Reddam v. Comm'r

• Decision Date: 13 June 2014
• Docket Number: No. 12–72135.,12–72135.
• Citation: 755 F.3d 1051
• Parties: John Paul REDDAM, Petitioner–Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

755 F.3d 1051

John Paul REDDAM, Petitioner–Appellant,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.

No. 12–72135.

United States Court of Appeals,Ninth Circuit.

Argued and Submitted April 10, 2014.

Filed June 13, 2014.

David W. Wiechert (argued) and Jessica C. Munk, Law Office of David W. Wiechert, San Clemente, California, for Petitioner–Appellant.

Kathryn Keneally, Assistant Attorney General, Tamara W. Ashford, Deputy Assistant Attorney General, Gilbert S. Rothenberg, Richard Farber, and Judith A. Hagley (argued), Attorneys, Tax Division, Department of Justice, Washington, D.C., for Respondent–Appellee.

Appeal from a Decision of the United States Tax Court.

Before: JEROME FARRIS and ANDREW D. HURWITZ, Circuit Judges, and PAUL L. FRIEDMAN, District Judge.^*

OPINION

HURWITZ, Circuit Judge:

John Paul Reddam claimed a deduction on his 1999 tax return of $50,164,421 for a capital loss purportedly generated by several Cayman Islands entities. The Commissioner of Internal Revenue disallowed the deduction, finding that the transaction lacked economic substance. After a bench trial, the Tax Court affirmed. Reddam v. Comm'r, No. 22557–08, 2012 WL 1215220 (T.C. Apr. 11, 2012). We have jurisdiction over Reddam's appeal under 26 U.S.C. § 7482(a)(1) and affirm.

I. Factual Background

A. Reddam's $48,500,000 capital tax gain and search for tax reduction strategies

In 1995, Reddam founded several companies (collectively “DiTech”) that originated, purchased, and serviced residential home loans. Reddam was the sole shareholder, chief executive officer, and chairman of the board of each entity. Between 1995 and 1997, DiTech grew significantly.

Reddam used KPMG ¹ for his personal taxes and DiTech's corporate returns. KPMG also served as DiTech's auditor. In 1998, Reddam hired a KPMG partner, Scott Carnahan, as the president of DiTech.

In 1998, Reddam considered either taking DiTech public or selling it; he also investigated ways to reduce the tax liability associated with those strategies. Carnahan therefore introduced Reddam to a KPMG tax partner, Carl Hastings. Hastings recommended that Reddam pursue a tax and investment program marketed by KPMG: the Offshore Portfolio Investment Strategy (“OPIS”).

According to KPMG's marketing materials, OPIS utilized “100% leverage offshore” to allow investors “to avoid U.S. regulatory rules that limit the amount of financing permissible in securities transactions.” The materials stated that the strategy “[m]aximizes U.S. investor's basis in foreign bank stock and thereby minimizes gain, or maximizes loss, on the disposition of such stock,” something that would only be desirable to a U.S. investor with other significant gains to offset.² KPMG emphasized that the costs of investing in OPIS were not based on potentialinvestment gains, but were instead tied to the amount of “capital gain [tax] exposure” to be eliminated.

After several meetings with KPMG tax partners, Reddam understood OPIS to be a “complicated, technical” investment strategy that involved “some kind of basis shift,” whose “details were all very, very complicated.” He understood that OPIS employed “hedging,” so that any potential upside relied entirely on a rise in an underlying foreign bank stock. However, in general, Reddam did not “understand how [OPIS] works.”

Reddam knew that OPIS might “make money,” but chiefly was drawn to its potential “to be successful relative to generating a tax loss.” He sought the advice of KPMG tax partners because he was “looking to make sure that I paid the lowest tax rate that I could.”

Before investing, Reddam had Carnahan contact KPMG's competitors to inquire if they were offering similar “tax elimination” products. He was informed that several were, but Ernst & Young was not, because it did not think such a product “worked.” Carnahan advised Reddam to seek independent advice because he was “a little concerned that the same people pitching the transaction and receiving a fee for that transaction would also be giving the [tax] opinion on that transaction.” Nonetheless, Reddam never sought independent investment or legal advice.

In April 1999, GMAC Mortgage Corporation purchased DiTech, making an initial payment of $70,000,000. Reddam incurred a $48,500,000 capital tax gain and decided to “enter the OPIS transaction.”

In early May 1999, Reddam hired KPMG as his “tax advisor” with respect to OPIS. KPMG again “recommend[ed] that [Reddam] seek independent advice concerning the investment aspects of the proposed transaction.” Reddam never did.

B. Simplified overview of Reddam's OPIS transaction

The Tax Court opinion thoroughly explains the byzantine OPIS transaction. ³Reddam, 2012 WL 1215220, at *3–12. Given the transaction's complexity, we detail only those aspects necessary to explain our holding, and append KPMG's graphical description of an OPIS transaction to this opinion.⁴

First, Reddam ⁵ entered into an Investment Advisory Agreement with Presidio, a firm owned and operated by former KPMG partners. Several entities were then created: (i) a domestic limited liability company owned by a foreign person (that therefore owed no U.S. taxes, see26 U.S.C. §§ 881– 85), Clara Street, LLC; (ii) a Cayman Islands corporation, Clara Street Ltd. (owned by Clara Street, LLC); and (iii) a Cayman Islands limited partnership, Cormorant LP (“Cormorant”), whose limited partner was Clara Street LLC and general partner was Clara Street Ltd. Presidio also created investment accounts at Deutsche Bank for Reddam and the entities.

Second, Reddam deposited $6,000,000 ⁶ into his Deutsche Bank account, of which $2,500,000 was used to purchase Deutsche Bank common stock. The remaining funds were used to (a) enter into a “rate swap transaction” under which Reddam made two fixed rate payments to Clara Street LLC in exchange for the LLC's agreement to make payments to Reddam based on the average price of Deutsche Bank stock during the timeframe of the OPIS transaction (May to July 1999), and (b) buy a call option (the “first call option”) from Clara Street LLC for $150,000 that permitted Reddam to either (i) purchase fifty percent of Clara Street Ltd., or (ii) receive the value of Clara Street Ltd. in cash.

Third, Cormorant borrowed approximately $42,000,000 from Deutsche Bank to purchase Bank stock. The stock was pledged as collateral for the loan, and Deutsche Bank retained significant control over the stock. Deutsche Bank was also given a security interest in Clara Street LLC and Clara Street Ltd., the companies that owned Cormorant.

Fourth, Cormorant and Deutsche Bank engaged in several options transactions. Cormorant purchased options exercisable from May to July 1999 that had strike prices within a narrow range, most of which were tied to the price of Deutsche Bank stock during that time period.⁷ The options permitted Deutsche Bank to purchase a portion of the Bank stock owned by Cormorant if the price was within a certain narrow range during May to July 1999.

Fifth, Cormorant sold all the Deutsche Bank stock it held back to the Bank, using the proceeds to pay off the loan originally used to purchase the shares. Although the value of Deutsche Bank stock had risen in the interim, Cormorant made virtually no profit because the purchase agreement required Cormorant to sell ninety percent of the stock at a price below its purchase price.

Sixth, Reddam purchased call options from Deutsche Bank that permitted him to purchase Deutsche Bank stock in July or August, 1999 (the “back end options”).

Seventh, Reddam exercised the first call option, opting to have Clara Street LLC pay him a cash settlement, rather than sell him the shares in Clara Street Ltd.

Eighth, Reddam sold his back end call options to Deutsche Bank for a profit of approximately $200,000.

Finally, Reddam sold the $2,500,000 of Deutsche Bank stock he purchased directly for approximately $2,900,000.

C. Simplified overview of Reddam's calculation of basis in underlying securities from OPIS transaction

The purported tax benefits of OPIS hinge on transferring basis from an off-shore entity to a U.S. taxpayer. Consequently, we set forth Reddam's position on how his bases in the securities underlying his OPIS transaction should have been calculated.

Reddam paid approximately $2,500,000 for shares in Deutsche Bank. Cormorant purchased approximately $42,000,000 of Deutsche Bank stock, using the proceeds of the loan it obtained from Deutsche Bank. Cormorant and Reddam were related parties. See26 U.S.C. § 318. Reddam therefore took the position that, for tax purposes, he constructively owned Cormorant's Deutsche Bank stock. See§ 318(a)(2)(A), (a)(2)(C), (a)(4), (a)(5). Similarly, Reddam took the position that Cormorant constructively owned the $2,500,000 worth of shares that he purchased directly. Thus, on his 1999 tax returns, Reddam calculated his total basis in the Deutsche Bank stock, including the purchase prices and the various brokerage fees, as approximately $43,800,000.

When Cormorant sold its shares in Deutsche Bank back to the Bank for $42,000,000, Cormorant ordinarily would be treated as having been completely redeemed under 26 U.S.C. § 302(b)(3). But, Reddam took the position that because Cormorant also constructively owned Reddam's $2,500,000 worth of Deutsche Bank shares, Cormorant's sale was neither a complete redemption under § 302(b)(3), nor a substantially disproportionate redemption under § 302(b)(2). Rather, Reddam contended that after the sale, there was no “meaningful reduction” in Cormorant's ownership of Deutsche Bank. United States v. Davis, 397 U.S. 301, 313, 90 S.Ct. 1041, 25 L.Ed.2d 323 (1970) (“[T]o qualify for preferred treatment under [§ 302(b)(1) ], a redemption must result in a meaningful reduction of the shareholder's proportionate interest in the corporation.”). Reddam took the position that Cormorant's sale of the $42,000,000 of stock to Deutsche Bank was actually a dividend Cormorant was required to include in...