Saba Partnership v. Comm'r of IRS
| Decision Date | 21 December 2001 |
| Docket Number | CROSS-APPELLEES,No. 00-1328,00-1385,CROSS-APPELLANT,00-1328 |
| Parties | (D.C. Cir. 2001) SABA PARTNERSHIP, ET AL., APPELLANTS/v. COMMISSIONER OF INTERNAL REVENUE SERVICE, APPELLEE/ |
| Court | U.S. Court of Appeals — District of Columbia Circuit |
Appeals from the United States Tax Court (No. IRS-1470-97; 1471-97).
Thomas C. Durham argued the cause for appellants/crossappellees. With him on the briefs was Joel V. Williamson.
Richard Farber, Attorney, U.S. Department of Justice, argued the cause for appellee/cross-appellant. With him on the briefs was Edward T. Perelmuter, Attorney. Stuart L. Brown, Attorney, Internal Revenue Service, entered an appearance.
Before: Edwards, Rogers and Tatel, Circuit Judges.
Opinion for the Court filed by Circuit Judge Tatel.
Through an elaborate scheme involving partnerships with a foreign bank operating in a tax-free jurisdiction, a diversified U.S. company generated over $190 million worth of tax losses while incurring an actual loss of only $5 million. The Tax Court found that because certain of the partnerships' transactions lacked economic substance, they created no gains or losses for federal tax purposes. At the same time, the Tax Court declined to address the government's alternative contention that both partnerships were shams for federal tax purposes. The partnerships, together with the company, now appeal, and the government crossappeals. We vacate and remand to the Tax Court for reconsideration in light of our recent decision in ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (D.C. Cir. 2000), where we invalidated what appears to be a similar--perhaps even identical--tax shelter on the grounds that the entire partnership, not merely the specific transactions at issue, was a sham for federal tax purposes.
This case involves the legality of a tax shelter marketed by Merrill Lynch to a small number of U.S. corporations. Designed for corporations anticipating large capital gains, the shelter takes advantage of certain Internal Revenue Code provisions and related Treasury Department regulations that govern installment sales where the taxpayer lacks advance knowledge of the installment payments' value. See 26 I.R.C. § 453; Temp. Treas. Reg. § 15A.453-1(c)(3)(i) (1984). To build such a shelter, the Merrill Lynch client forms a partnership with a foreign corporation operating in a tax-free jurisdiction. This partnership then buys and immediately sells a debt instrument on an installment basis. Although the transaction is basically a wash, generating hardly any economic gain or loss, Merrill Lynch's lawyers' interpretation of the relevant provisions allows the partnership to claim a massive tax gain, which is allocated to the foreign partner, and a massive tax loss, which the U.S. corporation keeps for itself. A detailed description of this shelter and the code provisions on which it depends appears in ASA, 201 F.3d at 506-8. In that case, we affirmed a Tax Court determination that another Merrill Lynch client that had adopted the shelter, AlliedSignal, had "not entered into a bona fide partnership" for federal tax purposes. Id. at 515.
The facts of this case appear similar to those of ASA. In 1990, appellant Brunswick Corporation, a diversified manufacturer, decided to divest itself of certain business groups. Because the sales would generate massive capital gains, Merrill Lynch proposed that Brunswick generate compensatory paper losses by forming a partnership with a foreign bank. In an extensive memorandum, Judith P. Zelisko, an attorney and Brunswick's Director of Taxes, laid out step by step how Merrill Lynch's proposal would "generate sufficient capital losses to offset the capital gain which w[ould] be generated on the sale of [certain divisions]." Saba P'ship v. Comm'r, 78 T.C.M. (CCH) 684, 689. Because of this document's significance, we quote it in substantial part:
Step 1:
BC [Brunswick] and an unrelated foreign partner [FP] would form a Partnership no later than March 1, 1990 with BC contributing $20 million in cash and the FP contributing $180 million in cash. The Partnership would have a fiscal year-end of March 31st since that would be the year-end of the FP, the majority Partner.
Step 2:
Partnership buys a private placement note for $200 million with the cash in the Partnership and holds the note for one month.
Step 3:
Before March 31, 1990, the Partnership would sell the $200 million private placement note for $160 million in cash and five-year contingent note with an assumed fair market value (fmv) of $40 million. Under this contingent note, payments would be made to the Partnership over a five-year period equal to [a variable interest rate] times a fixed notional principal....
The Partnership would recognize gain on the sale of the private placement note calculated as follows:
BC's share of the gain equals its 10% ownership in the Partnership for a taxable gain to BC of $12.67 million in 1990.
Step 4:
In April 1990 or later, (i.e., until there has been some movement in the value of the contingent note) BC buys 50% of FP's interest in the Partnership for $90 million, assuming that the fmv of the contingent note is still $40 million. With this purchase, BC's basis in its Partnership interest is $122.67 million calculated as follows:
Step 5:
The Partnership distributes the contingent note to BC assuming a fmv of $40 million. In addition, the Partnership would distribute approximately $32.72 million in cash to FP which is the equivalent cash distribution to FP given its percentage ownership.
Step 6:
BC sells the contingent note for cash. This sale of the contingent note by BC generates the capital loss.
After the sale of the note, BC's tax basis in the Partnership is zero and the Partnership still has 127.28 in cash (160-32.72).
Step 7:
In April 1991, the Partnership will be terminated ...
Id. at 689-90. The Zelisko memorandum also notes that Merrill Lynch would earn a fee of "5-10% of the tax savings"; that the fee "would not be due if the tax law changed prior to implementation"; that "[l]egal fees for BC and operating expenses of the Partnership ... would be paid by BC"; and that the foreign partner would earn "40-75 basis points on the FP's equity investment." Id. Finally--and ironically-the memorandum reminds Zelisko's superiors that "[t]here cannot have been any agreements, negotiations, or understandings of any kind among the Partners or their representatives regarding the possible liquidation of the Partnership or the assets to be distributed to each respective Partner upon termination and liquidation of the Partnership or the transactions described in Steps 4 and 5." Id.
To execute the scheme, Merrill Lynch enlisted the same Dutch bank, Algemene Bank Netherlands, N.V. (ABN), that had served as the foreign partner in the shelter at issue in ASA. See ASA, 201 F.3d at 508. Merrill Lynch drafted a "credit proposal" for ABN that, like the Zelisko memorandum, outlined the partnership's investment steps, including (1) the purchase of highly rated private placement notes (PPNs); (2) the sale of the PPNs for cash and contingent notes; and (3) Brunswick's gradual buy-down of ABN's partnership interest. Id. at 692. In a separate memorandum to ABN, Merrill Lynch confirmed that "ABN will receive ... an upfront fee [of] around $600,000." Id. Previously, Merrill Lynch had assured ABN that in these types of deals, it would face "virtually no credit risk [since] the paper invested in [would] be of the highest credit quality and [would] have short term maturities," and that interest rate risk would be eliminated by a series of "perfect hedges." "Legal and tax risk," Merrill Lynch assured ABN, "will be covered by opinions of legal and tax counsel." Id.
Because Brunswick ultimately sold more assets than originally anticipated, it implemented the scheme outlined above on two separate occasions using two separate partnerships: Saba Partnership and Otrabanda Investerings Partnership.
On February 26, 1990, Brunswick contributed $20 million, and ABN contributed $180 million to the newly formed Saba Partnership (Zelisko memorandum, Step 1). Id. at 693. Saba immediately--in fact, the very same day--bought $200 million worth of 5-year PPNs (Step 2). Merrill Lynch then began to negotiate the sale of the notes and, on March 6, transmitted a summary of terms to two potential buyers. On March 23, just prior to the close of Saba's first taxable year, Saba sold the PPNs, worth $200 million, for an immediate cash payment of $160 million and four indefinite debt instruments, known as LIBOR (London Interbank Offering Rate) notes, worth approximately $38.5 million (Step 3). Id. at 695. Saba could have reduced its $1.5 million loss by selling the PPNs to a money market fund and then purchasing LIBOR notes, but because such funds cannot issue LIBOR notes, Saba eliminated them from consideration. Id. Saba could also have eliminated the loss by investing in LIBOR notes directly...
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