Reddam v. Comm'r of Internal Revenue

• Decision Date: 11 April 2012
• Docket Number: Docket No. 22557-08
• Parties: JOHN PAUL REDDAM, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

JOHN PAUL REDDAM, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 22557-08

UNITED STATES TAX COURT

Filed April 11, 2012

Jeffrey A. Hartman, David W. Wiechert, and Jessica C. Munk, for petitioner.

H. Clifton Bonney, Jr., Elizabeth S. Martini, and Mary E. Wynn, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GOEKE, Judge: Respondent issued a notice of deficiency disallowing petitioner's claimed capital loss deduction of $50,164,421 and making acorresponding computational adjustment regarding claimed itemized deductions of $366,759 for the 1999 tax year. These adjustments resulted in an $8,209,727 deficiency. Respondent's determination stems from petitioner's participation in an Offshore Portfolio Investment Strategy (OPIS transaction). Petitioner timely filed a petition with this Court.¹

The sole issue for decision is whether petitioner is entitled to deduct the capital losses. We hold that petitioner may not deduct the capital losses because his investment in the OPIS transaction lacked economic substance.²

FINDINGS OF FACT

Petitioner resided in California at the time his petition was filed. In 1995 petitioner formed DiTech Funding Corp., DiTech Escrow Corp., and DiTech Real Estate Corp. (collectively referred to as DiTech).³ Petitioner was the sole shareholder, chief executive officer, and chairman of the board of each DiTech entity until the sale of the assets of those entities in 1999. DiTech engaged in thebusiness of originating, underwriting, purchasing, selling, and servicing residential mortgage loans. The business quickly evolved into a very successful enterprise; by 1998 DiTech had grown to 700 employees and was generating approximately $45 million in annual revenue.

Petitioner maintained a longstanding professional relationship with KPMG Peat Marwick LLP (KPMG),⁴ an international accounting firm, which continued throughout the period at issue. Petitioner initially hired KPMG, in 1994, to serve as an outside auditor for SC Funding, a separate company that petitioner had previously operated. Scott Carnahan was the KPMG audit partner originally assigned to audit SC Funding. Eventually, Carnahan left KPMG and became the president of DiTech on July 1, 1998.

I. Petitioner's Sale of DiTech

In 1997 petitioner began to consider monetizing some of his personal shareholdings in DiTech. After discussions with PaineWebber, DiTech's investment adviser, in the fall of 1997 petitioner considered taking DiTech public though an initial public offering (IPO). In June 1998 DiTech announced tentative plans for a potential IPO of a minority interest in DiTech; however, PaineWebbereventually recommended delaying the IPO until market conditions became more favorable for the successful implementation of the plan.

In October 1998 petitioner was approached by representatives of the GMAC Mortgage Corp. (GMAC) concerning a potential purchase of DiTech. Petitioner negotiated the major points of the deal with GMAC, including how pricing for the transaction would be structured. In April 1999 DiTech agreed to sell substantially all of its assets to GMAC. The purchase price consisted of a "closing payment" and an "earn out" payment to be made over a period of years. GMAC paid DiTech approximately $70 million for the closing payment in 1999. Under the terms of the asset purchase agreement, petitioner was entitled to potential future earn out payments in excess of $170 million.

Petitioner recognized ordinary income and a $48,489,549 capital gain as a result of the sale of the assets in 1999.

II. Petitioner's Attempts To Minimize Taxes

Around the same time petitioner sought to monetize his DiTech holdings, he also began to consider various ways to reduce his overall tax liabilities. Petitioner considered moving his business and residence to Nevada in an attempt to eliminate State income taxes, and he traveled to Nevada in 1997 to search for potentialhomes. Petitioner also became aware that KPMG was offering certain tax strategies which might be beneficial to a taxpayer with petitioner's tax portfolio.

In early 1998 petitioner was introduced by Mr. Carnahan, then still with KPMG, to Carl Hasting, a partner at KPMG. Mr. Hasting was selling products to clients with large gains or significant incomes. One such product was the OPIS transaction.

The OPIS transaction was developed and sold by KPMG and implemented with the assistance of Presidio Advisors LLC (Presidio) and Deutsche Bank AG (Deutsche Bank). In general terms, the OPIS transaction was structured to shift additional tax basis to a taxpayer's equity investment and options in a large financial institution. Shortly after the purported basis shift, the taxpayer would sell the equity interest and options, resulting in a large capital loss. The benefits of the OPIS transaction as advertised by KPMG were that it: (1) enabled a U.S. investor to maximize leverage in stock of a foreign bank and thereby potentially increase investment return; and (2) maximized the U.S. investor's basis in foreign bank stock, thereby minimizing gain, or maximizing loss, on the disposition of such stock.

At the time of his initial meeting with Mr. Hasting, petitioner had not yet sold DiTech and was not immediately interested in participating in any tax planning tominimize taxable gains. Nonetheless, petitioner continued to engage in a series of meetings with Mr. Hasting in the spring of 1998 to discuss various tax strategies. Some time after Mr. Carnahan began working for DiTech, Mr. Hasting presented the OPIS transaction to petitioner. Mr. Carnahan understood that the transaction was structured to eliminate, not simply defer, a tax gain for a participant; however, as Mr. Carnahan was not particularly knowledgeable in tax law, he did not understand the OPIS transaction in any detail.

After Mr. Hasting described the transaction to petitioner, petitioner asked Mr. Carnahan to inquire as to whether other accounting firms were offering other similar products. In response, Mr. Carnahan initiated individual dialogues with representatives from Pricewaterhouse, Deloitte, and Ernst & Young, all international accounting firms. Representatives from both Pricewaterhouse and Deloitte believed that they offered similar products, and they each asked to speak with petitioner in an attempt to sell their respective transactions; however, the Ernst & Young representative offered only a tax deferral product and expressed his misgivings that the KPMG transaction, as structured, did not "work". Mr. Carnahan relayed all the information he received from the representatives to petitioner.

Mr. Carnahan, while limited in his understanding of the transactions, advised petitioner that there was no clear differentiation between the KPMG plan and the other plans offered by the accounting firms. Mr. Carnahan also noted that the "more likely than not" opinions issued by the KPMG national office as well as Brown & Wood in support of the OPIS transaction were "valuable documents". Nonetheless, Mr. Carnahan did not advise petitioner on the investment aspects of the transaction and specifically requested that petitioner hire competent counsel to provide more technical tax advice. Petitioner never heeded Mr. Carnahan's suggestion and continued his consideration of the OPIS transaction without the aid of outside counsel.

Petitioner met with Mr. Hasting again in the fall of 1998. Shortly thereafter, Mr. Hasting had petitioner execute a nondisclosure agreement which provided that petitioner could not discuss the details of the OPIS transaction with others without KPMG's prior written consent. Petitioner was also advised to form a grantor trust to execute the transaction. On April 27, 1999, petitioner formed the J. Paul Reddam Trust (Reddam Trust)⁵ for this purpose.

On May 19, 1999, petitioner executed an engagement letter with KPMG related to the OPIS strategy. In the letter KPMG recommended that petitioner seek independent advice concerning the investment aspects of the transaction and stated that the minimum fee for KPMG's services would be $597,500. A revised engagement letter later increased this minimum fee to $622,500.

At the request of KPMG, petitioner also engaged the services of Presidio to implement the OPIS transaction. Petitioner had not previously used the services of Presidio and never communicated with anyone at Presidio about the transaction.

III. OPIS Entities

In addition to Reddam Trust, several entities were formed with the assistance of Presidio to facilitate the OPIS transaction: (1) a domestic limited liability company, Clara Street LLC (Clara LLC), owned by a foreign person; (2) a Cayman Islands corporation, Clara Street Ltd. (Clara Ltd.); and (3) a Cayman Islands limited partnership, Cormorant LP (Cormorant). Clara LLC owned 500 shares of Clara Ltd. and an unrelated third party owned 1 share. Clara LLC was also the limited partner of Cormorant; Clara Ltd. was the general partner.

As part of petitioner's OPIS transaction, Reddam Trust, Clara LLC, and Clara Ltd. opened individual accounts with Deutsche Bank. Reddam Trust and Cormorant's accounts were characterized as "portfolio accounts" (respectively, petitioner's and Cormorant's DB portfolio accounts). Cormorant's DB portfolio account was divided into a U.S. dollar subaccount, a euro subaccount, and a security subaccount. Reddam Trust gave John Larson, a principal of Presidio, trading authority over petitioner's DB portfolio account.

IV. The OPIS Transactional Structure

The OPIS transaction incorporated a series of coordinated steps. Petitioner referred to this structure as a "formula" or "recipe".

On May 25, 1999, Presidio instructed petitioner to wire $6 million to petitioner's DB portfolio account. According to the instructions, $2.5 million was to be used by petitioner to purchase a "long position in Deutsche Bank common stock" and the remaining $3.5 million was to be used for the purchase of both a swap and a call option, discussed infra.

Peti...