Issue of Material Fact Exists Regarding Transfer Pricing Adjustments

BROADWOOD INVESTMENT FUND LLC et al.
Petitioners,
v.
UNITED STATES OF AMERICA,
Respondent.

UNITED STATES DISTRICT COURT
CENTRAL DISTRICT OF CALIFORNIA
SOUTHERN DIVISION

ORDER DENYING DEFENDANT'S MOTION FOR PARTIAL SUMMARY JUDGMENT [218]

Before the Court is Defendant United States of America's (“Defendant” or “the government” or “the U.S. government”) Motion for Partial Summary Judgment (Dkt. 218-3) against Petitioners Broadwood Investment Fund, LLC (“Broadwood Investment Fund”), Dragon Coeur LLC-I-B, Mosman Investment Fund LLC (“Mosman”), Han Kook LLC I, and Han Kook LLC I-A, by and through their tax matters partner Broadwood Investment Holdings, LP (“Broadwood Investment Holdings”) (collectively, “Petitioners”). The Court heard oral argument on June 8, 2018.

This case involves the U.S. tax implications of a series of financial transactions beginning in the late 1990s that resulted in: (1) the transfer of non-performing loans (“NPLs”) from Chinese and Korean banking entities to Petitioners (which are partnerships apparently controlled by Henry Nicholas); and (2) Petitioners claiming approximately $300 million in tax losses based on the acquisition of the NPLs. See generally Amended Petition (Dkt. 29); Joint 26(f) Report (Dkt. 35); see, e.g., Government's Statement of Undisputed Facts (“SUF”) (Dkt. 219-2) ¶¶ 24, 42; Declaration of Thuy Luu (“Luu Decl.”) (Dkt. 218-5) Exs. A, B. In 2007, the Internal Revenue Service (“IRS”) notified Petitioners through Notices of Final Partnership Adjustment (“FPAAs”) that the IRS was disallowing millions of dollars in Petitioners' claimed losses and deductions. See SUF ¶¶ 51, 55. Among multiple grounds for disallowing the deductions and losses, the IRS applied section 482 of the Internal Revenue Code, 26 U.S.C. § 482 (“Section 482), which allows the IRS to adjust certain tax items among commonly controlled or owned entities if such an adjustment “is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such” entities. See 26 U.S.C. § 482; see generally Amended Petition. Petitioners brought this consolidated action challenging the adjustments in the FPAAs. See generally Amended Petition.

Although Petitioners' challenge to the adjustments is brought on various grounds, the instant Motion focuses solely on the IRS's application of Section 482 to two portfolios of NPLs originating in China. See Notice of Motion (Dkt. 218) at 2. Specifically, the U.S. government seeks partial summary judgment upholding the Section 482 determination that Petitioner Broadwood Investment Fund's inside basis in a portfolio of NPLs acquired from Cinda Asset Management Company is limited to $1,898,554. Id. Similarly, the government seeks partial summary judgment upholding the Section 482 determination that Petitioner Mosman's inside basis in a portfolio of NPLs acquired from China Orient Asset Management Company is limited to $2,390,903. Id.

I. FACTS¹

A. China's Major Banks Accumulate Non-Performing Loans in the 1990s

In the mid-1990s, there were four major state-owned banks in China: Industrial and Commercial Bank of China, China Construction Bank, Bank of China, and Agricultural Bank of China (the “Banks”). Petitioners' Statement of Additional Facts (“SAF”) (Dkt. 230-1) ¶ 59; SUF ¶ 1. These Banks had based past lending decisions not only on traditional financial considerations, but also on policy goals, such as helping certain industries, geographic areas, or particular companies. Id. Over time, the Banks' lending standards led to defaults by many borrowers, which filled the Banks' portfolios with non-performing loans (“NPLs”). Id. ¶ 60. The increasing number of non-performing loans eventually threatened the solvency of the Banks and the stability of China's economy. Id.

In 1995, the Chinese government created a uniform classification system for non-performing loans that was less stringent than international standards. SUF ¶ 2. The Chinese government also set strict limits on the amount of reserves that Chinese banks could set aside for loans and limited the amount of debt that could be written off (with larger amounts of debts requiring higher levels of government approval). Id. As a result of these practices and other factors, Chinese banks accumulated a massive amount of non-performing loans on their books. Id. ¶ 3. The result was serious concern over the solvency of Chinese banks, including China Construction Bank and Bank of China, which as of 1999, were two of the four largest state-owned banks in China. Id. ¶ 1.

B. China Implements Bank Reform in the Late 1990s

During the late 1990s, the Chinese government enacted a bank reform program. SAF ¶ 61. In 1999, as part of this program, the Chinese government created four asset management companies: China Orient, Cinda, Great Wall, and Huarong (the “AMCs”). SAF ¶ 61. Each of the AMCs was paired with one of the four largest state-owned Banks. SUF ¶ 4. For example, China Construction Bank was paired with Cinda, and Bank of China was paired with China Orient. Id.

The parties dispute the extent and nature of the Chinese government's ownership of the AMCs. The U.S. government asserts that the AMCs were not independent entities, but rather were arms of the Chinese government. See SUF ¶¶ 5, 6 (citing Declaration of Nicholas R. Lardy (“Lardy Decl.”) (Dkt. 218-4) ¶ 7 (expert opinion that the AMCs were not independent entities, but arms of the Chinese government)). Nicholas Lardy, an expert for the U.S. government on the topic of the Chinese banking and financial system, see Lardy Decl. ¶¶ 1–4 (describing academic, professional, and publication experience), stated the following opinion about ownership of the AMCs:

It is my opinion that the AMCs were not independent entities, but rather arms of the Chinese government. The Chinese government created and funded the AMCs. All four AMCs and partner banks were regulated and supervised by the same set of governmental bodies, notably the Ministry of Finance and the People's Bank of China (China's central bank). All of these bodies were 100 percent Chinese-government-owned and controlled under the supervision of the State Council (the equivalent of China's cabinet). Each AMC received NPLs [non-performing loans] from its partner bank, drew leadership from the top executive ranks of its partner bank, and leased physical assets (such as office space) from its partner bank.

Id. ¶ 8. Further, the U.S. government points out that Petitioners' operative pleading, the Amended Petition, alleges that the Chinese government owned the four Banks and that the Chinese government created the “government-owned” AMCs to purchase distressed debt from the Banks. See Government's Response to SAF (“GR”) (Dkt. 232-1) ¶ 83 (citing Amended Petition ¶¶ 44(a), (e) (“In 1999, the PRC created government-owned Asset Management Corporations (“AMCs”) to purchase the distressed debt from the banks, and to then sell, service or otherwise dispose of the NPLs in order to address this solvency concern.”)). In addition, the U.S. government cites to a July 2001 article by O'Melveny and Meyers LLP, entitled “China's Bank Asset Management Companies: Gold In Them Thar Hills?” that states: “In legal form, the Bank AMCs are wholly state-owned, non-bank financial institutions.” GR ¶ 83 (citing Declaration of Chase Scolnick in Opposition to Partial Summary Judgment (Dkt. 230-3) Ex. 4 (Dkt. 230-5) at 200).

In response, Petitioners dispute that the AMCs are arms of the Chinese government, but do not dispute that the Chinese government has an “amorphous” common ownership of the AMCs. See Petitioners' Statement of Genuine Disputes (“SGD”) ¶¶ 5–6. Further, Petitioners argue that the underlying support for Lardy's assertion lacks foundation and is not “based on sufficient facts or data.” Petitioners' Objection to Evidence (“POE”) (Dkt. 230-2) ¶ 5 (citing Fed. R. Evid. 702). In addition, Petitioners argue that the IRS has not proffered documents or testimony regarding the identities of the AMCs' shareholders between 1999 and 2001 or what their relationship was with the Chinese government. Id.; GR ¶ 83.

The Chinese government required and directed the four AMCs to buy approximately Renmibi (RMB) 1.3 trillion in non-performing loans from the four Banks at full face value. SAF ¶ 61; SUF ¶ 7, 8. The AMCs paid for the non-performing loans in part with bonds that had the backing of the Chinese government. SUF ¶ 8. The transactions were policy-driven, and meant to recapitalize the Chinese banks. Id. The transactions recapitalized the Banks, relieved them of the burden of managing the non-performing loans, and allowed them to focus on improving their finances. SAF ¶ 62. It also helped reform the banking system, facilitate foreign investment, and prepare for China's planned entry into the World Trade Organization. Id. The Chinese government's stated purpose for this program was to boost its economy. Id.

The transactions between Banks and the AMCs included the assets at issue in this Motion: in 1999 Cinda acquired from China Construction Bank non-performing loans in which it eventually contributed an interest to Broadwood Investment Fund, and China Orient acquired from Bank of China non-performing loans in which it eventually contributed an interest to Mosman. SUF ¶ 7. Ultimately Henry Nicholas acquired an interest in the assets at issue. SUF ¶¶ 24, 42. The government asserts that because this case is being litigated at the partnership level (i.e. whether the partners can claim tax losses), it is not relevant whether Nicholas has yet claimed tax losses based on these assets, but it is clear, the government contends, that he intends to do so at some point “or there would be no purpose to maintaining this case.” Mot. at 1 n.1.

C. Petitioners Acquire Non-Performing Loans

1. The Cinda Non-Performing Loans

The first of two series of NPL transactions at issue involved Cinda AMC. First, Cinda acquired NPLs from China Construction Bank. SUF ¶ 12. On December 10, 2001, Cinda declared the Cinda-Dragon 2001 Trust (“the Cinda Trust”). Id. ¶ 11. The same day, Cinda assigned to the Cinda Trust a portfolio of loans that it had acquired from China Construction Bank. Id. ¶ 12. In exchange, Cinda received 20,000 trust units, which constituted the entire interest in the Cinda Trust. Id. The portfolio contained non-performing loans with a collective nominal value of $250,068,811. Id. ¶ 13. Houlihan Valuation Advisors issued a report stating its opinion “that as of December 7, 2001, the present value of the Portfolio is stated reasonably at 3.05% of the . . . $250,068,811 . . . nominal face value of the loans,” or $7,627,000. Id. ¶ 14.

Then Cinda sold the NPLs to Petitioners through a complex set of transactions. On December 10, 2001, Cinda contributed 5,423.5 trust units to Broadwood Investment Fund in exchange for a 99% ownership interest in Broadwood Investment Fund. The trust units represented 27.1175% of the aggregate beneficial interests in the Cinda Trust. Id. ¶ 15. Chenery Management, Inc. (“Chenery”) acquired the remaining 1% interest in Broadwood Investment Fund in exchange for a promissory note of $19,179. Id. ¶ 16. Broadwood's undivided interest in the Cinda Trust's portfolio of loans originated by China Construction Bank had a nominal value of $67,812,376. Id. ¶ 17. On or about December 24, 2001, Cinda exchanged 98% of the ownership interest in Broadwood Investment Fund for a 99% interest in Broadwood Investment Holdings. Id. ¶ 20. Chenery acquired a 1% interest in Broadwood Investment Holdings in exchange for a promissory note of $18,986. Id. ¶ 22. On or about December 24, 2001, Henry Nicholas purchased Cinda's 99% interest in Broadwood Investment Holdings for $1,879,567. Id. ¶ 24. The record contains no evidence that Petitioners or Chenery had any role in structuring the terms of the 1999 transfer of non-performing loans from China Construction Bank to Cinda AMC. SAF ¶ 78.

2. The China Orient Non-Performing Loans

The second series of NPL transactions at issue involved China Orient AMC. Before December 6, 2001, China Orient acquired a portfolio of non-performing loans from Bank of China. SUF ¶ 31. The total “Aggregate Face Value” of the portfolio, or what the U.S. government characterizes as the “total purported nominal value,” was $217,377,027. Id.; SGD ¶ 31. A report by PricewaterhouseCoopers estimated that between 11% and 18% of the face value of the loans in the portfolio could be recovered. SUF ¶ 32; SGD ¶ 32.

Then China Orient sold the NPLs to Petitioners through a complex set of transactions. On or about December 6, 2001, China Orient contributed to Mosman Investment Fund an 11% undivided interest in that portfolio, in exchange for a 99% ownership interest in Mosman Investment Fund. SUF ¶ 33. On December 6, 2001, Chenery contributed a promissory note in the amount of $24,153 to Mosman Investment Fund, and, in exchange, Chenery received a 1% interest in Mosman Investment Fund. Id. ¶ 34. The nominal value of Mosman Investment Fund's interest in the portfolio of non-performing loans was $23,911,473. Id. ¶ 35. On December 10, 2001, China Orient exchanged 98% of the ownership interest in Mosman Investment Fund for a 99% interest in Mosman Investment Holdings. Id. ¶ 38. Chenery acquired the remaining 1% interest in Mosman Investment Holdings in exchange for a promissory note of $23,909. Id. ¶ 40. On or about December 23, 2001, Nicholas purchased China Orient's 99% interest in Mosman Investment Holdings for $2,366,994. Id. ¶ 42. The record contains no evidence that Petitioners or Chenery had any role in structuring the terms of the 1999 transfer of non-performing loans from Bank of China to China Orient AMC. SAF ¶ 79.

On December 26, 2001, Broadwood Investment Holdings merged with Mosman Investment Holdings, LLC. SUF ¶ 43. It also merged with Han Kook LLC II; Han Kook LLC II-A; and Dragon Coeur LLC II-B, which concern asset classes that are not at issue in this Motion. Id. Broadwood Investment Holdings was the surviving entity. Id.

D. The IRS Makes Section 482 Adjustments

On December 28, 2007, the IRS issued Notices of Final Partnership Administrative Adjustment (“FPAAs”) to Broadwood Investment Fund and Mosman Investment Fund concerning their Form 1065 U.S. Returns of Partnership Income for 2002, 2003, and 2004. SUF ¶¶ 51, 55; SGD ¶¶ 51, 55. The FPAAs disallowed in full the losses reported from Broadwood Investment Fund and Mosman Investment Fund's dispositions of their NPLs. SUF ¶¶ 51, 55. The IRS's determinations adjusted Broadwood's inside basis (the partnership's amount of capital investment in assets for tax purposes) in its interest in the Cinda Trust's portfolio from $67,812,376 to $1,898,747, and Mosman's inside basis in its interest in the China Orient's portfolio from about $23 million to $2,391,147. See SUF ¶¶ 54, 58.² Accompanying the FPAAs were Form 886-A Explanation of Items, which explained that, as one alternative theory for the adjustments, the IRS was applying Section 482 to adjust the transfer price in China Construction Bank's sale of the NPLs to Cinda, and the transfer price in Bank of China's sale of the NPLs to China Orient, “so it is an arm's length transfer.” SUF ¶¶ 52, 56. “The end result,” the IRS's explanation continued, “. . . would be that the non-performing loans would be purchased at fair market value rather than face value and there would be no built-in losses in the first place.” Id.

II. PROCEDURAL HISTORY

On December 1, 2008, Petitioners filed an Amended Petition challenging the IRS's FPAAs sent to each Petitioner. See Amended Petition at 5. On September 21, 2012, the Court granted summary judgment in favor of the U.S. government on the basis that Petitioners were sham partnerships (Dkt. 118). On August 3, 2015, the Ninth Circuit reversed, holding that the Court erred in granting summary judgment in favor of the government, explaining that Petitioners had presented sufficient evidence to raise a genuine issue of material fact as to the partners' intent — i.e. whether “the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.” See Mem. Disposition (Dkt. 130). On September 28, 2015, the Ninth Circuit's Mandate (Dkt. 131) issued.

On February 14, 2018, the government filed the instant Motion for Partial Summary Judgment. On May 7, 2018, Petitioners filed their Opposition, and on May 21, 2018, the government filed its Reply (Dkt. 232).

III. LEGAL STANDARD

Summary judgment is proper if “the movant shows that there is no genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law.” Fed. R. Civ. P. 56(a). Summary judgment is to be granted cautiously, with due respect for a party's right to have its factually grounded claims and defenses tried to a jury. Celotex Corp. v. Catrett, 477 U.S. 317, 327 (1986); Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 255 (1986). A court must view the facts and draw inferences in the manner most favorable to the non-moving party. United States v. Diebold, Inc., 369 U.S. 654, 655 (1992); Chevron Corp. v. Pennzoil Co., 974 F.2d 1156, 1161 (9th Cir. 1992). The moving party bears the initial burden of demonstrating the absence of a genuine issue of material fact for trial, but it need not disprove the other party's case. Celotex, 477 U.S. at 323. When the non-moving party bears the burden of proving the claim or defense, the moving party can meet its burden by pointing out that the non-moving party has failed to present any genuine issue of material fact as to an essential element of its case. See Musick v. Burke, 913 F.2d 1390, 1394 (9th Cir. 1990).

Once the moving party meets its burden, the burden shifts to the opposing party to set out specific material facts showing a genuine issue for trial. See Liberty Lobby, 477 U.S. at 248–49. A “material fact” is one which “might affect the outcome of the suit under the governing law. . . .” Id. at 248. A party cannot create a genuine issue of material fact simply by making assertions in its legal papers. S.A. Empresa de Viacao Aerea Rio Grandense v. Walter Kidde & Co., Inc., 690 F.2d 1235, 1238 (9th Cir. 1982). Rather, there must be specific, admissible, evidence identifying the basis for the dispute. See id. The Court need not “comb the record” looking for other evidence; it is only required to consider evidence set forth in the moving and opposing papers and the portions of the record cited therein. Fed. R. Civ. P. 56(c)(3); Carmen v. S.F. Unified Sch. Dist., 237 F.3d 1026, 1029 (9th Cir. 2001). The Supreme Court has held that “[t]he mere existence of a scintilla of evidence . . . will be insufficient; there must be evidence on which the jury could reasonably find for [the opposing party].” Liberty Lobby, 477 U.S. at 252.

IV. DISCUSSION

The U.S. government asks the Court to grant partial summary judgment on the Section 482 adjustment, arguing that the IRS properly adjusted — for U.S. tax purposes — the sale price of the NPLs between the Chinese Banks and the AMCs to reflect the fair market value, and arguing that the adjustment was a reasonable exercise of the IRS's discretion. Mot. at 2, 8.

Section 482 provides in relevant part as follows:

In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.

26 U.S.C. § 482.

Petitioners oppose the Motion, making the following five arguments: (1) the IRS has limited discretion and cannot apply a result-oriented Section 482 analysis to code compliant deals; (2) Section 482 does not apply to transactions, as here, between foreign entities that are not subject to U.S. income tax; (3) Section 482 does not apply to a transaction where the pricing is set by foreign law, which includes the transactions at issue; (4) Section 482 does not authorize reallocation of “basis”; (5) the IRS has not established lack of economic substance. See generally Opp'n.

In its Reply, the U.S. government raises seven arguments. See generally Reply. First, the government contends that there is no dispute of material fact on the Section 482 issue. Id. at 2. Specifically, the government asserts that undisputed facts establish that the Banks and AMCs were commonly owned and controlled at the time of the NPL sales, and that the AMCs did not pay the Banks an arm's length price for the NPLs. Id. at 2–6. Second, the government argues that Petitioners have not shown any reason why the Section 482 adjustment was arbitrary or capricious. Id. at 7–8. Third, the government argues that Section 482 allows the IRS to make adjustments to “code compliant” transactions. Id. at 8–12. Fourth, the government argues that Section 482 can apply to two foreign entities. Id. at 12–18. Fifth, the government argues that the “foreign legal restriction” rule — under which the IRS may not apply Section 482 where pricing is determined by foreign law — does not apply in circumstances, as here, where the entities involved in the transaction themselves create the legal restriction that sets the price. Id. at 18–20. Sixth, the government argues that Section 482 permits reallocation of “basis.” Id. at 20–21. Seventh, the government argues that Section 482 applies regardless of the economic substance of the transactions. Id. at 21–22.

The parties have raised several disputed legal issues regarding Section 482. However, the Court need not reach those issues because the government has not established the absence of a genuine issue of material fact as to the threshold Section 482 issue of whether the four Chinese entities involved in sales of NPLs — Cinda, China Construction Bank, China Orient and Bank of China — were under the common ownership or control of the Chinese government, at the time of the NPL sales. See SGD ¶¶ 5–6; SAF ¶¶ 82–83, GR ¶¶ 82–83; cf. Peking Investment Fund, LLC. v. C.I.R. (“Peking”), Docket No. 12772-09, at 13 (Tax Court, Feb. 12, 2018) (“Disposing of the [partial summary judgment] motion before us does not require a resolution of the legal issue of whether section 482's reach extends to transactions between nontaxpayers, because [the government] has not established that CCB and Cinda were under common ownership or control in June 2001 when Cinda acquired the CCB NPL portfolio from CCB.”). Therefore, the Court will turn to the issue of common ownership or control.

A. Common Ownership or Control of the Banks and AMCs

Common ownership or control of the organizations involved in a transaction is a threshold requirement for a Section 482 adjustment of the transaction. See Mot. at 9. Section 482 in relevant part provides: “In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate. . . .” 26 U.S.C. § 482.

Either common ownership or common control — but not necessarily both — must be present for the IRS to make a Section 482 adjustment. See Austin Inv. Fund, LLC v. United States, No. CV 11-2300 (CKK), 2015 WL 7303514, at *4 (D.D.C. Nov. 19, 2015) (citing Sunshine Dep't Stores, Inc. v. Commissioner, T.C. Memo. 1981-586, aff'd sub nom. Sunshine Dep't Stores, Inc. v. IRS, 705 F.2d 470 (11th Cir. 1983)). Common “control or ownership must exist when the [organizations] deal with each other,” i.e. conduct the transaction. Charles Town, Inc. v. C.I.R., 372 F.2d 415, 419 (4th Cir. 1967) (quoting Rooney v. United States, 305 F.2d 681, 683 (9th Cir. 1962)).

Federal regulations do not define common ownership, and they define common control to include:

any kind of control, direct or indirect, whether legally enforceable or not, and however exercisable or exercised, including control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose. It is the reality of the control that is decisive, not its form or the mode of its exercise. A presumption of control arises if income or deductions have been arbitrarily shifted.

26 C.F.R. § 1.482-1(i). The question of common control “involves a factually intensive inquiry, with attributes suggesting that a decision by summary judgment is inappropriate.” W. L. Gore & Assocs. v. Commissioner, 1995 Tax Ct. Memo LEXIS 97, *6-7, T.C. Memo 1995-96, 69 T.C.M. (CCH) 2037 (Tax Court, March 7, 1995) (citing Procacci v. Commissioner, 94 T.C. 397, 412 (1990)); see also Charles Town, 372 F.2d at 419 (“The question of control is one of fact.”).

At least three courts have addressed the question of whether the Chinese government had common ownership or control over China's Banks and AMCs during the sale of non-performing loans in the late 1990s and early 2000s.

The first case, Southgate, involved a sale of non-performing loans from China Construction Bank (“CCB”) to Cinda AMC in 2000, and the parties did not dispute that “Cinda and CCB are wholly state-owned companies and that myriad branches of the Chinese government have oversight and regulatory roles related to Cinda and CCB.” Southgate Master Fund LLC v. United States, 651 F. Supp. 2d 596, 647 (N.D. Tex. 2009), aff'd on other grounds, 659 F.3d 466 (5th Cir. 2011). Following a bench trial, the district court held that Cinda and CCB were not “commonly controlled entities” for the purposes of Section 482. Id. at 647. The court explained:

The Chinese government does not “control,” i.e., direct the management decisions of, Cinda or CCB because (a) the entities are separate “enterprise legal persons” with control over their own assets and property; (b) they do not share management; (c) they have separate management structures, with separate presidents or governors; (d) they have separate “supervisory boards”; (e) they are subject to a wide and different range of regulatory and supervisory influences, but they are not under the supervision of any single regulatory or governmental entity; and (f) they are different entities — an AMC and a bank — with different scopes of business. . . .

Based on the foregoing, the Court finds that although in the broad sense of a communist-controlled state all entities are government owned, for purposes of this tax question the separation is sufficient, as with General Motors in this country, to make Cinda not controlled by the Chinese government. . . .

Id. The court explicitly held there was lack of common control (and the court implicitly declined to find that there was common ownership for Section 482, despite the fact that there was “overarching ownership by the Chinese state”):

Cinda and CCB were separate legal and commercial entities with separate internal management, separate supervisory boards, separate regulatory authorities and different lines of business. . . . To find [that Cinda and CCB were commonly controlled despite overarching state ownership], the Court effectively would have to rule that virtually all Chinese entities are commonly controlled because of the pervasive state ownership in communist China.

Id.

In the second case, Austin, the district court reached a contrary result, granting summary judgment in favor of the government on a Section 482 adjustment of a 1999–2000 sale of non-performing loans, holding that Bank of China and China Orient AMC were under common ownership of the Chinese government. See Austin Inv. Fund, 2015 WL 7303514, at *4. In Austin, like in Southgate, the parties did not dispute that the Chinese government owned both the Bank and the AMC. Id. However, the Austin district court explicitly disagreed with the Southgate decision, and instead held that the plain language of Section 482, which simply requires that the entities be commonly “owned,” compels the conclusion that the Chinese government's actual ownership of the entities was sufficient to establish common ownership for the purposes of Section 482. Id.

Finally, in Peking, which concerned a June 2001 sale of NPLs from CCB to Cinda, the Tax Court denied the IRS's motion for summary judgment on a Section 482 adjustment. See Peking at 12–14 (citing Southgate Master Fund, 651 F. Supp. 2d at 661). In Peking, the IRS had submitted two exhibits in support of common ownership and/or control. Id. The first exhibit was an unsigned letter dated December 19, 2001, purportedly from or on behalf of Cinda, describing Cinda as “a corporation incorporated in the Peoples Republic of China and wholly owned by the Ministry of Finance of the Peoples Republic of China.” Id. The letter said nothing about CCB's ownership. Id. The second exhibit was a memorandum that Dorsey & Whitney prepared describing its due diligence in regard to the CCB non-performing loan, expressing the firm's understanding “that Chinese government policy and regulations would have required that the loans be transferred at face value from CCB to Cinda.” Id. The Tax Court held that the IRS had not submitted sufficient evidence to establish that, at the time of the transaction, CCB and Cinda were under common ownership of the Chinese government for the purposes of Section 482. Id. Next, the IRS cited the petitioner's acknowledgment of “amorphous” state ownership of CCB and Cinda in support of its motion. Id. However, the Tax Court explained that “[c]ommon ownership, [within the meaning of Section 482], can be either direct or indirect, but the ownership, in either case, should be clear.” Id. Thus, the court concluded, “We are unconvinced that 'amorphous' common ownership is sufficient to authorize the Commissioner to make adjustments under section 482.” Id.

In this case, the government argues that there is no dispute of material fact that Cinda, China Orient, CCB, and Bank of China were commonly owned and controlled by the Chinese Government. Reply at 2. First, the government contends that the Tax Court's holding in Peking — that there was a factual dispute over whether Cinda and CCB were commonly owned — was incorrect because Section 482 “contains no exception for 'amorphous' common ownership or vast state-owned enterprises such as China.” Reply at 4 (“Section 482 governs entities 'owned or controlled directly or indirectly by the same interests,' thus expressly envisioning a sprawling common ownership.” (citing Treas. Reg. § 1.482-1(i)(4) (2001) (“control” includes any kind of control, direct or indirect)). However, the Tax Court's interpretation of the Internal Revenue Code is “entitled to respect because of its special expertise in the field.” Boyd Gaming Corp. v. C.I.R., 177 F.3d 1096, 1098 (9th Cir.) (quoting Pahl v. Commissioner, 150 F.3d 1124, 1127 (9th Cir. 1998)). Thus, particularly at summary judgment, when the Court must draw inferences in the manner most favorable to Petitioners, the Court is unwilling to part ways from the Tax Court's Peking holding: that amorphous common ownership is not sufficient to sustain a grant of summary judgment in favor of the government on Section 482. See id.; Diebold, Inc., 369 U.S. at 655.

Second, the government argues that the IRS in Peking “lacked the robust evidentiary support on common ownership and control that the United States has here (and which Petitioners cannot rebut).” Id. In terms of evidence, the government relies primarily on the Declaration of its expert, Nicholas Lardy. See Reply at 3 (citing Lardy Decl.). Lardy states that in 1999, the Chinese government created and funded the four AMCs to remove NPLs from the books of the four largest state-owned Banks at full face value and rescue the banks from insolvency. Lardy Decl. ¶¶ 16–17. Next, he states that each AMC was paired with one of the four Banks and was responsible for disposing of its partner bank's NPLs, drew leadership from the top executive ranks of its partner bank, and leased physical assets (such as office space) from its partner bank. Id. He also states that all four AMCs and partner Banks were regulated and supervised by the same set of governmental bodies, notably the Ministry of Finance and the People's Bank of China (China's central bank), and all of these government bodies were 100 percent Chinese-government-owned and controlled under the supervision of the State Council (the equivalent of China's cabinet). Id. According to Lardy, the Chinese government dictated the terms on which the AMCs acquired the NPLs from the originating banks, those terms were policy-based, not market-based, and the Chinese government implicitly backed the bonds the AMCs issued to pay the Banks for the NPLs. Reply at 3 (citing Lardy Decl. ¶¶ 19, 20, 22, 23, 25). In addition, the U.S. government contends that Petitioners' own expert, Ted Osborn, agrees that the Chinese government created Cinda and China Orient to recapitalize the state-owned banks and stabilize the banking system. Id. (citing Declaration of Ted Osborn (“Osborn Decl.”) (Dkt. 230-8) ¶¶ 5, 7). Indeed, Osborn states that the Chinese government created the four AMCs, required them to purchase the NPLs from the Banks at full face value, and gave them debt collection powers that the Banks lacked, but Osborn does not state or express any opinion as to whether the Chinese government controlled the AMCs. See generally Osborn Decl.

To show the absence of a genuine issue of material fact on common ownership or control, the U.S. government must show that no reasonable fact-finder could find that the Chinese government did not have common ownership or control over the AMCs and Banks at the time of the NPL sales, drawing all reasonable inferences in Petitioners' favor. See 26 U.S.C. § 482; Sierra Med. Servs. All. v. Kent, 883 F.3d 1216, 1222 (9th Cir. 2018); see also Vinick v. C.I.R., 110 F.3d 168, 171 (1st Cir. 1997) (explaining that when the government brings a motion for summary judgment that depends on the applicability of a tax statute, the government bears the burden of demonstrating that the statute “applies and that [the government] deserves judgment as a matter of law” (citing O'Connor v. United States, 956 F.2d 48, 50 (4th Cir. 1992)). The Court will address in turn common ownership and common control.

As to common ownership, the U.S. government has put forward an expert's opinion that the Chinese government was the owner of the relevant entities and dictated the terms of the transactions. See Reply at 3. However, as Petitioners point out, the U.S. government has not put any evidence in the record regarding the identities of the AMCs' shareholders between 1999 and 2001 or what their relationship was with the Chinese government. See SUF ¶ 83. In response, the U.S. government objects that Petitioners have not established any foundation showing that the AMCs in fact had shareholders. GR ¶ 83. However, it is a reasonable inference that an asset management company — even if government-created — has shareholders. Thus, in light of the absence of evidence on whether or not the AMCs had shareholders, or if there were shareholders, what their relationship was with the Chinese government, a reasonable trier of fact could find that the Chinese government did not have common ownership. See Peking at 13 (“Common ownership, [within the meaning of Section 482], can be either direct or indirect, but the ownership, in either case, should be clear.”).

Next, as to common control, the government — through Lardy's expert declaration — has presented substantive evidence suggesting the Chinese government had control over the entities at issue. See generally Lardy Decl. However, common control “involves a factually intensive inquiry, with attributes suggesting that a decision by summary judgment is inappropriate.” W. L. Gore & Assocs. v. Commissioner, 1995 Tax Ct. Memo LEXIS 97, *6-7. Furthermore, in Southgate, the only court decision that has addressed after a trial whether the Chinese government commonly controls AMCs and Banks, the district court held that the Chinese government did not commonly control Cinda or CCB (two of the four entities at issue in this Motion), for six reasons:

Southgate Master Fund, 651 F. Supp. 2d at 647 (N.D. Tex. 2009). The Southgate district court also expressed concern that ruling otherwise would effectively mean “that virtually all Chinese entities are commonly controlled because of the pervasive state ownership in communist China.” Id. Therefore, even though Petitioners have not put forward substantive opposing evidence, given the factually intensive and far-reaching questions involved in the common control inquiry at hand, it would be premature to resolve this issue at summary judgment, relying primarily on an expert's declaration.

Thus, the U.S. government has not established the absence of a genuine issue of material fact, and entitlement to judgment as a matter of law, regarding whether the Chinese government had common ownership or common control over the Banks and AMCs at the time of the NPL transactions. See Fed. R. Civ. P. 56(a); Celotex, 477 U.S. at 323. Accordingly, the Court DENIES the government's Motion for Partial Summary Judgment.

V. DISPOSITION

For reasons stated above, the Court DENIES the government's Motion for Partial Summary Judgment.

DATED: June 11, 2018

DAVID O. CARTER
UNITED STATES DISTRICT JUDGE