreed” to anything. (JA2220:520-21; JA2221:524). It is likely for this reason that the Tax Court did not rely on the emails in making its own determination. They similarly cannot constitute an alternative basis for affirmance. (See infra at 26-28).

• The IRS further argues that “notations on Bricolage's spreadsheets that Deutsche Bank is 'using the 7 day forward rate' in its settlement calculations” show an agreement to rig the rates. (IRS Br. at 66; id. at 60 (asserting that “Bricolage's spreadsheets . . . expressly noted that Deutsche Bank would be utilizing the 7-day forward rate in its settlement calculations”)). But that is not what the notations the IRS cites say. Instead, they say: “For the equity roll amount, Thomas Chin is taking the US Dollar amount with interest of 7 days and then converting that amount to Eur or DKK using the 7 day forward rate.” (JA6464 (emphasis added); JA6476 (emphasis added)). There is no evidence in the record regarding the meaning of “equity roll amount,” but in its briefing below the IRS asserted that this phrase referred to the amount of cash each Partnership actually invested in the trades — not the loans that were used to finance the balance of each transaction, and not the large payment that would ultimately have to be used to repay those loans. (JA1356-57 (IRS Post-Trial Brief)). Accordingly, the IRS did not argue below — and the Tax Court did not find – that this statement about “equity roll amount” had anything to do with an agreement to rig the exchange rates that would be applied in converting that large payment to the currency needed to repay the loans. The IRS's current speculation about what this phrase means is inconsistent with its speculation on the same subject in the Tax Court, and in all events it is only speculation. It cannot constitute an alternative basis for affirmance. (See infra at 22-29). Moreover, the very same “Bricolage spreadsheets” the IRS cites also show that the Delta Group projected that the transactions would turn a profit or loss and none would net to zero. (See JA6463; JA6489; JA6543; JA6597; JA6627; JA6681).

• The IRS next contends that “Bricolage's promotional materials” support a finding that the rates were rigged because they “promis[ed] that the large payout 'will' cover the loan.” (IRS Br. at 66). But in the Tax Court the IRS admitted that the document it now cites as “promotional material” did not refer to any of the transactions at issue here. More specifically, the IRS offered that document in connection with the parties' Sixth Stipulation of Facts, as Exhibit 376-R (which it described only as “a document entitled 'Investment Opportunity'”). (See JA579).⁴ Petitioners objected to it — and to various other IRS exhibits attached to the Fifth and Sixth Stipulations of Facts — on “limited” relevance grounds (see JA575), explaining that the transactions discussed in those exhibits were not the transactions at issue in these proceedings and therefore should not have any bearing on the economic substance of those transactions. (JA1959-60; JA1962). In response, the IRS explained that these documents were not being offered for that purpose, but rather to show the kinds of trading activity in which the Partnerships had engaged in prior years. The court accepted them as part of the “background narrative,” emphasizing that they would not “color [its] view of what happened” in the relevant transactions. (JA1960).⁵ The document thus plainly formed no part of the basis for the Tax Court's findings. In light of the IRS's concessions below, it may not now argue that this document constitutes an alternative basis for affirming those findings. (See infra at 22-29).

• The IRS goes on to assert that its “expert's analysis” of those “promotional materials” and of “Deutsche Bank's spreadsheets” further supports a finding of rigging. But the IRS's expert did not attempt to prove that the transactions were rigged; his analysis assumed they were. (See JA2378). His testimony therefore cannot constitute evidence of rigging; to the contrary, since rigging was an assumption underlying his analysis, the IRS was required to prove the truth of that assumption with separate evidence. See Williams, 567 U.S. at 57 (“Under settled evidence law, an expert may express an opinion that is based on facts that the expert assumes, but does not know, to be true. It is then up to the party who calls the expert to introduce other evidence establishing the facts assumed by the expert.”) (emphasis added). (See JA1008, ¶ 4 (Tax Court Order confirming that the IRS would have to prove any facts its expert assumed)).⁶

• The IRS also contends that emails sent from Deutsche Bank to Delta on December 7 and 18, 2001 attached not only copies of Deutsche Bank's own spreadsheets, but also copies of spreadsheets that (in each instance) “Bricolage had sent Deutsche Bank earlier in the day” — such that these one-way emails from Deutsche Bank to Delta were in fact part of an “exchange” of emails. (IRS Br. at 50; id. at 51). But the IRS offered no evidence (and no argument) below that anything attached to either of those emails had been sent to Deutsche Bank by Bricolage or any other the Delta Group affiliate — let alone sent earlier the same day. It is therefore not surprising that the Tax Court did not base its finding on this newly-alleged “fact.” It is at best pure speculation, made for the first time on appeal, and cannot form an alternative basis for affirmance. (See infra at 26-28).⁷

• Finally, the IRS contends that the fact that Deutsche Bank sent emails computing payouts to the Partnerships on the seventh day “on only the losing options” (that is, the “small payment” on which the Partnerships would then earn interest over a period of two years — see App. Br. at 10-12) somehow shows rigging. (IRS Br. at 67). Wholly apart from the fact that there is no evidence that what the IRS submitted represented the complete universe of all communications, because it is undisputed that in each instance the large payments resulted in no net payout to the Partnerships it would not be surprising if Deutsche Bank emailed the Delta Group only about the payouts it was actually making. Accordingly, these emails cannot provide an alternative ground for affirmance either. (See infra at 26-28).

When all of this non-evidence is put aside, what is left is an argument that the fact that none of the three block trades produced a gain or loss after seven days proves that the parties agreed in advance to settle them at a rate that would ensure that result. This reasoning is circular. The question is what caused the transactions' undisputed failure to produce a gain or loss. The outcome itself cannot constitute sufficient proof of the IRS's proffered cause. (See App. Br. at 46-50).

Dewees v. Commissioner, 870 F.2d 21(1^st Cir. 1989), on which the IRS bases its argument that the results form a “pattern” that itself has evidentiary weight (IRS Br. at 58), does not change the analysis. Dewees was “one of 1,000 similar cases before the Tax Court” involving “thousands of transactions” that undisputedly followed a “pattern.” 870 F.2d at 31. Here, in contrast, the only evidence before the Tax Court was that Deutsche Bank settled three block trades (which all took place within 22 days) using the 7-day forward rates in effect when the trades were placed rather than the spot rates in effect when they were settled. There is no evidence that Deutsche Bank did so with respect to any other trade, and the IRS disclaimed any intent to argue that it did (JA1959-60).⁸

That Dewees found a “pattern” over thousands of transactions says nothing to whether the same could be said of three. It is likely for this reason that the Tax Court did not rule on this ground. It cannot provide an alternative basis for affirmance. (See infra at 22-29).

We make one more observation. Notwithstanding the IRS's self-admittedly “circumstantial” evidence (see IRS Br. at 49-50; 55-56), among the things one would expect to see if the parties had agreed in advance on the exchange rates is their actual use of the same rates to record the results of the transactions. That undisputedly did not occur: the Partnerships recorded those result at different rates than what the Tax Court found they had “stipulated” with Deutsche Bank. (See IRS Br. at 56-57; accord App. Br. at 49-50 n. 27). The IRS's argument that this is not inconsistent with an advance agreement fixing the rates is double-talk.

* * * * *

None of the alternative “evidence” the IRS presses on appeal could support the Tax Court's finding that the transactions were rigged without the adverse inference that it improperly drew against Petitioners. This Court should therefore reverse that finding as clearly erroneous.

B. The IRS Had The Burden To Prove Rigging

We respectfully submit that the Tax Court committed clear error regardless of the burden of proof. But if there is any doubt, the Court should find that the IRS bore the burden of proving that the transactions were rigged and did not meet that burden.

In the opening brief, Petitioners argued that the IRS bore both (a) the burden to prove that the Deutsche Bank spreadsheets meant what it said they meant, and (b) the overall burden of proof with respect to its theory of rigging, which was not revealed in the FPAAs. (See App. Br. at 19-21; id. at 38-40). In response, the IRS argues that (a) it adequately explained the Deutsche Bank spreadsheets through expert testimony and arguments of counsel; and (b) its rate-rigging theory was not “new matter” as to which it should bear the burden of proof. (IRS Br. at 45-48). Each of these arguments misses the mark.

The IRS claims that the Deutsche Bank spreadsheets reflect the literal terms of the transactions and include the 7-day forward rates because the parties had agreed ex ante that these rates would actually apply in seven days. Petitioners contend the spreadsheets are pricing analyses that include the 7-day forward rates only because it is common practice to price a transaction so that if the market does what it is projected to do (that is, if the 7-day forward rate as of day one turns out to be the actual spot rate on day seven), there will be no profit or loss. (See App. Br. at 17-18). The question at trial was whose explanation was correct.

The Tax Court stated that it would be the IRS's burden to prove what the spreadsheets were. (JA2219:515-16). As a matter of law, such proof could not be made through arguments of counsel or though an expert who had no personal familiarity with the documents (see JA2385:832); it required evidence. See Fed.R.Evid. 901(a) (“the proponent must produce evidence sufficient to support a finding that the item is what the proponent claims it is”). The IRS's failure to offer any should have been fatal to its position.⁹

The IRS's argument that its rate-rigging theory was not “new matter” as to which it bore the burden of proof as a matter of law is similarly flawed. The IRS does not deny that its position in the FPAAs was that the transactions as written were “prearranged” to include no “real risk or opportunity for gain.” (See IRS Br. at 47). But once it got to Tax Court and saw Petitioners' explanation of how the transactions' profit potential was embedded in the currency conversions necessary for the loan repayments rather than in the paired option trades themselves (see App. Br. at 11-12), the IRS changed course and conceded that, absent an agreement to fix in advance the exchange rates that would apply when the loans were repaid, the transactions would entail “tremendous risk.” (JA1355; JA 1504; see infra at 22-24). Its expert admitted that no such agreement appears in any of the transaction documents (see JA2351:757-59); the IRS claimed that such an agreement was made orally. (JA695-96; JA716-17; JA742-44; JA1005-06).

The IRS does not deny that it developed this theory long after it issued the FPAAs, after reviewing documents produced to it by Deutsche Bank. This fact is sufficient to make the theory “new matter” on which the IRS bears the burden of proof. (See App. Br. at 40 and n.20). Nor does the IRS deny that proof of the existence or absence of an agreement to rig the rates requires different evidence from proof of the transactions' profit potential absent rigging. This fact is independently sufficient to shift the burden of proof to the IRS. (See id. at 40 and n.21).

* * * * *

To the extent that the burden of proof has any bearing it should lie with the IRS. But regardless of the burden of proof, the Tax Court's finding that the transactions were rigged is based on a legally improper adverse inference and is not otherwise supported by competent evidence. The Court should therefore reverse it.

II. THE FINDING THAT THE TRANSACTIONS LACKED PROFIT POTENTIAL CANNOT BE AFFIRMED ON ALTERNATIVE GROUNDS

If the Court agrees that the Tax Court erred in finding that the transactions were rigged, it should reverse the finding that they lacked profit potential. That finding cannot be affirmed on other grounds because (a) the IRS formally conceded below that absent rigging the transactions would entail “tremendous risk”; (b) the Tax Court's holding was expressly based only on a finding that the transactions were rigged; and (c) on this record, the Court could not affirm on the alternative grounds now urged by the IRS even if the IRS had not conceded them below.

A. Because The IRS Effectively Stipulated Below That The Transactions Would Involve “Tremendous Risk” If The Exchange Rates Were Not Rigged, It May Not Argue Otherwise Now

The IRS's argument that “[e]ven without the parties' agreement to fix the exchange rates, the offsetting-options trades lacked economic substance” (IRS Br. at 68) is directly contrary to what the IRS effectively stipulated below: that the transactions in fact entailed “tremendous risk” (and accordingly, in the Tax Court's words, a “correlative potential for profit” — see JA1939) if they were not rigged. More specifically, in the Tax Court the IRS proposed the following finding of fact:

(JA1355 (IRS Opening Post-Trial Brief), emphasis added; accord JA1504 (IRS Post-Trial Answering Brief: “If the Euro/Krone 7-day forward exchange rate had not been locked in, the FX binary option pair trades would have involved tremendous risk.” (emphasis added)).¹⁰ Petitioners agreed with this portion of the IRS's proposed findings. (JA1581 (Petitioners' Post-Trial Answering Brief)). As a result, the fact should be deemed established.¹¹

The IRS cannot seek affirmance based on an argument that contradicts facts it formally admitted in the Tax Court. See Christian Legal Soc. Chapter of the Univ. of Calif. v. Martinez, 561 U.S. 661, 677-78 (2010)(“formal concessions . . . have the effect of withdrawing a fact from issue and dispensing wholly with the need for proof of the fact”) (citation and internal quotations omitted); accord In re Papst Licensing GmbH & Co. KG Litigation, 767 F. Supp.2d 1, 6 (D.D.C. 2011) (party “should be held to the affirmative statements of fact that it made to the Court”); see generally Oscanyan v. Arms Co., 103 U.S. 261, 263 (1880) (“any fact, bearing upon the issues involved, admitted by counsel, may be the ground of the court's procedure equally as if established by the clearest proof”). Its alternative ground for affirmance should be rejected on this basis alone.

B. The Tax Court's Only Basis For Finding That The FX Options Lacked Profit Potential Was Its Conclusion That The Parties Agreed In Advance On The Rates At Which They Would Settle

The IRS asserts that this Court can nevertheless affirm on the alternative ground that the transactions lacked “any substantial risk or potential for profit” even without rigging because the Tax Court somehow found as much. (See IRS Br. at 44). But the Tax Court found no such thing. Instead, it held:

(JA1939, emphasis added). “[T]hat risk,” the court went on, “was eliminated when Delta and Deutsche Bank fixed the applicable exchange rates in advance.” (Id., emphasis added). In other words, it was the advance fixing of the exchange rates — and nothing else — that eliminated any risk (and with it any profit potential).¹²

Any remaining doubt on this score is dispelled by the Tax Court's treatment of Petitioners' expert evidence that the transactions had a substantial probability of making a profit or loss — with a potential to more than double the amount of cash invested or to lose almost as great a sum, even for currency fluctuations within the euro/krone “peg” (see JA365-368) — if the exchange rates were not fixed in advance.¹³ Said the court:

Dr. Chance [Petitioners' expert] assumed that the trades would be settled at whatever the spot rates might happen to be on that date. That assumption was contrary to the facts established at trial. As we have found, Delta and Deutsche Bank agreed in advance that the option payouts would be calculated using the seven-day forward rates for the euro/krone, dollar/krone, and dollar/euro that prevailed when they entered into the option contracts. Because the exchange rates at which the options would be settled were agreed in advance, neither party bore any meaningful foreign-exchange risk. Dr. Chance's entire analysis was premised on a contrary-to-fact assumption, and his report and testimony thus have no probative value.

(JA1928-29, emphasis added). In other words, far from finding that the transactions lacked profit potential even if the exchange rates were not agreed in advance, the Tax Court refused to consider Petitioners' evidence of such profit potential on the ground that it was of “no probative value” in light of the court's conclusion that such an agreement existed. Rigging was, in short, the only basis for the court's conclusion that the transactions lacked profit potential — a fact that is hardly surprising in light of the IRS's formal concession that absent rigging they would have involved “tremendous risk” (see supra at 22-24).

C. The IRS's Alternative Argument For Affirmance Would Be Unavailing Even Without Its Concession Below

Even if the IRS had not conceded below that without rigging the transactions would entail “tremendous risk,” its alternative basis for affirmance would face two independently-fatal barriers.

First, although on de novo review this Court may affirm on grounds argued below but not relied upon by the lower court,¹⁴ the Tax Court's factual determination that the transactions lacked profit potential because they were rigged is reviewed for clear error. If the determination that the transactions were rigged was erroneous, the Court may not affirm based on an alternative factual conclusion that the Tax Court did not actually make (let alone one that is contrary to the Tax Court's findings — see supra at 24-25). See Radtke v. Caschetta, 822 F.3d 571, 575 (D.C. Cir. 2016) (where lower court's factual determination was clearly erroneous because it was based on a flawed premise, Court of Appeals could not affirm based on a view that other evidence might have supported that determination; “we, as an appellate court, cannot reimagine the lower court's factual findings”).

Second, although on appeal the IRS claims it argued in the Tax Court “that the use of paired, offsetting options” in itself rendered the transactions incapable of producing a profit that was not “de minimis” (see IRS Br. at 22-23), in each of the places in the record it cites in support of its assertion that made such an argument what the IRS actually argued was that the offsetting options standing alone (that is, without the loans that were an integral part of the transactions) lacked the potential for meaningful profit. But Petitioners never argued otherwise; their argument about profit potential was all about — and only about — the fact that currency fluctuations between and among the euro, krone, and dollar created a potential for profit (or loss), largely in connection with the repayment of the loans used to finance the options. (See App. Br. at 10-12).

The IRS's consistent rejoinder to the only argument Petitioners actually made about profit potential was the assertion that “the use of agreed-upon forward exchange rates” among the euro, krone and dollar with respect to those loans deprived the transactions of any profit potential. (See, e.g., JA1818 (IRS Post-Trial Answering Brief); accord JA1503-04). The IRS's position was so dependent on rate-rigging that its expert did not even offer an opinion on whether the transactions could have had profit potential if they were not rigged. Instead, he acknowledged under oath that his analysis assumed they were rigged, and that the IRS had not even told him that the question of rigging was in dispute. (JA2378).

Because the IRS did not argue below that the transactions lacked profit potential absent rigging, even if this Court were empowered to affirm on alternative grounds it could not do so on that basis unless the IRS could show “exceptional circumstances” to support that result. See U.S. v. Coughlin, 610 F.3d 89, 108-09 (D.C. Cir. 2010) (“absent exceptional circumstances we generally will not [affirm] on grounds that were not raised in the district court”) (citation and internal quotations omitted); Skinner v. U.S. Dept. of Justice and Bureau of Prisons, 584 F.3d 1093, 1100 (D.C. Cir. 2009) (“we generally do not decide cases on grounds that were not raised in the district court, absent exceptional circumstances”). The IRS does not even attempt to argue that such circumstances exist here, and we respectfully submit that they do not. See Muhammed v. Close, 540 U.S. 749, 755 (2004) (“Having failed to raise the claim [advanced as an alternative basis for affirmance] when its legal and factual premises could have been litigated, Close cannot raise it now.”).

* * * * *

We emphasize that the IRS clearly conceded below that the transactions would involve “tremendous risk” (and thus tremendous profit potential) if they were not rigged. For this reason alone, the IRS is precluded from arguing that the Tax Court's ruling should be affirmed on the alternative ground that the transactions lacked profit potential even without rigging. But if the Court finds the IRS free to make that argument, it should decline to affirm on that basis — both because affirmance on alternative grounds is limited to matters that are reviewed de novo, and because in all events the IRS has shown no “exceptional circumstances” that could excuse its failure to make the argument below.

III. THE TAX COURT ALSO ERRED IN FINDING THAT THE TRANSACTIONS LACKED A BUSINESS PURPOSE

The IRS is incorrect when it argues (at 41-42) that Horn v. Commissioner, 968 F.2d 1229 (D.C. Cir. 1992), does not hold that a transaction has economic substance if it has either profit potential or a business purpose. In Horn, this Court stated: “it is important to recognize that a transaction undertaken for a nontax business purpose will not be considered an economic sham even if there was no objectively reasonable possibility that the transaction would produce profits.” 968 F.2d at 1237 (emphasis in original). Thus, business purpose alone is enough to validate the transactions even if they lacked profit potential. The cases on which the IRS relies do not even address this Court's rule on economic substance, let alone alter that rule.¹⁵

If the Court finds that the Tax Court erred in concluding that the transactions were rigged, it need go no further: the finding of lack of economic substance should be reversed on that ground alone.¹⁶ If it upholds the finding of rigging, however, it should nevertheless reverse on the ground that the transactions were undertaken for a business purpose.

The IRS's contrary argument is based almost entirely on a characterization of the transactions as “POPS transactions.” (See, e.g., IRS Br. at 31-33; 35; 36). But they were not POPS transactions, and the Tax Court acknowledged as much. (See supra at 1-3). Rather, they were intended to position the Partnerships for use in future investment products that (a) were being designed to be less aggressive than the products (such as POPS) that the IRS has previously targeted; and (b) would be marketed and sold for a profit. (See App. Br. at 24-25).¹⁷ The IRS does not effectively respond to any of the points Petitioners made about the transactions that are actually at issue here.

In contrast to the cases the IRS cites on pages 81-82 of its brief (all of which involved transactions that were designed at the outset for the purpose of sheltering the income of their designer), Beer's ultimate use of some of the losses generated by these transactions resulted only from the complete failure of the very business for which the transactions were supposed to make money. (See App. Br. at 35-36). As the IRS has elsewhere successfully argued, that business was driven by a profit motive that qualified it as a “trade or business” within the meaning of the tax law. See Chai v. Commissioner, 851 F.3d 190, 210-15 (2d Cir. 2017). The IRS may not now expediently argue the opposite.¹⁸

Activity designed to serve that profit motive — such as the transactions at issue here — has a business purpose. Even if the transactions lacked the potential to generate profit on their own, under Horn that business purpose gave them economic substance. (See App. Br. at 54-56).

CONCLUSION

For the reasons set forth above and in the opening brief, the Tax Court's ruling that the transactions lacked economic substance should be reversed.

Respectfully submitted,

Adrienne B. Koch
(akoch@katskykorins.com)

David L. Katsky
(dkatsky@katskykorins.com)

Elias M. Zuckerman
(ezuckerman@katskykorins.com)

Haley E. Adams
(hadams@katskykorins.com)
KATSKY KORINS LLP
605 Third Avenue
New York, New York 10158
(212) 953-6000

Attorneys for Appellants Delta Currency Trading, LLC, Cabrini Partners Fund, LLC, Alligator Partners Fund, LLC, Endeavor Partners Fund, LLC and Satellite Partners Fund, LLC

June 25, 2019