Long Term Capital Holdings v. U.S.

• Court: U.S. District Court — District of Connecticut
• Writing for the Court: Arterton
• Citation: Long Term Capital Holdings v. U.S., 330 F.Supp.2d 122 (D. Conn. 2004)
• Decision Date: 27 August 2004
• Docket Number: Civil No. 3:01CV1714 (JBA).,Civil No. 3:01CV1290.,Civil No. 3:01CV1713.,Civil No. 3:01CV1711.,Civil No. 3:01CV1291.
• Parties: LONG TERM CAPITAL HOLDINGS, et. al., petitioners v. UNITED STATES of America, respondent.

330 F.Supp.2d 122

LONG TERM CAPITAL HOLDINGS, et. al., petitioners v. UNITED STATES of America, respondent.

Civil No. 3:01CV1290.

Civil No. 3:01CV1291.

Civil No. 3:01CV1291.

Civil No. 3:01CV1711.

Civil No. 3:01CV1713.

Civil No. 3:01CV1714 (JBA).

United States District Court, D. Connecticut.

August 27, 2004.

COPYRIGHT MATERIAL OMITTED

COPYRIGHT MATERIAL OMITTED

Charles W. Pieterse, Whitman, Breed, Abbott & Morgan, Greenwich, CT, Christopher P. La Puma, David J. Curtin, John A. Galotto, William F. Nelson, McKee & Nelson, Washington, DC, Maciej A. Piatkowski, Michael F. Cavolo, Whitman, Breed, Abbott & Morgan, Greenwich, CT, for Plaintiffs.

Charles P. Hurley, Jennifer G. Cohen, Washington, DC, John B. Hughes, New Haven, CT, Kevin P. Jenkins, Nicole Bielawski, Stacey Hallett, Washington, DC, Carl Riehl, DeBevoise & Plimpton, New York, NY, David N. Rosen, David N. Rosen, Counselor at Law, P.C., New Haven, CT, for Defendants.

FINDINGS AND OPINION

ARTERTON, District Judge.

Table of Contents

  I. Summary .....................................................................127
                 II. Factual Background ..........................................................128
                     A. Long Term Entities .......................................................128
                

     B. Babcock and Brown ("B & B") and Onslow Trading and Commercial LLC
                          ("OTC") ................................................................131
                     C. CHIPS and TRIPS Transactions .............................................132
                        1.  CHIPS IVA and IVB ....................................................132
                        2.  TRIPS I ..............................................................135
                        3.  Purported Tax Consequences of CHIPS IVA and IVB and TRIPS I ..........135
                     D. OTC and Long Term ........................................................136
                        1.  OTC/Long Term Transaction ............................................136
                        2.  Long Term/B & B/UBS Transaction ......................................138
                        3.  Long Term's Tax Returns ..............................................139
                        4.  B & B and OTC After CHIPS and TRIPS ..................................139
                        5.  The Origin of a Transaction for Long Term ............................142
                        6.  Long Term and B & B ..................................................143
                        7.  Long Term and Shearman & Sterling ....................................145
                        8.  Long Term and King & Spalding ........................................147
                            a.  Kuller's Claimed Pre-Tax Expectation of Profit Analysis ..........149
                            b.  Kuller's Credibility .............................................151
                        9.  Long Term and OTC ....................................................153
                            a. Communication Among Long Term's Principals ........................153
                            b. Unusual Nature of OTC's Contributions .............................155
                            c. Long Term's and OTC's Intent Regarding the OTC Transaction ........155
                            d. Scholes' November 12, 1996 Memorandum .............................157
                        10. The Turlington Problem ...............................................158
                        11. Petitioner's Expert: Frank J. Fabozzi ................................160
                        12. Scholes' Economic Analysis ...........................................161
                        13. Government's Expert: Joseph Stiglitz .................................163
                        14. IRS Audit and Long Term's Response ...................................165
                III. Discussion ..................................................................165
                     A. Burden of Proof ..........................................................165
                        1. Cooperation with Reasonable Requests ..................................166
                        2. Net Worth .............................................................170
                        3. Conclusion on Burden of Proof .........................................170
                     B. Lack of Economic Substance ...............................................171
                        1. Objective Economic Substance ..........................................172
                        2. The Scope of the Transaction for Purposes of Measuring Costs and
                            Reasonable Expectation of Return .....................................174
                        3. Reasonably Expected Return ............................................175
                        4. Costs of the OTC Transaction ..........................................175
                           a. Legal Fees .........................................................176
                           b. "Consulting Arrangement" with B & B ................................177
                           c. The Turlington Payment .............................................178
                           d. Scholes' Allocation and Noe's Bonus ................................180
                           e. Economic Structure of OTC Contributions ............................181
                           f. B & B's Investment Through UBS .....................................183
                        5. "Things Economic Happened"—Tr. [Doc. # 207] at 3228:25-3229:1 .........185
                        6. Subjective Business Purpose ...........................................186
                     C. Step Transaction Doctrine ................................................191
                     D. Penalties ................................................................196
                        1. Burden of Proof .......................................................196
                        2. Gross Valuation Misstatement ..........................................199
                        3. Substantial Understatement of Income Tax ..............................200
                           a. Substantial Authority ..............................................201
                           b. Reasonable Belief ..................................................205
                        4. Reasonable Cause Exception ............................................205
                           a. Receipt and Content of King & Spalding Advice ......................206
                           b. King & Spalding's Written Opinion ..................................208
                           c. Long Term's Lack of Good Faith .....................................211
                 IV. Conclusion ..................................................................212
                

Appendix—Timeline of OTC Transactional Events ....................................212
                

I. Summary

Petitioners Long-Term Capital Holdings ("Holdings"), Long-Term Capital Management L.P. ("LTCM"), Long-Term Capital Portfolio L.P. ("Portfolio"), Long-Term Capital Fund,¹ Eric Rosenfeld, and Richard Leahy filed petitions under 26 U.S.C. § 6226(a)(2) seeking (a) readjustment of the IRS denial of $106,058,228 in capital losses for petitioners' 1997 tax year in connection with the sale by Portfolio on December 30, 1997 of preferred stock for $1,078,400 with a claimed basis of $107,136,628, and (b) a determination that the IRS imposition of penalties pursuant to 26 U.S.C. § 6662(a), (b)(1-3), (h) was erroneous. Jurisdiction is conferred by 28 U.S.C. § 1346(e). The Court's findings of fact and conclusions of law set out in this opinion are based on the bench trial held June 23, 2003 — July 30, 2003.

Petitioners' claim that Portfolio sold stock on December 30, 1997 with a tax basis one hundred times in excess of its fair market value arises from two separate sets of transactions. The first set is comprised of nine cross border lease-stripping transactions, five of which utilized a master lease or wrap lease structure and were termed "Computer Hardware Investment Portfolio" ("CHIPS") and four of which utilized a sale/lease back structure and were termed "Trucking Investment Portfolios" ("TRIPS").

In the CHIPS transactions, Onslow Trading and Commercial LLC ("OTC"), an entity incorporated under the laws of the Turks and Caicos Islands, purportedly leased from General Electric Capital Computer Leasing ("GECCL") computer equipment already subject to existing leases to end-users and then immediately subleased its rights in the equipment to U.S. based partnerships. The new sublessees then pre-paid 92.5% of the rent due under the subleases. The prepayments, totaling tens of millions of dollars, were made with loans to the U.S.-based partnerships from Barclays Finance & Leasing B.V. ("Barclays") and were guaranteed by GECCL. OTC, formed under foreign laws and resident in the United Kingdom, paid no U.S. taxes upon receipt of the rent prepayments and deposited them into a Barclays branch bank account. OTC then exchanged the master leases, the subleases and the bank accounts with the prepayment deposits for preferred stock in certain U.S. corporations; OTC received approximately $1,000,000 in preferred stock for every $100,000,000 of prepayments and lease positions it gave up. OTC's transfer was timed to be prior to accrual of rent under the subleases such that under UK law OTC paid no taxes on the prepayments. Pursuant to 26 U.S.C. §§ 351, 358, these exchanges were claimed to be tax free exchanges and OTC claimed an adjusted basis in the preferred stock tranches it received of approximately $100,000,000.

In the TRIPS transactions, Wal-Mart sold fleets of trucks to NationsBanc and First American National Bank, the banks leased the trucks to OTC, and OTC subleased the trucks back to Wal-Mart. Wal-Mart guaranteed OTC's obligations to the banks and prepaid a percentage of the rent due under the sublease. In TRIPS I, the prepayment was 92.5% of the rent due, approximately $27 million, which OTC deposited in a bank account. Again, before the sublease rent accrued, OTC exchanged its lease positions and bank deposits for preferred stock of American corporations. The ratio of exchange again approximated $1 of preferred stock received for every $100 of lease positions and prepayment deposits given up.

OTC, in a purported transaction under 26 U.S.C. § 721, contributed to Long Term the tranches of preferred stock it received from the TRIPS and CHIPS transactions, which had a fair market value of approximately $4 million...