Partnerships Rely on Boca Investerings and Insist They Too Have Economic Substance

In 1989, Brunswick Corporation entered into two arrangements designed by Merrill Lynch to create substantial paper capital losses for itself that would allow it to shelter from tax the substantial capital gains it expected to report from the impending sales of certain of its businesses and the sale of its stock in a Japanese corporation. The partnerships would purchase short-term private placement notes (PPNs) and sell the PPNs several weeks later for 80 percent cash and 20 percent debt instruments that would pay out over several years (LIBOR-indexed installment notes). The partnerships would report a large gain in the first year, most of which would be allocated to the foreign partner.

The next year, Brunswick would acquire a majority interest in the partnerships and sell the LIBOR notes, creating a large tax loss because the basis available for recovery would exceed the notes' value. The primary foreign entity was Algemene Bank Netherlands N.V. (ABN), and the partnerships formed were Saba Partnership and Otrabanda Investerings Partnership. Brunswick ultimately used the nearly $200 million paper losses created by the transactions to shelter from tax the capital gains it reported in 1987, 1989, and 1992-1995. The IRS determined that the transactions that gave rise to the paper gains and losses lacked economic substance, and, therefore, adjusted the partnership returns filed by Saba and Otrabanda to eliminate the gains and losses reported from the transactions. Saba and Otrabanda then filed Tax Court petitions contesting the proposed adjustments. The Tax Court upheld the IRS's determination that the tax-motivated transactions engaged in by Saba and Otrabanda lacked economic substance.

The partnerships argue that the recent U.S. district court decision of Boca Investerings Partnership v. United States (Doc 2001- 25944 (181 original pages) [PDF] or 2001 TNT 197-12 ) confirms the necessity of a remand with respect to the partnership issue in this case. In Boca Investerings, the district court concluded that the partnership met the requirements of partnership status. Saba and Otrabanda maintain that the decision in Boca Investerings involves facts that are virtually identical to those presented by their transactions in the instant case. The partnerships request that they be given the same opportunity to be fully heard on the partnership issue as was granted to Boca Investerings Partnership. Saba and Otrabanda further insist that the decision in Boca Investerings confirms that their transactions had economic substance since the facts of their investments are indistinguishable from those of Boca Investerings.

[1] Pursuant to Circuit Rule 28(g), the Partnerships hereby file this Second Supplemental Brief. This brief is limited to a discussion of Boca Investerings Partnership v. United States, No. 97- 0602 (PLF) (D.D.C. filed October 5, 2001). We have attached a copy of the decision in Boca Investerings to this brief

[2] The decision in Boca Investerings involves facts which are virtually identical to those presented by the Partnerships' transactions. (Boca 23-25¹) After a careful review of the facts and law, the District Court in Boca Investerings held in the taxpayer's favor with respect to the two issues presented by the Partnerships' appeal and the Commissioner's cross-appeal. We discuss first Boca Investerings' resolution of the issue presented by the Commissioner's cross-appeal, ie., whether the Partnerships should be treated as partnerships for federal tax purposes. We next discuss the District Court's resolution of the economic substance issue decided in the Tax Court's opinion.

A. THE DECISION IN BOCA INVESTERINGS CONFIRMS THE NECESSITY OF A

[T]he facts as found by this Court from the evidence at trial in

The District Court identified a series of "crucial factual findings" present in ASA but not present in Boca Investerings. These facts included:

o "the so-called 'Bermuda Agreement'"

The District Court held that the absence of these factors represented a "crucial difference between this case and ASA Investerings." (Boca 168)

[4] The Partnerships are confident that, given the opportunity on remand, they will be able to demonstrate that their facts, including undisputed facts already in the record, are identical to those of Boca Investerings and materially different from the facts of ASA.

[5] As set forth in the Partnerships' Reply Brief:

o the Partnerships did not enter into anything remotely

[6] In ruling that Boca Investerings was a partnership for federal tax purposes, the District Court correctly held it was "irrelevant" that Boca Investerings' formation was motivated in part by a desire to reduce taxes. (Boca 150-51)

[7] The District Court also correctly held, that under § 704(e)(1), Boca Investerings qualified as a partnership for federal tax purposes because the partners "owned capital interests in Boca" and "capital was a material income producing factor" with respect to Boca's operation. (Boca 147-48) The District Court's analysis of § 704(e)(1) confirms the analysis set forth at pages 51-53 of the Partnerships' Reply Brief.

[8] In Boca Investerings, the District Court, having heard the evidence, concluded that Boca Investerings met the requirements of partnership status as set forth in Commissioner v. Culbertson, 337 U.S. 733 (1949). As stated in Boca Investerings, Culbertson requires a review of ALL the facts and takes into account a variety of factors. (Boca 139-41) The Partnerships ask nothing more than that they be given the same opportunity to be heard on the partnership issue as was granted to Boca Investerings Partnership.

B. THE DECISION IN BOCA INVESTERINGS CONFIRMS THAT THE

[10] The District Court held that Boca Investerings' transactions had economic substance because, from an objective ex ante perspective, they presented a reasonable possibility of generating a profit. (Boca 164) The District Court based its decision, in part, on evidence that Boca Investerings' partners addressed "concerns about the credit quality, rate of return, and risk profile of the partnership's potential investments." (Boca 159)

[11] The facts of the Partnerships' investments are indistinguishable from those of Boca. Brunswick's management understood that the LIBOR Notes could be very profitable, especially in an environment of higher interest rates. (JA000529-30, JA000532, JA000556, JA000563-65, JA000609-11, JA001043) Mr. O'Brien, Brunswick's Treasurer, created and studied computer models to evaluate the profitability of the LIBOR Notes. (JA000573-74) These models and other materials confirmed the LIBOR Notes could be very profitable. (JA001040-41, JA001045-46, JA001088-1100)

[12] The Tax Court found as a fact that Mr. O'Brien "believed that interest rates would rise." (JA000038) The evidence presented at trial supports this finding. (JA0000588, JA001050-72) There is no dispute that the Partnerships and Brunswick would have earned substantial profits if interest rates had risen. (Brief for Appellees 11-12) ("The purchaser of a LIBOR Note makes a profit if the rate rises").

[13] Mr. O'Brien was also concerned with the credit quality of the Partnerships' investments. (JA000568) After Saba's formation, Merrill Lynch proposed that Saba purchase private placement notes issued by Continental Bank. Mr. O'Brien refused, because he was concerned over Continental's credit quality. Mr. O'Brien subsequently agreed to the purchase of private placement notes issued by Chase Manhattan Bank, but only after he studied materials concerning Chase's credit risk and prospects. (JA000581-82, JA001074-87)

[14] The Tax Court's opinion recognized that the Partnerships' investments could produce profits of nearly $11 million at projected interest rates. As stated above, the Commissioner has agreed that these projected profits could have been even larger if interest rates had increased above projected levels. (JA000144)

[15] Finally, it is not in dispute that the Partnerships did profit from their investments. The Partnerships' tax returns show income in the following amounts:

                                SABA

[16] Aside from the possibility of profit, the District Court held that Boca Investerings' transactions should be respected because they had practical economic consequences other than tax benefits. The District Court in Boca Investerings made extensive findings of fact to the effect that Boca Investerings and its partners were exposed to credit, default, credit downgrade, liquidity, and interest rate risks. (Boca 108-12) The Tax Court acknowledged that the Partnerships were exposed to identical risks. (JA000136-37) Exposure to such risks creates "practical economic effects" which require that a transaction be upheld, since "a transaction that has economic consequences other than tax benefits will not be disregarded even if it was motivated by tax considerations." (Boca 157, 164)

[17] The only difference between Boca Investerings and Saba is that in Saba the Tax Court erroneously equated a motive to avoid tax with a lack of business purpose. In recent months, two Circuit Courts have criticized the Tax Court's erroneous view of business purpose. (Ptshp. Reply 9 n.3, 19) The Tax Court in effect held that since Brunswick acted with a motive to reduce its tax, its actions necessarily lacked a business purpose, even if the Partnerships' transactions might have aided Brunswick's business. Since the Tax Court believed that a motive to avoid tax was conclusive, it did not evaluate the evidence indicating that Brunswick could have profited from the LIBOR Notes and that the Partnerships shielded excess cash from takeover attempts.

[18] In Boca Investerings, the District Court did not make the mistake of equating a tax avoidance motive with a lack of business purpose. Rather, the District Court correctly held that a subjective motive to avoid tax is not determinative as to whether a transaction lacks business purpose. (Boca 150-51)

[19] The District Court opinion also addresses the deductibility of the losses in question under § 165. The District Court reviewed the detailed rules of § 453 and their legislative history and agreed that these rules were "an exception" to the general rules for recognizing gain and loss. (Boca 136) (Brief for the Appellee 31) ("Section 453 is an exception to the general rule for recognizing gain or loss"). See Hallmark Cards, Inc. v. Commissioner, 90 T.C. 26 (1988) (Commissioner may not reject a method of accounting specifically authorized in the Code).

Dated: October 11, 2001

[20] I hereby certify that on October 11, 2001, I caused the foregoing Second Supplemental Brief for Appellants to be served on the other parties to this action by sending such copies to opposing counsel, via hand-delivery, at the following address:

Edward T. Perelmuter

² The Partnerships' tax returns reflect that Partnership expenses, such as management fees, legal fees, accounting fees, audit fees, commercial paper charges, and other fees were paid by the Partnerships. These fees were reported as deductions on the Partnerships' tax returns, and these fees thus reduced the income shared by the partners. (JA000747, JA000754, JA000773, JA000779, JA000802, JA000808, JA00853, JA000859) In contrast, in ASA, Allied Signal directly paid ASA Investerings' "legal, accounting., and various financial services fees." ASA Investerings Partnership v. Commissioner, 76 T.C.M. (CCH) 325, 332 (1998), aff'd, 201 F.3d 505 (D.C. Cir.), cert. denied, 121 S. Ct. 171 (2000).