Partnership Argues Claims Court Erred in Upholding FPAAs Disallowing Losses From Short Sales

1. The full name of every party or amicus represented by me is:

Marriott International Resorts, LP., and Marriott International JBS Corporation

2. The name of the real party in interest (if the party named in the caption is not the real party in interest) represented by me is:

None. (The parties named in the caption are the real parties in interest.)

3. All parent corporations and any publicly held companies that own 10 percent or more of the stock of the party or amicus curiae represented by me are:

Marriott International, Inc.

4. ___ There is no such corporation as listed in paragraph 3.

5. The names of all law firms and the partners or associates that appeared for the party or amicus now represented by me in the trial court or agency or are expected to appear in this court are:

Crowell & Moring LLP; Harold J. Heltzer, Robert L. Willmore, Howard M. Weinman, and Alex E. Sadler

December 29, 2008

The following cases currently before this Court may be affected by this Court's decision herein: Jade Trading, LLC v. United States, Docket No. 2008-5045; and Stobie Creek Investments, LLC v. United States, Docket No. 2008-5190. As discussed in Appellants' Argument below, Jade Trading and Stobie Creek also involve the question of whether a contingent obligation can constitute a "liability" within the meaning of section 752 of the Internal Revenue Code.

On October 24, 2008, Appellants timely filed their Notice of Appeal. Fed. R. App. P. 4(a)(1)(B). Jurisdiction over such appeal is conferred on this Court by 28 U.S.C. § 1295(a)(3).

In order to free up the capital tied up in these financing arrangements so that it would have the funds to develop more resort properties, MORI sold these Mortgage Notes to third parties. A37, A370-71. During the years in question, it accomplished such sales by accumulating and then securitizing the Mortgage Notes into portfolios which could be sold.¹ A37, A515. So as to obtain the highest possible credit rating, and thereby the highest possible price, for a securitized portfolio of Mortgage Notes, the Mortgage Notes were transferred to and sold by a bankruptcy-remote entity. A515-16, A330-32. The purpose of using such an entity as part of the sale was to protect the purchaser of the Mortgage Notes in the event that MORI were to become insolvent. A365-66, A395-96. In 1994, that bankruptcy-remote entity was Marriott International Resorts, L.P. ("MIR"), the partnership in these actions. A515-16, A330-32.

The securitized portfolios of Mortgage Notes at issue here were sold to Teachers Insurance and Annuity Association of America ("TIAA"). A.433-34, A515. The sales were priced to provide TIAA with a yield of 240 basis points (that is, a 2.4% spread) above average yields on U.S. Treasury securities adjusted to a constant maturity of four years. A515, A345, A144. As a consequence, in order for TIAA to receive the agreed upon yield, the amount that would be paid by TIAA for the Mortgage Notes would fall if interest rates rose between the time the Mortgage Notes were originally issued and the time of their ultimate sale to TIAA. A515, A329-32, A345-46.

In late 1993, Marriott was spun off from its former parent, Marriott Corporation. A516. During 1994, while the new Marriott was determining its financial policies, it decided to hold onto the Mortgage Notes, which were earning an attractive rate of interest. A516, A345, A370-73, A380-82, A393-94, A397. Marriott was concerned, however, that, during the period that it was holding the Mortgage Notes, an increase in interest rates could result in Marriott receiving substantially less for those Mortgage Notes when they were ultimately sold to TIAA. A515, A330-32, A345-46.

Early in 1994, one of Marriott's financial advisers, CS First Boston ("CSFB"), provided tax planning advice to Marriott that included a description of a hypothetical transaction involving a short sale of U.S. Treasury securities. A517, A334, A368-69, A374-79. While Marriott did not engage in the hypothetical transaction described in the CSFB materials (A517, A334, A368-69, A374-79),² it learned through its discussions with CSFB that one way in which it could reduce the interest-rate risk of holding the Mortgage Notes until their sale to TIAA was through a hedge involving a short sale of U.S. Treasury securities. A517, A334, A368-69, A374-79. Marriott also learned that such a short sale hedge could provide significant tax benefits. A517, A334, A368-69, A374-79.

In late April of 1994, authorization was obtained from Marriott's Corporate Growth Committee to implement an interest rate hedge using a U.S. Treasury Note short sale with respect to the amount of MORI Mortgage Notes that had been accumulated as of that time (approximately $65 million). A516, A345-48, A350. Authorization was also obtained for additional possible short sale hedges as MORI accumulated additional Mortgage Notes, though in no event would the aggregate amount of short sales exceed MORI'S actual mortgage exposure. A516-17, A346-47.

On or about April 25, 1994, MORI sold short ("First Short Sale") U.S. Treasury Notes with a face amount of $65,000,000, for which it received $63,703,816. A437, A39. As noted, the size of the First Short Sale reflected the amount of Mortgage Notes that MORI had already accumulated. A516-17, A345-48. The proceeds were invested in repurchase obligations ("Repos") that adjusted to the prevailing 30-day LIBOR rate. A437, A39.³

As discussed above, MIR was established as the bankruptcy-remote entity required for the sale of the securitized portfolios of Mortgage Notes to TIAA. A515-16. MIR had two partners: Marriott International JBS Corporation ("JBS"), a 1% general partner (and MIR's tax matters partner), and MORI, a 99% limited partner. A432-33, A437. On or about May 6, 1994, MORI contributed to MIR (1) Mortgage Notes with a face amount of approximately $65,200,000, and (2) the Repos purchased with the proceeds from the sale of the shorted Treasury securities. A438. MIR, in turn, assumed MORI'S obligation to close the First Short Sale by eventually purchasing replacement securities and returning them to the lender of the securities. A438. JBS contributed $1,000,000 to MIR. A438, A39.

Subsequently, MORI accumulated additional Mortgage Notes for sale to TIAA. On or about August 15, 1994, MORI sold short ("Second Short Sale") U.S. Treasury Notes with a face amount of $10,000,000, for which it received $9,463,451 in proceeds that MORI also invested in Repos. A438, A39. On August 16, 1994, MORI contributed to MIR (1) Mortgage Notes with a face amount of approximately $11,900,000, and (2) the proceeds from the Second Short Sale. A439. As with the First Short Sale, MIR assumed MORI'S obligation to close the Second Short Sale. A439, A39.

Five months after the First Short Sale (on September 29, 1994), MIR closed the First Short Sale by purchasing replacement U.S. Treasury Notes with a face amount of $65,000,000 at a cost of $62,667,034. A439-40, A40. Two months after the Second Short Sale (on October 17, 1994), MIR closed the Second Short Sale by purchasing replacement U.S. Treasury Notes with a face amount of $10,000,000 at a cost of $9,279,811. A439-40, A40.

As Marriott had anticipated, interest rates in fact rose during the time period that the short sales were open. A517, A350, A364, A380-82. The two short sales accomplished their hedging purpose; that is, the gain from the short sales offset the reduction in the sales price of the Mortgage Notes that resulted from the increase in interest rates. A517, A350.

On October 28, 1994, MORI transferred its partnership interest in MIR to an existing Marriott subsidiary, Marriott International Capital Corporation ("MICC"). A440, A40. This resulted in a technical termination, and subsequent reconstitution, of the MIR partnership for Federal income tax purposes. A440, A41. Consistent with the then prevailing position of the IRS and with various court decisions holding that contingent obligations did not constitute partnership "liabilities" under Section 752, MORI'S basis for its interest in MIR reflected the basis of the contributed Mortgage Notes and Repos, but was not reduced by MIR's obligation to close the short sales. In the termination, the basis of MORI (and then MICC) for the MIR partnership interest was transferred to MIR's assets, the Mortgage Notes. A41-42, A441-42. Since this basis was higher than the fair market value of the Mortgage Notes, MIR recognized a loss on the sale of the Mortgage Notes to TIAA in November 1994. This loss was reflected in Marriott's 1994 consolidated Federal income tax return. A42-43, A442.

On February 2, 2001, the IRS issued two Notices of Final Partnership Administrative Adjustment ("FPAA") with respect to the above transactions.⁴ A47-51, A66-72. The FPAAs disallowed the loss reflected on Marriott's consolidated return on the ground, among others,⁵ that the obligation assumed by MIR to close the short sales by purchasing the replacement U.S. Treasury Notes and returning them to the lender of those notes was a "liability" within the meaning of Section 752. A47-51, A66-72. With respect to the first short tax year, the pertinent FPAA had the effect of reducing the partners' basis in the MIR partnership by $75 million. A47-51. With respect to the second short tax year, the pertinent FPAA had the effect of decreasing the tax basis of the Mortgage Notes sold to TIAA by approximately $73 million. A66-72.

On April 30, 2001, Appellants filed two Complaints in the Court of Federal Claims (the "trial court") -- one with respect to each short tax year -- asking the court to redetermine the adjustments proposed in the two FPAAs. A35-51, A52-72. The cases were consolidated, and, after discovery was completed, the parties filed cross-motions for summary judgment with respect (and only with respect) to the question of whether the obligation to close a short sale was a "liability" within the meaning of Section 752 in 1994, the year in which all the transactions in question occurred. For the reasons set forth in its Opinion and Order of August 28, 2008 (Marriott Int'l Resorts, L.P. v. United States, 83 Fed. Cl. 291), the trial court granted the Government's motion for summary judgment and denied Appellants' cross-motion for partial summary judgment. Judgment in favor of the Government was entered on the same day, and Appellants' Complaints were dismissed. Appellants timely filed their Notice of Appeal on October 24, 2008.

It also is clear that the obligation to close a short sale by purchasing the replacement securities and delivering those securities to the securities lender is by its very nature a contingent obligation. This is because the cost of closing the short sale, and even whether the short sale generates a profit or loss, cannot be determined until the replacement securities are purchased. Indeed, in addition to the price of the replacement securities, there are many other contingencies involved in short selling, including that the short seller may be forced to close the short sale prematurely because he cannot meet additional margin requirements as the price of the shorted securities increases. There are also instances where short sales have never been closed for a variety of reasons. These contingencies are described in an expert report submitted by Marriott during the summary judgment briefing.

Although the law was clear in 1994 that the obligation to close a short sale is a contingent obligation, and thus not a liability under Section 752, the trial court came to a contrary holding. It based its ruling on two conclusions, both of which are incorrect. First, it cited the Federal Reserve Board's Regulation T, which regulates short sale transactions. 12 C.F.R. Part 220 (1994). Specifically, the trial court found it significant that Regulation T requires the broker-dealer which lends the shorted securities to maintain collateral to protect itself in the event the short seller is unable to return the replacement securities. Second, the court cited a 1988 revenue ruling (Rev. Rul. 88-77, 1988-2 C.B. 128) which it believed placed Marriott on "indirect notice" in 1994 that the obligation to close a short sale was a Section 752 liability because the incurrence of the short sale obligation creates basis in property.⁶

With respect to the significance of the collateral required by Regulation T, the trial court was simply wrong in concluding that the existence of collateral changes a clearly contingent obligation into a fixed and certain obligation. To the contrary, the collateral has no effect whatsoever on the contingent nature of a short sale transaction because, whether or not the short sale is collateralized, the cost of closing the short sale cannot be known before the short sale is closed. Moreover, the amount of required collateral is not fixed and certain, but fluctuates as the price of the shorted securities fluctuates.

With respect to Rev. Rul. 88-77, the trial court did not understand the genesis or purpose of the ruling, which had absolutely nothing to do with either short sales or contingent obligations. Rather, Rev. Rul. 88-77 was issued by the IRS to address an entirely different issue involving the treatment of accounts payable of a cash basis partnership, which are fixed obligations unrelated to short sales. The trial court, however, read Rev. Rul. 88-77 much more broadly as mandating that the concept of a "liability" under Section 752 be construed in such a fashion as to maintain symmetry between outside basis (the basis of the partners in their partnership interests) and inside basis (the basis of the partnership in its assets). Applying this broad construction of Rev. Rul. 88-77, the trial court concluded that Marriott had "indirect notice" in 1994 that the obligation to close a short sale would be treated as a Section 752 liability in order to maintain this symmetry between outside and inside basis.

There are, however, a number of serious problems with the trial court's analysis and application of Rev. Rul. 88-77, beside the fact that it is unsupported by the genesis and purpose of the ruling. First, the trial court's conclusion that Rev. Rul. 88-77 trumps Helmer and its progeny cannot be reconciled with two recent decisions by the Court of Federal Claims (see Jade Trading, infra; Stobie Creek, infra), as well as several recent decisions of U.S. District Courts (see Klamath, infra; Cemco, infra; Sala, infra), all of which continue to recognize the validity of the Tax Court trilogy and the principle that contingent obligations are not Sections 752 liabilities. In other words, if the trial court is right in its broad reading of Rev. Rul. 88-77 and the need for basis symmetry, two judges of the Court of Federal Claims and three U.S. District Judges are mistaken in their interpretation of Section 752.

Second, the IRS itself concluded that it needed a regulation in 2003 to define the term "liability" under Section 752 to include certain contingent obligations, including obligations involving short sales. In its Rulemaking Notice for those regulations, the IRS specifically observed that this definition did not follow Helmer. Again, if the trial court were right regarding the significance of Rev. Rul. 88-77, and the overarching requirement of basis symmetry, there would have been no need for that regulation, and Helmer would have been a moot consideration.

Third, internal IRS documents from 1995 produced by the Government in this case show that the IRS was well aware in 1995 that Rev. Rul. 95-26⁷ was contrary to the then well understood principle that contingent obligations are not Section 752 liabilities. However, despite its misgivings that it was being asked to "cram through [a] result," and that "it [was] not an entirely clean way of doing it," the IRS issued the ruling at the Treasury Department's specific urging. Nevertheless, because of Helmer, the IRS concluded it could not include options in the scope of the ruling even though it fully recognized that "options and short sales have a lot in common."

Fourth, despite the trial court's view regarding the importance of basis symmetry, the Government is perfectly comfortable in taking positions which result in inside/outside basis asymmetry so long as such asymmetry is to the Government's advantage. Indeed, the district court in Klamath, infra, in rejecting the same argument by the Government, noted that the Government consistently took the position that a contingent obligation was not a Section 752 liability, notwithstanding any resulting basis asymmetry, as long as it benefited the Government.

Fifth, notwithstanding the trial court's views, asymmetry between outside and inside partnership basis occurs routinely, and is certainly no reason for rejecting a well established and widely applied rule that contingent obligations are not Section 752 liabilities.

Finally, the trial court's ruling creates an asymmetry between the treatment of short sales under Section 752 and I.R.C. § 1233. Under the latter Code provision, a short sale is considered an open transaction for income tax purposes until the short sale is closed. In other words, under I.R.C. § 1233, the short seller cannot recognize any gain or loss until the replacement security has been purchased and returned to the security lender. Short sales are treated in this fashion for income tax purposes precisely because they are contingent transactions. While the trial court stated that it did not find I.R.C. § 1233 "controlling," the indisputable fact of the matter is that the trial court's holding creates a significant disparity between the treatment of short sales under two different sections of the Code. This is both unnecessary, and violates the well established principle that "the tax laws must be interpreted and applied as uniformly as possible." Bunce v. United States, 28 Fed. Cl. 500, 508 (1993).

A. In A Series Of Pre-1994 Tax Court Decisions, The IRS Prevailed In Its Position That Contingent Obligations Are Not "Liabilities" For Purposes Of Section 752.

Section 752 is part of subchapter K of the Code, which governs the income taxation of partners and partnerships. The section provides for adjustments to the tax basis of a partner's interest in a partnership resulting from the assumption of a liability from the partnership or contribution of a liability to the partnership, as follows:

For decades, the IRS consistently took the position that the term "liability" for partnership tax purposes refers only to the fixed and certain obligations of a partnership, such as indebtedness. In contrast to a fixed obligation, it was the IRS's longstanding position that a contingent obligation -- that is, where the fact or amount of the taxpayer's obligation was not fixed -- is not a liability under Section 752.

The IRS's refusal to recognize contingent obligations as partnership liabilities was predicated in large part on the so-called "all-events test," a fundamental tenet of tax accounting under which an expense cannot be deducted from income until all events have occurred fixing the fact and amount of liability. The all-events test thus determines the year in which income and deductions may be taken into account by taxpayers who use the accrual method of accounting. Under that test, a fixed liability does not exist for income tax purposes until the fact of liability is established and the amount is determinable with reasonable accuracy.⁹

The IRS's position on what type of obligation can constitute a liability for purposes of Section 752 invariably worked to the detriment of taxpayers, in that it prevented taxpayers from taking a contingent obligation as an expense against the partnership's taxable income or recognizing the obligation as a liability for partnership tax purposes. The IRS successfully and repeatedly maintained this position in tax disputes before the U.S. Tax Court and other tribunals.

The seminal case is Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975), in which the IRS prevailed on its position that a contingent obligation was not a partnership liability under Section 752. There, a partnership received a cash option premium for granting a call option to a third party, and then distributed the premium to its partners in the same year even though the option had neither been exercised nor expired. The IRS successfully contended that the outside basis should not be increased to reflect the partnership's receipt of the option premium because no Section 752 "liability" existed, even though the inside basis had been increased by the amount of the premium. The Tax Court agreed with the IRS's position in Helmer, notwithstanding the obvious resulting asymmetry between inside and outside basis. Id. at 730-31.¹⁰

Another pertinent case is Long v. Commissioner, 71 T.C. 1 (1978), aff'd in part and rev'd in part, 660 F.2d 416 (10th Cir. 1981), which dealt with an estate's recognition of taxable gain on the liquidation of the decedent's partnership interest. The question there turned on whether certain claims against the partnership in litigation could be considered "liabilities" includable in the estate's outside basis under Section 752. Because these claims had been in litigation at the time of the decedent's death, the Tax Court held that the claims were not sufficiently definite to be treated as liabilities that could be included in the decedent's outside basis. The Tax Court reasoned: "Although they may be considered 'liabilities' in the generic sense of the term, contingent or contested liabilities . . . are not 'liabilities' for partnership basis purposes at least until they have become fixed or liquidated. . . .Those liabilities should be taken into account only when they are fixed or paid." 71 T.C. at 7-8.¹¹

The decision most directly on point is La Rue v, Commissioner, 90 T.C. 465 (1988), in that the obligations in that case were the economic equivalent of the short sale obligations at issue here. In La Rue, the Tax Court addressed whether reserves reflecting certain "back office" errors of a brokerage partnership were liabilities that could be included in the outside basis of its partners' interests upon the acquisition of their interests by a third party. These back office errors included the brokerage's failure to execute numerous trade orders by purchasing securities for its customers. The brokerage's resulting obligation was identical to that of closing a short sale, i.e., definite securities had to be purchased and delivered by the brokerage to its customers. The partners contended that the reserve established for these back office errors was a Section 752 liability that increased their outside bases. Id. at 477-78.

The Tax Court accepted the IRS's argument that the partnership's obligations to purchase and deliver securities for its customers were not Section 752 liabilities. Citing its opinion in Long, the Tax Court held that the all-events test determines when a liability is includable in basis under Section 752. Id. at 478. Under that test, a liability can only be included in basis "for the taxable year in which all the events have occurred which determine the fact of liability and the amount thereof can be determined with reasonable accuracy." Id. The Tax Court concluded that, even though the partnership had a legal obligation to remedy the back office errors (establishing the fact of liability), the all-events test was not satisfied because the amount of the liabilities was not determinable with reasonable accuracy "until the securities are actually purchased . . . and the transaction closed." Id. at 479. As the Tax Court explained:

B. The IRS's Position That Contingent Obligations Are Not Section 752 "Liabilities" Has Been Reaffirmed By The Court Of Federal Claims And Several U.S. District Courts.

The holding of these Tax Court cases (often referred to as Helmer and its progeny) that contingent obligations do not constitute Section 752 liabilities has been reaffirmed by the Court of Federal Claims in Jade Trading, LLC v. United States, 80 Fed. Cl. 11, 44-45 (2007), and Stobie Creek Investments, LLC v. United States, 82 Fed. Cl. 636, 664-66 (2008), both of which are currently on appeal to this Court (Docket Nos. 2008-5045 and 2008-5190, respectively).

In Jade Trading, the taxpayer entered into a "spread" transaction involving offsetting options. The taxpayer contributed its purchased option to Jade Trading, which assumed the taxpayer's obligation under the sold option. The issue before the court was whether the obligation under the assumed option was a Section 752 liability. The Jade Trading court expressly rejected the Government's argument that the obligation was a Section 752 liability. Citing Helmer, Long and La Rue, the court concluded that the obligation assumed by Jade Trading was a contingent obligation and, therefore, could not be a "liability" under Section 752. Jade Trading, 80 Fed. Cl. at 44-45. The Court of Federal Claims again reached the same conclusion a few months later in Stobie Creek, 82 Fed. Cl. at 664-66, another case involving offsetting options.

In addition, at least three U.S. District Courts have read Helmer, Long and La Rue identically. See Klamath Strategic Investment Fund, LLC v. United States, 440 F. Supp.2d 608, 615-17 (E.D. Tex. 2006), appeal pending, Docket Nos. 40861, 40915 (5th Cir.); Cemco Investors, LLC v. United States, 2007-1 U.S.T.C. ¶ 50,385 at 87,973 (N.D. Ill. 2007), aff'd, 515 F.3d 749 (7th Cir. 2008);¹²Sala v. United States, 552 F. Supp.2d 1167, 1197 (D. Colo. 2008), appeal pending, Docket No. 08-1333 (10th Cir.). Significantly, the court in Klamath, in ruling against the Government on this point, held that, given that the IRS had successfully asserted in litigation for two decades that contingent obligations were not liabilities under Section 752, taxpayers "could justifiably rely on [these Section 752 cases] when making tax decisions". Klamath, 440 F. Supp.2d at 625-26.

C. In Issuing Its 2003 Proposed Regulations Defining A "Liability" Under Section 752, The Government Conceded That Contingent Obligations Had Not Previously Been Considered To Be Partnership Liabilities.

In 2003, the Treasury Department promulgated proposed regulations which included a definition of the term "liability" for purposes of Section 752. This proposed definition reversed the IRS's longstanding position regarding contingent liabilities and specifically defined the term "liability" to include certain types of contingent obligations.¹³ The discussion in the Notice of Proposed Rulemaking regarding this proposed definition of "liability" included examples of the various types of obligations covered by the proposed definition, among those being "obligations under a short sale." See Notice of Proposed Rulemaking, 68 Fed. Reg. 37,434, 37,436 (June 24, 2003). Significantly, the Rulemaking Notice, in the same paragraph, concedes that "[t]he definition of a liability contained in these proposed regulations does not follow Helmer v. Commissioner." Id. As the Court of Federal Claims observed in Stobie Creek, supra: "Treasury recognized that a definition of liability that would include contingent obligations would effect a change in the law." 82 Fed. Cl. at 667-68; see also Marriott Int'l Resorts, 83 Fed. Cl. at 303 ("By promulgating the regulation, the government intended to change the law governing liabilities under Section 752. . . .").

In sum, any taxpayer reviewing the case law in 1994 would have arrived at one, and only one, conclusion; that being, that contingent obligations are not "liabilities" under Section 752.¹⁴

A short sale is a sale of a security that the seller must borrow in order to deliver. The short seller, in turn, has an executory obligation to return the borrowed security to the lender at an unspecified point in the future. Short sales can be done for speculative reasons (i.e., where the short seller expects the value of the security to decline) or, as was the case here, to hedge the risk that the value of an asset held by the short seller will decline.

A short sale is recognized to be a contingent obligation and treated as such for Federal income tax purposes. The obligation to close a short sale by purchasing the replacement security for delivery to the lender is by its very nature a contingent obligation because the timing and amount of a short sale obligation are not determinable until the borrowed securities are actually returned to the securities lender. Indeed, in some cases there is no need to close a short sale, which may remain open indefinitely. As discussed in section V, infra, because the short seller's gain or loss cannot be determined until the short sale is closed, the Code and Treasury Regulations treat short sales as tax-deferred "open" transactions that do not give rise to taxable income or loss until the short sale is closed. See I.R.C. § 1233; Treas. Reg. § 1.1233-1(a)(1) (2008).

With respect to the contingent nature of short sales, as part of its summary judgment briefing, Marriott submitted the expert witness report of Dr. Owen A. Lamont, a recognized expert on short sale transactions. In his expert report, Dr. Lamont explained the mechanics of short selling generally as well as the nature of the obligation that is created when a security is borrowed for a short sale. See A400-21.

With respect to the mechanics of short selling, Dr. Lamont describes the various steps of a short sale, including the purposes for which short sales are typically undertaken (e.g., speculation and hedging). In his report, Dr. Lamont describes the contingent nature of short selling. His opinions are succinctly set forth in his summary:

Dr. Lamont also notes that, with respect to the price risk short sellers face (i.e., the risk that the price of the security will rise), short sellers "never know exactly at what price they will cover [return the replacement security], when they will cover, or what event might force them to cover." A409-10. In that regard, the short seller does not necessarily control when he will close the short position. Since short sales are typically day-by-day, the lender can demand that the securities be returned at any point. Id. The short seller may be forced to close the short sale to the extent he cannot (or will not) post additional collateral as the value of the borrowed security rises. A411.¹⁵

In addition, there are some circumstances where a short sale is never closed or is not closed for many years. One such circumstance is where the security ceases to have value, a so-called "terminal short.". A412-13. Another circumstance is where the borrower does not want to close the short sale in order to defer recognition of capital gains, and the lender does not demand the return of the security because he is receiving income from the security's loan. In such a situation, the short sale can remain open for years. A413.

Accordingly, as the IRS recognizes in the context of determining the profit or loss a taxpayer must report from a short sale transaction, a short sale is by its very nature an open transaction until the replacement security is purchased by the short seller. Until such time, there is no profit or loss, nor can the investor determine the amount of any profit or loss. Moreover, external factors beyond the short seller's control can impact the timing of the obligation, the manner in which it is satisfied, and the ultimate profit or loss. Just as in La Rue with respect to the replacement securities the brokerage was required to purchase, no Section 752 "liability" exists because the amount of the liability cannot be determined with reasonable accuracy. La Rue, 90 T.C. at 479-80.

B. The Requirement That A Short Seller Maintain Collateral With The Securities Lender Does Not Make The Cost Of Closing The Short Sale Any Less Contingent.

In its opinion, the trial court concluded that Federal Reserve Board Regulation T, 12 C.F.R. Part 220 (1994) (Addendum Ex. E), bears on the Section 752 issue because the regulation requires that collateral be maintained with the broker-dealer while a short sale is outstanding. Typically, but not necessarily, this initial collateral includes the proceeds from the short sale plus an additional margin amount (the entire amount of the required collateral is referred to as the "margin requirement"). With respect to short sales of exempted securities -- which includes securities issued by the Federal government (such as U.S. Treasury Notes)¹⁶ -- the margin requirement is 100 percent of the current value of the security plus an additional margin required by the broker-dealer in good faith. 12 C.F.R. § 220.18(d).

The margin requirement is not "fixed," but fluctuates with the value of the shorted security subject to a "maintenance margin." This maintenance margin is not specifically addressed in Regulation T, but is established by the applicable Exchange rule, typically New York Stock Exchange Rule 431. See generally Charles F. Rechlin, Securities Credit Regulation in 22 West's Securities Law Series §§ 3:32 & 3:33 (2d ed. 2007); Steven Lofchie, Lofchie's Guide to Broker-Dealer Regulation 564-65, 569, 589, 596 (2005).¹⁷ Accordingly, the amount of collateral that the broker-dealer holds pursuant to Regulation T fluctuates with the value of the shorted security.

Contrary to the trial court's opinion, the existence of collateral -- in whatever amount -- is completely irrelevant to whether the amount of the obligation itself is contingent. For the reasons already discussed, the amount of the pertinent obligation -- that is, what it actually costs the short seller to fulfill the obligation to return the borrowed securities -- simply cannot be determined until the short seller purchases the replacement securities he must deliver to the broker-dealer in order to close the short sale. Until that event occurs, the cost of closing the short sale by definition is contingent and undetermined, and the obligation thus cannot constitute a liability for purposes of Section 752.

The requirement that the broker-dealer maintain collateral securing the short sale does not change the contingent nature of a short sale one iota; that is, it does not make the ultimate cost of closing the short sale any more fixed or certain. To the contrary, the amount of the required collateral is itself unfixed and uncertain because the margin requirement changes as the value of the shorted security changes. Hence, the dreaded "margin call," which requires the short seller to provide additional collateral as the shorted security increases in value. See Richard D. Friedman, Stalking the Squeeze: Understanding Commodities Market Manipulation, 89 Mich. L. Rev. 30, 45 n.36 (Oct. 1990) ("A genuine securities short seller . . . may hold her position as long as she is able to meet her margin calls -- indefinitely, if she has the financial wherewithal to withstand a significant rise in the price of the security.").

That the existence of collateral does not alter the contingent nature of the underlying obligation was clearly recognized by the District Court in Klamath, supra. The court there rejected the Government's argument that the existence of collateral alters the Section 752 analysis.¹⁸ In this regard, it noted that the Tax Court had arrived at essentially the same conclusion in La Rue, supra, with respect to the reserve that had been established to pay the obligation to purchase the securities needed to correct the back office trading failures. Although this reserve was the "functional equivalent" of collateral, La Rue nonetheless held that the obligation to correct those trading failures was too contingent to constitute a Section 752 liability. See Klamath, 440 F. Supp.2d at 618. Even though this discussion in Klamath and La Rue was cited by Marriott in the summary judgment briefing, the trial court did not explain why it came to a contrary conclusion regarding the significance of collateral to the Section 752 analysis.

It is unclear exactly what the trial court meant by "indirect notice." There is no such legal doctrine or term of art, and the trial court offered no explanation.¹⁹ Regardless of what was meant, however, the trial court was incorrect because Rev. Rul. 88-77 did not provide any notice, indirect or otherwise, that a short sale obligation was a Section 752 liability. As a matter of historical fact, Rev. Rul. 88-77 had nothing to do with short sale obligations or other contingent obligations, nor did it reflect any intent by the IRS to treat such obligations as partnership liabilities. Rather, Rev. Rul. 88-77 was issued for the specific purpose of clarifying that a narrow category of fixed debt obligations -- the accounts payable of cash basis partnerships -- should be excluded from the definition of a "liability."

To understand the genesis of Rev. Rul. 88-77, brief background is required. Incorporation of a sole proprietorship is generally tax-free. I.R.C. § 351. However, taxable gain is recognized to the extent that the liabilities assumed by the new corporation exceed the adjusted basis of the assets transferred to it. I.R.C. § 357(c). In the 1960s, this treatment had harsh and unintended consequences when a taxpayer incorporated his business. When a cash basis taxpayer's accounts payable (which were treated as liabilities) exceeded the basis of the assets transferred to the new corporation, he was forced to pay tax on the difference even though he had been unable to claim deductions for the accounts payable since he used the cash method. See Raich v. Commissioner, 46 T.C. 604, 610-11 (1966).

The perceived unfairness of this situation generated considerable controversy and prompted the Ninth and Second Circuits to exclude the accounts payable of cash basis taxpayers from the definition of a liability for purposes of I.R.C. § 351 reorganizations. See Thatcher v. Commissioner, 533 F.2d 1114 (9th Cir. 1976); Bongiovanni v. Commissioner, 470 F.2d 921 (2d Cir. 1972). The Tax Court followed suit in Focht v. Commissioner, reversing Raich and holding that obligations of a cash basis taxpayer were not liabilities under I.R.C. § 357(c) to the extent that their payment would have been deductible. 68 T.C. 223, 229, 237 (1977), acq., 1980-2 C.B. 1. To resolve any ambiguity, Congress codified Focht in the Revenue Act of 1978 ("1978 Act"). See Pub. L. 95-600, § 365, 92 Stat. 2854-55 (1978); S. Rep. 95-1263, 95th Cong., 1st Sess. 185 (1978) ("This provision of the bill would codify the approach taken by the Tax Court in the Focht case.").

The 1978 Act codified Focht by enacting section 357(c)(3), which provides that "a liability the payment of which . . . would give rise to a deduction" shall not be treated as a liability. I.R.C. § 357(c)(3)(A). While the 1978 Act changed the definition of a liability for purposes of I.R.C. § 351, the IRS's official interpretation of Section 752, as set forth in Rev. Rul. 60-345, 1960-2 C.B. 211, continued to treat the accounts payable of cash basis partnerships as liabilities. In the legislative history to the Deficit Reduction Act of 1984, Congress disapproved of Rev. Rul. 60-345 and directed the IRS to revoke the ruling in favor of a definition that was consistent with the treatment of liabilities under I.R.C. § 357(c). See H.R. Rep. No. 861, 98th Cong., 2d Sess. 856-57 (1984) ("The committee intends that, similar to the amendments recently made to section 357(c) (and contrary to Rev. Rul. 60-345, 1960-2 C.B. 211), these accrued but unpaid items should not be treated as partnership liabilities for purposes of section 752.").

The IRS issued Rev. Rul. 88-77 in response to this congressional mandate. The ruling's holding was narrowly tailored to address the proper treatment of the accounts payable of cash basis partnerships:

A few weeks after Rev. Rul. 88-77 was issued, the Treasury Department promulgated Temp. Treas. Reg. § 1.752-1T(g), which included a definition of "liability" virtually identical in language to Rev. Rul. 88-77. See T.D. 8237, 1989-1 C.B. 180, 192 (Dec. 30, 1988). There again was absolutely no indication that the IRS was changing its interpretation of Section 752 with respect to contingent obligations. In this regard, the preamble to the temporary regulation did not suggest in any manner that the temporary regulation was redefining the term "liability" beyond its traditional parameters, as one would expect if such a significant change had been intended. Nor did the preamble suggest that the definition was inconsistent with Helmer and its progeny.²⁰ Moreover, all references to "liability" in the preamble spoke in terms of "debt" or payments to "creditors." In short, like Rev. Rul. 88-77, the 1989 temporary regulation dealt only with Congress' mandate to exclude certain cash basis payables from the definition of liabilities under Section 752.

When the Treasury Department issued proposed regulations under Section 752 in 1991, the temporary regulation's definition of "liability" was omitted without explanation. See Notice of Proposed Rulemaking, 56 Fed. Reg. 36,704 (July 31, 1991). The 1991 proposed regulations did not revoke Rev. Rul. 88-77, which remained in effect.

Viewed in its proper historical context, it is clear that Rev. Rul. 88-77 addressed a discrete category of fixed debt obligations unrelated to short sales and did not provide "indirect notice" to any taxpayer that a short sale obligation would thereafter be treated as a liability under Section 752.²¹

When Marriott executed the relevant short sales in 1994, it understood, based on every interpretation of Section 752 since the statute's enactment forty years earlier, that a contingent obligation, such as the obligation to close a short sale, was not a partnership liability. In nevertheless extrapolating Rev. Rul. 88-77 to short sales, the trial court observed that "the intention that symmetry will apply with the partnership basis rules . . . . supplied the analytical foundation for Rev. Rul. 88-77 and provided indirect notice to Marriott that the short sales in 1994 might well not produce the tax consequences it sought." Marriott Int'l Resorts, 83 Fed. Cl. at 305. The implication is that Marriott should have understood after Rev. Rul. 88-77 that the obligation to close a short sale would be treated as a liability because the short sale proceeds increased basis in partnership assets, producing an asymmetry between inside basis and outside basis.

However, asymmetry between inside and outside basis also existed in Helmer. There, the partnership received cash proceeds (the option premiums) for undertaking an obligation. These proceeds clearly created basis inside the partnership. Unless the corresponding contingent obligations were treated as a liability (thereby increasing the partners' outside basis under Section 752(a)), asymmetry between inside and outside basis therefore necessarily resulted. In fact, it was only because of this asymmetry that there was even a tax liability. But, notwithstanding this inside/outside basis asymmetry, the IRS and the Tax Court concluded that this obligation was not a partnership liability under Section 752. Accordingly, the trial court's view that Marriott was on "indirect notice" in 1994 that a short sale obligation was a liability because it created inside/outside basis asymmetry would have required Marriott to conclude in 1994 that Helmer had been incorrectly decided by the Tax Court.

Indeed, if the trial court's reasoning regarding the significance of Rev. Rul. 88-77 and the overarching requirement of symmetry between outside and inside basis is valid, then Helmer stopped being good law in late 1988. There is no principled distinction between short sales and options which would justify one application of Rev. Rul. 88-77 for short sales and a completely different application of Rev. Rul. 88-77 for options. In fact, options are sometimes used as a mechanism for short selling. See, e.g., Frank J. Fabozzi, Short Selling: Strategies, Risks and Rewards 36 (Wiley 2004) ("Buying puts and selling calls are two ways to implement short selling in the options market."); Rodney D. Boehme, Bartley R. Danielson & Sorin M. Sorescu, Short-Sale Constraints, Differences of Opinion, and Overvaluation, 41 Journal of Financial & Quantitative Analysis 455, 462 (June 2006) (noting that investors "can use options to synthetically short a security"); Stephen Figlewski & Gwendolyn P. Webb, Options, Short Sales, And Market Completeness, 48 Journal of Finance 761, 776 (June 1993) (Investors who cannot undertake direct short sales "will buy puts and write calls as a substitute for selling a stock short directly.").²² Simply put, if Rev. Rul. 88-77 stands for the principle that the obligation to close a short sale is a partnership liability, then it logically must also stand for the same principle with respect to the options, such as the option at issue in Helmer.

Yet, as discussed in Section I above, we know that Helmer and its progeny are not bad law. To the contrary, they have continued to be recognized as good law by the Court of Federal Claims in Jade Trading, supra, and Stobie Creek, supra, as well as by the District Courts in Klamath, supra, Cemco, supra, and Sala, supra. Even the IRS, in issuing its proposed regulations in 2003 defining the term "liability" to include certain contingent obligations, acknowledged the continuing force of Helmer when it observed that its definition of "liability" did not follow Helmer.²³See section I.C., supra.

The simple fact of the matter is that the trial court's decision regarding the import of Rev. Rul. 88-77 and the importance of basis symmetry cannot be reconciled with Jade Trading, Stobie Creek, Klamath, Cemco and Sala. If the trial court is correct that Rev. Rul. 88-77 effectively overruled Helmer in those instances where the contingent obligation creates an asymmetry between outside and inside partnership basis, then the contrary decisions by those courts are all incorrect.²⁴ Marriott respectfully submits that a more reasonable conclusion is that the trial court is wrong in its belief that basis symmetry trumps the teaching of Helmer and its progeny.

B. Internal IRS Documents Show That, At The Time The IRS Changed Its Position In 1995 Regarding Short Sales And Issued Revenue Ruling 95-26, It Clearly Understood That The Obligation To Close A Short Sale Did Not Fit Within The Definition Of A "Liability" Set Forth In Revenue Ruling 88-77.

Ironically, the IRS's own internal documents are inconsistent with the trial court's view that Rev. Rul. 88-77 placed Marriott on "indirect notice" in 1994 that the obligation to close a short sale is a liability for purposes of Section 752. These documents, which were generated in the course of issuing a 1995 revenue ruling dealing specifically with the treatment of short sales under Section 752, show that the IRS clearly understood at the time that Rev. Rul. 88-77 did not apply naturally to short sale obligations. Nevertheless, at the Treasury Department's urging, the Service issued the revenue ruling -- despite misgivings that it was being asked to "cram through" a result, and that using Section 752 was not "an entirely clean way of doing it." A358.

In 1995, the year after Marriott engaged in the relevant Treasury Note short sales, the IRS issued Rev. Rul. 95-26, 1995-1 C.B. 131. In that ruling, the IRS summarily concluded that the obligation to close a short sale was a "liability" for purposes of Section 752. As support for this ruling, the Service cited Rev. Rul. 88-77. The ruling does not, however, mention Helmer, Long or La Rue, or any other case or authority addressing the proper treatment of contingent obligations under Section 752.

According to documents produced by the Government in this case, the IRS issued Rev. Rul. 95-26 in order to shut down a specific transaction (different from the transactions here) involving a short sale that the Treasury Department regarded as abusive. A353. When the IRS proposed the ruling, it understood that "the definition of a liability as stated in Rev. Rul. 88-77 may not generally be considered as including short sales." A354. However, the Treasury Department was determined to treat the obligation to close a short sale as a Section 752 "liability" to achieve the desired objective. As stated in one 1995 IRS internal document:

The IRS's internal documents also reflect the Service's understanding that, under then existing law, options were not Section 752 liabilities: "'Existing authority is contrary to a position that options create liabilities.' Helmer held that no partnership liability is created upon receipt of option payments by a partnership." A358. While acknowledging that "[o]ptions and short sales have a lot in common," A357, the IRS's apparent solution for dealing with Helmer was to "put out short sale ruling and say nothing about options." A358.²⁵

In sum, the IRS's own documents confirm that Rev. Rul. 95-26 was not a natural extension or reasoned application of Rev. Rul. 88-77, which had nothing to do with short sales or other contingent obligations. Rather, the documents reveal that the 1995 ruling was a result-oriented effort to "cram through" an interpretation of Section 752 -- at least with respect to short sales -- that diverged sharply from Helmer and other authorities without having to follow notice-and-comment rulemaking procedures.

The issuance of Rev. Rul. 95-26 in 1995 -- the year following the transactions at issue here -- was the first notice that Marriott or any other taxpayer received that the IRS had reversed course on a decades-long policy and was going to treat the contingent obligation to close a short sale as a Section 752 liability.²⁶ The trial court's conclusion that Rev. Rul. 88-77 placed Marriott on "indirect notice" in 1994 of this policy change is belied by the above discussed IRS documents which show that the IRS clearly understood in 1995 that Rev. Rul. 95-26 was a significant change in then existing law, and deliberated internally whether it needed to use rulemaking to accomplish that change.

C. The Trial Court's Analysis Is Incompatible With The Longstanding Interpretation Of Section 752 That Contingent Obligations Are Not "Liabilities," Even If Such Treatment Creates Asymmetry Between Inside And Outside Basis.

In holding that the short sale obligations at issue were partnership liabilities, the trial court reasoned that Section 752 demands symmetry between inside and outside basis. Marriott Int'l Resorts, 83 Fed. Cl. at 305-06. In that regard, the trial court observed that, if Section 752 were interpreted to permit asymmetry between inside basis and outside basis, "manipulation of basis could readily generate distortion of gain or loss." Id. at 305.

In fact, it is the IRS which changes its position regarding the importance of symmetry between outside and inside basis depending on what position maximizes tax revenue. For example, as discussed above, the IRS was perfectly comfortable with the inside/outside basis asymmetry in Helmer, supra, because asymmetry between outside and inside basis worked to the IRS's advantage there. That is, the partners were required to pay taxes on the distribution of the option premiums received by the partnership even though a corresponding obligation existed that might completely offset any gain from those premiums. To the extent the inside/outside basis asymmetry created a "distortion of gain or loss," 83 Fed. Cl. at 305, it was to overstate the taxable gain from the option transaction. That was not a particularly fair result for the partners; but it was the result the IRS advocated and the Tax Court upheld. The fact that the result was only possible by creating asymmetry between outside and inside basis was of no apparent moment to either the IRS or the Tax Court. In other words, asymmetry between inside and outside basis was perfectly acceptable to the IRS so long as it benefited the Government and not the taxpayer.

However, when the IRS was faced with transactions where the well established treatment of contingent obligations under Section 752 might benefit taxpayers, it reversed course and began arguing that Section 752 and, more broadly, subchapter K of the Code demands symmetry between inside and outside basis. The trial court erred in adopting this argument, which is incompatible with every interpretation of Section 752 through 1994. Indeed, the IRS made the identical argument in Klamath, which the District Court rejected as conflicting with prior rulings and as being plainly result-oriented:

In justifying its view that inside/outside basis symmetry should be a "strong consideration" in interpreting Section 752, 83 Fed. Cl. at 305, the trial court quoted the Tax Court's statement in Salina, supra, that "I.R.C. §§ 705 and 752 were 'intended to avoid distortions in the tax reporting of partnership items by promoting parity between a partnership's aggregate inside basis in its assets and its partners' outside basis in their partnership interests.'" Id. (quoting Salina, 80 T.C.M. (CCH) at 698). Unfortunately, this quotation from Salina -- while literally correct -- is incomplete, as is readily apparent from reviewing the partnership tax treatise which the Salina court cites for this principle. See Salina, 80 T.C.M. (CCH) at 696-97 (quoting 1 William S. McKee, William F. Nelson & Robert L. Whitmore, Federal Taxation of Partnerships and Partners § 7.01 [1] at 7-2 (3d ed. 1997) ("McKee")). That treatise explains that Section 752 promotes basis equality by adjusting partners' outside bases for liabilities, such as borrowing, that generate cash or other proceeds (thereby creating inside basis) but not taxable income (thereby having no corresponding effect on outside basis under I.R.C. § 705). See McKee, supra, ¶ 7.01[1] at 7-1 to -2 (3d. ed. 2004). However, the contingent obligations in options and short sales differ materially from borrowing in that they generate taxable income (or loss) when they are closed. Through 1994, the IRS and the Tax Court had consistently held that the outside basis consequences of such obligations were controlled by I.R.C. § 705, not Section 752, and would be determined when the transactions were closed. See, e.g., Rev. Rul. 73-301, 1973-2 C.B. 215, 216 (1973).²⁷

Furthermore, the treatise relied upon in Salina goes on to explain in detail that, notwithstanding the general preference of subchapter K for inside/outside basis equality, the IRS's treatment of a short sale obligation as a Section 752 liability is illogical (because incurring such an obligation does not increase the partnership's basis in any asset), inconsistent with Helmer and Rev. Rul. 73-301, and contradicts the Code's statutory scheme for the taxation of short sales. See McKee, supra, ¶ 7.01 [1] at 7-5 to -7 (3d. ed. 2004). The treatise concludes: "Because the tax consequences of a short sale are kept open, a short sale is like an option, which the Service has successfully argued in Helmer does not create a liability for § 752 purposes even though the basis of the optionor [ i.e., the partnership] is increased by the tax-deferred option premium." Id. at 7-7. The treatise's analysis of short sales, and not that of the trial court or the Tax Court in Salina, accurately reflects the well understood interpretation of Section 752 at the time Marriott executed its short sales in 1994.

D. Asymmetry Between Inside And Outside Basis Occurs Routinely And Is Not A Reason To Characterize A Contingent Short Sale Obligation As A Liability.

The trial court's conclusion that Section 752 requires inside/outside symmetry also ignores the reality that discrepancies between inside and outside basis occur routinely. In fact, "[t]here are a number of events that may cause this inside-outside basis equality relationship to break down." McKee, supra, ¶ 6.01 at 6-4 (3d. ed. 2004). Inside/outside basis disparities arise from such common occurrences as a partner's death (because the basis of the decedent's assets is adjusted to fair market value), the sale or exchange of a partnership interest (because the purchaser's basis is his cost, which may differ from the partnership's inside basis), and partnership distributions (because distributed property does not always retain its original basis). See generally id. Accordingly, it is not uncommon for a partner to have "an 'outside' basis in his partnership interest that may differ materially from his share of the partnership's 'inside' basis in its assets." Terence F. Cuff, Bipolar Disorder and the Section 743/755 Regulations, 812 PLI/Tax 825, 830 (2000).

In light of the many instances in which inside/outside basis asymmetries arise during the ordinary activities of a partnership, it is clear that Section 752 does not require that inside/outside basis symmetry be mechanically maintained at all times. There is nothing inherently problematic or impermissible when an inside/outside basis asymmetry arises, and the trial court erred in treating the avoidance of such asymmetry as the guiding principle in its interpretation of Section 752.

Short sales are taxed as open transactions because the manner and cost of covering the short sale are inherently contingent, and it cannot be determined with certainty whether the short seller will realize taxable gain or loss until the replacement securities are delivered. As explained by one commentator:

In light of the uncertainties inherent in a short sale obligation, I.R.C. § 1233 precludes the short seller from treating the obligation as income or loss until the short sale is closed. In addition, I.R.C. § 1233 establishes that, for income tax purposes, the securities borrowing does not create any basis. If basis were created equal to the market value of the borrowed securities or the proceeds received in the short sale, open transaction treatment would be unnecessary. Rather, "[u]nder the peculiar rules governing short sales, the 'basis' of the securities that are sold is simply not relevant to the taxation of the transaction, because the tax consequences are deferred and ultimately determined by reference to the cost of the securities that are used to repay the loan (which are not the securities that were originally sold)." McKee, supra, ¶ 7.01[1] at 7-6 to -7 (3d. ed. 2004).

Accordingly, treating the obligation to close a short sale as a Section 752 liability for partnership basis purposes is fundamentally inconsistent with its treatment as an open transaction under I.R.C. § 1233 for income tax purposes. This asymmetric and internally inconsistent treatment of short sales for partnership basis purposes and income tax purposes violates the fundamental principle that "the tax laws must be interpreted and applied as uniformly as possible." Bunce v. United States, 28 Fed. Cl. 500, 508 (1993).²⁸

The trial court found the Tax Court's decision in Salina to be "persuasive insofar as it refuses to apply the 'open transaction' principles reflected in I.R.C. § 1233 to the definition of liability in I.R.C. § 752." Marriott Int'l Resorts, 83 Fed. Cl. at 304-05. In Salina, the Tax Court had observed that it was "not convinced that the treatment of a short sale as an open transaction for income tax purposes under section 1233 is controlling with respect to the proper treatment of the transaction for purposes of the partnership basis adjustment provisions contained in subchapter K." 80 T.C.M. (CCH) at 698. However, while it may be true that I.R.C. § 1233 does not control Section 752, the fact remains that the reason short sales are treated as tax-deferred open transactions for income tax purposes under I.R.C. § 1233 is that the timing, manner and cost of closing the short sale are contingent on external factors. These are the very same considerations that led the IRS and Tax Court to conclude that the contingent obligations at issue in Helmer, Long and La Rue were not partnership liabilities under Section 752. Thus, when Marriott's short sales were executed, Section 752 had been interpreted and administered consistently with I.R.C. § 1233, in that the outside basis consequences of contingent obligations were, like their income tax consequences, deferred until the contingencies were removed. Through 1994, the IRS strove to achieve symmetry in the tax treatment of contingent obligations, even if it created asymmetry between inside and outside basis in a particular case. The contrary result urged by the Government in this case -- symmetry in basis but asymmetry in tax treatment -- reflects the IRS's efforts, beginning after the tax years at issue here, to change this longstanding interpretation of Section 752.

²The steps of this hypothetical transaction are described in the trial court's opinion at 83 Fed. Cl. 294. Marriott, however, never engaged in this hypothetical transaction, a point it repeatedly made in the course of the summary judgment briefing. See A430-31, A275.

³That is, the interest rate on the Repos reset every 30 days. A437. As a result, unlike the Mortgage Notes whose value fluctuated with prevailing interest rates, the Repos had a constant value.

⁴ Since MIR had terminated on October 28, 1994, for Federal income tax purposes, there were two short tax years at issue for the partnership: the first from January 1 through October 28, 1994, and the second from October 29 through December 30, 1994. The IRS issued a separate FPAA with respect to each short tax year. A47-51, A66-72.

⁵ The other grounds were not addressed in the parties' cross-motions for summary judgment and are not at issue in this appeal.

⁶ The borrowing of the shorted security obviously does not create basis. Rather, the basis is in the proceeds obtained if and when the shorted securities are sold.

⁷ In that 1995 ruling, the IRS for first time took the position that the obligation to close a short sale is a "liability" for purposes of Section 752.

⁸ A partner's basis for his partnership interest is commonly referred to as "outside basis," and the partnership's basis for its assets is commonly referred to as "inside basis."

⁹ The all-events test is set forth in Treas. Reg. § 1.461-1(a)(2)(i) (2008), which provides in pertinent part: "Under an accrual method of accounting, a liability . . . is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability."

¹⁰ The IRS's position in Helmer was similar to its interpretation of Section 752 in Rev. Rul. 73-301, 1973-2 C.B. 215 (discussed at 52 n.27, infra), which involved a partnership's distribution of advance progress payments from a long-term construction contract. Rev. Rul. 73-301 was preceded by a 1968 General Counsel Memorandum, GCM 33948, 1968 GCM LEXIS 135 ("The liabilities referred to in Section 752 of the Code are those liabilities which arise from a debtor-creditor relationship with a sum certain due at a fixed or determinable date of maturity.").

¹¹ The Tax Court's analysis was specifically affirmed by the Tenth Circuit. See Long v. Commissioner, 660 F.2d 416, 419 (10th Cir. 1981)("[The Tax Court] held that because the lawsuit claims against the partnership were indefinite and contingent liabilities, they should not be recognized for basis adjustment purposes until the exact amounts of the liabilities were established. . . .We agree with this approach and holding.").

¹² The Seventh Circuit affirmed on other grounds relating to the retroactive application of the 2003 Treasury Regulation, discussed infra.

¹³ Treas. Reg. § 1.752-1(a)(4)(ii) (2003) (defining "liability" to mean "any fixed or contingent obligation to make payment . . ."). The 2003 Regulation is described by the trial court at 83 Fed. Cl. at 303. As noted by the court, while there has been litigation regarding the retroactive application of certain provisions of the regulation, the short sale transactions here predate those potentially retroactive provisions. Id.

¹⁴ In 2000 the Tax Court held in a memorandum opinion that the obligation to close a short sale is a Section 752 liability. See Salina Partnership L.P. v. Commissioner, 80 T.C.M. (CCH) 686 (2000). Citing Black's Law Dictionary as authority, the court concluded that the obligation to close a short sale is a "liability." Id. at 700. But see Long, 71 T.C. at 7-8 (meaning of "liability" under Section 752 is not based on "generic sense of the term"). A significant problem with the Salina court's analysis is that, under the Black's Law Dictionary definition relied on by the court, the contingent obligations in Helmer, Long, La Rue, Jade Trading, Stobie Creek, Cemco, Klamath and Sala would all be considered Section 752 liabilities. While the trial court found Salina persuasive with regard to the I.R.C. § 1233 issue (discussed in section V, infra), it did not adopt Salina's analysis based on Black's Law Dictionary. The Fifth Circuit in Kornman & Assoc's, Inc. v. United States, 527 F.3d 443 (5th Cir. 2008), specifically rejected an analysis based on Black's Law Dictionary. Id. at 451-52 ("This case cannot be resolved simply by referring to the definition of 'liability' in BLACK'S LAW DICTIONARY.").

¹⁵ As Dr. Lamont notes in his report, these events can cause a so-called "short squeeze," when many short sellers are required to cover their positions at the same time. A411. Such a short squeeze apparently occurred in 1991 with respect to two-year U.S. Treasury Notes when Salomon Brothers nearly cornered the supply of those securities. A412. Other events can make it difficult for a short seller to obtain replacement securities. For example, as a result of the credit crisis only a few weeks ago, delivery failures of Treasury securities were at historic levels. See Dan Jamieson, Delivery Failures Plague Treasury Market, Investment News (Oct. 30, 2008) (Addendum, Ex. L).

¹⁶See 12 C.F.R. § 220.2(r) (referring to the definition of "exempted security" found in section 3(a)(12) of the Securities Exchange Act of 1934, 15 U.S.C. § 78c(a)(12)).

¹⁷ The actual operation of the maintenance margin can be complex. For illustrative examples, see Rechlin, Securities Credit Regulation § 3:38.

¹⁸ The investors were required to provide the bank with collateral in excess of the maximum obligation. See Klamath Strategic Investment Fund, LLC v. United States, 472 F. Supp.2d 885, 896-98 (E.D. Tex. 2007), appeal pending, Docket Nos. 40861, 40915 (5th Cir.).

¹⁹ The trial court observed, however, that Rev. Rul. 88-77 did not put Marriott on "explicit notice." Marriott Int'l Resorts, 83 Fed. Cl. at 304.

²⁰ This should be contrasted with the Notice for the 2003 Treasury Regulation discussed above, which specifically indicated that the proposed definition of "liability" included certain contingent obligations and did not follow Helmer. See section I.C., supra.

²¹ As noted by the trial court, Rev. Rul. 88-77 was also cited by the Fifth Circuit in Kornman, supra, in its decision earlier this year holding that the short sale obligation in that case was a Section 752 liability. But Kornman was decided primarily on the basis of two revenue rulings issued in 1995 -- Rev. Rul. 95-26 and Rev. Rul. 95-45 -- and Rev. Rul. 88-77 was not analyzed in any detail in Kornman. There was no discussion in Kornman of the genesis or purpose of Rev. Rul. 88-77, nor is it apparent that these issues were even briefed to the Fifth Circuit. The two 1995 revenue rulings were significant in Kornman because the transactions there occurred in 1999, and the court felt that those two rulings placed the taxpayer on notice, "certainly by 1995, that the IRS considered the obligation to close a short sale to be a liability under section 752." Kornman, 527 F.3d at 462. Because the transactions here occurred in 1994, the trial court correctly noted that Kornman was "not a precedent squarely applicable to Marriott's transactions." 83 Fed. Cl. at 304.

²²See also Alice W. Cunningham, Short-Sale Obligations and Basis in Partnership Interests, 72 Tax Notes 1663, 1670 (1996) ("A short seller's executory obligation to return borrowed securities is no different from an optionor's executory obligation to perform if the option is exercised . . . ."). Indeed, IRS internal documents produced during discovery in this case show that in 1995 the IRS recognized that options and short sales were fundamentally similar. A357 ("Options and short sales have a lot in common. In both cases bet . . . same, though maybe different magnitude and cost.").

²³ Moreover, the extensive litigation regarding the retroactive application of the definition in the 2003 Regulation would be completely unnecessary if Helmer were not good law.

²⁴ Indeed, as discussed below, the court in Klamath recognized this fact and specifically noted that the Government's basis asymmetry argument was inconsistent with Helmer.

²⁵ Treasury apparently felt that a regulation was necessary to overrule Helmer. A358. But, because there was no Tax Court decision expressly addressing short sales, Treasury and the IRS concluded they could use a revenue ruling to proceed against short sales. Id.

²⁶ As noted by the trial court, "the pertinent analysis focuses on the law as it stood in 1994 at the time of Marriott's transactions, prior to Revenue Ruling 95-26 . . . ." Marriott Int'l Resorts, 83 Fed. Cl. at 303. "Marriott was not put on explicit notice. Its transaction in 1994 preceded Revenue Ruling 95-26 which addressed short sales. The earlier revenue ruling issued in 1988, Revenue Ruling 88-77, neither expressly mentioned short sales nor cited the Federal Reserve Board's Regulation T." Id. at 304 (emphasis added).

²⁷ In Rev. Rul. 73-301, 1973-2 C.B. 215, the IRS held that a partnership's receipt of progress payments under a long-term construction contract that were treated as deferred income (i.e., not yet included in income under the partnership's method of tax accounting) did not constitute a partnership liability. The partners had received progress payments related to the construction contract, and wanted to treat the amount of the payments as a partnership liability which would increase their basis for their partnership interests. In rejecting that position, the IRS ruled that: "The income or loss from performance of the contract will affect the basis of the partnership interests of the partners, as provided in section 705(a), when such income or loss is recognized for Federal income tax purposes." Id. at 216. As a result, the partnership had inside basis (the cash progress payments) that was not reflected in the partners' outside basis for their partnership interests.

²⁸ The Tax Court in Salina found that, in light of the different purposes served by Section 752 and I.R.C. § 1233, treating a short sale obligation as a partnership liability "does not create tension or conflict with the deferred recognition of gain or loss prescribed for short sale transactions under section 1233." 80 T.C.M. (CCH) at 698. The Fifth Circuit made a similar observation in Kornman. 527 F.3d at 460. However, in that the same type of obligation is treated inconsistently under two Code provisions, there clearly is a tension or conflict. Furthermore, through 1994 the IRS and the Tax Court had interpreted Section 752 so as to avoid any such tension or conflict with the income tax treatment of transactions that, like short sales, are left open for income tax purposes. See, e.g., La Rue, supra (citing all-events test in interpreting Section 752).