PricewaterhouseCoopers Summarizes Economic Substance Case Law

 2010

After the options were closed out and expired and the only remaining assets in the partnership were the built-in-gain assets, a 99-percent interest in the partnership was transferred, causing a section 708(b)(1)(B ) termination of the partnership. A section 754 election was made, and the bases of the partnership's built-in-gain assets were adjusted under section 743(b) to reflect the partner's outside basis. The built-in gain assets declined in value and were eventually sold. At the time of the sale the basis in the stock including the section 743(b) adjustment resulted in a tax loss, whereas the original basis in the built-in-gain assets would have resulted in a tax gain.

The District Court disallowed the loss, ruling that the transactions had no business purpose other than tax avoidance and lacked economic substance. The court, considering both the objective features of the transactions and the subjective intent of the parties, found that under either analysis the transactions were without economic substance and were shams. From a subjective standpoint, the court found, the transactions had no business purpose of any kind. The taxpayers did not enter into the transactions for profit or to provide a hedge or to protect against financial or economic risk; the only reason they entered into the transactions was to shelter capital gains and ordinary income from taxation. From an objective standpoint, the court found, the transactions were not reasonably designed and implemented to serve a hedging or other risk-shifting function and had no reasonable possibility of profit. The court noted that "[n]o one with the slightest understanding of the tax laws could reasonably believe that $160 million in basis could be created out of thin air, or that $160 million in income could be made to vanish in a puff of smoke."

This case has important implications with respect to application in the First Circuit of the economic substance doctrine and section 7701(o). Historically, the First Circuit has adopted a version of the doctrine that looks to both the subjective and objective features of the transaction, without a rigid two-part test. In previous cases such as Granite Trust Co. v. U.S.,² the First Circuit had held that it would respect transactions that serve no business purpose (subjective test) provided the transactions are "not fictitious or so lacking in substance as to be anything different from what they purported to be" (objective test). In its analysis of the current case, the District Court suggests that the First Circuit's holding in Dewees v. Comm'r³ may be interpreted as having overruled prior First Circuit economic substance cases law mandating a rigid two-part test. While this commentary is included only in dicta, it creates uncertainty as to whether one may rely on judicial precedent in the First Circuit in light of the new mandatory two-part economic substance test under section 7701(o) because cases such as Granite Trust had not applied the economic substance doctrine.

The District Court also held that the partnerships were shams because there was no non-tax business purpose for their creation. Rather, the partnerships were created solely for the purpose of avoiding taxes, and did not engage in activities that either served a reasonable hedging purpose or provided a reasonable possibility of profit. In addition, the court held that the offsetting options pairs should be collapsed as a single position for U.S. federal income tax purposes.

Under section 6226(f), "the Court has jurisdiction to determine the 'applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item.'" The government argued that the penalties that indirectly related to partnership items are within the court's jurisdiction. The taxpayer challenged the penalty, arguing that even if the adjustments indirectly relate to partnership items, the statute provides the "court with jurisdiction only over penalties that directly relate to partnership items." The court stated that although it makes partnership-level factual determinations that are potentially relevant to the imposition of accuracy-related penalties, it does not have jurisdiction to determine whether any underpayment of tax resulting from the adjustments at issue is subject to one or more accuracy-related penalties at the partner level.

In each SILO transaction, Wells Fargo used its own funds and funds borrowed from a third-party bank (the "Lender") to buy depreciable assets from a tax-exempt entity. The portion of the consideration comprised of the borrowed funds was transferred to a subsidiary of the Lender (the "Debt Payment Undertaker"). The remaining consideration was transferred, in part, to the tax-exempt entity (the "Incentive Payment") and, in part, to another subsidiary of the Lender (the "Equity Payment Undertaker"). The consideration received by the Equity Payment Undertaker was immediately invested in securities.

Following its acquisition of the assets, Wells Fargo leased the assets back to the tax-exempt entity for a term of 15 to 25 years. At the expiration of the lease, the tax-exempt entity had an option to reacquire the assets. The payment to exercise such option was intended to be fully funded by the consideration transferred from Wells Fargo to the Equity Payment Undertaker.

Based on the arrangements described above, Wells Fargo deducted the $115,174,203 in depreciation, interest, and transaction costs. The Service disallowed the deductions. The U.S. Court of Federal Claims held for the Service and ruled that Wells Fargo was not entitled to the tax deductions because, among other things, the SILO transactions lacked economic substance. In reaching its conclusion, the court ruled that the SILO transactions lacked both objective economic substance and a non-tax business purpose.

In ruling that the SILO transactions lacked objective economic substance, the court made the following findings:

• The source of the non-tax, economic benefit to Wells Fargo, when the tax-exempt entity exercises its option to reacquire the assets, is simply the return of its funds transferred to the Equity Payment Undertaker, plus the interest earned on such funds during the lease term;

• Wells Fargo could have realized the same return by directly investing in the securities, without involving a tax-exempt entity; and

• The net present value of the non-tax, economic benefit to Wells Fargo, when the tax-exempt entity exercises its option to reacquire the assets, is less than the total cost to Wells Fargo for participating in the SILO transactions.

• The "motivating reason for the Wells Fargo SILOs was the desire to reduce the company's taxes as much as possible";

• There was a lack of any arms'-length negotiations regarding the substantive terms of the SILO transactions;

• The terms of the SILO transactions were "more the product of a software model, than any negotiations or commercial realities"; and

• The appraisals of the fair market value of the depreciable assets were inflated.

• 3. Jade Trading LLC v. U.S, 80 Fed. CL. 11 (2007), aff'd, 598 F.3d 1372 (Fed. Cir. 2010).

Citing Coltec, the court said that a technical interpretation of the Code supporting the tax treatment of a transaction will not guarantee that the transaction is valid for U.S. federal tax purposes. The court applied an "objective" analysis of the transaction, finding that the transaction lacked economic substance on the grounds that: (1) the loss created by the transaction was fictional; (2) there was no true investment; (3) there was a needless contribution of the options into the partnership; and (4) the tax advantage gained from the transaction greatly exceeded the amount of the investment and potential return. Consequently, the court denied the taxpayers' petition for readjustment of the partnership items and affirmed the assessment of tax penalties.

The U.S. Court of Appeals for the Federal Circuit affirmed the U.S. Court of Federal Claims' decision denying the tax loss. The court vacated and remanded the lower court's judgment regarding the assessment of penalties against the partners.

In order to facilitate Midcoast's acquisition of Bishop's assets, Midcoast's advisors contacted Fortrend International LLC ("Fortrend"), an investment bank, to determine if Fortrend would be willing to purchase Bishop's stock from Langley and then sell a portion of Bishop's assets to Midcoast. Fortrend agreed and began negations with Langley. In order to effect the acquisition of Bishop's shares, Fortrend formed K-Pipe Merger Corporation ("K-Pipe"). On September 30, 1999, K-Pipe submitted an offer to Langley to purchase Bishop's stock. The next day, Midcoast offered to purchase the majority of Bishop's assets from K-Pipe.⁵ One week after the submission of the offers, K-Pipe purchased all of Bishop's stock for $122.5 Million.⁶ The following day, K-Pipe sold almost all of Bishop's assets to Midcoast for $122.6 million plus an additional $79 million that Midcoast paid to Bishop's creditors.⁷

Midcoast took the position that its basis in Bishop's assets was equal to the $192 million purchase price paid for Bishop's assets. Accordingly, Midcoast began taking depreciation deductions on the Bishop assets based on the premise that Midcoast had in fact purchased assets. The Service disagreed. The Service asserted that K-Pipe was a mere conduit and that sale of stock to and purchase of assets from K-Pipe should be disregarded. Instead the Service argued that Midcoast had directly purchased the Bishop stock from Langley and obtained Bishop's assets in a carryover basis transaction. As a result, the Service argued that Midcoast had improperly claimed depreciation deductions and asserted a substantial underpayment of taxes penalty under section 6662.

The trial court granted the Service's motion for summary judgment. In reaching its decision, the trial court looked to the substance over form doctrine and stated that substance over form principles had been applied in numerous iterations, including both conduit theory, step transaction doctrine, and the economic substance doctrine.⁸ The trial court indicated that conduit theory most closely fit the facts at bar.

Applying conduit theory, the trial court looked to (1) whether there was an agreement between the principals to do a transaction before the intermediary participated; (2) whether the intermediary was an independent actor; (3) whether the intermediary assumed any risk; (4) whether the intermediary was brought into the transaction at the behest of the taxpayer; and (5) whether there was a non tax-avoidance business purpose to the intermediary's participation. The trial court concluded that many of these facts were present in the instant case and weighed in favor of declaring K-Pipe a mere conduit in the transaction.

On appeal, the Court of Appeals for the Fifth Circuit affirmed the trial court's application of conduit theory and noted that the facts in Enbridge Energy were similar to Blueberry Land Co. v. Comm'r, where an intermediary agreed to buy the seller's stock, sell the assets of the corporation to a buyer, and then liquidate the corporation.⁹ In Blueberry Land, the court ruled that the intermediary "served no real or useful economic purpose apart from tax savings . . ."

The Fifth Circuit distinguished its analysis in Enbridge Energy from its prior decision in Compaq Computer Corp. v. Comm'r¹⁰ on the grounds that transactions involving an intermediary "had both a reasonable possibility of profit attended by a real risk of loss and an adequate non-tax business purpose. The transaction was not a mere formality or artifice but occurred in a real market subject to real risks." However, the Fifth Circuit did not find any of Midcoast's asserted business reasons for inserting K-Pipe into the transaction compelling. Thus, the Fifth Circuit affirmed the trial court on the grounds that the transaction was designed solely for the purpose of avoiding tax that Midcoast had not shown adequate non-tax reasons for using a conduit entity.

In a LILO transaction, a U.S. taxpayer generally enters into a lease for property from a tax-exempt entity and then leases it back to that entity for its use. The tax-exempt entity has a shorter sublease term than the lease of the U.S. taxpayer. At the expiration of the sublease, the original owner has an option to buy back the remainder of the U.S. taxpayer's lease. Additional terms often vary depending on the nature of the transaction.

In Consolidated Edison, Consolidated Edison Development, Inc., ("CED") a public utility company engaged in a LILO transaction ("The RoCa3 Transaction") with Electriciteitsbedrijf Zuid-Holland, N.V. ("EZH") in 1997. The RoCa3 Transaction involved the lease of a 47.47 percent interest in EZH's RoCa3 Facility for a term of 43.2 years to CED in return for rental payments (the "Lease Agreement"). The rental payments consisted of (i) an immediate rental payment in the amount of $120 million, due at closing, made up of a $39 million equity commitment from CED and a nonrecourse note from a third party for $80 million, and (ii) a final rent payment in the amount of $831 million, due upon the termination of the lease.

Additionally, pursuant to a Sublease Agreement, there was a sublease of this same 47.47 percent interest in the RoCa3 Facility back to EZH for a term of 20.1 years. At the end of the sublease, one of three options may be exercised: (1) the Sublease Purchase Option (under which EZH could buy-out CED's remaining interest), (2) the Sublease Renewal Option (under which CED could require EZH to renew the sublease for 16.5 years) and (3) the Retention Option (under which CED could retain its interest in the RoCa3 Facility under its lease and would be required to satisfy the nonrecourse debt obligation immediately). The latter two options were both exercisable by CED if EZH did not exercise the Sublease Purchase Option.

A LILO transaction is designed to provide a pretax profit that for accounting purposes under Financial Accounting Standards 13 is front-loaded into the early years of the transaction. The IRS disallowed certain rental, interest, and transaction cost deductions taken by Consolidated Edison associated with this LILO transaction, and Consolidated Edison brought this action as a result. In order for the RoCa3 Transaction to be eligible for the deductions taken, the court stated that the "form of the Transaction must mirror its substance, and the Transaction must possess an economic purpose other than to generate tax deductions."¹¹ In regards to the form and substance of the transaction, the court determined that the RoCa3 Transaction was, in form and substance, a true lease in which CED had the benefits and burdens of a leasehold interest as a result of the RoCa3 Transaction.

The court proceeded to examine the economic substance of the RoCa3 Transaction, and noted that both Frank Lyon and Coltec were binding on the court and set out the general approach to reviewing economic substance. However, neither case provided a formula to determine whether there was economic substance and, therefore, the court would engage in lengthy trial to evaluate the true nature of the RoCa3 Transaction.

In order for a transaction to have economic substance, there must be an objective reasonable possibility of profit and the subjective intent to enter into the transaction must be imbued with a business purpose beyond the beneficial tax treatment. Considerations of economic substance are factually specific to the transaction involved. In this case, the tax advantages that CED could derive from the RoCa3 Transaction were undisputed by either party. The non-tax reasons for entering into the RoCa3 Transaction included:

The court then evaluated each of the three separate, viable options that could be exercised at the end of the sublease term and determined that none of the options were certain to be exercised at the time the Transaction was consummated and that each option offered some potential economic profit. While no specific minimum pre-tax profit has been established for recognizing the economic substance of a leasing transaction, the court, relying on AWG Leasing Trust v. U.S., 592 F.Supp.2d at 980, provided that a pretax profit of 3.4 percent would suffice to imbue a transaction with economic substance.¹⁵

Therefore, based on the specific facts of the RoCa3 Transaction, the court determined that the transaction had economic substance and upheld the claimed deductions. The court noted that all the cases dealing with LILO transactions support the concept that the transaction at issue must be viewed as a whole, in order to review the multiple-party transaction, and to determine whether the transaction is encouraged by business or regulatory realities, is imbued with tax-independent consideration, and is not shaped solely by tax-avoidance features that have meaningless labels attached, as well as whether the transaction varies control or changes the flow of economic benefits.¹⁶

In this case, Con Ed demonstrated non-tax reasons for the RoCa3 Transaction and the transaction was proven to have risk associated with it. Additionally, the fact that there were direct and indirect profit opportunities and none of the Option alternatives were certain to be exercised supported a finding that the Transaction had economic substance. Therefore, the court held that, "the plaintiff has established, through its witnesses and the exhibits, that the RoCa3 Transaction was a unique LILO transaction, which provided tax and bookkeeping advantages to the plaintiff; was, in form, a true lease; possessed economic substance; and, therefore, should be respected as qualifying for the tax deductions claimed."¹⁷

The CARDS transaction at issue in Country Pine had three phases: the loan origination phase, the loan assumption phase, and the operational phase. Three parties were required to carry out the CARDS transaction: a bank (lender), a borrower, and an assuming party. Zurich Bank acted as the lender, and Fairlop Trading, a Delaware LLC with two UK residents as its members, acted as the borrower.

The CARDS transaction was based on the premise that a participant would enter into the CARDS transaction and use an assumed portion of certain loan proceeds to make an investment. The investment property would then be swapped as collateral, which in theory would be successful if the rate of return on the investment property exceeded the costs of entering into the CARDS transaction. If not, it would produce a loss.

Specifically, the CARDS transaction in Country Pine involved Zurich Bank and Fairlop Trading entering into a credit agreement whereby Fairlop Trading pledged collateral in order to borrow funds from Zurich Bank. Zurich Bank applied a "haircut" to the pledged collateral which varied depending on the type of collateral pledged. Fairlop Trading borrowed Euros from Zurich Bank, and then exchanged the borrowed funds with Zurich Bank for promissory notes worth the same amount, which effectively had the result of each party owing each other the same amount.

Thereafter, certain members of Country Pine purchased some of the borrowed Euros and one of the Fairlop-Zurich Bank notes by contributing their own note into the newly formed Country Pine. Those members of Country Pine also agreed to become jointly and severely liable for the entire amount of the Fairlop-Zurich Bank notes and as a result, claimed a higher basis in their note based on basis of the Fairlop-Zurich Bank notes. Country Pine and Zurich Bank then entered into a cross-currency swap of the purchased Euros into U.S. dollars based on an exchange rate from an earlier period. This produced a loss due to the high basis in the purported high-basis note that was claimed by the members on their 2001 return.

The IRS' notice of adjustment claimed that (1) the CARDS transaction lacked economic substance, was entered into primarily for tax-avoidance purposes, and was prearranged; (2) application of the substance-over-form or step-transaction doctrine would disallow the loss; or (3) neither Country Pine nor any member was entitled to a deduction under sections 165, 465, or 988.

The court first analyzed the objective profit potential of the transaction giving rise to the claimed tax loss and concluded that Country Pine and the members engaged in the CARDS transaction to create a tax loss and that the transaction had no profit potential. The Tax Court noted that the CARDS transaction consisted of prearranged steps entered into to generate a tax loss; none of the loan proceeds ever left Zurich Bank's control; the loan proceeds were never at risk because the various loan agreements required Fairlop Trading, the members, and Country Pine to immediately pledge trustworthy collateral for the loan amounts. Furthermore, the court noted that, after entering into the CARDS transaction, none of the parties ever made any additional contributions to capital or ever attempted to use the loan proceeds, and the terms and interest rates of the currency swap and the forward contract allowed Country Pine to back out of the transactions without paying any amounts other than the fees required as part of the transaction. Accordingly, there was no chance that Zurich Bank, Fairlop Trading, or the members would ever lose any money on the CARDS transaction.

The court concluded that the claimed loss is also disallowed because the members did not have a non-tax business purpose for entering into the CARDS transaction. Although the members testified that the decision was made to secure financing for future real estate investments, the court did not find the testimonies credible, citing substantial evidence that the decision to enter into the CARDS transaction was solely tax motivated. Furthermore, Country Pine testified that the decision to enter into the transaction in 2001 was to take advantage of the tax benefits; notes taken by the members during presentations in which the transaction was being proposed and considered focused on the tax benefits; and the members never researched or evaluated an investment in real estate. The members repeatedly testified that they did not read any of the relevant documents but only signed the signature pages. According to the court, the members' lack of due diligence in researching the CARDS transaction indicates that they knew they were doing nothing more than purchasing a tax loss and not entering into a legitimate business or financing transaction with any non-tax objectives.

Accordingly, the court concluded that the CARDS transaction lacked economic substance as it had neither an objective profit potential nor a subjective business purpose.

In the late 1990s, as China was looking to join the World Trade Organization, the nonperforming loan ("NPL") market in China developed as a means for China to shift NPLs off of the balance sheets of its state-owned commercial banks to special purpose state-owned asset management companies ("AMC") that would collect on the debt or sell portfolios of NPLs to investors. One such AMC was China Cinda Asset Management Company ("Cinda"). In 2002, Beal, an experienced investor in NPLs, through an employee ("Montgomery"), began negotiations with Cinda for the purchase of an NPL portfolio with a face amount, including accrued but unpaid interest, of approximately $1.1 billion.

Although Beal was interested in the NPL investment, he did not initially pursue it due to other recent acquisitions. Instead, Montgomery left Beal, and in late 2002 he formed Montgomery Capital Advisors LLC ("MCA") to continue to pursue the Cinda NPL investment with the understanding that Beal may be interested in the investment at a later time. Montgomery ultimately negotiated the price of the NPL portfolio from Cinda at 1.7 percent of $1.1 billion face value.

In late 2002, to effectuate the purchase of the NPL portfolio, which MCA could not do alone, Cinda formed Eastgate, a Delaware LLC, as its U.S. investment vehicle, and contributed the NPL portfolio to it. Cinda's tax basis in the NPL portfolio was $1.37 billion. On the same day, Montgomery (through MCA) and Eastgate formed Southgate, also a Delaware LLC, with Eastgate owning a 99-percent interest and MCA owning a 1-percent interest. The plan was for Montgomery to pursue an investor in Southgate on behalf of Cinda, and the formation of Southgate was important to confirm Cinda's ownership of the NPL portfolio, and thereby establish legal recourse for the potential investor in Southgate, and remove the NPL portfolio from Cinda's balance sheet.

Following the formation of Southgate, Montgomery proposed the NPL investment opportunity again to Beal. This time Beal agreed to the investment. Beal purchased 90 percent of Eastgate's interest in Southgate for $19.4 million. Southgate did not have a section 754 election in effect so the basis of the NPL portfolio was not adjusted to reflect Beal's basis in Southgate. In 2002 some of the NPLs were sold for $3.2 million resulting in a loss of $294 million. Pursuant to section 704(c), 90 percent (i.e., approximately $265 million) of the loss was allocated to Beal.

Beal's basis in Southgate was approximately $29 million, which was not sufficient to fully utilize the loss. In order to increase his outside basis, Beal contributed securities with a fair market value of $180.6 million and a $300 million face value. Beal entered into a repo agreement pursuant to he sold a portion of the securities for $162 million and agreed to repurchase the same at the same price plus interest. Beal contributed the securities to Southgate and Southgate assumed the liability for the repo. This resulted in Beal being treated as contributing an additional $180.6 million to Southgate, thereby increasing his basis in Southgate, and allowing utilization of the loss.

The Service disallowed deduction of the losses by Beal, asserting that Beal engaged in an abusive tax shelter known as DAD. The Service argued the purpose of the DAD tax shelter was to shift to Beal artificial tax benefits associated with losses on the NPL that actually were incurred by Cinda, and therefore lacked economic substance. Beal argued that the NPL investment was done by an experienced investor in distressed assets who was seeking to profit from a partnership that owned a NPL portfolio, and the transaction was structured to optimize the tax consequences of the investment, consistent with the Code and regulations.

The district court applied Fifth Circuit precedent to analyze the economic substance of the transaction using the conjunctive test (i.e., subjective business purpose and objective potential for economic profit). The court determined the NPL investment by Southgate had economic substance, but that the basis-building transaction did not.

Regarding the NPL investment, in reaching its conclusion, the court considered the following facts as satisfying the economic substance test: (1) that the investors were sophisticated and experienced in NPLs, (2) the particular NPLs were of better quality than the debt involved in the typical DAD case (e.g., department store checks or credit card debt), (3) the investors were able to sell some of the NPLs to raise working capital even though it triggered the built-in loss in question, and (4) Southgate's collection efforts were better than the collection agents in other DAD cases.

However, the court held the basis-building transaction lacked economic substance. According to the court, "objectively, the [basis-building transaction] lacked economic substance because Southgate did not have a reasonable possibility of profit from it, despite the opportunity for profit from the original NPL transaction. . . . Beal effectively reserved for himself all guaranteed income streams from the [securities] and sole discretion to award gains or losses from the securities to the partnership. The possibility of Beal . . . allow[ing] Southgate to profit from the [securities] effectively to his own economic detriment was not a reasonable possibility of profit for Southgate." Id. at 655. As to the subjective economic substance analysis, the court found that Beal had not established any valid business purpose for the basis-building transaction other than the tax benefits obtained. The court said that reasons proffered by Beal read like afterthoughts designed to disguise the true purpose. Likewise, Beal's assertion that the basis-building transaction increased Southgate's equity base to pursue other NPL deals was viewed as without merit.

The court also held that Southgate was a sham partnership. Although the NPL transaction was not a sham per se, the court found that the underlying structure was nothing more than a sham to gain tax benefits for Beal.

The court held that Beal's reliance on his two more likely than not tax opinions provided him with substantial authority for taking his position, and therefore did not impose any penalties. In reaching its conclusion, the court noted that the judicial doctrines regarding economic substance were "amorphous, require intensive fact-finding, and generally lack the sort of black-letter, multi-part tests that allow definitive answers [and the tax opinions] were properly framed as educated guesses in light of what the IRS might find and what a court might conclude, bolstered by substantial statements of both fact and law, and reasonably relied upon by Southgate's architects." Id. at 666.

Within two months, taxpayer acquired the second member's interest causing the partnership to liquidate. The taxpayer claimed a basis under section 732(b) in the only asset deemed distributed on liquidation, a foreign currency position, equal to its basis in its partnership interest. The Tax Court disregarded the transaction at issue under the economic substance doctrine and upheld the assessment of penalties under section 6662.

Recognizing the split in the Court of Appeals as to the economic substance doctrine (i.e., conjunctive or disjunctive test), the Tax Court found the transaction nonetheless failed both the subjective and objective prongs of the doctrine. With respect to the subjective prong, the court held that the taxpayer failed to establish that a non-tax business purpose existed for entering into the transactions. The court cited as evidence the lack of the taxpayer's need for the foreign currency positions and lack of investigation into the foreign currency aspects of the option contracts, the irrational pricing of the options, and admission of the advisor entities into the single-member LLC. When analyzing the objective prong, the court held that the taxpayer did not have a reasonable prospect of earning a profit from the transactions. The court noted that the spot market exchange rate was not determined in an objective manner or by an independent agent as was common in the industry, and that the fees owed to the advisors eliminated any pretax profit generated on the options. In conclusion the court held that the transactions revealed a prearranged set of transactions that were not imbued with any meaningful economic substance independent of tax benefits.

The long and short options expired worthless. Shortly thereafter the partnership dissolved and distributed stock to Sub in redemption of its partnership interest. Sub sold the stock for a small economic loss but a large tax loss.

The Service argued that the option spread was a sham lacking economic substance, that the partnership was a sham and should be ignored for U.S. federal income tax purposes and, alternatively, that the taxpayer treated the digital option spread incorrectly on its return. The Service also asserted that the taxpayer should not be able to deduct for U.S. federal income tax purposes the fees paid to a law firm in connection within the transaction.

The Tax Court applied the economic substance standard applied by the Sixth Circuit. Under this inquiry the court first evaluated whether the transaction has any practicable economic effects other than the creation of income tax losses. If a transaction meets this standard, then the court will evaluate whether the taxpayer was motivated by profit to participate in the transaction. The Tax Court held the transaction lacked economic substance and failed the first prong of the test. The court noted that the taxpayer did not actually suffer a $10 million economic loss, finding that the loss was purely fictional. The court noted that the options were contributed to a partnership solely to allow the taxpayer to increase its basis in the partnership by the long option, while ignoring the sold short option under section 752.

The Tax Court that the taxpayer was not entitled to deduct them for U.S. federal income tax purposes certain expenses (e.g., legal fees associated with the transaction) because the transaction lacked economic substance.

The District Court held that the transaction lacked economic substance and that the transactions at issue were economic shams. The court applied the step transaction and substance-over-form doctrines to invalidate the transaction. The court also held that the short position was a section 752 liability, relying on Rev. Rul. 88-77 and asserting that to avoid asymmetry between the cash received, which clearly was a tax asset, and the contingent obligation, the obligation had to be treated as a section 752 liability. The court also held that Treas. Reg. § 1.752-6T was validly applied retroactively.

The court determined that the transactions had no practical economic effect apart from tax benefits. The court examined the objective economic substance of the transaction and found that the transactions lacked objective economic substance because they did not appreciably affect the taxpayers' beneficial interest except to reduce taxes. The court then looked to the taxpayers' subjective business purposes and determined that they had no business purpose for engaging in the transactions other than tax avoidance. The court held that the transactions did not have economic substance because the taxpayers received no economic benefit, other than the increase in basis, from the transactions.

In 2004, characterizing the transactions as loans, as opposed to sales as claimed by the taxpayer, the Service assessed a tax deficiency against Schering-Plough Corp. ("Schering-Plough") in the amount of $473 million with respect to certain lump-sum payments received in 1991 and 1992 that were not included in taxable income. Schering-Plough paid the deficiency and thereafter filed suit for a full refund.

In 1991 and 1992, Schering-Plough, the U.S. parent of a multinational group of corporations, sought to repatriate earnings from its foreign subsidiaries for U.S. operations, without the imposition of tax. A simple loan from the foreign subsidiaries to the domestic parent would have created a tax liability under section 956 and subpart F. Merrill Lynch proposed a solution to Schering-Plough's tax issue with an interest rate swap-and-assign transaction that enabled Schering-Plough to obtain cash to finance its domestic operations in a tax-efficient manner and avoid increasing its balance sheet.

Schering-Plough entered into two 20-year interest-rate swap transactions with the Dutch bank ABN. Under the swaps, the two parties agreed to exchange periodic payments based on a hypothetical amount and two different interest-rate indices. The swaps obligated Schering-Plough and ABN to make periodic payments to one another reflecting the movement of the particular interest rate assigned to each respective side of the transaction.

In typical interest rate swaps, these periodic payments net against each other and are not assignable. Under the agreements with ABN, Schering-Plough had the right to assign or otherwise transfer its right to receive payments from ABN (the "receive legs").¹⁸ Accordingly, it assigned the receive legs to its foreign subsidiaries. In return, the subsidiaries made lump-sum payments to Schering-Plough totaling approximately $690 million, thereby effecting the desired repatriation. Schering-Plough did not report the lump-sum payments from its CFC as income under general federal income tax principles. It deferred income recognition pursuant to Notice 89-21,¹⁹ which sets forth rules for ratable taxation of payments received in exchange for the assignment of future income streams from notional principal contracts.

The Service recharacterized the transactions as loans from the CFC to the taxpayer, which would be subject to income inclusion under section 956. Relying heavily on testimony from the Government's expert witnesses, the court concluded that under the general doctrine of substance-over-form, the cash flows from the swap-and-assign transactions produced an economic result that was similar to a loan, with fixed maturity dates, set principal amounts, interest payments by Schering-Plough (routed through ABN to the Swiss subsidiaries), and fixed repayment schedules. In so doing, the court gave little weight to the fact that the payment streams differed and varied over time, and that the Swiss subsidiaries ultimately may not receive repayment of the purported principal amount.

The Service treated the lump sum payment from the CFC as loan proceeds, which Schering-Plough would repay by routing payments through the bank to the CFC via the separated "legs" of the interest rate swap (i.e., Schering-Plough would repay the loan by making payments to the bank on the "pay leg" of the swap, which payments the bank largely would pass along to the CFC via payments on the "receive leg"). The Service's position was that because the transaction was a loan, rather than the sale of a cash flow stream, Notice 89-21 did not apply. The court also concluded that the transactions had no appreciable economic effect on the parties and that the taxpayer lacked non-tax motivation. As such, the court said that the taxpayer could not avoid the purpose of subpart F by relying on an administrative notice designed to address timing of income in certain transactions in anticipation of regulations.

Having found that the transactions were loans in substance, the court proceeded to address the economic substance of the swap-and-assign transactions. Applying the analysis in ACM Partnership, the court purported to examine both the "objective" economic substance and the "subjective" business purpose of the transactions. Concluding that the arrangement had minimal impact on ABN's net financial position and did not benefit Schering-Plough economically aside from the tax benefits received, the court held that the use of cash from the lump sum payments Schering-Plough received should not be considered an economic benefit.

The court also found that Schering-Plough had very little interest rate risk from the transactions, as a result of having entered into other hedging arrangements. Finally, the court held that Schering-Plough's willingness to spend a significant amount on trading fees and consulting fees to carry out the transaction was persuasive evidence that it lacked any profit motive.

With respect to Schering-Plough's business purpose for the swap-and-assign-transactions, the court rejected the company's claims as to the effect that they had on financial reporting, cash management, hedging, and yield enhancement. Relying again on the testimony of the Government's expert witnesses, the court concluded that the transactions could not have supported such claims. The court also found that Schering-Plough had not performed any pre-transaction analysis as to the potential business impact of the transactions.

In addition, the court examined how prices were set for the transaction, finding that Schering-Plough and its financial advisors first determined the amount of repatriation required (i.e., the amount of the lump sum payments from the Swiss affiliates) and then engineered the notional principal amount to meet that requirement. Moreover, the court expressed doubt about the business purpose of the transactions as a general matter, pointing to the involvement of well-informed, compensated third-party banks, the general atmosphere under which the transactions were implemented, and the manner in which the transactions played out.

The court held that the swap-and-assign transactions into which Schering-Plough entered should not be respected as sales of future income streams, but instead accepted the Government's argument that those transactions were, in substance, loans, with no appreciable economic effect on the parties and without sufficient non-tax business purpose motivations for entering into them.

2008

Generally, in a LILO transaction, a taxpayer purports to lease property from a tax-exempt entity and simultaneously sublease the property back to the lessor for a shorter term. The tax benefit of a typical LILO is deferral with minimal risk to the taxpayer. BB&T, a U.S. financial services company, entered into the LILO at issue with Sodra Cell AB ("Sodra"),²¹ a leading wood pulp manufacturer, hoping to reduce its tax liability. The property at issue was an interest in pulp manufacturing equipment ("the Equipment") at Sodra's mill. Through a series of agreements, BB&T leased the Equipment from Sodra for a 36-year term and simultaneously subleased it back to Sodra for a 15.5year term. BB&T agreed to pay Sodra rent in two installments and it secured a non-recourse loan to make the initial payment. Pursuant to the terms of the agreements, the rent payments were equal to the loan payments.

The Service disallowed rental and interest deductions claimed by BB&T on its tax return under Sections 162(a)(3) and 163(a). BB&T filed a complaint in district court seeking a refund of taxes it claimed to have overpaid. The court took BB&T at its word that the transaction met the criteria for economic substance,²² which courts generally use to analyze LILO transactions. However, because a summary judgment was requested, the court evaluated the claims for the rental and interest deductions separately under the substance-over-form doctrine, noting that "we look to the objective economic realities of a transaction rather than to the particular form employed by the parties."²³

Rental Payment. The district court concluded that BB&T was not entitled to a deduction for its rental payment because it had not acquired a genuine leasehold interest in the Equipment. This conclusion was based on the decision in Frank Lyon,²⁴ which set forth the premise that "in substance, a true lease for tax purpose requires a demonstration that the lessor retains significant and genuine attributes of the traditional lessor status." Here, all the rights and obligations obtained by BB&T were immediately returned to Sodra under the sublease, no money other than the "incentive to complete the deal" given to Sodra was exchanged, and Sodra was able to use the Equipment in the same manner as it did prior to the transaction with little to no interruption. Based on these facts and circumstances, the court found that BB&T did not retain significant and genuine attributes of a traditional lessor needed to establish a true lease relationship between itself and Sodra and was thus denied rent deductions under section 162(a)(3).

Interest Deduction. The district court also disallowed the interest deductions under section 163(a) on the loan, concluding that BB&T had not acquired genuine indebtedness. As a general rule, indebtedness is defined as "an existing, unconditional, and legally enforceable obligation for the payment of a principal sum, and in keeping with principles of substance over form, deductible interest can only accrue on genuine indebtedness."²⁵ Further, courts have held that "indebtedness must be indebtedness in substance and not merely in form."²⁶ Here, the loan was not regarded as a true indebtedness by the court because the purported loan was structured in an offsetting manner requiring no further financial obligations of the parties after closing and was merely a circular flow of cash in which the loan was paid from the proceeds of the loan itself.²⁷

The Service argued that under Coltec Indus., Inc. v. U.S.,³⁰ Shell's transfer of non-income producing, high-basis properties had neither economic substance nor a non-tax business purpose, and served only to artificially inflate Shell's tax basis in the Shell Frontier APS received and sold by Shell Western, and further to generate a double tax deduction that could be realized upon Shell Frontier's disposition of those properties. Shell countered that the transfer of the non-producing properties to Shell Frontier raised $164 million in cash without incurring outside debt and served the legitimate non-tax goals of improving management of the properties while preserving assets that Shell believed had significant long-term potential.³¹

The court rejected the Service's argument that the transfer of built-in loss properties to Shell Frontier had been devised for the purpose of triggering a capital loss, finding that the section 351 transaction had both a business purpose and economic substance. The court distinguished Coltec based on the objective impossibility of Coltec's stated goal of insulating itself from the asbestos liabilities by transferring those liabilities to a subsidiary.³²

In concluding that the formation of Shell Frontier had economic substance, the court focused on the fact that when Shell's general tax counsel presented the proposal to Shell's president, he intentionally refrained from discussing the specific tax implications of the exchange and Shell's management ultimately approved the Shell Frontier plan on non-tax business grounds. The court found that the business purpose of forming Shell Frontier was to raise cash, preserve long-term properties, and increase management efficiency. Furthermore these business purposes were consistent with Shell's overall strategy of improving its return on investment and increasing cash flow by investing strategically to increase production and by restructuring some of its assets.

In conclusion, the court stated, "this is not a case in which the taxpayer has engineered a transaction solely for tax purposes, but one in which the taxpayer has undertaken a transaction to accomplish legitimate, non-tax objectives and has permissibly structured it so as to maximize the attendant tax benefits under then-existing law."³³

The court first examined whether the AWG Transaction had economic substance. In analyzing the economic substance of the AWG Transaction, the court looked to the Sixth Circuit case, Dow Chemical (435 F.3d 594, 2006), to see "whether the transaction has any practicable economic effects other than the creation of income tax losses." The court determined that the transaction had economic substance, concluding that the taxpayer had a reasonable expectation of making a "small, but guaranteed, pre-tax profit" as well as a "small chance of making a large profit." The "small, but guaranteed, pre-tax profit" was tied to the internal rates of return banks received on their leveraged leases, which was between 2.5 and 3.5 percent. If the purchase option was exercised at the end of the lease, the AWG Transaction would return an internal rate of return of approximately 3.4 percent. In the context of the potential to make a "large profit," if the service contract option was exercised, the internal rate of return for the AWG Transaction would be between 5 and 8 percent. Because the court found that the transaction was not a complete economic sham, it then analyzed "substance over form."

The court considered the issue of substance over form in respect to two aspects (i) the lessor's acquisition of the depreciable property, and (ii) its indebtedness to the banks financing the AWG Transaction. The taxpayer argued that at the closing of the transaction in 1999, it became the economic owner of the Facility and should be entitled to depreciation deductions. The court concluded that the transaction was not a true sale because:

"In sum, the AWG Transaction does not allocate the rights, responsibilities, and risks between the German corporation and AWG in a way that resembles a traditional sale." Accordingly, the court concluded that, in reality, the AWG Transaction was a financing arrangement designed in significant measure to increase tax deductions.

Clearmeadow became a partnership for U.S. federal tax purposes. Shortly thereafter, Clearmeadow paid $1,000 to acquire $1,487.51 Canadian dollars. Clearmeadow was then liquidated and its assets distributed. When Clearmeadow was liquidated, the partner claimed a tax basis in the distributed property (i.e., Canadian dollars) equal to its basis in the partnership (i.e., the cost of the long position $2.5 million). On December 24, 2001, a portion of the Canadian dollars was sold for $323.08. On its 2001 tax return, the partner claimed a loss of $1,004,040.

The Court of Federal Claims granted the government's motion for summary judgment. The court stated that Treas. Reg. § 1.752-6T applied retroactively, thus reducing the asserted basis by the amount of liabilities assumed. The court also held that the taxpayer's claims would fail under the economic substance doctrine.

The taxpayer argued that it did not violate the economic substance doctrine because it complied with the letter of the law. Rejecting the taxpayer's argument, the Court stated that "the doctrine would serve little purpose were it to apply only after a transaction has already run afoul of other requirements of the Code." It noted that the Court of Federal Claims, which had adopted the taxpayer's view of the economic substance doctrine in Coltec Industries, Inc. v. U.S., 62 Fed. Cl. 716, 754 (2004), was reversed by the Court of Appeals for the Federal Circuit.³⁵

The Court of Federal Claims in Clearmeadow stated that factors to examine to determine whether a transaction has economic substance include a business or corporate purpose, the objective economic reality of the transaction, a reasonable possibility of profit, whether the transaction performs a function other than reducing taxes, and if the transaction affects the taxpayer's financial position in any way. The court held that the economic substance doctrine was not satisfied primarily because the taxpayer conceded the issue in its pleadings and did not examine the above factors.

The trust contributed the long option to another partnership of Cemco ("CIP"), and CIP assumed the trust's obligation under the short option. CIP spent about $50,000 to buy Euros at an exchange rate of $0.89 dollars per euro. Thereafter, CIP liquidated and distributed its assets (both dollars and Euros) to the trust. The trust transferred to Cemco the Euros it had received from CIP. Finally, on the last business day of the year, Cemco sold the Euros for $50,000 and claimed a loss for U.S. federal tax purposes of $3.5 million.

The Service disallowed the loss and assessed a 40-percent penalty. The district court held for the government. The district court applied Treas. Reg. § 1.752-6T to disregard the transaction -- which as a result generally subtracted from the partnership's basis in an asset the value of any corresponding liability. Cemco did not challenge the validity of the regulation.

On appeal, Cemco argued that Treas. Reg. § 1.752-6T was invalid as a retroactive regulation. The court held that the regulation could be validly applied on a retroactive basis relying on the fact that the transaction at issue occurred after the Service issued Notice 2000-44, and therefore Cemco was on notice of the Service's change of position on what constituted a section 752 liability.

The options were worthless on the settlement date (i.e., 17 days after the options were acquired). Thereafter, each Stobie Creek member transferred its interest in Stobie Creek to an S corporation wholly owned by that member. The transfers caused Stobie Creek to terminate under section 708(b)(1)(B), and each member's high outside basis in Stobie Creek was spread over that member's share of Stobie Creek's other assets (i.e., appreciated stock). The stock was sold and the members determined their gain using the high basis.

The Court of Federal Claims concluded that the option obligation was not a section 752 liability under Helmer v. Comm'r,³⁶ Long v. Comm'r,³⁷ and LaRue v. Comm'r.³⁸ The court then held that the retroactive application of Treas. Reg. § 1.752-6T was invalid because there was no evidence that Congress intended to cover partnership transactions in the grant of legislative authority to section 358(h) and section 309(c) of the Community Renewal Tax Relief Act of 2000. The court held, however, that the transaction lacked economic substance because of its predominant tax avoidance features.

Citing Coltec, the court stated that while a legitimate business purpose beyond tax avoidance exists where the taxpayer demonstrates a reasonable possibility of profit separate and apart from the tax benefits created by the transactions,³⁹ here the profit potential was objectively unrealistic.⁴⁰ While the taxpayer advanced legitimate business purposes for creating the partnership used in the transaction, as Coltec emphasized, the transaction to be analyzed is the one that gave rise to the alleged tax benefit.⁴¹ Applying the disjunctive test to determine whether the transaction should be disregarded, the court stated: "[n]otwithstanding . . . testimony that . . . a 30 percent chance of doubling [the] investment existed, the [options] had no objectively reasonable possibility of returning a profit and therefore lacked an objective business purpose. The transactions were integral to a 'preconceived' tax shelter scheme that was not structured to create a viable profit-producing investment, but, rather, to inflate the basis in an unrelated asset that would yield large capital gains upon sale. The end result was a 'foregone conclusion.'"⁴²

The court also found under either the interdependence test or the end result test that the step transaction doctrine applies to the transactions. Accordingly, the court held that the tax consequences must turn on the substance of the transaction and not on the form by which the taxpayers engaged in it.

The U.S. Court of Appeals for the Federal Circuit affirmed the application of the economic substance doctrine and imposition of accuracy related penalties. The government did not appeal the lower court's ruling on the application of Treas. Reg. § 1.752-6T and the Federal Circuit therefore disregarded the transaction solely under the economic substance doctrine.

Tax Court held that the partnership was a sham, lacked economic substance, or should be disregarded for tax purposes. The court stated that "the determination of whether a partnership should be disregarded for tax purpose is a partnership item . . . because it directly affects many of the components of the partnership's and partners' tax reporting." The Court held that Petaluma was formed for the "purposes of tax avoidance by artificially overstating basis in the partnership interests." The Court also held that the sale of the Petaluma assets lacked economic substance in both fact and substance. Furthermore, the Court agreed with the Service that the partners' outside basis should be zero because Petaluma is disregarded for tax purposes.

The circuit court affirmed the Tax Court's holding determining that Petaluma was a sham and should be disregarded for tax purposes, but reversed the holding that the Tax Court had jurisdiction to determine that the partners had no outside basis in the partnership and the holding that it had jurisdiction to determine whether accuracy-related penalties applied and that the valuation misstatement penalties did apply in this case.

The taxpayer transferred its partnership interest to a related party resulting in a section 708(b)(1)(B) termination of the partnership causing a deemed distribution of the assets to each partner and a re-contribution of the assets to a new partnership. On the deemed distribution, the tax basis of the assets to the taxpayer was based on its basis in the partnership interest. The partnership sold the assets claiming a tax loss of $71 million, although its economic gain was $1.7 million.

The court granted the government's motion for summary judgment. The court noted that the case turned on the treatment of the short options under section 752 and that at the time of the transaction none of the precedents addressed short sales in this regard. The concept was introduced into an analysis of section 752 in Revenue Ruling 95-26, which was issued a year after the taxpayers' transactions. The court held that, "[n]onetheless, in 1994 Marriott had indirect notice that the obligation to close a short sale might well give rise to a liability under section 752." The court citing Kornman noted that Revenue Ruling 88-77 emphasized that the Service considered that symmetry had a bearing on the interpretation of section 752 and defined liability under section 752 to "include an obligation only if, and to the extent that incurring the liability creates or increases the basis to the partnership of any of the partnership's assets (including cash attributable to borrowings)." Here, as in Kornman, the cash received in the short sale was an asset of the partnership and the basis of the partnership's assets was increased by those receipts. Symmetrical treatment, according to the court, called for recognition of the corresponding obligation to replace the borrowed Treasury notes.

On the same day that it executed the short sale, the trust contributed the brokerage account to a Valiant Investments 99-100, L.P. ("Valiant") for a 99.99 percent limited partnership interest. By acquiring the brokerage account, the Valiant assumed the obligation to replace the borrowed Treasury notes. On December 28, 1999, the trust transferred its interest in Valiant to GMK-GMK II, L.P. ("GMK") in return for a 99.99 percent limited partnership interest. On December 30, 1999, GMK sold its interest in Valiant to an employee of a related party for a $1.8 million promissory note. On that same day, the short sale was closed at a total cost of approximately $102.7 million. GMK reported a short-term capital loss of $102.7 million from the sale of its partnership interest in Valiant (i.e., $104.5 million basis over $1.8 million amount realized).

The district court granted the Service's motion for summary judgment, holding that the obligation to replace the shorted Treasury notes was a liability. The district court held that a plain reading of section 752 indicates that GMK should have treated the obligation to replace the borrowed Treasury notes as a liability under section 752. The district court relied upon the definition of "liability" contained in Black's Law Dictionary, Revenue Ruling 95-26, and Salina Partnership, L.P., both of which held that an obligation to close a short sale is a liability under section 752. The district court rejected the taxpayers' contingent liability argument, because it held that the obligation to replace borrowed securities in a short sale is a liability.

The Court of Appeals for the Fifth Circuit affirmed the district court opinion that the obligation to close a short sale is a liability for purposes of section 752.

Less than a month later, GP liquidated distributing cash and two foreign currency contracts to the S corporation. The S corporation took a basis in the distributed property equal to its basis in GP. Because the partner's basis did not account for the assumption of the short option, its basis in GP far exceeded the value of the property received. The property received on liquidation was disposed of, resulting in a $60.45 million tax loss. Although GP was liquidated in 2000, Sala continued his participation in the foreign currency investment program through a limited liability company ("LLC").

Five issues were presented to the district court: (1) whether the transactions constituted sham transactions; (2) whether Sala entered into the transactions for profit; (3) whether the transactions, as executed, allowed the tax loss; (4) whether any allowable tax loss was retroactively disallowed under Treas. Reg. § 1.752-6; and (5) whether the government is entitled to an offset of any excess interest payments made by Sala with an accuracy-related penalty.

Before analyzing whether Sala was entitled to the loss, the court first defined the scope of the "transaction" that caused the loss-that is, whether the transaction includes only the portions involving GP or also includes the reinvestment of GP liquidation proceeds into LLC and the trading occurring from 2001 onward. The court found that unlike Klamath,⁴³ the evidence here shows that not only the investors, but also the promoters and managers of program, intended the program to be long term including the GP and LLC portions. The court relied on Salina Partnership LP v. Comm'r,⁴⁴ for the proposition that the taxpayer's entire investment transaction was the transaction to be examined. The expectation of all the parties was that the program was to be ongoing and included GP and LLC portions. Therefore, the court held that for purpose of determining whether the loss-generating transaction was bona fide, both the GP portion and the LLC portion must be considered together as a single transaction.

The court also refused to apply the step transaction doctrine to bifurcate the transaction. The court held that the end result test should not apply because the intended end result of Sala's participation in the program was to achieve significant returns from his investment in LLC. The court noted that the intended tax benefits were irrelevant to the "end result" inquiry. The court noted that Sala was an extremely cautious investor who invested a great deal of time and energy carefully researching and choosing his investments and that Sala's participation in the GP test period fell within the realm of behavior one would expect from such an investor. The court also noted that "Sala's investment in GP was not a circuitous sojourn on the path to his investment in LLC, but was instead a checkpoint that protected him -- albeit only to a small degree -- from plunging headfirst into an uncertain five-year strategy." The GP steps were not taken for the purpose of reaching the ultimate result of investing in LLC, but were steps taken for the purpose of protecting Sala from having to "reach the ultimate result" investing in LLC.

Under the interdependence test, the court found that each step had a reasoned economic justification standing alone. The court held that the evidence showed that Sala invested in the program for profit, and each step of the transaction helped assure that goal and that Sala could have achieved the tax loss without the use of GP or reinvesting in LLC. The court noted that each step Sala took made objective sense standing alone without contemplation of the subsequent steps in the transaction. The court noted that the initial phases of the program were structured so that an investor could exit the program before committing his full $9 million.

The court stated that the transaction will be accorded tax recognition only if it has economic substance which is compelled or encouraged by business realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached. The court noted that a finding that either a transaction lacked objective economic substance or was not motivated by a non-tax business purpose is sufficient to find a transaction to be a sham. The court found that in light of the potential and actual profits, the program offered a reasonable opportunity for profits exclusive of the tax benefits and therefore, possessed economic substance. Although the taxpayer admitted that the program was structured to provide significant tax benefits, the court found that each step of the program was structured to provide non-tax business benefits as well. Therefore, the court held that the transactions had a business purpose other than tax avoidance. The court evaluated each entity and step in the transaction and found that all had economic substance.

The court implicitly adopted the view that the option obligation was not a section 752 liability, because the court treated the option obligation as a contingent liability under section 358(h). The court held that Treas. Reg. § 1.752-6T was invalid principally because there was no evidence that Congress intended to focus on partnership transactions in enacting section 358(h) in the Community Renewal Tax Relief Act of 2000; the court believed that only transfers by corporations to partnerships were intended to be covered. The court also held that the 2003 regulations and the notice changed the law in existence before that time, as reflected in Helmer⁴⁵ and its progeny.

On appeal, the Tenth Circuit reversed solely on the grounds that the transaction lacked economic substance. Citing Coltec, the court refused to integrate the transaction where the loss was triggered from the balance of the transaction. So framing the transaction at issue, the Tenth Circuit reversed and remanded the case back to the District Court.

At the time of the distribution Countryside had higher basis in the LTP then the distributee partners had in their Countryside interests. By using a tiered structure and selective section 754 elections, the tax basis of the building held by Countryside was increased to fair market value, while the tax basis in the AIG notes was not reduced. This allowed Countryside to sell the building in early 2001 for no gain. The redeemed partners held a partnership interest with low outside basis but high inside basis in the AIG notes, allowing for the repayment of the notes and reinvestment of the proceeds in a tax deferred manner by allowing the partners to defer the gain inherent in the sold building until the redeemed partners sold their distributed partnership interests.

The Tax Court held that the AIG notes were not marketable securities within the meaning of section 731(c)(2). If the notes were treated as marketable securities, then the distribution of the partnership interests would be treated as a distribution of money, triggering gain to the extent that the value of the notes exceeded the tax bases of the distributee partners. On this narrow issue, the Tax Court held that the AIG notes were not marketable securities because there was no arrangement with AIG to convert them to cash within the meaning of section 731(c)(2)(B)(ii).

Alternatively, the Service argued that "the lack of economic substance surrounding [the notes] purchase and distribution negates the ability" of the partners to achieve nonrecognition treatment on the distribution. The court believed that if the liquidating distribution of the AIG notes had legitimate business purpose and economically changed the positions of Countryside's partners, the form of the transaction "cannot be disregarded and converted by respondent into a transaction . . . that never occurred simply because the transaction that did occur was tax motivated." The court concluded that the redemption of two of the partners with the AIG notes accomplished a legitimate business purpose and altered the economic positions of the two redeemed partners, Countryside, and the continuing partners. As a result, the court ruled that the "redemption may be respected for tax purposes [even] if the means undertaken to accomplish it are chosen for their tax advantage."

2007

The strategy was structured as a three-stage seven-year program: stage I lasted 60 days; stage II lasted from day 60 through day 180; and stage III lasted from day 180 through the seventh year. At each stage investors were required to contribute significantly more capital, but also retained the right to exit the plan every 60 days. Nix and Patterson each implemented the strategy through a separate entity structure. This summary describes only a single structure.

To implement the strategy Klamath was formed with Patterson as a 90-percent partner and a party related to the investment marketer as a 10-percent partner. Patterson made two contributions to Klamath (i.e., $1.5 million of her own funds and $66.7 million borrowed funds). The borrowed funds were acquired through a loan with stated principal of $41.7 million and a $25 million loan premium. The loan premium was given for a higher than market interest rate. If the loan was paid early a prepayment amount would be due. The prepayment was initially $25 million and decreased over the life of the loan.

The $66.7 million loan proceeds were contributed to Klamath, and Klamath assumed the obligation under the loan arrangement. Patterson increased her basis in Klamath for the $66.7 million contributed and adjusted her basis under section 752 for $41.7 million but not for the $25 million prepayment amount. Klamath used the funds to purchase contracts on dollars and Euros and made some small short-term forward contracts on foreign currencies. Patterson elected to withdraw from Klamath at the end of stage I. She received cash and Euros on liquidation. She claimed a basis in the Euros of approximately $25 million and claimed a tax loss of roughly the same when the Euros were sold.

The district court granted the government's motion for summary judgment. Although the court held for the government on economic substance grounds, it concluded that neither the loan premium nor the prepayment amount were liabilities under section 752, relying on the contingent nature of the obligations and on Long and LaRue. The court rejected the government's argument that inside and outside basis must be in conformity, citing Helmer, when inside and outside basis nonconformity was also present. The court also held that the law changed when the government issued regulations in 2003 and that Treas. Reg. § 1.752-6T was invalid as a retroactively applicable regulation because there was no evidence in the legislative history to section 309(c) of the Community Renewal Tax Relief Act of 2000 that Congress intended to cover transfers to partnerships. Also, because the transaction occurred before the Notice 2000-44 was issued, the taxpayers were entitled to rely on the law as it existed at that time.

On appeal the Court of Appeals for Fifth Circuit affirmed the district court's holding that the transaction lacked economic substance. The court noted that to be respected a transaction must have economic substance compelled by business or regulatory realities, be imbued with tax-independent considerations, and not shaped totally by tax avoidance factors. The court noted that the absence of one of these factors will render the transaction void for tax purposes. The court affirmed the lower court's holding that the transaction lacked economic substance because the evidence indicated that the loans were only intended to be outstanding 70 days. The taxpayers argued that the transaction had profit potential as evidenced by the investments made. The court noted that these investments were made with the $1.5 million contributed from the taxpayer's own funds.

The court refused to reconsider the lower court's holding that the premium loan obligation was not a section 752 liability. The court declined to address the lower court's determination on the invalidity of the retroactive application of the temporary regulation, holding that the government lacked standing to appeal the ruling.

As part of the Heinz stock repurchase program, HCC transferred 3,325,000 shares of the Heinz stock to Heinz in exchange for a zero coupon convertible note (the note was convertible into 3,510,000 shares of Heinz stock at any time after three years of issuance) issued by Heinz. Shortly after HCC transferred the Heinz shares to Heinz, HCC sold the remaining 175,000 shares of Heinz stock to an unrelated buyer for approximately $7 million and claimed a capital loss on the sale. Following the sale of the remaining Heinz shares, HL merged downstream with and into HCC with HCC surviving (the "Merger"). Following the Merger, HCC exercised its right to convert the zero coupon convertible note into Heinz shares.

Heinz asserted that it redeemed the 3,325,000 shares from HCC in exchange for a zero coupon convertible note pursuant to section 317(b). Heinz further stated that such redemption should be treated as a section 301 distribution by reason of section 302(d) because HCC's proportionate interest in Heinz increased due to the zero coupon convertible note's treatment as an option under section 318(a)(4). Therefore, HCC's basis in the 3,325,000 shares redeemed by Heinz should be added to HCC's basis in its remaining 175,000 shares that it continued to hold following the redemption. Consequently, when HCC sold the remaining 175,000 shares of Heinz to an unrelated third-party for approximately $7 million, HCC recognized a capital loss equal to the difference of $131 million purchase price for the entire 3,500,000 shares and the $7 million received from the unrelated third-party.

The Service asserted that Heinz did not redeem the 3,325,000 shares pursuant to section 317(b) because Heinz did not exchange property for stock within the meaning of such section. Furthermore, the Service argued that the transaction undertaken by Heinz and its subsidiaries lacked economic substance and had no bona fide business purpose. Also, the Service asserted that step transaction should apply, and HCC's purchase of the Heinz stock and the exchange of such stock for a zero coupon convertible note should be stepped together, causing the transaction to be viewed as if Heinz purchased its stock directly from the public.

In its ruling, the U.S. Court of Federal Claims stated that in analyzing a transaction, the consideration of the business purpose and economic substance of such transaction are factors in determining whether the transaction had any practical economic effects other than the creation of income tax benefits.⁴⁷ Under such an approach, a taxpayer must prove that its transaction is both purposeful and substantive, and if either is lacking, then the transaction is a sham.

In the case of Heinz, HCC possessed the burdens and the benefits as owners of the Heinz stock for the following reasons: (i) HCC incurred substantial debt (not guaranteed by Heinz) to purchase the Heinz stock, (ii) HCC received dividends from Heinz while it possessed the Heinz stock, (iii) HCC bore the risk of loss and opportunity for gain as to the value of the Heinz stock it possessed, and (iv) HCC was under no obligation to distribute or disgorge any profits it received from the Heinz stock. However, the court ruled that the transaction did not possess economic substance and did not have a genuine business purpose. The court stated that the only purpose of the transaction was the production of a capital loss.

The court rejected Heinz's argument that HCC acquired the Heinz stock for investment purposes based on its view of the facts. Specifically, the court noted that HCC hired an investment bank to design the zero coupon convertible note six weeks before it acquired its first shares of Heinz, HCC paid interest on the borrowing and incurred additional expenses even though HCC planned to have a majority of its Heinz stock redeemed, and the main purpose of the Heinz stock repurchase program was to have shares available for stock options, which could not be accomplished as long as HCC held the Heinz stock. Consequently, the court ruled that the transaction was a sham "imbued with no significant tax-independent considerations, but rather characterized, at least in terms of HCC's participation, solely by tax avoidance features."⁴⁸

2006

While the Federal Circuit agreed with Coltec with respect to the technical treatment of the basis consequences under section 358, it nevertheless denied the loss, holding that Coltec had failed to prove the transaction possessed economic substance. While Coltec acknowledged that a purpose of the transaction was tax avoidance, it argued that the transaction possessed economic substance because (1) the creation of Garrison to manage the asbestos liabilities would make Coltec more attractive and (2) the transaction would add a barrier to veil-piercing claims against Coltec.

In analyzing whether the transaction possessed economic substance, the court indicated the test was an objective inquiry into the economic reality of the proposed transaction, rather than the subjective motivation of the taxpayer. Furthermore, the court stated that its focus was on the transaction that actually gave rise to the alleged tax benefit.⁴⁹ Thus, the court suggested that while, as a whole, a transaction may have business purpose, an individual step in the overall transaction that gives rise to an asserted tax benefit may lack such a business purpose and cause the asserted tax benefit to be denied.

In this context, the court identified the transfer of the promissory note (which represented the bulk of the value transferred) to Garrison in exchange for the assumption of the asbestos-related liabilities by Garrison as the transaction that actually gave rise to the alleged tax benefit. Thus, the first stated business purpose, the creation of Garrison to manage the asbestos-related liabilities in order to make Coltec more attractive, was rejected by the court, because such business purpose focuses on the wrong transaction, namely the creation of Garrison as a separate subsidiary to manage Coltec's asbestos-related liabilities. The court acknowledged that while such a transfer may have a business purpose, the transfer of the note in exchange for Garrison's assumption of liabilities was a separate transaction, unrelated to the fact that Garrison took a managerial role in administering the asbestos-related liabilities.⁵⁰ Thus, the court concluded, the taxpayer had failed to show a business purpose to be served by linking Garrison's assumption of the asbestos-related liabilities with the centralization of litigation management.

The court also rejected Coltec's second stated business purpose, that the transaction would add a barrier to veil-piercing claims against Coltec. Specifically, the court found that the formation of Garrison and the transfer of the asbestos-related liabilities to it would not add any further protection for Coltec, but rather made Garrison a corporate conduit for the payment of asbestos-related claims.

The court concluded by finding that the transfer of the asbestos-related liabilities to Garrison in exchange for a note lacked economic substance and served only to inflate the basis of the Garrison stock, and accordingly held that the transfer of the liabilities in exchange for the note should be disregarded for tax purposes because the step was irrelevant and added nothing to the business purpose of consolidating claims. In its holding, the court viewed as insufficient to establish economic substance the subjective views of Coltec's executives. The court stated that:

The IRS contended that Dow's COLI plans lacked economic substance and hence disallowed the deductions. The trial court upheld the economic substance of Dow's transactions and the claimed tax deductions based on the court's finding that Dow would make cash investments in later years consistent with its long-term business needs and financial incentives. Unlike the COLI plans in the previously decided AEP, CM Holdings, and Winn-Dixie, this would make Dow's plans cash-flow positive in their later years. Additionally, unlike those other COLI plans, the trial court found that Dow's plans, taking into account future contributions, would reflect inside build-up and were not mortality neutral.

On appeal, a divided panel of the Sixth Circuit reversed the trial court. The court held (1) that the trial court's determination on economic substance was subject to de novo review and (2) that the taxpayer's future investment must be disregarded as a matter of law if it departs drastically from the taxpayer's prior conduct during the course of the transaction. The Sixth Circuit, citing Rose v. Comm'r,⁵³ noted that "the proper standard in determining if a transaction is [an economic sham] is whether the transaction has any practicable economic effects other than the creation of income tax losses." If the transaction is not an economic sham, the intent for profit motive is then evaluated. If it is determined that the transaction is an economic sham, the entire transaction should be disallowed for federal tax purposes and therefore, the need to determine a profit motive is unnecessary.

Disregarding Dow's planned future cash investments, the Sixth Circuit concluded that "the district court erred in including in its cash-flow analysis the highly-contingent positive cash flows projected for later years," which then undermined the trial court's findings with respect to economic substance. In addition, the Sixth Circuit said that the trial court's focus on true mortality neutrality was an "erroneously high bar," and said the proper test was whether Dow would significantly benefit from mortality gains. Because it concluded Dow would not do so under its plans, the court said this provided further evidence that the COLI plans were an economic sham.

The aircraft contributed by the GECC subsidiaries generated significant book depreciation, which reduced the partnership's section 704(b) book income. The taxable income of the partnership, however, was quite large because the aircraft had been fully depreciated for tax purposes and therefore generated no tax depreciation. Under Treas. Reg. § 1.704-1(b)(1)(vii) (the bottom-line allocations rule), the allocation of tax items follows the allocation of book items. As a result, the foreign banks were allocated large amounts of taxable income and very little section 704(b) book income (i.e., their economic share). In addition, the partnership agreement arguably guaranteed the foreign banks reimbursement of their initial investment with an annual rate of return of between approximately 8.5 and 9 percent, subject to the "possibility of a small increase in the event of unforeseen, extraordinary partnership profits."

The district court, using the economic substance test, "determined that because, in addition to the strong and obvious tax motivations, the taxpayer had some additional non-tax motivation to raise equity capital, the transaction could not be considered a sham." The Second Circuit, however, held that the government "is entitled in rejecting a taxpayer's characterization of an interest to rely on a test less favorable to the taxpayer, even when the interest has economic substance. This alternative test determines the nature of the interest based on a realistic appraisal of the totality of the circumstances."

The Second Circuit held that the foreign banks' interest, for U.S. federal tax purposes, was not bona fide equity participation because it was overwhelmingly in the nature of a secured lender's interest. The court found that failure of the interests under the Comm'r v. Culbertson,⁵⁵ totality-of-thecircumstances test mandated that outcome. The court remanded the case for the district court to consider the application of section 704(e) without addressing the district court's conclusion that the partnership was not a sham.

On remand, the district court posited that the Second Circuit's holding that the interests were "debtlike" did not necessarily distinguish the foreign bank's interests from other debt-like instruments that are not considered debt for U.S. federal tax purposes. The district court cited numerous cases establishing the Second Circuit's long-standing position that debt-like instruments can be considered equity. The district court held that where, as here, there is a requirement for the partner to return some required distributions of income, and there is at least some exposure to risk of loss, the debt-like interests may still constitute capital interests.

The district court then analyzed the foreign banks' interests under section 704(e). The district court analyzed case law holding that section 704(e)(1) supplanted Culbertson. But importantly, the district court said that even if Culbertson still applies, section 704(e)(1) applies as an alternative test (i.e., a taxpayer could fail the Culbertson test and still prevail under section 704(e)(1)). Accordingly, the district court held that the foreign banks should be recognized as partners under section 704(e) because they owned a capital interest in a partnership in which capital is a material income-producing factor.

2005

Applying the economic substance doctrine, the Tax Court held that "[n]otwithstanding its form, the transaction did not, in substance, represent contributions of property in exchange for partnership interests." The Tax Court held that the transaction failed the objective prong because the sole purpose of the transaction was to transfer an enormous tax loss associated with the selling partner's built-in loss assets. Likewise the court held that transaction failed the subjective prong because neither of the parties could realize significant non-tax benefits from the transaction.

Alternatively, the Tax Court concluded that the step-transaction doctrine applied to recast the contributions of built-in loss assets as direct sales from the selling partner to the purchasing partner followed by the contribution of the assets to the partnership by the purchasing partner. The Tax Court also held that the partnership obtained no basis in the built-in loss assets because they were worthless at the time of contribution and therefore did not constitute a "contribution of property" within the meaning of section 721 and the partnership basis rules.

During 1996, the selling partner contributed cash and the built-in loss asset to Long-Term Capital Partners LP ("LTCP"), a hedge fund, in exchange for a partnership interest. The selling partner borrowed the cash contributed from a UK entity related the general partner of LTCP. The general partner of LTCP purchased the selling partner's interest in LTCP. The selling partner claimed a loss for U.S. federal income tax purposes on the sale and because the partnership did not have a section 754 election in effect, the general partner claimed to step in the shoes of the selling partner with regard to the built-in loss inside the partnership. As the partnership sold the built-in-loss assets, the loss was allocated to the general partner under section 704(c).

The court concluded that the transaction was purely tax-motivated, notwithstanding the parties' efforts to imbue it with a business purpose (earning fees). Notably, the court believed that the transaction was brought to the taxpayer as a tax product. The transaction was far more complex than necessary to accomplish the stated business purpose and was not carried out in a way that indicated it had no motive other than tax savings, the court found.

Alternatively, the court held that under the "end result" test of the step transaction doctrine, steps should be collapsed and the selling partner treated as if it sold the built-in-loss asset to the general partner, who had a cost basis in the stock.

The general partner argued that the 40-percent penalty should not be applied because: (1) there was not a misstatement of value, only a misstatement of basis; (2) the basis misstatement was the result of a legal dispute, not a factual dispute; and (3) the underpayment was not attributable to the basis misstatement. The court rejected these arguments because: (1) section 6662(e)(1)(A) defines a valuation misstatement to include misstatements concerning the correct amount of the valuation or adjusted basis-therefore, a valuation misstatement as it appears in section 6662(b)(3) includes both valuation and basis misstatements; (2) section 6662(e)(1)(A) does not differentiate between factual and legal determinations, and it is incorrect that "the penalty cannot apply where the transaction is 'recast' for tax purposes using a legal doctrine such as the step transaction or economic substance doctrine;" and (3) the underpayment was directly dependent on the valuation misstatement because the amount of the tax benefit was determined by the amount of the misstatement.

The taxpayers also formed a charitable remainder trust known as Oliver & Co., which designated J&J as the grantor, the taxpayers as the trustees, and a charitable organization as the beneficiary. J&J purported to transfer to Oliver & Co. certain assets. Oliver & Co. never made a distribution to any charitable beneficiary.

After formation of the AMC Trust, the taxpayers continued to operate their asphalt business in the same manner as they did when it was reported by J&J. Also, the income from the asphalt business was reported on AMC Trust's Form 1041. AMC Trust claimed income and deductions, flowing from the profits of the asphalt business to Oliver & Co. Neither AMC Trust nor Oliver & Co. reported any taxable income or any tax liability for the years in issue. Also for the years in issue, the taxpayers reported little to no tax on their Form 1040. Attached to the taxpayers' Form 1040 were a disclaimer statement and various tax protest materials claiming that the assessment and payment of income tax is voluntary.

The issue in this case was whether certain trusts established by the taxpayers should be respected for U.S. federal tax purposes. The taxpayers contended that the trusts were established for "asset protection" purposes. However, the multiple trusts gave them the same protection against potential creditors as the previous corporate form.

Prior to the creation of the trust, the taxpayers enjoyed full and unrestricted use of all the business assets and income produce by the asphalt business. After the creation of the trust, the taxpayers continued to have full and unrestricted use of the asphalt business assets. Thus, the taxpayers' relationship to the asphalt business and other assets did not change when the trusts were created. Further, the taxpayers conceded that none of the trusts had an independent trustee. The only difference in the asphalt business was the difference of form created by the trusts. There was no material difference in the manner in which the business was operated or the assets that were used before and after creation of the trust.

The court held that AMC Trust and Oliver & Co. were shams, lacking economic substance, and were to be disregarded for U.S. federal income tax purposes. The net income of the asphalt business was properly taxable to the taxpayers.

2004

The Service argued that the transaction must be disregarded for U.S. federal income tax purposes because the transaction was undertaken solely for tax avoidance purposes. However, the district court ruled that the transaction had economic substance, although the transaction was undertaken solely for tax avoidance purposes, because under Fourth Circuit precedent the disjunctive test applies to determine whether a transaction has economic substance. In holding that the BDC transaction had economic substance, the district court stated that "a corporation and its transactions are objectively reasonable, despite any tax-avoidance motive, so long as the corporation engages in bona fide economically-based business transactions."⁵⁹

On appeal, the Fourth Circuit affirmed, in part, and reversed and remanded, in part. The Fourth Circuit held that BDC was not required to reduce its basis in its BDHMI stock when BDC transferred the contingent liabilities to BDHMI, but remanded the case to the district court to determine whether the transaction had a reasonable profit expectation. While the Fourth Circuit affirmed the disjunctive test articulated in Rice's Toyota World, Inc. v. Comm'r,⁶⁰ it stated that the district court misapplied the objective prong of the disjunctive test (i.e. the economic substance prong) as set out in Rice's Toyota World, Inc. In determining whether a transaction satisfies the objective prong, the focus is not on the general business activities of the corporation but rather whether the transaction has a reasonable expectation of profit apart from the tax benefits.

2003

AHP, an AHP subsidiary, and two unrelated foreign corporations formed a partnership, Boca Investerings ("Boca"). The partners contributed $1.5 billion to the partnership in exchange for interests of 9 percent, 1 percent, 83 percent, and 7 percent, respectively, based on each partner's respective capital contribution. Boca purchased private placement notes ("PPNs") and subsequently sold them for cash and contingent installment payment agreements or LIBOR notes.

Boca treated the sales as contingent payment installment sales, resulting in a gain, which was allocated in accordance with the partnership agreement. After the sale, AHP and its subsidiary increased their interest in Boca from 10 percent to 55 percent by purchasing one of the foreign corporation's interests in the partnership. Boca then distributed the LIBOR notes to AHP and its subsidiary, and the cash to the two foreign partners. AHP and its subsidiary then sold the notes and recognized a large capital loss.

The district court determined that Boca was a valid partnership and should be recognized for U.S. federal income tax purposes. The court found a legitimate business purpose for creating the partnership and purchasing the PPNs. Therefore, it was irrelevant that Boca was organized partially by a desire to reduce taxes. Boca purchased the PPNs at on-the-market prices in arm's-length transactions. Boca included the interest income from the PPNs in taxable income. Boca also possessed the burdens and risks of owning the PPNs, including the credit, default, credit downgrade, liquidity and interest-rate risks. The partnership was also exposed to the same risks with respect to the LIBOR notes. The value of the notes depended, in part, on the note issuer's credit quality. If the creditworthiness of the LIBOR note issuers declined, the value of the notes would decrease. Additionally, if interest rates went up, an investor holding a LIBOR note could earn a profit by continuing to hold the note or selling the note to reflect the higher value.

Thus, the opportunity for Boca and its partners to make a profit by holding the LIBOR notes depended on market conditions, including interest rates and the credit quality of the LIBOR note issuers. Because of the sensitivity of the notes' value to fluctuations in interest rates, there was a risk that the holder of the notes would make or lose substantial amounts of money.

The court concluded that AHP evaluated all of the transactions, including the purchase of the PPNs and the LIBOR notes, from an investment perspective on a pretax basis, and entered into the transaction to make a profit. Thus, the court held that the transactions financing the purchase and sale of the PPNs had economic substance and should be recognized for tax purposes, and that Boca's sales of the PPNs/LIBOR notes were sales under section 1001. To reach a different conclusion would be inconsistent with AHP's intent to make a profit. As long as the creation of Boca was not solely motivated by tax purposes, it should be recognized as a partnership for tax purposes, the court concluded.

THE BOCA APPEAL

On appeal, the United States Court of Appeals for the District of Columbia reversed the lower court's decision, finding that the district court did not properly apply the holding of ASA Investerings.⁶¹ According to the appellate court, the business purpose doctrine applied in ASA Investerings establishes that while taxpayers are allowed to structure their business transactions in such a way as to minimize their tax, these transactions must have a legitimate non-tax avoidance business purpose to be recognized for tax purposes. The court further explained that ASA requires that a legitimate non-tax business necessity must exist for the creation of the otherwise sham entity inserted into the partnership for tax avoidance reasons in order to meet the intent test of Comm'r v. Culbertson,⁶² as applied to this type of transaction. The court then reaffirmed the test set forth by the Supreme Court in Culbertson, which provides that the existence of a partnership depends upon whether, considering all the facts, the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.

The D.C. Circuit pointed out that the district court never made any findings of fact to indicate that AHP needed a partnership with a foreign corporation as a partner to invest in LIBOR notes or PPNs. The court also noted that nothing in the record indicated that AHP ever considered or weighed the benefits of using a different type of transaction in order to make these investments, including the option of purchasing them directly. Moreover, the court found that the foreign partners in Boca were "concocted" because neither existed prior to the transaction's commencement or served any other purpose, and both were funded through loans from the same bank. The court concluded that AHP's participation in the partnership defies common sense from an economic standpoint, because it could have purchased the PPN's and LIBOR notes directly and avoided millions in transaction costs.⁶³

On December 9, 1993, FBE assigned its two-percent interest in Andantech to Equipment Investors Co., Inc. ("EICI"), a Delaware corporation. BP assigned its 98-percent interest in Andantech to RD Leasing ("RDL"), a subsidiary member of a U.S. affiliated group parented by Norwest Corp., in exchange for stock. The transfer by BP of a 98-percent interest to RDL caused a technical termination of the partnership under section 708(b)(1)(B). This transfer caused the bank loan to Andantech to become due and payable. The repayment of the bank loan was secured by capital contributions from RDL and EICI. It was anticipated that RDL would be entitled to depreciation with respect to 98-percent of the cost of the equipment and that Andantech would report a nominal amount of rental income in the short year starting after the technical termination of Andantech. In 1996, Comdisco exercised its early termination option on the lease, paying a nominal amount of cash for the equipment.

For the short year ending on December 10, 1993, Andantech reported income of approximated $87 million, which was allocated entirely to BP and FBE. For the short year ending on December 31, 1993, Andantech reported a loss of approximately $2.2 million that was allocated pro rata to RDL and EICI. For the full year ended December 31, 1994, Andantech reported a loss of approximately $50 million that was allocated pro rata to RDL and EICI.

The Tax Court held that the Andantech was not a valid partnership because neither BP nor FBE intended to join together as partners for the purpose of carrying on the business of leasing computer equipment prior to December 10, 1993, and EICI did not intend to join with RDL for the purpose of carrying on the business of leasing computer equipment after December 10, 1993.⁶⁴ The Tax Court focused on BP's and FBE's sole concern with potential tax liability and financial risk associated with the transactions.⁶⁵ The sole reason for the participation of the two Belgian individuals in the partnership was to allocate the income from the sale of the rental stream, after which the interest in the partnership would be transferred to a U.S. corporate investor who would reap the benefit of ongoing depreciation deductions.⁶⁶ Andantech, in the view of the Tax Court, was a mere conduit used to strip income from the lease transaction, avoid U.S. federal income taxation, and, under the step transaction doctrine, should be disregarded.

The final issue addressed by the Tax Court was whether the sale-leaseback transaction should be respected for U.S. federal income tax purposes, i.e., whether the transaction had business purpose and economic substance. The Tax Court concluded that the sale-leaseback transaction had no reasonable possibility for profit and that RDL was not motivated by any business purpose other than obtaining tax benefits.⁶⁷ In assessing the reasonable possibility for profit, the Tax Court looked to the residual value of the computer equipment, stating that the key to profitability rested in achieving the projected residual values for the equipment. Because the residual values were determined to be approximately less than or equal to the projected balances due on the balloon notes, there was no realistic potential for RDL to recover its investment or earn a pretax profit.

In applying the business purpose test, the Tax Court considered whether RDL was motivated to participate in the transactions for any business purpose other than obtaining tax benefits. The Tax Court considered the following factors to determining the presence or absence of non-tax motivation: (i) the presence or absence of arm's-length negotiations between the parties; (ii) the relationship between the selling price and the fair market value of the equipment; (iii) the structure of the financing; (iv) the degree to which the parties adhered to the contractual terms of the transactions; (v) the reasonableness of the income and residual value projections; and (vi) the insertion of other entities. Based on its consideration of these factors, the Tax Court held that there was little support for the conclusion that a valid non-tax business purpose existed for the transactions.

On appeal, the D.C. Circuit affirmed the Tax Court's decision that Andantech should be disregarded for tax purposes and remanded for reconsideration of the remaining issues, relating to the allocation of the deductions to the partners and the application of certain jurisdictional questions, to the Tax Court.⁶⁸ The D.C. Circuit determined that the partnership should be disregarded for U.S. federal income tax purposes under the sham-transaction doctrine under the rationale of ASA Investerings Partnership v. Comm'r.⁶⁹ The D.C. Circuit agreed with the Tax Court's analysis as to the invalidity of Andantech, stressing that the basic inquiry as to whether a partnership is valid is "whether, all facts considered, the parties intended to join together as partners to conduct business activity for a purpose other than tax avoidance," and that the "absence of a non-tax business purpose is fatal."⁷⁰

2001

Based on the partners' capital contributions, 90 percent of the gains were allocated to the foreign bank, which was not subject to U.S. federal income tax, while the remaining gain was allocated to Brunswick. After the close of the partnerships' first tax year, Brunswick increased its interest in the partnerships by purchasing a portion of the foreign bank's partnership interests. The partnerships then distributed cash to the foreign bank and the LIBOR notes to Brunswick, which then sold the notes for cash. Brunswick reported large capital losses on its 1990 and 1991 tax returns as a result of these transactions.

Brunswick argued that an economic substance analysis was not warranted and that it should be required to show only that the transactions resulted in contingent sales of the PPNs and CDs within the meaning of sections 1001(a) and 453(a). The Tax Court rejected that position, finding the transactions to be "virtually identical" to the transaction in ACM Partnership.⁷³

In reaching its conclusion, the Tax Court evaluated two primary factors: (1) the partnerships' subjective business motivations for carrying out the transactions (i.e., whether there were valid, non-tax business purposes for the transactions), and (2) whether the transactions had economic effect, other than the creation of tax benefits. The Tax Court reasoned that the investments at issue, bank notes and CDs, and the subsequent sale of these instruments for LIBOR notes, lacked a credible business purpose, other than to obtain tax benefits. In light of overwhelming evidence (e.g., internal corporate memoranda) that the partnerships were organized solely to generate tax benefits, the court was not persuaded by the partnerships' argument that their investments were precautionary measures against a leveraged buyout. The court also did not accept the argument that the LIBOR notes served as a hedge against declining marine sales caused by rising interest rates. In fact, the court found that the partnerships only accepted partial payment in the form of LIBOR notes in an effort to qualify as a contingent installment sale. Moreover, the court found Brunswick's modest interest in the LIBOR notes not to be a meaningful hedge against Brunswick's declining marine sales.

Having found that the partnerships' investments served no business purpose, the Tax Court applied the same economic substance test applied by the Third Circuit in ACM Partnership, and held that the contingent installment sale transactions did not meaningfully change Brunswick's economic position before and after the transactions, with the exception of tax benefits. Notably, the test applied by the Tax Court in Saba is similar to the test set forth by the Tax Court in Compaq, lending support to the approach espoused by the IRS in Notice 98-5.⁷⁴ In both Saba and Compaq, the Tax Court disallowed the tax benefits claimed, finding that there was no business purpose for the underlying transaction apart from obtaining the tax benefits.

The relevant facts supporting the court's conclusion in Saba included: (1) the partnerships assumed only minimal financial risks by investing in the notes and CDs because they had invested their funds with highly rated banks and had the option to put or sell the investments back at their original purchase prices with accrued interest; (2) the partnerships incurred significant losses on their purchase and sale of the notes and CDs, as well as the subsequent sale of the LIBOR notes; (3) the partnerships and Brunswick intended to hold the LIBOR notes for only a brief period which would not allow them sufficient time to recoup their transaction costs; and (4) the partnerships and Brunswick were investing in LIBOR notes at a time when they expected the value of the notes to decline with falling interest rates.

THE SABA APPEAL

On appeal, the Court of Appeals for the D.C. Circuit vacated the Tax Court's prior decision that the tax-motivated transactions lacked economic substance, and remanded the case to the Tax Court for a determination consistent with these findings.⁷⁵ On appeal, the taxpayer filed a second reply brief, arguing that the Tax Court incorrectly determined that the partnerships at issue were not genuine partnerships for tax purposes. In supporting its position, the taxpayer relied on Boca Investerings, in which the district court concluded that the partnership met the requirements of a valid partnership. The D.C. Circuit vacated the Tax Court's decision and remanded the case back to the Tax Court to be reconsidered in light of the D.C. Circuit's opinion in ASA Investerings, which held that the partnerships were not valid entities.

SABA ON REMAND

On remand, the Tax Court concluded that: (i) there was no meaningful distinction between the two partnerships (Saba and Otrabanda) and the partnership determined to be a sham in ASA Investerings, and (ii) the partnerships were not organized or operated for a non-tax business purpose under the rationale of Moline Properties.⁷⁶ The taxpayer argued that Moline Properties established a two-part test, under which an entity is respected for tax purposes if either: (1) its purpose is the equivalent of a business activity (not tax avoidance), or (2) it conducts business activities. The taxpayer contended that the partnerships' investments in commercial paper (and the profits derived therefrom) proved that the partnerships were operated for a non-tax business purpose. The taxpayer further argued that, unlike ASA Investerings, the partners in these partnerships shared in the profits derived from the commercial paper.

In rejecting these arguments, the Tax Court explained that courts have understood the "business activity" reference in Moline to exclude business activity whose sole purpose is tax avoidance. For the same reasons it articulated in its original decision, the Tax Court did not agree that the partnerships were organized and operated to achieve non-tax business purposes. The Tax Court was not persuaded that the partnerships' relatively modest profits from their short-term investments demonstrated that the partnerships were operated for a non-tax business purpose because the partnerships could have realized profits from any number of investment strategies at far lower transaction costs than they did. Moreover, the court felt that any expected profits from the partnerships' investments paled in comparison to the approximately $170 million of capital losses that the partnerships generated. The minimal business activity that was cited did not, in the court's view, amount to a non-tax business purpose for the partnerships.

The projections relating to the COLI program indicated that Winn-Dixie would sustain a pre-tax loss (but an after-tax profit) for every year the plan remained in effect (projected for 60 years). The cumulative 60-year projections indicated that Winn-Dixie would sustain an aggregate pre-tax loss of approximately $682 million but would also receive an aggregate after-tax profit in excess of $2 billion. The difference between the pre-tax and after-tax effects was attributable to the income tax savings that would result from deducting the interest and, to a lesser extent, the administrative fees. For the tax year at issue, Winn Dixie claimed deductions for accrued interest on the COLI policy loans and for fees related to the administration of the COLI policies. The IRS disallowed these deductions on the basis that the COLI program was tax motivated, unsupported by any independent business purpose, lacked economic substance, and was a sham in substance.

The Tax Court held that the transactions associated with Winn-Dixie's COLI program lacked both economic substance and business purpose (other than tax reduction).

THE WINN-DIXIE APPEAL

On appeal, the United States Court of Appeals for the Eleventh Circuit affirmed the Tax Court's decision.⁷⁷ The Eleventh Circuit acknowledged Winn-Dixie's argument that it was statutorily permitted deductions for the interest related to the COLI policies and, therefore, the application of the sham transaction doctrine was inappropriate.⁷⁸ Ultimately, however, the court ruled that, under Knetsch,⁷⁹ the sham-transaction doctrine applies where a structure is used to provide no financial benefit to a taxpayer other than its tax consequences, and that the sham-transaction doctrine does apply even if a certain "loophole" in the tax law has not been closed by Congress.⁸⁰

The Eleventh Circuit stated that "That doctrine provides that a transaction is not entitled to tax respect if it lacks economic effects of substance other than the generation of tax benefits, or if the transaction serves no business purpose."⁸¹

The Court of Appeals then noted that the Tax Court had found, without challenge, that Winn-Dixie never could have generated a pretax profit on its COLI program.⁸² Further, the Tax Court did not err in concluding that the program failed to meet any business need of Winn-Dixie, such as indemnifying it for loss of key employees, nor was it an employee benefit since Winn-Dixie was the beneficiary of the policies. Therefore, the Eleventh Circuit concluded the Tax Court did not err in concluding that Winn-Dixie's COLI program lacked sufficient economic substance.⁸³

On appeal, the United States Court of Appeals for the Eighth Circuit reversed and remanded the district court's decision. The Eighth Circuit first reviewed the facts in greater detail than the district court had done. Generally, under the terms of tax treaties between the United States and the countries in which the sellers of the ADRs were located, the withholding rate on ADR dividends paid to U.S. citizens was fifteen percent. Therefore, the record owner of the ADR would receive 85percent of the dividend in cash, but the gross income, 100 percent of the dividend, would be fully taxable in the United States. In this case, the record owner was entitled to a fifteen-percent foreign tax credit against U.S. federal income taxes owed.

IES purchased ADRs with a settlement date prior to the date of record for the dividends on the ADRs, and then sold them with a settlement date subsequent to the date of record for the same dividends. The purchase and sale of the ADRs generally took place within hours of each other. Generally, the trades of the ADRs worked as follows:

ADR sellers would be identified that had announced dividends but had not had its record date yet and that were tax-exempt for federal income tax purposes.

Before the record date, the seller would loan the ADRs to a counterparty.

Before the record date, the counterparty would sell the ADRs short to IES (the short sale simply means the counterparty sold borrowed property it would later have to repay to the seller). The purchase price equaled market price plus 85 percent of the ADR's expected gross dividends.

IES sold the ADRs back to the counterparty for fair market value.

IES sold the ADRs ex-dividend, for less than they purchased them for, incurring a capital loss. IES also recognized ordinary income from the dividends it received and claimed a fifteen-percent foreign tax credit for the amount withheld under the applicable treaties between the United States and the countries where the sellers were located. The end results of these transactions were, in substance:

The Eighth Circuit noted that the government's argument with respect to there being no real potential for profit was that IES had acquired only the net dividend rights (the 85-percent amount net of the foreign tax credit). Under this view, the only way that IES would have accrued an economic benefit is if it received the foreign tax credit. The Eighth Circuit rejected this argument and found that IES had acquired the gross dividend (100 percent of the amount of dividends paid). The Court of Appeals held that "[t]he foreign corporation's withholding and payment of the tax on IES's behalf is no different from an employer withholding and paying to the government income taxes for an employee: the full amount before taxes are paid is considered income to the employee."⁸⁶ Therefore, the court held that the entire amount of the ADR dividends was income to IES and that IES then accrued an economic benefit from the dividends.

The Eighth Circuit also found that IES had a business purpose outside of tax considerations for entering into the ADR transactions, in that there was an element of risk of loss born by IES. Although IES went to great lengths to minimize that risk, there remained a risk that the dividend would not ultimately be paid. The court stated that "IES's disinclination to accept any more risk than necessary in these circumstances strikes us as an exercise of good business judgment consistent with a subjective intent to treat the ADR trades as money-making transactions."⁸⁷ The court further noted that each party to the transactions was operating legitimate businesses both prior and subsequent to the ADR transactions. The court also stated that taking advantage of duly enacted tax laws in conducting the ADR trades does not convert the transactions into shams for tax purposes.

2000

In January 1990, AlliedSignal decided to sell its interest in Union Texas Petroleum Holdings, Inc. ("UTP") upon which it expected to realize a capital gain of approximately $447 million. A member of AlliedSignal's board indicated that Merrill Lynch & Co. had developed a tax proposal that could create capital losses to offset AlliedSignal's expected gain on the sale of UTP. AlliedSignal met with representatives of Merrill, who outlined a proposal under which AlliedSignal would form a partnership with a foreign partner not subject to U.S. federal income tax. The partnership would be capitalized with cash contributions, primarily from the foreign partner, who would be the majority partner after the initial contributions. The partnership would then purchase high-grade, floating-rate private placement notes, which would include put options, permitting the notes to be sold to the issuer at par.

Thereafter, the partnership would sell the PPNs for consideration consisting of 80 percent cash and 20 percent LIBOR notes. The partnership would report the sale of the PPNs using the installment method. The partnership would then purchase high-grade financial instruments. Income on such instruments would be allocated among the partners. AlliedSignal would then buy a portion of the foreign partner's interest and become the majority partner. The partnership would next distribute the LIBOR notes to AlliedSignal and cash to the foreign partner. AlliedSignal would then sell the LIBOR notes. The partnership would liquidate within 12 to 24 months of formation.

Merrill indicated that this strategy would create a large capital gain upon the sale of the PPNs and a large capital loss upon the sale of the LIBOR notes due to the manner in which the contingent payment rules allocate basis (i.e., pro rata over the taxable years in which payments could be received).⁸⁸ This proposal was approved by AlliedSignal's board of directors shortly after Merrill's presentation, before Merrill had revealed the foreign partner's identity to AlliedSignal. AlliedSignal was assured, however, that the foreign partner would be an AA-or AAA-rated international bank that would participate in the venture at AlliedSignal's direction.

Unbeknownst to AlliedSignal, Merrill had already selected ABN to serve as the foreign partner in the transaction. An officer of ABN who was responsible for getting the venture approved followed ABN's standard procedures for processing loans in excess of $25 million, which required the approval of a credit committee. As part of this approval process, the officer prepared several internal memos that described the transaction. These memos contained the following language:

"AlliedSignal Inc. has a capital gain tax liability and this will cure their liability. The remuneration will be 30 b.p.s. on the loan plus a fee directly from Allied Signal Inc. to ABN New York representing an additional 45 bps over the outstanding amounts bringing the total to 75 b.p.s. over LIBOR. Furthermore Allied Signal Inc. will make ABN whole for the difference between * * * [commercial paper] and LIBOR * * * upfront. The net income will be $5.5 million received partly over time in the loan and partly in fees from Allied Signal Inc. . . . Since the * * * [partnership] structure itself will not carry the possibilities for [a return of 70-80 b.p.s. over LIBOR], income will be received by ABN New York in upfront payments made by [AlliedSignal]."

The IRS challenged the transaction, contending that ASA was not a valid partnership. As an alternative position, the IRS contended that the transactions lacked economic substance. The Tax Court agreed with the IRS's primary argument and, as a result, did not address the alternative argument.

While the Tax Court in the ACM Partnership case took over 25 pages to analyze and opine on the economic substance of a similar transaction, the court in ASA Investerings took just six pages by taking a more direct approach. The Tax Court first started its analysis by citing the Supreme Court's decision in Culbertson⁸⁹ in which the court held that the existence of a valid partnership depends on whether: "considering all the facts -- the agreement, the conduct of the parties in execution of its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent -- the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise."⁹⁰

Next, the Tax Court dismissed the involvement of the ABN Affiliates as well as the AlliedSignal affiliate, instead treating ABN and AlliedSignal as the relevant parties. This allowed the court to review the facts at hand to determine whether ABN and AlliedSignal intended to join together in the present conduct of an enterprise.

The court then determined that the parties had divergent business goals and did not intend to join together in the present conduct of an enterprise. AlliedSignal entered into the venture solely to generate a capital loss; this was partially evidenced by the fact that AlliedSignal's board of directors focused only on the potential tax benefits when they approved the plan. In contrast, ABN entered into the venture solely to receive its specified return, which was not dependent upon the economic performance of ASA.

Additional factors that the court considered in holding that no partnership existed included the following:

THE ASA INVESTERINGS APPEAL

The Court of Appeals for the District of Columbia Circuit affirmed the Tax Court's ruling that taxpayer's partnership was formed purely to reduce domestic tax liability and, therefore, was not a separate taxable entity.⁹³ After reviewing the relevant provisions of the tax law applicable to the transaction undertaken by ASA, the D.C. Circuit attempted to boil down the essence of the ASA transaction into a concise example as follows:

"But suppose A finds a way of allocating the nominal tax gain to a tax-free entity, reserving for himself a nominal tax loss? Here is how he might do it: He forms a partnership with a foreign entity not subject to U.S. tax, supplying the partnership with $100,000 and inducing the "partner" to supply $900,000. The "partnership" buys for $1,000,000 property eligible for installment sale treatment under § 453, and, as the ink is drying on the purchase documents, sells the property, as in the last example, for $500,000 in cash and an indefinite five-year debt instrument. The cash payment produces a gain of $300,000, 90 percent of which goes to the non-taxable foreign entity. Then ownership adjustments are made so that A owns 90 percent of the partnership. In year 2 the instrument is sold, yielding a tax loss of $300,000, 90 percent of which is allocable to A. Presto: A has generated a tax loss of $240,000 ($270,000 loss in Year 2, offset by $30,000 gain in Year 1), with no material change in his financial position-other than receipt of the valuable tax loss. This example is AlliedSigna1's case, stripped to its essentials."⁹⁴

ASA argued on appeal that under Moline Properties, Inc. v. Comm'r,⁹⁵ the partnership could not be regarded as a sham. ASA Investerings suggested that Moline Properties established a two-part test to determine whether a tax entity is accepted as real for tax purposes: "(1) the entity's purpose is the equivalent of business activity (not tax avoidance), or (2) it conducts business activities."⁹⁶ The D.C. Circuit agreed that if engaging in a business activity alone were sufficient to validate a partnership, ASA Investerings would have qualified as a partnership. However, the D.C. Circuit clarified Moline Properties by stating, "the courts have understood the 'business activity' reference in Moline Properties to exclude activity whose sole purpose is tax avoidance."⁹⁷

The D.C. Circuit then found that while ASA might have had a business purpose for its investment in the LIBOR notes, the business activity was conducted solely for tax purposes. Moreover, the court also noted that AlliedSignal's share of the potential gain from ASA was "dwarfed" by its interest in the tax benefit.⁹⁸

In October 1992, Goldman Sachs informed ABN AMRO Bank, N.V. that it had a client interested in the STAMPS strategy, and that if ABN were interested in forming a partnership in connection with such strategy, the partnership would be most marketable to its client if the partnership held a $350 million short position in Treasury bills. On December 16, 1992, two limited liability companies formed by ABN (Caraville and Pallico) formed Salina as a Delaware limited partnership. Caraville contributed $750,000 and Pallico contributed $74.25 million to Salina. On December 17, 1992, Salina purchased $140 million in Treasury notes, financing approximately half of the purchase price through a repurchase agreement with Goldman Sachs. Also on December 17, Salina entered into a short sale of $350 million in Treasury bills. On December 14, 1992, the board of Directors of FPL authorized investing in the Salina partnership. The board of directors' minutes stated that investing in Salina would substantially increase the return of $75 million currently yielding only 3 percent. "In addition, the partnership could engage in certain transactions that could utilize certain tax losses."

On December 28, 1992, FPL executed the Salina partnership agreement and paid Pallico $76.5 million in exchange for its 98-percent limited partnership interest in Salina. Such purchase price included $390,000 of partnership gain during the period from December 17 to December 27, 1992. On December 28, 1992, Salina decided to liquidate its original investments in order to pursue the MAPS strategy. On December 30, 1992, Salina closed its short position and sold its long position. Salina reported a net capital gain of $344 million during its short tax year from December 28-31, 1992, of which $337 million was allocated to FPL. During 1993 and 1994, Salina actively employed the MAPS investment strategy. In 1993, the net return on investment was 8 percent, while in 1994, due to rising interest rates, there were no positive earnings.

The Tax Court determined that the capital gain reported by Salina did not exist under the applicable rules of subchapter K. Before reaching that issue, the Tax Court examined the application of the economic substance doctrine. The IRS argued that the analysis should be bifurcated, such that while a bona fide business purpose supported FPL's investment in the partnership after 1992, its 1992 investment "was structured solely to provide the company with a perceived tax benefit."

According to the Tax Court, "an evaluation of whether a transaction is a substantive sham generally requires: (1) A subjective inquiry whether the transaction was carried out for a valid business purpose independent of tax benefits, and (2) a review of the objective economic effect of the transaction. A taxpayer may establish that a transaction was entered into for a valid business purpose if the transaction is 'rationally related to a useful non-tax purpose that is plausible in light of the taxpayer's conduct and . . . economic situation.'. . . . Stated differently, a transaction has economic substance if it offers a reasonable opportunity of profit exclusive of tax benefits. . . . Generally, there must be a reasonable expectation that non-tax benefits will meet or exceed transaction costs. . . . Modest profits relative to substantial tax benefits are insufficient to imbue an otherwise dubious transaction with economic substance."

The court refused to bifurcate the FPL transaction into two parts in terms of the economic substance analysis.

"Although we agree with [the IRS] that Goldman Sachs structured FPL's purchase of the Salina partnership interest to provide FPL with a perceived tax benefit, this factor, standing alone, is insufficient to render the transaction a sham in substance. Considering all the facts and circumstances, we conclude that FPL entered into the Salina transaction to achieve a valid business purpose independent of tax benefits. The record demonstrates that FPL entered into the Salina partnership for the primary purpose of enhancing the return on its short-term investments."

The court believed that the investment in Salina provided FPL with a reasonable opportunity to earn profits independent of tax benefits. Further, the court rejected an argument based on Sheldon that tax benefits of $118.8 million (assuming that FPL's capital loss carryover would otherwise have expired) were disproportionate to potential profits of $5.3 million annually, and hence should be disallowed. The court viewed the IRS's assessment of the tax benefits of the strategy as "significantly inflated." The court concluded that FPL would otherwise have used "most, if not all" of its capital loss before it expired. "We are satisfied that the potential profits associated with the investment are not de minimis relative to the perceived tax benefit." Hence, the economic substance doctrine was not applicable. However, because of the court's technical analysis of the impact of the short sale on basis, the capital gain reported by Salina did not exist.

1990s

Schultz Transit asked S-NY Management Corp. to draft the operating agreement and management agreement to act as managing agent for Newman for a specified fee. One significant feature of the management agreement was a pooling arrangement (eight investor-owners were necessary to make the plan operative), whereby gross revenues on the one hand and operating expenses on the other would be pooled and divided. Schultz Transit was not a party to that agreement.

One of the elements of the operating agreement that Newman found attractive was that, as an owner of a truck, he would qualify for an investment tax credit. While the law is clear that a non-corporate lessor of a truck would not be entitled to the credit under these circumstances, S-NY believed that the agreement between Newman and Schultz Transit would be one of owner-independent contractor, and therefore would allow Newman to claim the credit. The Tax Court found, however, and Newman conceded that he was a full-time practicing attorney, and that Schultz Transit exercised total day-today control of the truck throughout the life of the agreement. The term of the operating and management agreements was five years, but Newman could cancel the agreements if a specific level of net profit was not realized by him in any three consecutive months.

Newman claimed an investment tax credit on the truck, pursuant to the operating agreement, on his 1982 tax return. The Tax Court, relying primarily on its findings that Shultz Transit exercised the day-to-day control of the truck and Newman reduced his risk of loss through the pooling arrangement, found that the Comm'r had correctly denied the deduction.⁹⁹

The Second Circuit agreed with the Tax Court in that the substance of an agreement takes precedence over its form.¹⁰⁰ Applying the theory of Lyon, the Second Circuit, however, would not ignore the form of the transaction. The Second Circuit held that there was ample evidence that Schultz Transit's motivation for the transaction was unrelated to tax purposes and because at least one party to the transaction was motivated by non-tax business reasons, the form of the transaction could not be ignored. In its application of the second factor from Lyon to the operating agreement, the Second Circuit construed the factor to require a "change in the economic interests of the relevant parties."¹⁰¹ Because Newman was to bear all economic risk of loss associated with owning the truck and Schultz Transit's risk was limited to that associated with the cargo transported on the truck, the Second Circuit held that the existence of such features were not representative of a lease. Therefore, the form of the operating agreement chosen by Newman and Schultz Transit that of an employer and an independent contractor was respected for tax purposes. Consequently, Newman was allowed to claim the investment tax credit.

In the agency agreement, the joint ventures appointed the Communications Group as its agent for purchasing computer equipment and leasing it to end users. The Communications Group was entitled to act for the joint ventures without disclosing its agency status, and the joint ventures were not liable in any manner on debt incurred by the Communications Group to finance the computer equipment purchases. The administrative services agreement stated that the Communications Group would perform various administrative tasks associated with the leasing of computer equipment purchased by the joint ventures. The Communications Group would receive annual management fees over a specified period for its services.

In the purchase agreement, the Communications Group agreed to sell computer systems that it had purchased and leased to unrelated third parties, to the joint ventures. The Communications Group financed the original purchase price for the computer systems through the use of installment notes with balloon payments and the issuance of a security interest in the equipment to the sellers. The terms of the leases generally were same as that for the installment notes, providing for monthly rental payments in an amount exactly corresponding to the Communications Group's monthly obligations to the sellers.

The purchase price paid by the joint ventures for its interest in the computer systems included a markup on the computer's original purchase price and was generally financed by giving the Communications Group a demand note that was subsequently satisfied, and a recourse installment note for the balance of the purchase price. The joint ventures also became obligated to pay to the Communications Group an implementation fee. In addition, the purchase agreement gave the Communications Group a nonexclusive right to remarket the computer equipment sold to the joint ventures upon expiration or termination of the lease, under which the Communications Group was entitled to twenty-five percent of the net proceeds of any remarketing they arranged.

In June 1982, the Communications Group began to pool the rental income from equipment that it managed and owned, and allocated the income to the various owners pursuant to a stated formula. To the extent an owner's share of the pooled income was greater than the rate calculated under the formula, the Communications Group was entitled to retain the excess as a "performance fee." In addition, the Communication Group's annual management fees were revised and set at a flat percentage of adjusted pool rental income. The net effect of these provisions was to ensure that annual cash flow of the joint ventures remained approximately at a break-even point during the term of the computer's lease.

In reaching its conclusion, the Tenth Circuit applied the standard established in Lyon, acknowledging that a transaction will be accorded tax recognition only if it has "economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached."¹⁰² In addition, the Tenth Circuit recognized the two-prong test as was applied in Rice's Toyota World for determining whether a transaction is a sham, but in doing so held that:

In one of the repo transactions, GDSII acquired a T-bill and entered into a repurchase agreement with the seller requiring GDSII to repurchase the T-bill from the seller on the date the T-bill matured. That transaction locked in an economic loss of a small sum, in that the interest charged by the seller of the T-bill was more than the sum of the interest earned under the T-bill and the gain recognized by GDSII on redemption of the T-bill. With respect to the other ten transactions, the initial repurchase agreement with the seller obligated GDSII to repurchase the T-bill from the seller well in advance of the maturity date of the T-bill. In each of these transactions, GDSII then entered into intermediate repo transactions, the last of which required GDSII to repurchase the T-bill from the "lender" at maturity. As such, the initial repo transaction involving the remaining ten trades did not lock in an economic loss; rather, if the rates charged by repo lenders dropped in relation to the rate born by the T-bills, GDSII could earn an economic profit with respect to its acquisition of the T-bills. As it turned out, however, all ten of the other repo transactions resulted in economic losses on redemption of the T-bills after the close of 1981.¹⁰⁶ With respect to four of the T-bills, GDSII had several opportunities to sell the T-bills in 1981 for prices that would have generated an overall economic profit; however, the taxpayer refrained from doing so under facts that indicated the reason for this failure was to preserve the mismatch of interest deductions in 1981 and interest income in 1982.¹⁰⁷

The Tax Court concluded that GDSII was not entitled to any interest deductions under section 163 with respect to the 1981 repo transactions because none of the repo transactions was undertaken for any purpose other than generating interest deductions, reasoning as follows:

"An overall comparison of this case with Goldstein, in concept and essence, reveals no material difference. Petitioner here, in conjunction with Mr. Blumstein (both of whom had some expertise in Government securities markets), caused GDSII to enter into T-bill purchases and repos near the end of each year in order to generate approximately a four-to-one deduction of interest for themselves and limited partners. Although petitioner and Mr. Blumstein may have had expertise in T-bills and other Government securities, they, nevertheless, did not (on behalf of GDSII) make significant purchases, if any, of T-bills or enter into repos in order to profit from haircuts, carry, or interest differentials during other parts of 1981. As to the transactions in question, the only focus and obvious goal was to create an entity or vehicle at each year's end to generate interest deductions for themselves and the limited partners. The transactions under consideration are not part of a continuum of trading which just happened to occur at year end. Instead, they clearly and succinctly represent transactions which each year-end were structured solely for the tax benefit and without any regard or apparent concern for the profit or loss factor or any other "purposive" reason.

"That is not to say that people do not or cannot make profits in this type of transaction. We also recognize that taxpayers may structure their transactions so as to obtain the maximum benefit legally obtainable. Gregory v. Helvering, 293 U.S. 465 (1935). Here, however, the sole objective was to obtain the interest deduction. This is abundantly evidenced by the use of repos to market with locked-in losses in the transactions with no potential for any profit. In instances where intermediate repos could have or did generate some gain from the carry, these amounts were nominal, either fixed or short-term and stable and, in any event, merely reduced the fixed losses by relatively insignificant amounts. Accordingly, although a limited number of the short-term intermediate repos had a small potential for gain, the overriding and clear intent was to seek the interest deduction. We must bear in mind that neither an objective to make a profit nor the need for a trade or business, at least in 1981 and 1982, was a requirement for an interest deduction and are not the direct focus of our inquiry. We have analyzed the profit potential as part of the overall inquiry into whether these transactions had "purpose, substance, or utility apart from their anticipated tax consequences." Goldstein v. Comm'r, 364 F.2d at 740; Knetsch v. United States, 364 U.S. 361, 366 (1960).

"Petitioners emphasize the use of the word "solely" in the Goldstein holding and argue that if there is any potential for profit the transaction has substance. Although there was no apparent potential for any gain, other than tax benefits, in Goldstein, we do not understand the principle of that case to, in any manner, exalt form over substance. The principle of that case would not, as petitioners suggest, permit deductions merely because a taxpayer had or experienced some de minimis gain. Goldstein, to the contrary, holds that the transactions, in form, were real, but that they lacked substance. That test was not a profit objective test. In explaining its rationale the Circuit Court stated:

In Sheldon, at least six of the eleven repo transactions presented GDSII with a potential for earning an economic profit. However, the Tax Court concluded that GDSII's sole motive for executing all eleven of the repo transactions was to generate tax deductions because: (i) the profit potential was nominal or infinitesimal in comparison to the net present value of the tax benefit derived from the mismatching of income and deduction, and (ii) GDSII's affairs were managed by skilled and experienced investors in a manner that demonstrated the purpose for the investments was to generate tax deductions, not earn an economic profit (i.e., their failure to sell T-bills in 1981 at prices that would have generated an economic profit to GDSII).

The taxpayers also executed remarketing and residual sharing agreements with Finalco under which the taxpayers agreed to pay Finalco a stated percentage of the proceeds received from the sale or releasing of the equipment for any remarketing services performed by Finalco. Under the residual sharing agreements, the taxpayers were entitled to a stated percentage of the proceeds received by Finalco from leasing the equipment during a stated portion of the original term of the owner lease (i.e., "interim revenue").

Based on these transactions, the taxpayers deducted depreciation and interest expenses on their U.S. federal income tax returns. The IRS disallowed the deductions based on a sham transaction analysis. The Tax Court agreed with the IRS's conclusions that the transactions were shams. The Ninth Circuit affirmed the Tax Court's decision that the transactions were shams by applying the two factors established by Lyon for determining whether a transaction is a sham, not as a rigid two-step test as was done in Rice's Toyota World, but instead as two more precise factors that should be considered in such an inquiry. The Ninth Circuit concluded that the Tax Court considered both the taxpayers' subjective business motivation for and the objective economic substance of the transactions in a manner consistent with Ninth Circuit law and that of other circuits and its findings were not clearly erroneous.

Similar to that of Rice's Toyota World, the facts of Casebeer provided ample evidence to the court that the taxpayers' primary motivation in entering into the transactions with Finalco was to claim tax deductions and investment tax credits attributable to the computer equipment. In particular, the taxpayers failed to investigate independently the equipment's fair market value and residual value, and the advice sought by the taxpayers was motivated solely by tax considerations.

In the Supreme Court, the focus of discussion shifted to the realization issue. The Court noted:

On December 28, 1981, the Pop, Soul, and New America Phonomasters limited partnerships each acquired master recordings of a designated artist with an initial purchase price from $10,000 to $50,000. Although the stated purchase price for the recordings, according to the purchase agreements, required the payment of additional fees from $27,000 to $50,000 and of royalties, there was no evidence that the second fees and royalties were ever paid. For the Rock Kandy Phonomasters limited partnership, there was insufficient evidence that enough master recordings to constitute an album existed in 1982.

The promoters then formed four entities or "co-tenancies" named Pop Phonomasters Leasing, New America Phonomasters Leasing, Soul Phonomasters Leasing, and Rock Kandy Phonomasters Leasing for the purpose of leasing the master recordings to investors, such as the petitioners in this case. An investor would join one of the co-tenancies as a co-tenant by signing an acceptance to an offer to participate in the co-tenancy, an operating agreement, and a lease agreement. The leases granted the lessee-investors the exclusive right to exploit the recordings in the United States for a three year term and required a fixed rental payment and the payment of a fee to a marketing agent for a total of $275,000 (at least $435,000 for Rock Kandy). The lease for each co-tenancy stated that the "stipulated loss value" of the recordings were $3,370,000 ($6,144,400 for Rock Kandy), and that the co-tenancies, which bore the full risk of loss, were required to insure the recordings for at least that amount.

The co-tenants appointed Frank Pasternak as "co-tenancy operator" ("CTO") to manage the affairs of all four co-tenancies. He had the exclusive right and duty to conduct the affairs of each co-tenancy. Pasternak, a CPA, knew little about the recorded music industry and had agreed to become cotenancy operator at the request of two of the promoters. He executed the leases, marketing agreements, and production and distribution contracts on behalf of the co-tenancies as he was instructed by the promoters without negotiating the terms of the agreements. He received none of the co-tenants' initial investments and kept no records of their interests.

The co-tenants' checks, payable to the various "leasing agents," were deposited in the agents' accounts. Pasternak executed releases permitting the leasing agents to take their commissions from the funds received by the co-tenancies and the balance was paid to a trust account at a law firm. Pasternak did not know what happened to the investors' funds after they went to the leasing agents. He did not know how much of the co-tenants' money, if any, was ultimately used to pay for rent or for marketing of the master recordings. Pasternak never maintained any books or records, not even of the amounts invested by each co-tenant. Although he signed the marketing agreements, he made no payments to any marketing agents as required by the leases and did not know whether any payments had ever been made.

The limited partnerships elected to pass through the investment tax credits that they received from the purchase of the master recordings to the co-tenancies. The amount of investment tax credit allocated among the co-tenants, with regard to the 1981 Pop, Soul, and New America leases, was based on the master recordings fair market value of $3,370,000. With regard to the 1982 Rock Kandy lease, the Pasternaks (the only persons in this appeal who invested in Rock Kandy) claimed an investment tax credit based on the Rock Kandy recordings' fair market value of $6,144,000. On the petitioners' tax returns, petitioners claimed investment tax credits and business expense deductions. The IRS disallowed the claimed deductions and credits arising from petitioners' investments in the leasing programs on the grounds that the transactions had no economic substance and were entered into solely to obtain the expected tax benefits.

The Sixth Circuit, in reviewing whether the transactions described above lacked economic substance and a profit motive, applied a disjunctive form of the test set forth in Rice's Toyota World. The court stated "[t]he threshold question is whether such transaction has economic substance. If the answer is yes, the question becomes whether the taxpayer was motivated by profit to participate in the transaction."¹⁰⁹ If it is determined that the transaction is a sham, the entire transaction is disallowed for U.S. federal income tax purposes, and the second inquiry is never made.¹¹⁰ The Sixth Circuit further stated "[t]he proper test for whether 'a transaction is a sham is whether the transaction has any practicable economic effects other than the creation of income tax losses.' If the transaction lacks economic substance, then the deduction must be disallowed without regard to the niceties of the taxpayer's intent."¹¹¹

With regard to the Rock Kandy co-tenancy, it was determined that the transaction lacked economic substance because of the lack of convincing evidence that master recordings sufficient to comprise an album actually existed on December 31, 1982. With regard to the master recordings leased by the Soul, Pop, and New America co-tenancies, the Tax Court determined that the transactions lacked economic substance because there were gross disparities between the values claimed for investment tax credit purposes and the fair market value as determined by the IRS's expert witness. In addition, the Sixth Circuit relied on the Tax Court's findings that the 1981 leasing transactions lacked economic substance based on evidence of the manner in which the co-tenancies carried on their activities. In particular, the primary focus of the analysis was on the person selected to manage the affairs of the partnerships, Frank Pasternak. The Sixth Circuit held:

The Second Circuit held that Greene should not be held to have realized income on the futures contracts after they were sold by the tax-exempt entity because Greene had no fixed right to any income prior to such a sale, and Greene maintained no control over the sale of the donated futures contracts. The Second Circuit further held that neither the end-result nor the interdependence test could be applied to convert two actual transactions (the contribution of the futures contracts by Greene and the sale of such futures contracts by the tax-exempt entity) into two hypothetical transactions (a sale by Greene of the futures contracts followed by a contribution of a portion of the proceeds from such a sale).

The Second Circuit held that the end-result test of the step-transaction doctrine was inapplicable in this case because in order to correctly apply the end-result test, the court would have to rule that the transactions in the case were part of a pre-arranged plan to dispose of the futures contracts. Citing Grove v. Comm'r,¹¹³ the court found no evidence to support a conclusion that a prearranged plan to dispose of the futures contract existed (i.e., there was no express condition on the gift that the tax-exempt entity sell the futures contracts). The Second Circuit, relying on S.C. Johnson & Son, Inc. v. Comm'r,¹¹⁴ also found there to be no evidence that Greene maintained control over the futures contract, despite his being president of the tax-exempt entity and a member of its board of directors.

In the Second Circuit's conclusion with regard to the interdependence test, it held that the relevant question was whether the tax-exempt entity's sale of the futures contracts would have had independent significance absent Greene's being entitled to a portion of the income from the sale of such contracts. The court held that based on the fact that the tax-exempt entities decision to sell the futures contracts was a means by which such entity maintained its operating funds, there was no doubt that the sale of the futures contracts was a wholly independent event.

The IRS disallowed the depreciation deduction and investment tax credits on the ground that the sale-leaseback transaction was a "sham." The Tax Court agreed with the IRS, holding that the transaction held no objective possibility of an economic profit for Sacks and that Sacks had "merely purchased a package of tax benefits."¹¹⁵ In addition, the Tax Court refused to treat Sacks' recourse note to BFS as valid indebtedness because it was owed to the seller rather than an independent third party (i.e., this was a two-party rather than a three-party financing transaction).

Returning to the principles of Lyon, the Ninth Circuit reversed the Tax Court. The court stated that, under Lyon, the test for determining whether or not a transaction is a sham is "whether the transaction had any practical economic effects other than the creation of income tax losses." In restating this principle, the court specifically noted that the application of the sham transaction doctrine does not entail a rigid two-step analysis of whether the taxpayer has shown that the transaction has: (i) a non-tax business purpose, and (ii) economic substance beyond the creation of tax benefits. Rather, the Ninth Circuit held that business purpose and economic substance "are simply more precise factors to consider" in applying the sham transaction doctrine.

In holding for the taxpayer, the Ninth Circuit recited the following factors in support of its conclusion that the taxpayer's sale-leaseback transaction with BFS had "genuine" economic effects: (i) Sacks' personal obligation to pay the purchase price was genuine; (ii) Sacks paid fair market value; (iii) the tax benefits would have existed for someone, either BFS or Sacks, so the transaction shifted them but did not create them from thin air; (iv) the business of putting solar water heaters on homeowners' roofs was genuine; and (v) the business consequences of a rise or fall in energy prices and solar energy devices were genuinely shifted to Sacks by the transaction. The Ninth Circuit specifically stated that where a transaction otherwise has true practical economic consequences that substantiate its form, the lack of pre-tax profit potential is not enough to cause the transaction to be treated as a sham:

Sacks' investment did not become a sham, according to the court, just because its profitability was based on after-tax instead of pre-tax projections. It is undisputed, as found by the court, that he stood to make money on an after-tax basis. "The fact that favorable tax consequences were taken into account . . . is no reason for disallowing those consequences." Where a transaction has economic substance, it does not become a sham merely because it is likely to be unprofitable on a pre-tax basis. If in a sale-leaseback, the purchaser retains significant risks and benefits of ownership and is "the one whose capital was committed" based on cash or negotiable full recourse promissory notes, then the possible imprudence of his investment does not disqualify him from taking the depreciation deductions and tax credits. This is true even though the investor paid more "because [the investor] anticipated the benefit of the depreciation deductions."¹¹⁶

The court emphasized that the absence of pre-tax profitability is effectively irrelevant in determining whether a transaction is a sham where Congress has intentionally used tax incentives to influence investors' conduct:

Under the proposed transaction, a partnership would be formed in which a foreign bank would hold a substantial interest. The partnership would buy short-term securities and shortly thereafter sell them for the same price. The consideration for the sale would be approximately 70 percent cash and the remaining amount in installment notes that would provide for six semiannual payments equal to a notional principal amount multiplied by the London Interbank Offering Rate ("LIBOR").¹²⁰ These installment notes would be considered contingent and, therefore, would fall within the special ratable basis recovery rule under the installment sale regulations, which provides that when a stated maximum selling price cannot be determined as of the close of the taxable year in which the sale or other disposition occurs, but the maximum period over which payments may be received under the contingent sale price agreement is fixed, the taxpayer's basis (inclusive of selling expenses) is allocated to the taxable years in which payment may be received under the agreement in equal annual increments.^156,121

The result of the approach would be that a large gain would be realized in the first year that would be allocated almost entirely to the foreign bank (with no U.S. federal income tax consequences to the foreign bank). The foreign bank's interest in the partnership would then be redeemed. Losses would be created in subsequent years that would almost entirely be allocated to Colgate and which could be carried back to offset its capital gain from the sale of its subsidiary.¹²²

Colgate initially had reservations with respect to Merrill Lynch's proposal because it did not seem to serve Colgate's business purposes.¹²³ However, Colgate became interested in using the partnership to invest in its own debt in order to rebalance its debt portfolio.¹²⁴ Colgate's debt acquisition objectives were then incorporated into the tax reduction strategy.

To accomplish its goal, in November 1989, Colgate (through a subsidiary) formed a partnership ("ACM") with a subsidiary of ABN, N. V. (a foreign bank), and a subsidiary of Merrill Lynch. Each partner contributed cash. At the outset, ABN held an 82.6 percent interest in the partnership, Colgate held a 17.1 percent interest and Merrill Lynch a 0.3 percent interest. The total contributions to the partnership were $205 million.

At the end of November 1989, ACM paid $205 million to purchase floating-rate notes that were paying interest at a rate that was only three basis points above the rate the funds were already earning in deposit accounts. The interest rates on the floating-rate notes were scheduled to reset only once a month, and ACM had prearranged to dispose of the notes in a 24-day period encompassing only one interest rate adjustment and virtually guaranteeing that ACM would have no real exposure to interest rate or principal value fluctuations with respect to the notes.¹²⁵ Twenty-four days later, ACM sold $175 million of the floating-rate notes in exchange for $140 million in cash plus LIBOR notes worth an estimated $35 million.¹²⁶ Colgate alone bore virtually all of the approximately $5 million in transaction costs.

In 1991, pursuant to a preconceived plan, Colgate purchased part of ABN's interest in ACM, and ACM redeemed the remainder of ABN's interest, leaving Colgate with a 99.7 percent interest in the partnership. Subsequent to redeeming the foreign partner (and pursuant to the same plan), ACM sold the LIBOR notes, recognizing a large capital loss. Virtually all of this loss was allocated to Colgate.

Both the Tax Court and the Court of Appeals for the Third Circuit held that the transaction lacked economic substance. The Third Circuit held that "both the objective analysis of the actual economic consequences of ACM's transactions and the subjective analysis of their intended purposes support the Tax Court's conclusion that ACM's transactions did not have sufficient economic substance to be respected for tax purposes."⁶² The purported purpose of the ACM partnership was to acquire Colgate debt and thereby to hedge against interest volatility. The court observed that the economic substance doctrine can apply equally to "shams in substance" as well as "shams in fact," and that even when the purported activity in the transaction actually occurs the transaction may be disregarded when (other than tax consequences) the transaction results in "no net change in the taxpayer's economic position."¹²⁷ In other words, as an objective matter, to be respected for tax purposes, a transaction must have practical economic effects other than the creation of tax losses.¹²⁸ The court found that there was "a lack of objective economic consequences arising from ACM's offsetting acquisition and virtually immediate disposition of the [floating-rate] notes . . . we find that these transactions had only nominal, incidental effects on ACM's net economic position."¹²⁹

The court stated that economic substance is a prerequisite to sustaining a transaction:

In 1983, UPS formed an offshore subsidiary, Overseas Partners Ltd. ("OPL"), a Bermuda corporation, and thereafter distributed the OPL stock to UPS's employee-shareholders. UPS also entered into an insurance arrangement with National Union Fire Insurance ("NUF"), an unrelated domestic insurer. Under the UPS-NUF insurance arrangement, UPS would collect and remit to NUF the EVCs (less any insurance losses paid). UPS also would administer all claims on behalf of NUF and be responsible for all bad debts or uncollectible items. In December 1983, NUF and OPL entered into a reinsurance contract whereby NUF was required to remit to OPL 100 percent of what NUF received from UPS less: (1) a commission (not to exceed $1 million); and (2) certain allowances to cover expenses. The reinsurance agreement could not be terminated by either party so long as the UPS-NUF insurance arrangement remained in effect. However, the termination of the UPS-NUF arrangement resulted in a simultaneous termination of the reinsurance contract.

For the taxable year 1984, UPS did not include the EVCs as income, nor did UPS claim a deduction for the amounts it remitted to NUF. Under applicable tax law principles, the premium income earned by OPL was not subject to U.S. tax until the income was repatriated back into the United States (i.e., as a dividend to its shareholders). Thus, if respected for U.S. federal income tax purposes, the arrangement would have allowed UPS to defer paying tax on the income attributable to the EVCs accumulated in a foreign corporation not subject to U.S. federal income tax.

The Tax Court held that the arrangement UPS had with NUF and OPL lacked economic substance and had no business purpose other than to confer tax benefits to UPS's and OPL's shareholders. Under the assignment of income doctrine, the income attributable to the EVCs properly belonged to UPS.¹³¹ The court's conclusion was based, in part, on the fact that under the arrangement NUF bore no risk or exposure to loss.¹³² Furthermore, UPS continued to perform the same functions and activities related to the EVCs, and bore the same economic risks, as it did prior to the arrangement. Thus, "[t]he difference between petitioner's EVC activity before and after January 1, 1984, was that, after that date, it remitted the excess of EVC revenues over claims paid (i.e., gross profit) to NUF, which, after subtracting relatively small fronting fees and expenses, paid the remainder to OPL, which was essentially owned by petitioner's shareholders."¹³³ UPS failed to prove that the arrangement was motivated by non-tax business reasons or that it had economic substance. The court, therefore, concluded that the arrangement was a sham transaction.

THE UPS APPEAL

On appeal, the United States Court of Appeals for the Eleventh Circuit reversed and remanded the Tax Court's decision.¹³⁴ The Eleventh Circuit noted that the Tax Court's core reasons supporting its finding that the restructuring of UPS's EVCs business warranted no respect were that: (1) the plan had no defensible business purpose, as the business realities were identical before and after the restructuring (i.e., UPS earns the EVCs and pays any claims due to its customers), (2) the premiums paid to NUF were well above industry standards, and (3) UPS memoranda and documents reflected UPS's sole motivation was tax avoidance.¹³⁵ The issue before the court was to determine whether the EVC plan had the kind of economic substance that would remove it from "shamhood," even if the business continued as it had before.

The Eleventh Circuit cited Lyon, and stated that the kind of "economic effects" required to permit a transaction to be respected for tax purposes include the creation of genuine obligations enforceable by an unrelated party. The Eleventh Circuit then determined that both the insurance policy between UPS and NUF, and the subsequent reinsurance treaty with OPL, did not completely foreclose the risk of loss to NUF. Even if the odds of losing money on the policy were slim, NUF had in fact assumed liability for the losses of UPS's EVCs, and that liability was found to be a genuine obligation. Further, even if NUF was a conduit used to transfer the EVCs to OPL, OPL was an independently taxable entity not under UPS's control. UPS was obligated to use the EVCs to pay the premiums on the insurance policy; it could not have used the proceeds for any other purpose.

The Court of Appeals stated that while it found the restructuring to have real economic substance, it still may be considered a sham if tax avoidance displaced business purpose.¹³⁶ A business purpose does not mean a reason for a transaction that is free of tax considerations, but rather one of going concern with a bona fide, profit-seeking motive. Citing Gregory, the Court of Appeals noted that tax planning was permissible. Clarifying its point, the Court of Appeals stated:

There may be no tax-independent reason for a taxpayer to choose between these different ways of financing the business, but it does not mean that the taxpayer lacks a business purpose. To conclude otherwise would prohibit tax-planning.¹³⁷

The Court of Appeals found that UPS was conducting a bona fide business, serving its customers' need to enjoy loss coverage and UPS's need to lower its liability exposure. Therefore, in spite of the Court of Appeals' finding that the restructuring was "more sophisticated and complex than the usual tax-influenced form-of-business," its underlying business purpose neutralized any tax-avoidance purpose.¹³⁸

Much like the taxpayer in ACM Partnership, the impetus for Compaq's investment was a desire to generate artificial losses to offset capital gain it had recognized earlier in the year.¹⁴⁰ To accomplish this, on September 16, 1992, Compaq instructed its broker to purchase 10 million ADRs in Royal Dutch Petroleum¹⁴¹ in twenty-three separate transactions (of approximately 450,000 ADRs) with special "next day" settlement terms. The broker was further instructed to sell the Royal Dutch Petroleum ADRs, and that each purchase and sale was to be completed before executing the next purchase trade. The sale transactions, however, used the standard five-day settlement period.

Due to the different settlement rules, while all twenty-three purchase and resale transactions were completed within one hour, Compaq was the shareholder of record of 10 million shares of Royal Dutch ADRs as of September 18, 1992, and thus became entitled to receive a dividend of $22,545,800. The dividend was subject to a fifteen-percent withholding tax rate under the United States-Netherlands Tax Treaty, resulting in a foreign tax payment of $3,382,050. Compaq claimed this amount as a foreign tax credit.

The Tax Court disallowed the foreign tax credit, finding that there was no business purpose for the transaction apart from obtaining the foreign tax credits effectively to create capital losses to offset the previously recognized capital gain. The court cited ACM Partnership, where the Tax Court held that in order to satisfy the business purpose requirement of the economic substance inquiry, "the transaction must be rationally related to a useful non-tax purpose that is plausible in light of the taxpayer's conduct and economic situation. In determining whether a transaction has a useful non-tax purpose, how a taxpayer conducts itself in a business fashion, considering and analyzing the ramifications of a transaction before proceeding with the transaction, should be considered.¹⁴² The court's conclusion was based, in part, on the fact that under a cash flow analysis, the taxpayer would have incurred a prearranged economic loss but for the foreign tax credits.¹⁴³ The court also cited the taxpayer's lack of due diligence and investigation as evidence of a lack of business purpose.

THE COMPAQ APPEAL

On appeal, the United States Court of Appeals for the Fifth Circuit reversed the Tax Court's decision.¹⁴⁴ The Fifth Circuit held that Compaq was entitled to a foreign tax credit for its holdings from a dividend paid on the ADRs.

In reaching its decision, the court cited Lyon, "[w]here . . . there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the government should honor the allocation of rights and duties effectuated by the parties."

The court stated that the mere existence of a tax benefit does not make the transaction a sham. To treat a transaction as a sham, the court adopted a two-part inquiry to determine whether or not the transaction had economic substance.¹⁴⁵ A court must find that the taxpayer was motivated by no business purpose other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of a profit exists. In this case, the court did not need to apply the two-part inquiry because it had already determined that the ADR transaction had both economic substance and a business purpose.

1980s

Rice paid off the recourse note in three years along with interest on the deferred installments. On its income tax returns for 1976, 1977, and 1978, it claimed accelerated depreciation deductions based upon its ownership of the computers, and interest deductions for its payments on the notes.

The Tax Court upheld the Service's disallowance of all the depreciation deductions and the interest expense deductions on both the recourse and nonrecourse notes because the court found that the sale-leaseback was a sham transaction.¹⁴⁶ The Tax Court, in considering the factors established in Lyon, found that Rice was not motivated by any business purpose other than achieving tax benefits in entering the transaction, and that the transaction had no economic substance because no reasonable possibility of profit existed.¹⁴⁷ The Tax Court accordingly held that the transaction should be treated for tax purposes as if Rice paid Finalco a fee, in the form of the cash payment made on the recourse note in the year of purchase, in exchange for the claimed tax benefits.¹⁴⁸

The Fourth Circuit Court of Appeals, affirming the Tax Court, adopted a two-prong test to determine if a transaction could be disregarded as a sham and recast in a form more consistent with its substance. Under the test, the two prongs were applied conjunctively (i.e., a transaction would be a sham only if both prongs were satisfied). The first prong, the subjective prong, would be satisfied if a court finds "that the taxpayer was motivated by no business purpose other than obtaining tax benefits in entering the transaction;" the second prong, which is objective, is "that the transaction has no economic substance . . ."¹⁴⁹

The Fourth Circuit affirmed the Tax Court with regard to the lack of business purpose for the transaction, stating that the record contained ample evidence to support the Tax Court's finding that Rice's sole motivation for purchasing and leasing back the computers under the financing arrangement used was to achieve the large tax deductions that the transaction provided in the early years (i.e., Rice had no profit motive). In reaching this conclusion, the Fourth Circuit first focused on the lack of any serious evaluation of the residual value of the computer equipment on the part of Rice and the terms of the contractual arrangement between Rice and Finalco. Based on the contractual arrangement, profit on the transaction depended upon Rice re-leasing or selling the computer equipment because Finalco had no obligation to pay rent under its lease unless it received adequate revenues in subleasing the computers. In addition, Finalco was entitled to a marketing fee of thirty percent of any release or sale proceeds if Finalco arranged the subsequent deal. The residual value of the computer equipment was, therefore, a crucial point for a person looking to make a profit.

Second, the Fourth Circuit focused on the fact that the amount Rice paid for the computer equipment was inflated and financed with mainly nonrecourse debt. The Tax Court inferred, and the Fourth Circuit agreed, that Rice intended to abandon the transaction at some future date by walking away from the nonrecourse notes before the transaction ran its stated course.¹⁵⁰ Not only did Rice pay more than Finalco to purchase the computer equipment, but considering the thirty percent marketing fee that Finalco was entitled to, the Fourth Circuit thought it more accurate to say that Rice acquired only seventy percent of the computer equipment for a price in excess of 100 percent of its value.

The Fourth Circuit's inquiry into the economic substance of the transaction in Rice's Toyota World focused on whether there was a reasonable possibility of profit from the transaction apart from the claimed tax benefits. As was discussed above, there was no hope of Rice earning a profit unless the computer equipment had residual value sufficient to recoup the amount paid on the recourse note less Rice's annual net return under the lease agreement. The Fourth Circuit agreed with the Tax Court's holding that the Service's experts were more creditable, stating:

Although Rice's experts presented a range of predicted residual values with a high end sufficient to earn Rice a profit, the [T]ax [C]ourt found the Service's experts to be more credible and to have used more reliable forecasting techniques. Rice's Toyota, 81 T.C. at 205. The [T]ax [C]ourt's finding that residual value was not sufficient to earn Rice a profit is amply supported by the record and is not clearly erroneous. This finding, in conjunction with the [T]ax [C]ourt finding that Rice would not find it imprudent to walk away from the transaction, abandoning the property subject to the sale and leaseback, supports the ultimate inference drawn by the [T]ax [C]ourt that the transaction lacked economic substance.

The loan was to bear interest at ten percent per annum payable annually, and any unpaid interest amount was treated as a new advance under the loan agreement. The loan agreement also included a provision that allowed IME to extract and liquidate gold sufficient to reduce the outstanding balance of the debt (adjusted for unpaid interest amounts) to an amount equal to seventy-five percent of the estimated market value. In addition to the interest from the loan, IME was to receive a two percent commission on the net amount of all gold sales.

Based on the direct $10,000 contribution and the additional $30,000 provided by IME, Saviano deducted $40,000 on its 1978 U.S. federal income tax return for mining expenses. The Service disallowed the deduction for the mining expense and the Tax Court agreed with the Service with regard to the $30,000 payment that originated from IME. The Tax Court concluded that the liability of the taxpayer under the loan agreement was too contingent to be treated as a bona fide debt for U.S. federal income tax purposes.

In 1979, because of an amendment to section 465 that eliminated the ability to deduct mining expenses funded by nonrecourse debt, Saviano and IME entered into a modified version of the 1978 transaction aimed at obtaining similar U.S. federal income tax results. In the 1979 transaction, IME obtained for Saviano, at no charge, a lease from the Paul Isnard mining concession in French Guiana. The lease had a fixed termination date of August 19, 1986, and also contained a provision authorizing termination if the lessee abandoned or discontinued the mining operation. The lessor was to be paid one dollar for each gram of extracted gold after development and extraction costs and government taxes were paid. Through IME, Saviano paid $8,000 as mining development expenses to General Miniere, S.A., a mining contractor.

In order to provide further funding for the venture, IME sold on behalf of Saviano a "gold option" to an unnamed third party. This "gold option" entitled the purchaser to buy the extracted gold at $2.50 per gram and was subject to the terms of the lease. The proceeds from the sale of the gold option and Saviano's $8,000 were paid to General Miniere by IME. Saviano claimed a deduction for $40,000 of mining expenses on his 1979 U.S. federal income tax return. Saviano did not, however, report the $32,000 received for the gold option as income in 1979. The Service disallowed the appellant's mining development deduction. The Tax Court determined that the $32,000 should have been reported as income by Saviano in 1979.

The Seventh Circuit Court of Appeals, with regard to both the 1978 and 1979 transactions, reviewed the economic substance of the transactions. With respect to the 1978 transaction, the court applied a slightly different analysis to reach the same conclusions as that of the Tax Court. In determining whether the loan agreement created a bona fide debt, the Seventh Circuit acknowledged the need for close scrutiny because of the nonrecourse nature of the loan and considered the reasonable likelihood that the debt would be repaid, the adequacy of the assets securing the debt, and the level of risk taken on by the lender.

Based on the analysis of similar situations in Gibson Products Company v. United States, 637 F.2d 1041 (5th Cir. 1981), and Brountas v. Comm'r, 692 F.2d 152 (1st Cir. 1982), the Seventh Circuit determined that the loan agreement did not create a bona fide debt because the only way the loan would be repaid was from proceeds of sales from the gold mine and such proceeds would be produced subject to the terms of the lease. In addition, the court noted the insufficient security provided under the loan agreement (i.e., the mineral lease itself). With regard to the level of risk taken on by the lender, the Seventh Circuit indicated that IME's sharing in the entrepreneurial rewards of the venture (i.e., a small percentage of sales as a commission) was more indicative of a joint venture than a debtor-creditor relationship. In fact, because the amount of the purported loan was three times the amount contributed directly by Saviano, IME actually assumed a greater level of risk with respect to the transaction.

With respect to the 1979 transaction, the Seventh Circuit determined that the option premium received by Saviano should have been included in income on his 1979 federal income tax return because the purported option was not a true option:

"[T]he contractual right sold to the unnamed third party was not a true option because it did not create an unconditional power of acceptance in the offeree, citing inter alia, Carter v. Comm'r, 36 T.C. 128, 130 (1961) and Koch v. Comm'r, 67 T.C. 71 (1976). That is, Saviano was not compelled to do, or to forebear from doing, anything under the terms of the "gold option." He could choose not to extract the gold and would be under no obligation to sell any gold to the unnamed third party. The Tax Court properly analyzed the economic substance of the contract and characterized it as a "conditional preferential right of first refusal." Based on the conclusion that the "gold option" was not a true option and that deferral of the income therefrom was not appropriate, the Tax Court ruled for the Comm'r as to the 1979 transaction, citing, inter alia, Saunders v. United States, 450 F.2d 1047 (9th Cir. 1971) and Booker v. Comm'r, 27 T.C. 932 (1957)."¹⁵¹

At issue in the Tax Court was whether the purported sales of cattle were so lacking in economic substance as to preclude being treated as sales for U.S. federal income tax purposes, and whether the benefits and burdens of ownership did not pass to the taxpayer. Although the Tax Court noted that the taxpayer's non-tax motives were entitled to some credibility, it placed greater weight on the objective facts of the case. The Tax Court held that the existence of a profit motive simply does not preclude a determination either that a transaction lacks economic substance or that the benefits and burdens of ownership did not pass to the taxpayer.¹⁵³ Accordingly, the Tax Court analyzed this case under a two-part analysis: (i) whether the transaction had economic substance; and (ii) whether the benefits and burdens of ownership passed to the taxpayer.

The Tax Court treated the term "economic substance" as synonymous with the phrase "realistic potential for profit."¹⁵⁴ The Tax Court held that a realistic potential for profit is found when the transaction is carefully conceived and planned in accordance with standards applicable to the particular industry, so that judged by those standards the hypothetical reasonable businessman would make the investment.¹⁵⁵ The Tax Court specifically stated, however, that the phrase "realistic potential for profit" does not mean that a transaction must make a profit or even that similar transactions generally are profitable.¹⁵⁶

In analyzing the benefits and burdens of ownership, the Tax Court considered a number of factors.¹⁵⁷ The Tax Court focused on the fact that the taxpayer acquired no rights or obligations with respect to the cattle, and the purported sales had no effect on Southern Star's unilateral authority over the property.¹⁵⁸ Consequently, the Tax Court held that the arrangement between the taxpayer and Southern Star did not transfer any benefits or burdens of ownership.

In addressing the issue of the proper legal standard for the sham determination, the Ninth Circuit held that under section 108 a loss resulting from a straddle transaction is deductible if the investor had a "reasonable expectation of profit." The Ninth Circuit held, however, that the reasonable expectation of profit standard is not applied until the court determines whether the transaction is a sham.¹⁵⁹

The Ninth Circuit, in first reviewing whether the test applied by the Tax Court was proper, stated that the typical focus is on whether the taxpayer has shown (i) a non-tax business purpose (a subjective analysis), and (ii) that the transaction has economic substance beyond the generation of the tax benefits (an objective analysis).¹⁶⁰ Interestingly, the Ninth Circuit stated that it did not intend to outline a rigid two-step analysis.¹⁶¹ The Ninth Circuit instead viewed the consideration of business purpose and economic substance as more precise factors to consider in the application of the court's traditional sham analysis (i.e., whether the transaction had any practical economic effects other than the creation of the income tax losses).¹⁶² The Ninth Circuit held that the Tax Court's failure to specifically delineate and apply a two-prong test was not, by itself, fatal. In addition, the Ninth Circuit concluded that the Tax Court applied a proper legal standard because it reviewed the transactions for economic effects other than the creation of income tax losses, and in doing so considered both economic substance and business purpose.¹⁶³

The Service disallowed the deductions for such losses, finding that they were incurred in transactions not entered into for profit. The Tax Court upheld the finding, and the Seventh Circuit affirmed, holding that straddles which involved no market risks were not economically substantial straddles and hedges, but were artificial transactions created by the brokers to evade taxes.

The Seventh Circuit stated that it was not the disparate tax treatment of granted and purchased options under the then enacted statute that influenced its holding.¹⁶⁴ The Seventh Circuit had instead agreed with the Tax Court's holding that the transactions as they actually occurred lacked economic substance because of the lack of profit motive on the part of the taxpayers. Although the transactions may have economic substance, if an investor would not have engaged in them but for the tax advantages they offer, losses incurred in such transactions are deductible only if they also satisfy the express statutory test applicable to loss deductions (under section 165, the transactions must have been entered into "for profit").¹⁶⁵ The Seventh Circuit concluded that no matter whether the "no non-tax motive or consequences" standard or the "no predominant tax motive" is applied to the facts of this case, there was no non-tax profit motive.

"By either standard -- "no non-tax motive or consequences," the test under the judge-made doctrine of substance over form, applicable to all deductions, or "no predominant non-tax motive," the statutory test applicable to the deduction of losses -- this is an easy case. There was no non-tax profit motive and the transactions did not impinge on the world. "The doctrine of Gregory v. Helvering . . . means that in construing words of a tax statute which describes commercial or industrial transactions we are to understand them to refer to transactions entered upon for commercial or industrial purposes and not to include transactions entered upon for no other motive but to escape taxation," Comm'r v. Transport Trading & Terminal Corp., 176 F.2d 570, 572 (2d Cir. 1949) (emphasis added); see also Comm'r v. National Carbide Corp., supra, 167 F.2d at 306. The transactions in this case were, as we shall see, devices whose only possible or contemplated effect was to avoid taxes, and a fortiori they were not engaged in for profit within the meaning of section 165(c)(2) as judicially glossed (the "predominant motive" test). Forget the gloss: the effort here to turn paper losses into tax benefits was contrary to the original, unembellished purpose of section 165(c)(2), on which see Fox v. Comm'r, 82 T.C. 1001, 1026-27 (1984) . . . The brokers promised a tax benefit in exchange for the taxpayers' deposits and they delivered on their promise. They were not brokering options trades, because their customers were assuming none of the risks, upside or downside, of such trades. In an inversion of the old-fashioned practice of "tax farming," these brokers were selling tax deductions. Compare Mahoney v. Comm'r, supra, 808 F.2d at 1219. So at least the Tax Court found on sufficient evidence. Its findings establish that the transactions lacked economic substance and also that they were not entered into for profit."

The taxpayers claimed a deduction for the first-year losses under section 165(c)(2), claiming these were losses incurred in transactions entered into for profit. The Service disallowed the deductions, and the Tax Court affirmed.¹⁶⁶ The Tax Court found that the straddles were substantive shams because the taxpayers did not enter into them with a profit motive. The Tax Court found this "was a prearranged sequence of trading calculated to achieve a tax-avoidance objective-not investments held for non-tax profit objectives."¹⁶⁷ Because it deemed the transactions shams, the Tax Court determined the losses were not deductible.

The Eleventh Circuit Court of Appeals affirmed the decision of the Tax Court, and in doing so, relied on well-established case law that stands for the proposition that although a taxpayer can structure a transaction to minimize its tax liability, the transaction must have economic substance.¹⁶⁸ In order to avoid being cast as a sham, a transaction must have business purpose and economic substance independent of any tax benefits. In its analysis, the Eleventh Circuit noted that section 165 is clearly aimed at economically motivated, or profit-motivated transactions. If a transaction were entered into with a profit motive, such transaction has a chance of being respected; where a transaction has no profit potential, however, it is likely a sham. The Eleventh Circuit held that the analysis of whether something is a sham must come prior to the for-profit analysis of section 165(c)(2). Consequently, the Eleventh Circuit applied the standard established by Knetsch that the inquiry under the sham transaction doctrine is whether a transaction has economic effects other than the creation of the tax benefits, and acknowledged the two factors established in Lyon and applied in Rice's Toyota World (i.e., business purpose and economic substance) in determining whether a transaction is a sham.

"We find, based on the record before us, that the sole function of these transactions was to obtain deductions to income for federal income tax purposes. We agree with the tax court's conclusion that this was "a prearranged sequence of trading calculated to achieve a tax-avoidance objective -- not investments held for non-tax profit objectives." Glass, 87 T.C. at 1163. Consequently, the losses and expenses incurred in connection with these straddle transactions are not deductible under I.R.C. § 165(c)(2) . . . In certain circumstances, we agree that an inquiry into the subjective intent of a taxpayer is appropriate. For purposes of this decision, however, we need not define with specificity the level of subjective profit motive or non-tax-avoidance purpose a taxpayer must possess in entering into a transaction for that transaction to pass scrutiny under the sham transaction doctrine. Because the sole function of these transactions was to create first year ordinary losses and capital gains treatment for subsequent offsetting gains, the transactions are shams. Whatever the taxpayers' motives in entering into these transactions, the transactions are not of the nature of the transactions at which I.R.C. § 165(c)(2) is directed. If a transaction is not what the statute intended, for whatever reason, then losses and expenses incurred in connection with the transaction are not deductible."¹⁶⁹

The Service disallowed all of the losses and investment tax credits claimed for 1979 and 1980 relating to the Picasso reproduction masters on the ground that: (i) the losses were not incurred in an activity entered into for profit; (ii) the reproduction masters were not used or available for use during 1979; and (iii) the taxpayers had not established a depreciable basis, the useful life of the reproduction masters, or the propriety of the depreciation method used. The Tax Court held that Rose's acquisition of Picasso reproduction masters in 1979 and 1980 was motivated primarily by tax considerations, that Rose did not have an actual and honest profit objective in acquiring the Picasso packages, and that the transactions were devoid of economic substance.

In affirming the decision of the Tax Court, the Sixth Circuit Court of Appeals acknowledged that the proper standard in determining if a transaction is a sham is whether the transaction has any practicable economic effects other than the creation of income tax losses, and that a taxpayer's subjective business purpose and the transaction's objective economic substance may be relevant to this inquiry.¹⁷¹ The Sixth Circuit relied on the Tax Court's determination that Rose's acquisition of the Picasso master reproductions was primarily motivated by tax considerations. Rose, by his own admission, stated that tax considerations played a major part in the decision to acquire the Picasso master reproductions. The court also noted that there was no reasonable possibility for Rose to recoup his cash investment other than through tax deductions and credits because the actual value of the property was negligible. Consequently, the Sixth Circuit held that Rose lacked an actual and honest profit objective. The Sixth Circuit agreed with the Tax Court's analysis based on the facts presented and held that it was correct and consistent with the analysis traditionally applied in determining whether a particular transaction is a sham.

1970s

Worthen subsequently proposed, and the federal regulators approved, a sale-leaseback arrangement that would provide Worthen with the use of the building without reflecting the mortgage debt on Worthen's books. Worthen solicited bids and selected Frank Lyon & Co. as the lessor in the sale-leaseback arrangement, with New York Life Insurance Company and First National City Bank (collectively, the "Bank") providing the mortgage financing. The parties executed "complementary and interlocking agreements under which the building was sold by Worthen to Lyon as it was constructed, and Worthen leased the completed building back from Lyon."

The lease of the building to Worthen was a triple net lease, which made Worthen responsible for all expenses usually associated with the maintenance of an office building, including repairs, taxes, utilities, and insurance. Under the lease, Worthen had the option to repurchase the building at various times, with the option price being fixed at the sum of the remaining balance of the mortgage loan and Lyon's initial investment together with interest at a six percent rate on that investment. On its U.S. federal income tax return, Lyon reflected accrued rent from Worthen as income, and asserted, as the owner of the building, its right to deduct depreciation on the building and the mortgage interest paid to the Bank.

The IRS denied the deductions claimed by Lyon based on its conclusion that Lyon was not the owner of the building for U.S. federal income tax purposes. According to the IRS, the transaction should be regarded as a sham, or in other words, ". . . an elaborate financing scheme designed to provide economic benefits to Worthen and a guaranteed return to Lyon," with Lyon serving merely as a conduit used to forward the mortgage payments made under the guise of rent paid by Worthen to Lyon and then by Lyon to the Bank as mortgagee. The IRS argued that the economics of the transaction more closely resembled a second mortgage loan to Worthen from Lyon for the equity Lyon had invested in the building, rather than a sale-leaseback, and claimed that the transaction was designed only to conform with certain tax-planning strategies and was without any valid business purpose.

The Supreme Court rejected the IRS's argument, holding that the IRS could not disregard the form of the transaction as a sale-leaseback because the sale-leaseback implemented by Worthen, Lyon, and the Bank had both business purpose and economic substance, both as to the advantages Worthen and Lyon derived from the structure, as well as the actual allocation of liabilities. Worthen had valid business reasons for raising capital through the transaction (the construction of its new headquarters), and the form of the transaction as a sale- leaseback was "compelled or encouraged" by non-tax business reasons- primarily, Worthen's need to satisfy its bank regulators by raising the necessary capital while avoiding debt on its balance sheet. Lyon secured three major advantages through the transaction's structure: (i) Lyon diversified its business affairs by virtue of the transaction; (ii) Lyon would receive a return of at least six percent on its cash investment if Worthen exercised its option to purchase the building; and (iii) Lyon obtained substantial income tax benefits. In return, Lyon incurred certain very real economic costs and bore risks that gave the transaction economic substance. Lyon bore the risk of the first mortgage loan since Lyon was primarily liable for its repayment whether or not Worthen complied with its rental obligations to Lyon. Lyon also carried the mortgage loan on its books as a liability, in accordance with generally accepted accounting principles in effect as of the time of the transaction.

The IRS also argued that the transaction should not be respected because Lyon would not have entered into the transaction were it not for the expected tax benefits. The Supreme Court held that this fact was simply not relevant:

The fact that favorable tax consequences were taken into account by Lyon on entering into the transaction is no reason for disallowing those consequences. We cannot ignore the reality that the tax laws affect the shape of nearly every business transaction.¹⁷²

Since the transaction had business purposes, its form had economic substance, and since the form complied with what actually occurred (not what the IRS argued might have occurred), the form of the transaction was respected and Lyon's tax benefits preserved. In so holding, the Supreme Court concluded that:

"[Where] . . . there is a genuine multiple party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax independent considerations, and is not shaped solely by tax avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties. Expressed another way, so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes. What those attributes are in any particular case will necessarily depend upon its facts."¹⁷³

1960s

The Supreme Court disallowed the taxpayer's interest deduction because "what was done, apart from tax motive, was [not] the thing which the statute intended . . . [The transaction was] a fiction, because each year Knetsch's annual borrowings kept the net cash value, on which any annuity or insurance payments would depend, at the relative pittance of $1,000. Plainly therefore, Knetsch's transaction with the insurance company did not `appreciably affect his beneficial interest except to reduce his tax. . . .'".

In affirming the Tax Court's decision, the Second Circuit Court of Appeals disagreed with the Tax Court's finding that the transactions were fictitious, noting they were "regular and . . . indistinguishable from any other legitimate loan transaction contracted for the purchase of Government securities." The Second Circuit, nonetheless, affirmed on the ground that the taxpayer could not earn a pre-tax profit on the transactions, and section 163 "does not permit a deduction for interest paid or accrued in loan arrangements . . . that cannot with reason be said to have purpose, substance, or utility apart from their anticipated tax consequences . . . Congress intended through the broad language of section 163 to permit an interest deduction to encourage purposive activity to be financed through borrowing . . . In other words, the interest deduction should be permitted whenever it can be said that the taxpayer's desire to secure an interest deduction is only one of mixed motives that prompts the taxpayer to borrow funds; or, put a third way, the deduction is proper if there is some substance to the loan arrangement beyond the taxpayer's desire to secure the deduction."

1930s

The Supreme Court held that there was no reorganization because there was no business or corporate purpose for the transaction.

² 238 F.2d 670, 678 (1st Cir. 1956).

³ 870 F.2d 21 (1st Cir. 1989).

⁴ Enbridge Energy Co. Inc. v. U.S., 553 F. Supp. 2d 716, 718 (S.D. Texas 2008).

⁵ Bishop retained a royalty interest (the "Butcher Interest") and subsequently sold that interest to a partnership consisting of K-Pipe and MIdcoast. In November of 2000, MIdcoast exercised a purchase option to acquire the K-Pipe's partnership interest and terminated the Butcher Interest.

⁶ K-Pipe obtained the capital necessary to effectuate the purchase of Bishop's stock by obtaining a loan from Rabobank Nederland, which was secured by $191.1 million in funds deposited in an escrow account by MIdcoast.

⁷ In total, K-Pipe received $128.9 million for the sale of the Bishop assets after taking into account the Butcher Interest and cash received from a receivable payable to Bishop. EnbrIdge Energy Co. Inc., 533 F. Supp. 2d at 722. As a result, K-Pipe received a $6.3 million profit from the transaction.

⁸ Id. at 726.

⁹ 361 F.2d 93 (5th Cir.1966).

¹⁰ 277 F.3d 778 (5th Cir.2001).

¹¹ Id. at 265.

¹² Id. at 307.

¹³ Id. at 312.

¹⁴ Indirect financial benefits included two-way technology transfer, environmental image-building, corporate education, and expansion of Con Ed's presence into new, stable markets, with future potential for more of the same in a newly deregulated worldwide industry. Id. at 313.

¹⁵ Id. at 327.

¹⁶ Id. at 339.

¹⁷ Id. at 340.

¹⁸ If Schering-Plough assigned the receive legs, it remained obligated to make its payments to ABN.

¹⁹ 1989-1 C.B. 651. The transaction took place before the issuance of Treas. Reg. § 1.446-3 in 1993 (regulations describing the timing of income and deductions for notional principal contracts).

²⁰ BB&T Corporation v. U.S., 523 F.3d 461 (4th Cir. 2008).

²¹ Sodra is considered tax-exempt for U.S. Federal tax purposes because it is a foreign entity, which is not subject to U.S tax.

²² See Rice's Toyota World, Inc. v. Comm'r, 752 F.2d 89 (4th Cir. 1985) (stating that under the economic substance doctrine, a transaction may be disregarded as a sham for tax purposes if the taxpayer "was motivated by no business purposes other than obtaining tax benefits" and "the transaction has no economic substance because no reasonable possibility of a profit exists.")

²³ See e.g., Frank Lyon Co. v. U.S., 435 U.S. 561 (1978). See also W.Va. N. R.R. Co. v. Comm'r, 282 F.2d 63, 65 (4th Cir. 1960) (stating that the substance of a transaction, rather than its form, governs for tax purposes).

²⁴ Frank Lyon Co. v. U.S., 435 U.S. 561 (1978).

²⁵ Howlett v. Comm'r, 56 T.C. 951 (1971).

²⁶ Midkiff v. Comm'r, 96 T.C. 724, 735, 1991 WL 83269 (1991) citing Knetsch v. U.S., 364 U.S. 365 -366 (1960).

²⁷ See Hines v. U.S., 912 F.2d 736,741 (4th Cir.1990), concluding that a loan transaction was a sham where ". . . the lease and debt payments between the three parties . . . were structured to be offsetting . . . [and this] circularity meant that the transaction became self-sustaining after the payments at closing with virtually no further financial input necessary from any of the parties."

²⁸ Shell expected that the transaction would raise substantial cash, approximately $100 million to $200 million, while permitting Shell to maintain control of the properties transferred to Shell Frontier.

²⁹ $27,587,591 of the claimed loss was carried back to 1990, resulting in an overpayment of taxes for that year in the amount of $18,971,341.

Subsequent to the formation of Shell Frontier, in 2004, Congress enacted section 362(e) so that in section 351 exchanges occurring after October 22, 2004, transfers of property with built-in losses require that either the transferee's basis in the transferred property, or, if the transferor so elects, the transferor's basis in the stock received, is reduced to fair market value. See the American Jobs Creation Act of 2004 enacted in Pub. L. 108-357, 118 Stat. 1596.

³⁰ 454 F.3d 1340 (Fed. Cir. 2006).

³¹ Alternatively, the Service argued that the non-income producing properties transferred to Shell Frontier were not "property" for purpose of section 351. The court disagreed, holding that the non-income producing properties transferred to Shell Frontier were "property" for purpose of section 351.

³² The court explained that merely shifting the contingent asbestos liability obligations among Coltec subsidiaries could not as a matter of law or logic have achieved the taxpayer's articulated purpose of protecting Coltec's core business from veil-piercing claims, because nothing precluded third party asbestos claimants from pursuing Coltec regardless of Garrison's assumed responsibility for paying potential claims. Coltec, 454 F.3d at 1359-60.

³³ 102 A.F.T.R. 2d at 2008-5113.

³⁴ 101 AFTR 2d 2008-2397, 592 F.Supp. 2d 953 (May 28, 2008).

³⁵ 454 F.3d 1340, 1354 (Fed. Cir. 2006).

³⁶ 34 T.C. Memo 1975-727.

³⁷ 71 T.C. 1 (1978), aff'd in part and rev'd on other grounds, 660 F.2d 416 (10th Cir. 1981).

³⁸ 90 T.C. 465 (1988).

³⁹ 454 F.3d at 1356.

⁴⁰ 892 Fed. Cl. at 696.

⁴¹ Id.

⁴² 82 Fed.Cl.at 697.

⁴³ 472 F.Supp. 2d 885 (2007).

⁴⁴ T.C. Memo 2000-352.

⁴⁵ T.C. Memo 1975-160.

⁴⁶ Heinz had a tax basis in the leased property of zero, which was also subject to nonrecourse debt of approximately $150 million. Heinz's transfer of the "safe harbour" leases, along with its HCC stock, prevented Heinz from recognizing gain under section 357(c) to the extent the liabilities assumed by HL exceeded Heinz's basis in the property transferred to HL.

⁴⁷H.J. Heinz Company and Subsidiaries v. U.S., supra at 583 quoting Keener v. U.S., 76 Fed. Cl. 455, 467 (2007).

⁴⁸Id. at 587.

⁴⁹ Id. at 1356 citing Basic Inc. v. U.S., 549 F.2d 740 (Ct. Cl. 1977).

⁵⁰ Id. at 1358.

⁵¹ Id. at 1359, 1360.

⁵² Id. at 1360. There is no further case history of Coltec. Coltec v. U.S., 549 U.S. 1206, cert. denied (2007).

⁵³ Rose v. Comm'r, 868 F2d 851, 853 (6th Cir. 1989).

⁵⁴ The regulation (the section 704(c) antiabuse rule) was effective for property contributed to a partnership on or after December 21, 1993. See T.D. 8500 (Dec. 21, 1993).

⁵⁵ 337 U.S. 733 (1949).

⁵⁶ 364 F.2d 734 (2d Cir. 1966).

⁵⁷ In particular, the costs included legal fees of $1 million, the B&B fee of $1.2 million, a settlement of $1.25 million, and various internal allocations and bonuses paid. to Long Term principals.

⁵⁸ 340 F.Supp.2d 621 (D.Md. 2004).

⁵⁹ Id. at 623-624 citing N. Indiana Public Service Co. v. Comm'r, 115 F.3d 506, 512 (7th Cir. 1997); Moline Properties v. Comm'r, 319 U.S. 436, 438-439 (1943); Frank Lyon Co. v. U.S., 435 U.S. 561, 583-584 (1978).

⁶⁰ 752 F.2d 89 (4th Circ. 1985)

⁶¹ 314 F.3d 625 (D.C. Cir. 2003).

⁶² 337 U.S. 733 (1949).

⁶³ Boca Investerings, 314 F.3d 625 (D.C. Cir. 2003) (citing ASA Investerings, 201 F.3d at 512 and Saba Partnership, 273 F.3d at 1141).

⁶⁴ 83 T.C.M. 1476 (2002).

⁶⁵ Id.

⁶⁶ Id.

⁶⁷ Id.

⁶⁸ Andantech, LLC v. Comm'r, 331 F.3d 972 (D.C. Cir. 2003).

⁶⁹ ASA Investerings Partnership v. Comm'r, 201 F.3d 505 (D.C. Cir. 2000).

⁷⁰ ASA Investerings, 201 F.3d at 512-13.

⁷¹ Quintron designed, manufactured, sold, and serviced aircraft flight stimulators and other electronic equipment. Loral was a major defense contractor engaged in designing, manufacturing, selling and servicing communications and satellite equipment.

⁷² 320 F. 3d 282 (2d Cir. 2002).

⁷³ 78 T.C.M. 684 (1999).

⁷⁴ 1998-1 C.B. 334.

⁷⁵ 273 F.3d 1135 (D.C. Cir. 2001).

⁷⁶ 85 T.C.M. 817 (2003).

⁷⁷ 254 F.3d 1313 (11th Cir. 2001).

⁷⁸ Id. at 1315.

⁷⁹ Knetsch, 364 U.S. at 363 (Supreme Court held that interest on loans taken against an annuity contract was nondeductible where the annuity had no financial benefit other than its tax consequences. Knetsch mandated the use of the sham transaction doctrine for debt that generated interest sought to be deducted under section 163(a) even if the interest deduction was not prohibited by section 264).

⁸⁰ The Tax Court in Winn-Dixie applied the economic substance doctrine to disallow interest deductions generated by a broad based leveraged COLI plan. See In Re CM Holdings, Inc., 254 B.R. 578 (2000). In this case, taxpayer purchased COLI policies on the lives of its employees, taking out large policy loans to pay the first three annual premiums and claiming interest deductions attributable to these loans. The court concluded that the interest deductions should be disallowed for two reasons. First, they should be disallowed because they were created as part of a transaction that was partially a factual sham and therefore, did not fall within the safe harbor for policy loan interest deductions of section 264. Second, the interest should not be deductible under section 163 because the deductions were created as part of a transaction that was a sham-in substance. A transaction may comply with the form requirements set forth in the Code for deductibility, but the transaction lacks the factual or economic substance that the form represents. In this scenario, expenses or losses incurred in connection with the transaction were not deductible. In considering whether the COLI plan had economic substance in this case, the court looked to the framework outlined by the third circuit in ACM Partnership: "The inquiry into whether the taxpayer's transactions had sufficient economic substance to be respected for tax purposes turns on both the "objective economic substance of the transactions" and the "subjective business motivation" behind them. However, these distinct aspects of the economic sham inquiry do not constitute discrete prongs of a "rigid two-step analysis," but rather represent related factors both of which inform the analysis of whether the transaction had sufficient economic substance, apart from its tax consequences, to be respected for tax purposes." 157 F.3d at 247. See also Casebeer v. Comm'r, 909 F.2d 1360 (9th Cir. 1990); James v. Comm'r, 899 F.2d 905 (l0th Cir. 1990); and Rose v. Comm'r, 868 F.2d 851 (6th Cir. 1989). The court in Winn-Dixie found that the only financial benefit provided to Camelot by its COLI plan, and the reason the transaction was profitable to all involved except the United States Treasury, was the tax benefit attributable to policy loan interest deductions. Moreover, Camelot tailored the elements of its COLI plan to maximize the interest deductions to the extent it expected to have taxable income to offset the deductions. The court concluded Camelot's COLI transaction lacked objective economic substance and a subjective business purpose apart from the interest deductions. As a consequence, all the interest deductions generated by the plan were disallowed as the product of a sham transaction. See also, American Electric Power, Inc. v. U.S., 136 F.Supp. 2d 762 (SD Ohio, 2001), aff'd, 326 F.3d 737 (6th Cir. 2003), cert. denied, January 12, 2004. Through a preplanned, highly structured and calibrated combination of features, taxpayer's leveraged COLI plan was designed to produce positive cash flows in each and every plan year using the tax benefits of the deductibility of policy loan interest, deferral of taxation of inside buildup, and non-taxation of death benefits to transform paper losses into positive earnings and to generate substantial positive cash flows totaling over half a billion dollars at the end of twenty years. The COLI plan in this case was remarkably similar to the transaction in Knetsch. Both cases included first-day, first-year loans, which paid for all but a small percentage of the total premium and generated substantial interest deductions. There was a pattern of annual borrowings, which consumed nearly all the equity in the annuity bonds and produced even more tax-deductible interest expense. The potential economic benefit of the annuity bonds was wiped out by the borrowings. The only real benefit was the tax deductions. The district court found the COLI plan as a whole was a sham in substance, and disallowed the interest deductions on the policy loans under section 264.

⁸¹ Winn-Dixie, 254 F.3d at 1316. See also, UPS, 254 F.3d 1014; Kirchman v. Comm'r, 862 F.2d 1486 (11th Cir. 1989).

⁸² Id.

⁸³ Id. at 1317.

⁸⁴ IES Industries, 253 F.3d at 352-353.

⁸⁵ 253 F.3d at 353.

⁸⁶ Id. at 354.

⁸⁷ Id. at 355.

⁸⁸ Merrill Lynch also indicated that this was a package deal in which Merrill would perform various duties including: (i) locating the foreign partner; (ii) arranging for the issuance and sale of the PPNs and LIBOR notes; and (iii) serving as the partnership's financial advisor. AlliedSignal was informed that the proposed strategy would involve approximately $12 million in transaction costs, which included Merrill's transaction and product fees of approximately $9 million and payments to the foreign partner for its participation based on the greater of approximately $3 million or 75 basis points on funds advanced to the partnership. In addition, AlliedSignal was required to pay all of the partnership's expenses.

⁸⁹ 337 U.S. 733 (1949).

⁹⁰ 76 T.C.M. 325 (1998).

⁹¹ 74 T.C. 476 (1980).

⁹² 76 T.C.M. 325 (1998).

⁹³ 201 F.3d 505 (D.C. Cir. 2000).

⁹⁴ ASA Investerings, 201 F.3d at 507-508.

⁹⁵ Moline Properties, 319 U.S. 436 (1943).

⁹⁶ ASA Investerings, 201 F.3d at 512.

⁹⁷ See, e.g., Knetsch, Zmuda v. Comm'r, 731 F.2d 1417 (9th Cir. 1984).

⁹⁸ ASA Investerings, 201 F.3d at 513.

⁹⁹ Newman v. Comm'r, 56 T.C.M. 748 (1988).

¹⁰⁰ 894 F.2d at 562.

¹⁰¹ 894 F.2d at 563.

¹⁰² Id. (citing Frank Lyon v. United States, 435 U.S. 561, 583-84 (1978)).

¹⁰³ Id. at 909 (citing Sochin v. Comm'r, 843 F.2d 351, 354 (9th Cir. 1988).

¹⁰⁴ 899 F.2d at 910.

¹⁰⁵ Pursuant to the repurchase agreement, GDSII sold the T-bill to the repo lender for an amount of cash used to fund the bulk of the purchase price of the T-bill (or, in an intermediate repo transaction, used to satisfy the taxpayer's obligation to repurchase the T-bills under a preceding repo transaction), and agreed to repurchase the T-bill from the repo lender at a price equal to the price received from the repo lender plus interest calculated at a rate that exceeded the rate born by the T-bill. In each instance, the price paid by the repo lender for the T-bill was less than the market value of the T-bill, with that discount being based on several factors, including the nature of the underlying security, the extent of the market in the security, and the creditworthiness of the repo borrower.

¹⁰⁶ In the case of six of those transactions, interim repo transactions actually reduced the overall economic loss by charging interest rates that were slightly below the T-bill yields.

¹⁰⁷ The Tax Court majority was clearly troubled by the taxpayer's entering into repos to maturity in lieu of selling the T-bills at prices that would have generated an economic profit. "Instead of entering into the four repos to maturity which exacerbated its losses, GDSII could have sold purchased T-bills upon the expiration of initial or intermediate repos. Petitioners' explanations for GDSII's failure to sell a single T-bill prior to maturity are wholly unpersuasive. In their reply brief, they argue (1) that "Wall Street Journal prices are not necessarily reflective of the prices at which a dealer can execute a transaction," (2) that "different dealers may have access to different information," and (3) that "quotations * * * do not take into account intra-day interest rate changes." Essentially, all three justifications amount to a claim by petitioners that GDSII lacked access to market information and, could not determine whether it made sense to sell T-bills rather than enter into unfavorable repos to maturity. We reject petitioners' explanations as having no merit. Dr. Meiselman reported that T-bills appreciated throughout December 1981, reflecting a demand generated by the tax advantages of earning income in one year and recognizing the income in a subsequent year. GDSII could have cut its losses or even profited by selling T-bills. Its decision to refinance, in four instances, betrayed an exclusive concern for tax benefits, i.e., a willingness to intentionally incur losses in order to defer the reporting of interest income until 1982 under section 454(b) by not selling the T-bills." 94 T.C. at 764-765.

¹⁰⁸ 499 U.S. at 567-568.

¹⁰⁹ 990 F.2d at 898 (citing Rose v. Comm'r, 868 F.2d 851,853 (6th Cir. 1989); Mahoney v. Comm'r, 808 F.2d 1219, 1220 (6th Cir. 1987)).

¹¹⁰ Id.

¹¹¹ Id.

¹¹² 990 F.2d at 901.

¹¹³ 490 F.2d 241 (2d Cir. 1973).

¹¹⁴ 63 T.C. 778 (1975).

¹¹⁵ See Sacks v. Comm'r, 64 T.C.M. 1003 (1992).

¹¹⁶ 69 F.3d at 991 (citations omitted).

¹¹⁷ 69 F.3d at 992.

¹¹⁸ ACM Partnership, 73 T.C.M. at 2191.

¹¹⁹ See Richard M. Lipton, "Tax Opinions for Corporate Tax Shelters," 148 J. TAX'N 331, 334 (1997).

¹²⁰ ACM Partnership, 73 T.C.M. at 2191.

¹²¹ Temp. Treas. Reg. § 15A.453-1(c)(3)(i).

¹²² See, also, Treas. Reg. § 1.701-2(d), Example 7.

¹²³ ACM Partnership, 73 T.C.M. at 2191.

¹²⁴ Id. at 2192.

¹²⁵ ACM Partnership, 157 F.3d at 250 and n. 35.

¹²⁶ In several transactions in December 1989, proceeds of the sale were used to purchase outstanding Colgate debt.

¹²⁷ Id. at 248.

¹²⁸ Id.

¹²⁹ Id. at 250.

¹³⁰ Id. at 252.

¹³¹ Because the court viewed the case as an assignment of income case, it did not reach the issue of whether an allocation must be made under sections 482 or 845.

¹³² Id. at 265.

¹³³ Id. at 268.

¹³⁴ 254 F.3d 1014 (11th Cir. 2001).

¹³⁵ Id. at 1017.

¹³⁶ Id. at 1019.

¹³⁷ Id.

¹³⁸ Id. at 1020.

¹³⁹ Compaq was decided prior to the enactment of section 901(k), imposing a minimum holding period for withholding tax on dividends with respect to stock.

¹⁴⁰ In 1992, Compaq sold its stock holdings in another computer company and recognized long-term gain of $231 million.

¹⁴¹ An American Depository Receipt, or ADR, is a trading unit issued by a trust, which represents ownership of stock in a foreign corporation that is held by the trust. On the U.S. stock exchanges, ADRs are the customary form of public trading of equity interests in foreign corporations.

¹⁴² UPS, 78 T.C.M. 262.

¹⁴³ See Notice 98-5, I.R.B. 1998-3, 49 (Jan. 19, 1998), generally to the same effect.

¹⁴⁴ 277 F.3d 778 (5th Cir. 2001).

¹⁴⁵ Other circuits have reached the same conclusion. See, Rice's Toyota World v. Comm'r, 752 F.2d 89 (4th Cir. 1985); Frank Lyon Co. v. U.S., 435 U.S. 561 (1978); ACM Partnership v. Comm'r, 157 F.3d 231 (3d Cir. 1998); and James v. Comm'r, 899 F.2d 905 (l0th Cir. 1990).

¹⁴⁶ Rice's Toyota World, Inc. v. Comm'r, 81 T.C. 184 (1983).

¹⁴⁷ Id. at 200-210.

¹⁴⁸ Id. at 207, 210.

¹⁴⁹ 752 F.2d at 91 (citing Rice's Toyota World, 81 T.C. at 209 (1983)).

¹⁵⁰ Id. at 93.

¹⁵¹ Id. at 651-652.

¹⁵² Southern Star was a management company that operated three cattle ranches in Florida, Kansas, and Missouri, respectively.

¹⁵³ 89 T.C. at 992.

¹⁵⁴ 89 T.C. at 993.

¹⁵⁵ 89 T.C. at 994.

¹⁵⁶ 89 T.C. at 993.

¹⁵⁷ See 89 T.C. at 997.

¹⁵⁸ 89 T.C. at 998.

¹⁵⁹ 843 F.2d at 353 (citing Enrichi v. Comm'r, 813 F.2d 293, 295 (9th Cir. 1987) and Mahoney v. Comm'r, 808 F.2d 1219, 1220 (6th Cir. 1987)).

¹⁶⁰ Bail Bonds By Marvin Nelson, Inc. v. Comm'r, 820 F.2d 1543, 1549 (9th Cir. 1987).

¹⁶¹ 843 F.2d at 354.

¹⁶² Id.

¹⁶³ Id.

¹⁶⁴ The Seventh Circuit, citing Gregory v. Helvering, 293 U.S. 465 (1935), stated that there is no rule against taking advantage of opportunities created by Congress or the Treasury Department for minimizing taxes.

¹⁶⁵ The Seventh Circuit relied on the interpretation of the term "for profit" in Miller v. Comm'r, 836 F.2d 1274 (10th Cir. 1988), which required that the non-tax profit motive predominate the purpose of the transaction.

¹⁶⁶ See Glass v. Comm'r, 87 T.C. 1087 (1986).

¹⁶⁷ Id. at 1163.

¹⁶⁸ 862 F.2d at 1491 (citing Frank Lyon Co. v. United States, 435 U.S. 561 (1978); Knetsch v. United States, 364 U.S. 361 (1960); Comm'r v. Court Holding Co., 324 U.S. 331 (1945); and Gregory v. Helvering, 293 U.S. 465 (1935)).

¹⁶⁹ 862 F.2d at 1493.

¹⁷⁰ A reproduction master is a photo screen negative used to produce an image but does not include the original work of art created by the artist.

¹⁷¹ 868 F.2d at 853.

¹⁷² 435 U.S. at 580. See also Comm'r v. Brown, 380 U.S. 563, 579-580 (1965).

¹⁷³ 435 U.S. at 583-84.