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Partnership Challenges Dividend Income, FTC Adjustments

JUL. 10, 2020

SIH Partners LLLP et al. v. Commissioner

DATED JUL. 10, 2020
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SIH Partners LLLP et al. v. Commissioner

[Editor's Note:

The exhibits can be viewed in the PDF version of the document.

]

SIHPARTNERS LLLP, EXPLORER PARTNER CORP., NOTICE PARTNER
Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.

UNITED STATES TAX COURT

PETITION FOR READJUSTMENT OF PARTNERSHIP ITEMS UNDER FORMER CODE SECTION 6226

Explorer Partner Corp. (“Petitioner”), in its capacity as a notice partner of SIH Partners LLLP (“SIHP”), hereby petitions for a readjustment of partnership items for the tax year ending December 31, 2012 (“2012 Tax Year”) set forth by the Commissioner of Internal Revenue (“Respondent”) in a Notice of Final Partnership Administrative Adjustment dated December 5, 2019 (the “FPAA”), and as the basis for this proceeding, alleges the following:

1. Petitioner

a. Petitioner is a Delaware corporation that elected to be treated as an S corporation for U.S. federal income tax purposes, as defined in section 1361.1 Petitioner's mailing address is 1201 North Orange Street, Suite 715, Wilmington, Delaware 19801-1186.

b. In 2012, Petitioner held a 1% interest in SIHP. Therefore, Petitioner is a notice partner of SIHP, as defined in section 6231(a)(8).2 Petitioner is filing this Petition in its capacity as a notice partner pursuant to section 6226(b)(1).

c. Petitioner is also the tax matters partner of SIHP.

d. Petitioner did not file a petition for readjustment of the FPAA in its capacity as tax matters partner of SIHP within the time prescribed in section 6226(a).

e. Petitioner was a partner during SIHP's 2012 tax year and, if the adjustments to partnership items in the FPAA are sustained, the tax attributable to such partnership items may be assessed against Petitioner. Petitioner therefore has an interest in the outcome of this case and satisfies the requirements of section 6226(d). Neither of the disqualifying events recited in section 6226(d)(1) applies to Petitioner.

2. Partnership

a. SIHP is a Delaware partnership with its principal place of business at 1201 North Orange Street, Suite 715, Wilmington, Delaware 19801-1186.

b. SIHP is treated as a partnership for U.S. federal income tax purposes.

c. SIHP timely filed its Form 1065 for the 2012 tax year with the Internal Revenue Service Center in Ogden, Utah.

3. Notice of Final Partnership Administrative Adjustment

a. The FPAA, dated December 5, 2019, was mailed to Petitioner by the Hartford, Connecticut, office of the Internal Revenue Service. A copy of the FPAA, including accompanying statements and schedules, is attached hereto and is marked as “Exhibit A.”

4. Amounts in Dispute

a. Respondent determined the following adjustments to SIHP's partnership items for its 2012 Tax Year:

i. A reduction in SIHP's qualified dividend income (“QDI”) in the amount of $170,764,863 with respect to the dividends SIHP received on certain Swiss stocks (the “Swiss Equities”);

ii. Reclassification of the $170,764,863 of SIHP's reported QDI as ordinary dividend income; and

iii. A reduction in SIHP's creditable foreign tax expense in the amount of $25,614,729 with respect to Swiss taxes withheld on the dividends paid on the Swiss Equities in 2012.

b. Petitioner disputes all adjustments made by Respondent in the FPAA.

5. Assignments of Error

Respondent's adjustments set forth in the FPAA are based on the following errors:

a.Respondent erred in determining that SIHP's holding period in the Swiss Equities should be reduced under section 246(c)(4)(C).

b. On the basis of the error in Paragraph 5.a, Respondent:

i. Erred in determining that SIHP did not meet the holding period requirements of section 1(h)(11)(B)(iii) for the QDI reported with respect to dividends paid on the Swiss Equities;

ii. Erred in reclassifying the QDI reported with respect to dividends paid on the Swiss Equities as ordinary dividend income; and

iii. Erred in determining that SIHP did not meet the holding period requirements of section 901(k)(1) for treating Swiss withholding taxes paid with respect to dividends paid on the Swiss Equities as creditable foreign taxes.

6. Supporting Facts

Petitioner relies upon the following facts:

Background

a. In 2012, SIHP received $170,764,863 in dividends on four Swiss Equities.

b. SIHP reported the dividend income in Paragraph 6.a as QDI on its 2012 Form 1065.

c. SIHP also reported $25,614,729 in creditable foreign tax expense related to Swiss tax withheld at the source on those dividends on its 2012 Form 1065.

d. To qualify for QDI treatment for dividend income, a taxpayer must hold the dividend-paying equity for at least 61 days during the 121-day period beginning on the date which is 60 days before the ex-dividend date of the equity. Section 1(h)(11)(B)(iii). Similarly, to be eligible to claim foreign tax credit for withholding taxes imposed on dividends, a taxpayer must hold the dividend-paying equity for at least 16 days during the 31-day period beginning on the date which is 15 days before the ex-dividend date. Section 901(k)(1).3 Collectively, the holding periods required under sections 1(h)(11)(B)(iii) and 901(k)(1) are referred to herein as the “Holding Period Requirements.”

e. SIHP held each of the Swiss Equities for a period longer than 61 days during the 121-day period beginning on the date that was 60 days before each Swiss Equity's ex-dividend date.

f. Thus, SIHP satisfied the Holding Period Requirements for claiming both QDI Treatment and a foreign tax credit with respect to the Swiss Equities unless SIHP's holding period in the Swiss Equities is reduced under section 246(c)(4)(C).

g. Respondent claims that SIHP's holding period in the Swiss Equities should be reduced under section 246(c)(4)(C). That section provides that a taxpayer's holding period in stock may be reduced where the taxpayer has diminished its risk of loss by holding one or more other positions that constitute “substantially similar or related property.”4

h. Whether SIHP held “substantially similar or related property” to the Swiss Equities is the core issue in this case. Respondent contends that SIHP did hold such property in the form of a total return swap (the “Portfolio Swap”).

i. If the Portfolio Swap is not “substantially similar or related property” to the Swiss Equities within the meaning of the of section 246(c)(4)(C) and the regulations thereunder, then SIHP undisputedly met all requirements for claiming both QDI treatment and a foreign tax credit.-

j. As discussed below, the Portfolio Swap was not “substantially similar or related property” to the Swiss Equities. Therefore, SIHP's holding period in the Swiss Equities cannot be reduced, SIHP satisfied the Holding Period Requirements, and Respondent's adjustments must be rejected in full.

SIHP's Business

k. SIHP is under common control with Susquehanna International Group, LLP (“SIG”). SIG is a privately-held investment firm engaged in both the dealing and trading of securities, commodities, and financial instruments.

l. SIG is an active participant in the options and futures markets in all major commodities and is a leading market maker of listed equity, index options, and exchange-traded funds. SIG trades these products primarily through entities under its management that are registered as broker-dealers with the U.S. Securities and Exchange Commission.

m. SIG engages in proprietary trading of financial instruments for its own benefit. Through its trading affiliates — including SIHP — SIG trades securities, commodities, and derivatives, seeking to earn returns from short-term appreciation and arbitrage profits. In particular, SIG seeks out investment opportunities that allow SIG to generate acceptable returns-with controlled risk.

The Swiss Equity Trade

n .The transaction at issue in this case is referred to herein as the “Swiss Equity Trade.”

o. Over the course of the 2012 tax year, SIHP held four Swiss Equities as part of the Swiss Equity Trade: (1) Novartis (Ticker Symbol: NOVN VX), (2) Roche (ROG VX), (3) Nestle (NESN VX), and (4) Swisscom (SCMN VX). The dividends described in Paragraph 6.a were paid on these Swiss Equities.

p. Each of the Swiss Equities was issued by a company resident in Switzerland. Each of those Swiss companies is “qualified foreign corporation” within the meaning of section 1(h)(11)(C)(i)(II) and Notice 2006-101, 2006-2 C.B. 930 (Oct. 30,2006).

q. As part of the Swiss Equity Trade, SIHP also entered into the Portfolio Swap with Morgan Stanley & Co. International PLC (“Morgan Stanley”). The Portfolio Swap was a total return swap — i.e., a financial derivative contract entered into with Morgan Stanley that gave SIHP exposure to a portfolio of positions (the “Reference Portfolio”).

r. Under the contractual terms of the Portfolio Swap, SIHP had the right to make adjustments to the composition of the Reference Portfolio. SIHP exercised that right during the 2012 tax year. Over the course of the 2012 tax year, the Reference Portfolio included short exposure to: the Swiss Equities, the S&P 500 index (“SPX”), the Russell 2000 ETF (“IWM”), and a China Large Cap ETF (“FXI” and, collectively with SPX and IWM, the “Indices”).

s. At all relevant times, the value of the short exposure to Swiss Equities in the Reference Portfolio represented less than 70% of the fair market value of the full Reference Portfolio.

t. The Portfolio Swap was a unitary financial position:

i. At all times, the Portfolio Swap referenced a single portfolio (i.e., the Reference Portfolio);

ii. All payments owed by SIHP and Morgan Stanley under the Portfolio Swap were required to be netted;

iii. Neither SIHP nor Morgan Stanley could demand payment with respect to any individual Swiss Equity or Index included in the Reference Portfolio; and

iv. Neither SIHP nor Morgan Stanley could separately assign any portion of the Portfolio Swap.

u. SIHP engaged in the Swiss Equity Trade for the purpose of earning a profit. SIHP expected to make a significant pre-tax profit from the Swiss Equity Trade.

v. SIHP was subject to Swiss withholding taxes on the dividends it received on the Swiss Equities. Swiss taxes were withheld at the source from the dividends described in Paragraph 6.a at a 35% tax rate. SIHP filed a request for a reclaim pursuant to the U.S.-Swiss Income Tax Treaty, which Treaty reduces the Swiss withholding tax rate on dividends paid to qualified U.S. persons to a 15% tax rate. SIHP's reclaim request remains pending with the Swiss government.

w. The creditable foreign taxes reported by SIHP, as described in Paragraph 6.c, reflects SIHP's liability for Swiss withholding taxes at a 15% rate on the dividends received on the Swiss Equities.

The Section 246(c)(4)(C) Rules

x. Although SIHP held each of the Swiss Equities for a period that exceeds the Holding Period Requirements, Respondent claims that SIHP's holding period in the Swiss Equities can be reduced under section 246(c)(4)(C).

y. Section 246(c)(4)(C) provides that a taxpayer's holding period in stock shall be reduced only when, “under regulations prescribed by the Secretary, a taxpayer has diminished his risk of loss by holding 1 or more other positions with respect to substantially similar or related property.”

z. The regulations defining “substantially similar or related property” are set forth in Treasury Regulation section 1.246-5 (the “1.246-5 Regulations”).

aa. The Treasury Regulations set forth a special set of rules applicable to positions that reference the value of a group of stocks of 20 or more unrelated issuers (a “Portfolio Position”). Treas. Reg. § 1.246-5(c)(1)(i)-(ii).

bb. In general, a Portfolio Position is “substantially similar or related to the stocks held by the taxpayer only if the position and the taxpayer's holdings substantially overlap as of the most recent testing date.” Treas. Reg. § 1.246-5(c)(1)(ii).

cc. To determine whether a Portfolio Position and the taxpayer's stock holdings “substantially overlap,” the 1.246-5 Regulations set forth a mechanical, bright-line test: the “Substantial Overlap Test.”

dd. The Substantial Overlap Test is a three-part test:

i. Step One. Construct a “Subportfolio” that consists of stock in an amount equal to the lesser of the fair market value of (i) each stock represented in the Portfolio Position and (ii) the stock in the taxpayer's stock holdings.

ii. Step Two. If the fair market value of the Subportfolio is equal to or greater than 70 percent of the fair market value of the stocks represented in the Portfolio Position, the Portfolio Position and the Subportfolio substantially overlap.

iii. Step Three. If the Portfolio Position does not substantially overlap with the Subportfolio under Step Two, repeat Steps One and Two by reducing the size of the Portfolio Position to see if a portion of the Subportfolio substantially overlaps with the reduced Portfolio Position.

ee. The 1.246-5 Regulations also provide that a Portfolio Position can be treated as “substantially similar or related property” under an anti-abuse rule set forth in Treasury Regulation section 1.246-5(c)(1)(vi) (the “Virtual Track Anti-Abuse Rule”).

ff. The Virtual Track Anti-Abuse Rule has two prongs, both of which must be met for the rule to apply:

i. Prong 1: The value of the Portfolio Position, or the stocks reflected in the value of the Portfolio Position, must be reasonably expected to “virtually track” changes in the value of the “[Swiss Equities], or any portion of the taxpayer's stock holdings and other positions of the taxpayer.” Treas. Reg. § 1.246-5(c)(vi)(A).

ii. Prong 2: SIHP must have held the Portfolio Swap “as part of a plan with a principal purpose [of obtaining] tax savings” with a value “significantly in excess of the expected pre-tax economic profits from the plan.” Treas. Reg. § 1.246-5(c)(vi)(B).

Application of the Section 246(c)(4)(C) Rules to the Portfolio Swap

gg. The Portfolio Swap was a “Portfolio Position” within the meaning of Treasury Regulation section 1.246-5(c)(l)(i), because the Portfolio Swap referenced the value of a group of stocks of more than 20 unrelated issuers.

hh. During 2012, the Portfolio Swap referenced a portfolio including short exposure to the Swiss Equities and short exposure to the three Indices (SPX, IWM, and FXI). SPX, by itself, reflects the value of a group of stocks of 500 unrelated issuers.

ii. Because the Portfolio Swap is a Portfolio Position, the Substantial Overlap Test determines whether the Portfolio Swap is “substantially similar or related property” to the Swiss Equities within the meaning of section 246(c)(4)(C).

jj. Under the Substantial Overlap Test, the Portfolio Swap is not “substantially similar or related property” to the Swiss Equities. The Portfolio Swap does not “substantially overlap” with the Swiss Equities within the meaning of the Substantial Overlap Test, because the value of the short exposure to the Swiss Equities in the Portfolio Swap portfolio represented less than 70% of the fair market value of the Portfolio Swap as described in paragraph 6.s.

kk. The Portfolio Swap also cannot be treated as “substantially similar or related property” to the Swiss Equities under the Virtual Track Anti-Abuse Rule, because:

i. The value of the Portfolio Swap was not reasonably expected to “virtually track” the value of the Swiss Equities, because more than 30% of the value of the Portfolio Swap reflected the performance of the Indices.

ii. Obtaining tax savings was not a principal purpose of the Swiss Equity Trade; and

iii. SIHP's tax savings were not “significantly in excess” of its expected pretax profits.

ll. Thus, SIHP's holding period in the Swiss Equities cannot be reduced under section 246(c)(4)(C), and SIHP complied with the Holding Period Requirements.

Respondent's Adjustments to SIHP's 2012 Form 1065

mm. After examination of SIHP's 2012 Form 1065, Respondent determined that SIHP's holding period in the Swiss Equities should be reduced under section 246(c)(4)(C), and on that basis determined that (1) the dividend income that SIHP received on the Swiss Equities was not QDI and (2) the Swiss withholding taxes paid by SIHP were not eligible for a foreign tax credit.

nn. Respondent's adjustments described in paragraph 6.mm are premised on his position that he can disregard the Portfolio Swap. Specifically, Respondent proposes to disaggregate or “bifurcate” the Portfolio Swap, and then separately analyze the Swiss Equities and Indices included in the Reference Portfolio to see if those individual Swiss Equities and Indices are “substantially similar or related property.”

oo. Respondent erred in “bifurcating” the Portfolio Swap. Instead, a Portfolio Position  — like the Portfolio Swap — must be treated as a single position for purposes of section 246(c)(4) and the regulations thereunder.

WHEREFORE, Petitioner prays that this Court will hear this case and determine that:

1. SIHP's Portfolio Swap was not “substantially similar or related property” with respect to the Swiss Equities under Treas. Reg. § 1.246-5 and therefore SIEP's holding period of the Swiss Equities was not reduced under section 246(c)(4).

2. SIHP satisfied the holding period requirement of section 1(h)(11)(B)(iii) and was properly entitled to QDI treatment for the dividends paid on the Swiss Equities.

3. SIHP satisfied the holding period requirement of section 901 (k)(1), making the Swiss taxes withheld on Swiss Equities' dividends eligible for a foreign tax credit.

4. To the extent the minimum holding period requirements under section 901(k)(1) were not satisfied, SIHP's partners are entitled to a deduction for the foreign taxes paid on the Swiss Equities.

5. No adjustment should be made to the QDI reported on SIHP's 2012 Form 1065.

6. No adjustment should be made to the ordinary income reported on SIHP's 2012 Form 1065.

7. No adjustment should be made to the creditable foreign taxes reported on SIHP's 2012 Form 1065.

8. Petitioner and each Partner is entitled to further relief as the Court, in its discretion, deems just and proper.

Dated: April 30, 2020

Rajiv Madan
T.C. Bar Number MR1190
Skadden, Arps, Slate, Meagher & Flom LLP
1440 New York Avenue, N.W.
Washington, DC 20005
(202)371-7020
(202) 661-9020 (fax)
raj.madan@skadden.com

Counsel for Petitioner

FOOTNOTES

1All “section” references are to the Internal Revenue Code of 1986, as amended and in effect for the year at issue (the “Code”), unless otherwise stated.

2In 2015, Congress amended sections 6221-6234 to remove the TEFRA Unified Audit Procedures (“TEFRA”). The TEFRA rules, however, remain applicable to SIHP's 2012 tax year.

3To the extent that a foreign withholding tax is not eligible for a credit under section 901(k)(l), the taxpayer treated as paying that foreign tax may instead claim a deduction.

4Although section 246 itself addresses eligibility to claim a dividends received deduction, both the QDI and foreign tax credit rules incorporate by reference section 246(c)(4). See section 1(h)(11)(B)(iii); section 901(k)(5).

END FOOTNOTES

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