ASA Investerings v. Comm'r of Internal Revenue

• Decision Date: 01 February 2000
• Docket Number: No. 98-1583,98-1583
• Citation: 201 F.3d 505
• Parties: (D.C. Cir. 2000) ASA Investerings Partnership, et al.,Appellants v. Commissioner of Internal Revenue, Appellee
• Court: U.S. Court of Appeals — District of Columbia Circuit

Page 505

201 F.3d 505 (D.C. Cir. 2000)

ASA Investerings Partnership, et al.,Appellants v. Commissioner of Internal Revenue, Appellee

No. 98-1583

United States Court of Appeals FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued October 19, 1999

Decided February 1, 2000

Appeal from the United States Tax Court(No. TAX-27320-96)

Jerome B. Libin argued the cause for appellants. With him on the briefs was Steuart H. Thomsen.

Edward T. Perelmuter, Attorney, U.S. Department of Justice, argued the cause for appellee. With him on the brief were Loretta C. Argrett, Assistant Attorney General, and Richard Farber, Attorney.

Before: Williams, Sentelle and Henderson, Circuit Judges.

Opinion for the Court filed by Circuit Judge Williams.

Williams, Circuit Judge:

In January 1990 Allied Signal, a company manufacturing aerospace and automotive products, decided to sell its interest in Union Texas Petroleum Holdings, Inc., an oil, gas, and petrochemical company. Anticipating a large capital gain, it sought to reduce the resulting tax burden by entering into a set of transactions via a partnership with several foreign corporations. The transactions took advantage of provisions of the Internal Revenue Code (and related regulations) designed to yield reasonable results when property is sold on an installment basis and the value of the installment payments cannot be known in advance. With the help of these provisions, transactions that in substance added up to a wash were transmuted into ones generating tax losses of several hundred million dollars; the offsetting gains were allocated to foreign entities not subject to United States income tax at all.

The Commissioner of Internal Revenue in 1996 issued a notice of final partnership administrative adjustment, reallocating to AlliedSignal much of the capital gain accrued by the partnership. ASA, via its "Tax Matters Partner," Allied Signal, petitioned for relief in the Tax Court, which agreed with the Commissioner that AlliedSignal had not entered into a bona fide partnership and upheld the Commissioner's determination. ASA Investerings Partnership, AlliedSignal, Inc., Tax Matters Partner v. Commissioner, 76 T.C.M. (CCH) 325 (1998) ("Tax Court Decision"). We affirm.

* * *

The hardest aspect of this case is simply getting a handle on the facts. To make them manageable, we first discuss the principal tax provisions in question and then show their application through a series of examples, ending with a simplified version of the transactions here. Only then do we lay out the exact transactions themselves.

Under the general provisions of the Internal Revenue Code ("IRC"), gains and losses are generally "realized" in the year that they are received or incurred. See 26 U.S.C. § 1001 (1994). A sale for future payments, however, presents several difficulties, among them that the deferred payment may be contingent in amount or otherwise not susceptible to accurate valuation. Section 453 of the Internal Revenue Code, 26 U.S.C. § 453, provides methods for taxation of such an "installment sale," defined as "a disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs." Id. § 453(b)(1). It specifies the "installment method" for such a sale, providing that "the income recognized for any taxable year from a disposition is that proportion of the payments received in that year which the gross profit ... bears to the total contract price." Id. § 453(c). Thus, if A owns a building with a basis of $100, and sells it for $300 to be paid in five $60 annual installments, A recognizes a taxable gain of $40 each year. The proportion of "gross profit" to "total contract price" is 200/300 or two thirds, so the income recognized for each year is two thirds of the receipts of that year.

In 1980 Congress expanded § 453, authorizing the Secretary to make the installment method available to deferred payment transactions for which the sales price is indefinite, or subject to a contingency. Section 453(j) (previously § 453(i)) mandates that the Secretary shall promulgate regulations "providing for ratable basis recovery in transactions where the gross profit or the total contract price (or both) cannot be readily ascertained." In response, the Treasury promulgated Temp. Treas. Reg. § 15A.453-1(c)(3)(i) (1981), which provides that in contingent payment sales (and subject to irrelevant exceptions), "the taxpayer's basis ... shall be allocated to the taxable years in which payment may be received under the agreement in equal annual increments."

Under these regulations, the taxpayer will have a recognized gain in years when payment from the sale exceeds the basis recovered; in years when payment is less than the basis recovered, "no loss shall be allowed unless the taxable year is the final payment year under the agreement or unless it is otherwise determined ... that the future payment obligation under the agreement has become worthless." Id.

The following examples should illustrate the ratable basis recovery rule. Property owner, A, sells a house with a basis and current value of $1 million in exchange for an instrument that will pay unpredictable amounts (e.g., a share of the property's gross profits) over a five-year period. In any year in which the payout equals or exceeds $200,000, A will recover $200,000 in basis under the ratable basis recovery rule and will have a taxable gain equal to the difference between the amount received from the note and $200,000. In a year in which the payout is less than $200,000, A will not report a loss, but instead will recover a portion of the basis equal to the payout; the unused basis will then be carried forward to the next year. See id. § 15a.453-(c)(3), example (2). Under the rule just quoted above, unused basis would be recovered only in the last year of scheduled payout.

The rule works similarly when the seller receives both an instrument with indefinite value and an immediate payment of cash. In a variation on the preceding case, for example, suppose A sells the property for a $500,000 cash payment and an indefinite five-year instrument. Once again, the basis is recovered over the course of five years. In the first year, A recovers $200,000 in basis; because he has received $500,000 that year, he must report a gain of $300,000. If A sells the note in Year 2 for $500,000, he can report a loss of $300,000, equal to the difference between the remaining basis in the note ($800,000) and the $500,000 he has received in exchange for the note.¹ In this example, of course, the results are rather unappealing to the taxpayer: although he had no real gain, he recognized a nominal one early, offset by an equal tax loss--but one that was deferred and therefore not a complete offset. Because of the rule against any recovery of basis in excess of gross receipts in any year except the last, the taxpayer cannot manipulate the timing in his favor.

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

Now for the specifics of this case: In 1990, AlliedSignal anticipated that it would soon realize a capital gain of over $400 million from the sale of its interest in Union Texas Petroleum Holdings, Inc. In February, AlliedSignal approached Merrill Lynch & Co. to discuss a set of transactions that Merrill had developed to create tax losses to shelter anticipated capital gains.

Under the plan AlliedSignal would form a partnership with a foreign entity, which in turn would supply the majority of the capital for and assume a majority stake in the partnership. In Year 1, the partnership would purchase short-term private placement notes ("PPNs"), which can be sold under the installment method of accounting provided for in IRC § 453. See 26 U.S.C. § 453(k)(2)(A) (implying that the sale of "stock or securities which are [not] traded on an established securities market" would be subject to the installment method). Several weeks later, the partnership would sell the instruments for 80% cash and 20% debt instruments, which would pay out over several years and thus would be subject to the ratable basis recovery rule. As in the example above, the partnership would report a large gain in the first year, equal to the difference between the substantial cash payment and the small share of basis recovered that year. The gain would be allocated according to each partner's interest, with the tax exempt foreign partner receiving the lion's share.

The next year, AlliedSignal would acquire a majority interest in the partnership, and sell the debt instruments. The sale would create a large tax loss because the basis available for recovery would far exceed the value of the instruments.

Merrill would serve as the partnership's financial adviser and, for a $7 million fee, would recruit the foreign partner and arrange for the subsequent investments. Tax Court Decision, 76 T.C.M. at 326....