Southgate Master Fund v. U.S.

• Decision Date: 30 September 2011
• Docket Number: No. 09–11166.,09–11166.
• Citation: 2011 USTC P 50648,108 A.F.T.R.2d 2011,659 F.3d 466
• Parties: SOUTHGATE MASTER FUND, L.L.C., by and through MONTGOMERY CAPITAL ADVISORS, LLC its Tax Matters Partner, Plaintiff–Appellant–Cross-Appellee,v.UNITED STATES of America, Defendant–Appellee–Cross-Appellant.
• Court: U.S. Court of Appeals — Fifth Circuit

659 F.3d 466

108 A.F.T.R.2d 2011-6488

2011-2 USTC P 50,648

SOUTHGATE MASTER FUND, L.L.C., by and through MONTGOMERY CAPITAL ADVISORS, LLC its Tax Matters Partner, Plaintiff–Appellant–Cross-Appellee,

v.UNITED STATES of America, Defendant–Appellee–Cross-Appellant.

No. 09–11166.

United States Court of Appeals, Fifth Circuit.

Sept. 30, 2011.

Michael Todd Welty, SNR Denton, L.L.P., Dallas, TX, Roy Theodore Englert, Jr. (argued), Robbins, Russell, Englert, Orseck, Untereiner & Sauber, L.L.P., Washington, D.C., for Plaintiff–Appellant–Cross–Appellee.Judith Ann Hagley (argued), Kenneth L. Greene, Supervisory Atty., Tax Div., App. Section, Gilbert Steven Rothenberg, Deputy Asst. Atty. Gen., U.S. Dept. of Justice, Washington, DC, David Gray Adams, Tax Div., U.S. Dept. of Justice, Dallas, TX, for Defendant–Appellee–Cross–Appellant.Appeals from the United States District Court for the Northern District of Texas.Before JOLLY, HIGGINBOTHAM and SMITH, Circuit Judges.PATRICK E. HIGGINBOTHAM, Circuit Judge:

We affirm in all respects the district court's judgment disposing of this petition for a readjustment of partnership tax items under 26 U.S.C. § 6226. The plaintiff, Southgate Master Fund, L.L.C., was formed for the purpose of facilitating the acquisition of a portfolio of Chinese nonperforming loans (“NPLs”). A partnership for tax purposes, Southgate's disposition of its portfolio of NPLs generated more than $1 billion in paper losses, about $200 million of which were claimed as a deduction by one of its partners in tax year 2002. The Internal Revenue Service determined that Southgate was a sham partnership that need not be respected for tax purposes and that Southgate's allocation of the $200 million loss to the deducting partner should be disallowed. The district court upheld these determinations. After laying out the pertinent factual background in Part I, we explain in Part II why the district court was correct to do so. The Service further determined that the accuracy-related penalties in 26 U.S.C. § 6662(b)(1)–(3) applied to the underpayments of tax resulting from Southgate's treatment of its losses. On this point, the district court disagreed, disallowing the accuracy-related penalties on the ground that Southgate had reasonable cause for, and acted in good faith with respect to, the tax positions that resulted in the underpayments of tax. Although this issue is a close one, we affirm the district court's decision to disallow the penalties.

I. Factual background

At issue on this appeal are the income-tax consequences of three interrelated transactions entered into by Southgate and its three members, D. Andrew Beal, Thomas Montgomery, and China Cinda. As a limited liability company (LLC), Southgate is treated as a partnership for federal-income-tax purposes. ¹ The Internal Revenue Code subjects partnerships to pass-through tax treatment. Partnerships do not pay income tax; instead, a partnership's income and losses flow through to its partners.² The Southgate partner³ whose individual income-tax liability will ultimately be affected by this action is Beal.⁴ Beal is a billionaire Dallas banker who has made a name and a fortune for himself as an investor in stressed and distressed debt. Montgomery is a certified public accountant and an associate of Beal's who specializes in locating stressed- and distressed-debt investment opportunities in foreign markets. Cinda is a Chinese-government-owned financial institution. The three transactions in question are the formation of Southgate itself, Southgate's acquisition from Cinda of a portfolio of Chinese NPLs with a face value of about $1.1 billion, and Beal's contribution to Southgate of approximately $180 million worth of Government National Mortgage Association (“GNMA”) securities. Summarized here are the relevant facts as found by the district court following a fifteen-day bench trial.

A. The business plan

Beal is the founder and sole owner of the Beal Financial Corporation and its subsidiary, Beal Bank (collectively, “the Bank”). Beal and the Bank's core business involves identifying and purchasing assets that are undervalued because the market has mispriced their level of risk. Included within this category are NPLs, which are loans as to which the borrowers are in default, are in arrears, or have otherwise failed to perform under the terms of the loan agreement. For years the Bank focused primarily on domestic investment opportunities. But as the domestic market began to price risk more efficiently, Beal and the Bank began to focus on identifying inefficiencies and investment opportunities in foreign markets. In 2001, Beal hired Montgomery to help him identify opportunities to invest in foreign NPLs. Over the next year, Montgomery identified NPL investment opportunities in half a dozen foreign countries. Most notably, in early 2002 Montgomery advised Beal on a purchase of a package of NPLs that were originated in Jamaica. The Bank paid $23 million for the NPLs (approximately five percent of their face value) and ultimately doubled its money on the investment. As the Jamaican NPL transaction was drawing to a close, Montgomery realized that if the transaction had been structured differently, it could have provided substantial income-tax benefits for Beal.

Around the same time that Beal and Montgomery were beginning to look for opportunities to invest in foreign NPLs, a robust market for NPLs was emerging in China. By the late 1990s, China's “big four” state-owned commercial banks had become saddled with huge numbers of NPLs. In an effort to reform and modernize its banks, the Chinese government created four new state-owned asset-management companies to assume and resolve the banks' NPLs. Cinda was one of these four new asset-management companies. The Chinese government required the asset-management companies to purchase the banks' NPLs at face value (that is, outstanding principal plus unpaid accrued interest), notwithstanding the fact that, because the loans were nonperforming, they were worth far less than their face values. From the Chinese government's perspective, the full-value-purchase requirement had the dual benefits of cleaning up the banks' balance sheets and providing the banks with an infusion of capital. In 2000 and 2001, China's big four banks sold approximately $169 billion worth of NPLs to the four asset-management companies. Cinda purchased loans with face values of approximately $45 billion.

The asset-management companies were charged with resolving the loans they had assumed. To that end, the statute that created these companies vested them with a series of so-called “super powers” that were designed to facilitate the companies' ability to resolve and collect on the NPLs. These super powers included the authority to restructure and compromise the loans, the right to pursue litigation against debtors, and the ability to toll the running of the statute of limitations.

As the size of the Chinese asset-management companies' NPL portfolios grew, investment banks and other sophisticated international investors began to enter the Chinese NPL market. Foreign investors believed that the availability of these new super powers increased the likelihood that value could be realized from Chinese NPLs. In November 2001, China Huarong, another of China's four new asset-management companies, auctioned off some of its NPLs. Goldman Sachs and Morgan Stanley both acquired portfolios of NPLs. Each retained Huarong to service its loans, and the market intelligence was that collections were strong and that the investment banks had enjoyed sizeable returns on their investments.

By early 2002 Montgomery was aware of this market intelligence and had identified the Chinese NPL market as a potential investment opportunity for Beal and the Bank. Over the next several months, Montgomery—acting in his capacity as an employee of the Bank—researched the emerging market in Chinese NPLs. Like many other sophisticated investors, Montgomery quickly became convinced that the market held significant potential for profit. Montgomery had a contact at Deutsche Bank, which had signed a brokerage deal with Cinda that made it Cinda's sourcing agent on all NPL deals. In July 2002, Montgomery's contact put him in touch with a representative from Cinda. Montgomery then began to conduct due diligence on acquiring a portfolio of NPLs from Cinda. Montgomery made several trips to China, where he met with representatives from Cinda and reviewed various NPL portfolios. Montgomery eventually determined that the pricing structure would be more favorable on an investment in unsecured NPLs rather than secured NPLs.

B. The tax plan

At the same time he was researching the profit potential of an investment in Chinese NPLs, Montgomery also began researching the potential tax benefits that could be created by such an investment. In May of 2002, Deutsche Bank introduced Montgomery to the law firm of De Castro, West, Chodorow, Glickfeld & Nass, Inc. (“De Castro”). Montgomery sought De Castro's advice on how to structure an acquisition of Chinese NPLs so that it would create tax benefits for Beal. In a series of memoranda that it sent to Montgomery in June and July of 2002, De Castro laid out its plan for such a transaction structure. In short, De Castro proposed to Montgomery that, once he had identified the portfolio of NPLs he was going to recommend that Beal acquire, he form a partnership with Cinda and have Cinda contribute the NPLs to the partnership. By purchasing a portion of Cinda's interest in the partnership to which it had contributed the NPLs instead of purchasing the NPLs directly from Cinda, Beal would be able to generate a paper loss that he could claim as a deduction on his individual tax return.

Understanding why De Castro proposed this structure requires a brief review of the relevant provisions of the Internal Revenue Code and its implementing regulations. The Code...