1998 Decisions

Opinions of the United

States Court of Appeals

for the Third Circuit

10-13-1998

ACM Partnership v. Commissioner IRS (Part I)

Precedential or Non-Precedential:

Docket 97-7484,97-7527

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Recommended Citation

"ACM Partnership v. Commissioner IRS (Part I)" (1998). 1998 Decisions. Paper 242.

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Volume 1 of 2 

Filed October 13, 1998 

UNITED STATES COURT OF APPEALS 

FOR THE THIRD CIRCUIT 

Nos. 97-7484 and 97-7527 

ACM PARTNERSHIP, 

SOUTHAMPTON-HAMILTON COMPANY, 

TAX MATTERS PARTNER, 

 Appellant in No. 97-7484 

v. 

COMMISSIONER OF INTERNAL REVENUE 

ACM PARTNERSHIP, 

SOUTHAMPTON-HAMILTON COMPANY, 

TAX MATTERS PARTNER, 

v. 

COMMISSIONER OF INTERNAL REVENUE 

 Appellant in No. 97-7527 

On Appeal from the United States Tax Court 

(Tax Court No. 10472-93) 

Argued June 23, 1998 

BEFORE: GREENBERG, ALITO, and McKEE, 

Circuit Judges 

(Filed October 13, 1998) 

 Albert H. Turkus (argued) 

 Fred T. Goldberg, Jr. 

 Pamela F. Olson 

 Skadden, Arps, Slate 

 Meagher & Flom, LLP 

 1440 New York Avenue, N.W. 

 Washington, D.C. 20005 

 William L. Goldman 

 Christopher Kliefoth 

 McDermott, Will & Emery 

 600 Thirteenth Street, N.W. 

 Washington, D.C. 20005 

 Attorneys for Appellant 
 and Cross Appellee ACM 

 Partnership, Southampton-Hamilton 

 Company, Tax Matters Partner 

 Loretta C. Argrett 

 Assistant Attorney General 

 Richard Farber 

 Edward T. Perelmuter (argued) 

 Tax Division 

 Department of Justice 

 Post Office Box 502 

 Washington, D.C. 20044 

 Attorneys for Appellee 

 and Cross Appellant 

 Commissioner of Internal Revenue 

OPINION OF THE COURT 

GREENBERG, Circuit Judge. 

I. INTRODUCTION 

Appellant ACM Partnership ("ACM"), through its tax 

matters partner Southampton-Hamilton Company 

("Southampton"), appeals from a decision of the United 

States Tax Court dated June 12, 1997. The Tax Court's 

jurisdiction rested on I.R.C. SS 7442, 6213 and 6226 based 

 2 

on appellant's timely filing of a petition seeking 

redetermination of a deficiency and review of a Final 

Partnership Administrative Adjustment. Appellate 

jurisdiction rests on I.R.C. S 7482(a)(1). Venue is proper 

pursuant to I.R.C. S 7482(b)(1)(A) as Southampton 

maintained its principal place of business within this 

circuit at the time it filed its petition. For the reasons that 

follow, we will affirm in part, reverse in part, dismiss the 

Commissioner of Internal Revenue's cross appeal, and 

remand for further proceedings. 

II. FACTUAL AND PROCEDURAL HISTORY 

This appeal concerns the tax consequences of a series of 

transactions executed between November 1989 and 

December 1991 by appellant ACM, a partnership formed on 

October 27, 1989, with its principal place of business in 

Curacao, Netherlands Antilles. Each of ACM's three 

partners was created as a subsidiary of a larger entity 

several days before ACM's formation. Southampton was 

incorporated under Delaware law on October 24, 1989, as 
a wholly-owned subsidiary of Colgate-Palmolive Company 

("Colgate"), an international consumer products company. 

Kannex Corporation N.V. ("Kannex") was incorporated

under Netherlands Antilles law on October 25, 1989, as an 

entity controlled by Algemene Bank Nederland N.V. ("ABN"), 

a major Dutch bank. ACM's third partner, Merrill Lynch 

MLCS, Inc. ("MLCS"), was incorporated under Delaware law 

on October 27, 1989, as a wholly owned subsidiary of 

Merrill Lynch Capital Services, an affiliate of the financial 

services holding company Merrill Lynch & Co., Inc. ("Merrill 

Lynch"). See ACM Partnership v. Commissioner, 73 T.C.M. 

(CCH) 2189, 2190, 2197 (1997); app. at 81-84, 89-91. 

A. The Proposed Partnership 

The concept behind the ACM partnership originated in a 

proposal which Merrill Lynch presented to Colgate in May 

1989. During the previous year, Colgate had reported 

$104,743,250 in long-term capital gains which were 

attributable in significant part to the sale of its wholly 

owned subsidiary The Kendall Company ("Kendall"). See 

 3 

app. at 74-75. Colgate had considered and rejected several 

proposals to reduce the tax liability arising from those 1988 

capital gains, see app. at 664, when Merrill Lynch 

representative Macauley Taylor approached Colgate's

Assistant Treasurer Hans Pohlschroeder in May 1989 and 

proposed an investment partnership that would generate 

capital losses which Colgate could use to offset some of its 

1988 capital gains. App. at 674-76, 784, 965.1 

Pohlschroeder related the plan to Colgate's Vice President 

of Taxation Steven Belasco, who expressed reservations 

because the plan entailed substantial costs, might not be 

recognized for tax purposes, and did not seem to serve 

Colgate's non-tax business purposes, and thus might not 

be well-received by Colgate's legal, financial, and

accounting departments who would be required to 

participate in the plan. See 73 T.C.M. at 2191; app. at 

1234-36. Colgate consulted a law firm for advice on the 

proposed transaction, which the law firm summarized as 

follows: 

 A (a foreign entity), B, and C form the ABC Partnership 

 (ABC) on June 30, 1989 with respective cash 

 contributions of $75, $24 and $1. Immediately 

 thereafter, ABC invests $100 in short-term securities 

 which it sells on December 30, 1989, to an unrelated 

 party. The fair market value and face amount of the 

 short-term securities at the time of the sale is still 
 $100. In consideration for the sale, ABC receives $70 

 cash and an installment note that provides for six 

 semiannual payments . . . Each payment equals the 

 sum of a notional principal amount multiplied by the 

 London Interbank Offering Rate (LIBOR) at the start of 

 the semiannual period.2 ABC uses the $70 cash and 

 the first payment on the installment note to liquidate 

 A's interest in ABC and uses the subsequent interest 

 payments to purchase long-term securities. 

_________________________________________________________________ 

1. The proposal was premised on I.R.C. S 1212(a), which permits a 

taxpayer to carry back a capital loss to offset capital gains recognized 

within the preceding three years. 

2. The LIBOR [London Interbank Offering Rate] is the primary fixed 

income index reference rate used in [Europeanfinancial] markets. 

(Footnote is by Tax Court.) 

 4 

73 T.C.M. at 2191. 

The law firm advised that the sale of the short-term 

securities would be reported as a contingent installment 

sale under the installment method which governs 

"dispositions[s] of property where at least 1 payment is to 

be received after the close of the taxable year in which the 

disposition occurs," I.R.C. S 453, and the ratable basis 

recovery rule which provides that, 

 [w]hen a stated maximum selling price cannot be 

 determined as of the close of the taxable year in which 

 the sale or other disposition occurs, but the maximum 

 period over which payments may be received under the 

 contingent sale price agreement is fixed, the taxpayer's 

 basis (inclusive of selling expenses) shall be allocated 

 to the taxable years in which payment may be received 

 under the agreement in equal annual increments. 

Temp. Treas. Reg. S 15a.453-1(c)(3)(i).3 Thus, the law firm 

advised, ABC would recover $25 of its basis in each of the 

4 taxable years from 1989 through 1992, and ABC would 

recognize gain to the extent that the payments received in 

any year exceeded the $25 or loss to the extent that the 

payments fell below the $25, but only if the loss were 

carried over to a year with sufficient reported gains against 

which to offset that loss. See 73 T.C.M. at 2191. 

On July 18, Pohlschroeder and Taylor, who had 

presented Merrill Lynch's proposal to Pohlschroeder's 

colleagues in Colgate's treasury department, discussed 
Colgate's concerns about the proposed partnership 

transaction, including its costs and its potential to serve 

Colgate's business purposes. Pohlschroeder's handwritten 

notes of the conversation read as follows: 

 . . . 

 Based on bus. purpose 

 Economic profit 

 Is this partnership profitable? 

_________________________________________________________________ 

3. All citations to the Internal Revenue Code and Treasury regulations 

with respect to both this case and the cases we cite are to the versions 

in effect at the time of the relevant transactions.

 5 

 Every single step to be substantiated 

 invest in your own debt 

 Consolidation of effective control but not majority 

 ownership. 

App. at 634, 791. 

Colgate was interested in the concept of using the 

proposed partnership to invest in its own debt because of 

recent developments which had weighted Colgate's debt 

portfolio toward fixed-rate long-term debt, leaving Colgate 

vulnerable to a decline in interest rates.4 Moreover, 

persistent rumors that Colgate was a likely target for a 

hostile takeover or leveraged buyout had decreased the 

value of Colgate's debt issues due to the risk that Colgate's 

credit rating would be downgraded if Colgate became more 

highly leveraged. Because of these factors, Colgate

perceived an opportunity to rebalance its debt profile, thus 

decreasing its exposure to falling interest rates, by 

acquiring its long-term debt issues at their presently 

discounted prices. See app. at 666-68, 880-82, 2762-63, 

2765, 2769-70; 73 T.C.M. at 2192. 

Colgate and Merrill Lynch discussed the possibility of 

using the proposed partnership to achieve these objectives. 

The acquisition of its own debt issues would decrease 

Colgate's exposure to falling interest rates because by 

acquiring those debt issues as an asset, Colgate effectively 

would reap the benefits of receiving the above-market 

interest payments due on those issues, thus hedging

against the burdens associated with owing those payments. 

See 73 T.C.M. at 2193. Acquiring the debt through the 

partnership instead of directly would keep the acquisitions 

off Colgate's books, thus permitting Colgate to carry out its 

_________________________________________________________________ 
4. The elevated proportion of long-term debt in Colgate's debt structure 

arose in part from Colgate's use of the proceeds from the Kendall sale to 

retire significant amounts of short-term debt and its issuance of longterm debt to finance an employee retirement plan. See 73 T.C.M. at 

2192; app. at 77-78, 669-70, 2761, 2764-70. This high proportion of 

long-term fixed-rate debt exposed Colgate to risk in the event of 

declining 

interest rates, as Colgate would receive diminished returns from its cash 

balances and short-term deposits, but would continue to owe interest on 

its debts at the higher fixed rate. 

 6 

debt acquisition strategy without alerting potential 

acquirors to the internal accumulation of debt issues 

which, by increasing the capacity for internal leverage, 

would increase Colgate's vulnerability to a hostile takeover 

bid. See 73 T.C.M. at 2192-93; app. at 101, 3249-50, 1921- 

26, 2793-99, 2810, 2819-20, 3255-61. Thus, the 

acquisition of Colgate debt through the partnership would 

allow Colgate to use partnership capital to acquire its debt 

issues immediately at advantageous prices, then to retire 

and reissue the debt when market conditions were more 

favorable. In the interim, the debt effectively would be 

retired because Colgate would not owe the obligations 

thereon to third parties, yet the debt would remain

outstanding for accounting purposes, reducing Colgate's 

vulnerability to potential acquirors. See app. at 673; 73 

T.C.M. at 2193. 

On July 28, 1989, Merrill Lynch presented a proposed 

partnership transaction summary which incorporated 

Colgate's debt acquisition objectives into the tax reduction 

proposal involving the contingent installment sale which 

Merrill Lynch had presented to Colgate in May 1989. See 

app. at 678-79. Merrill Lynch revised its proposals

throughout the summer and approached ABN about 

participating in the partnership with Colgate and Merrill 

Lynch. Merrill Lynch explained to ABN that the partnership 

would invest in Colgate long-term debt to serve Colgate's 

debt management objectives, would engage in a contingent 

installment sale, and would require ABN's participation for 

no more than 2-3 years. ABN agreed to meet with Colgate 

representatives in the middle of October 1989. See 73 

T.C.M. at 2193-94.5 

In a document dated August 17, 1989, Merrill Lynch set 

forth revisions to the planned partnership transactions 

which it had presented to Colgate on July 28, 1989. See 

app. at 275-77. This document, entitled "Revised 

_________________________________________________________________ 
5. ABN was familiar with its role in the proposed transaction, as Merrill 

Lynch had approached ABN in early 1989 while it was developing the 

proposal and had sought ABN's participation in a similar partnership 

arranged on behalf of another Merrill Lynch client. See 73 T.C.M. at 

2194; app. at 1670-75, 1103. 

 7 

Partnership Transaction Summary," see app. at 263-67, set 

forth the following proposal incorporating both the

contingent installment sales transaction which Merrill 

Lynch initially had proposed in May 1989 and the debt 

acquisitions which Merrill Lynch had incorporated in its 

July 28 proposal:6 

 1) A Colgate subsidiary contributes $30 million, A BN 

 contributes $169.3 million and Merrill Lynch

 contributes $.7 million. 

 2) The partnership invests its entire $200 million 

 capitalization in short-term, floating rate private 

 placement securities as "Interim Investments prior to 

 the acquisition of [Colgate] debt" which are to "earn a 

 return greater than comparably rated commercial 

 paper or bank deposits." 

 3) The partnership sells the short-term notes for a 

 combination of cash and LIBOR-based notes and uses 

 the cash to acquire Colgate debt. "The purpose of the 

 LIBOR notes will be to partly hedge the interest rate 

 sensitivity of long-term [Colgate] debt acquired by the 

 Partnership." 

 4) The partnership exchanges a portion of the long - 

 term Colgate debt for newly issued medium-term 

 Colgate debt, pursuant to a provision which affords 

 Colgate the option of making such exchanges through 

 the partnership. 

 5) The partnership adjusts its LIBOR note holdings. If 

 the partnership retains a substantial amount of long- 

 term debt, the Partnership "would likely . . . acquire 

 additional LIBOR-based assets or . . . other hedges to 

 reduce interest rate sensitivity of Partnership assets. 

 Alternatively, if a substantial amount of long-term 

 [Colgate] debt is exchanged, the Partnership would 

_________________________________________________________________ 

6. The August 17 transaction summary referred to Colgate as "XYZ 

corporation," ABN as "Partner A," and Merrill Lynch as "Partner B." 

However, the identity of the parties is clear from the role that each of 
them played in the ensuing transactions and from Pohlschroeder's 

testimony. See app. at 685. Except where there are direct quotations we 

have paraphrased the summary. 

 8 

 likely reduce its holding of LIBOR notes. Such a 

 reduction would be necessary because the Medium- 

 Term Debt, received in exchange for long-term [Colgate] 

 debt, is less interest rate sensitive than the long-term 

 [Colgate] debt. LIBOR Notes may either be sold directly 

 or distributed to one or more Partners in a non- 

 liquidating distribution." 

 6) If the partnership has not invested all of its capital 

 in Colgate debt and LIBOR instruments, the 

 partnership "may liquidate some or all of the remaining 

 Short-Term Notes and distribute the proceeds to one or 

 more of the partners."7 

 7) "Possible redemption of [ABN's] Partne rship interest. 

 Commencing one year after formation of the 

 Partnership, [ABN] has the right to have its Partnership 

 interest redeemed by the Partnership . . . . The 

 Partnership may redeem [ABN] in kind with 

 Partnership property of its choosing or in cash. For 

 example, assuming no change in asset values, the 

 Partnership could borrow $169.3 million collateralized 

 by its assets and use the proceeds to redeem [ABN]." 

 8) "If [ABN] is redeemed, the Partnership must be 

 consolidated with [Colgate] for financial reporting 

 purposes. Accordingly, all assets, including [Colgate] 

 debt . . . will appear on the [Colgate] consolidated 

 balance sheet. The [Colgate] debt will be effectively 

 retired at that time. . . . [I]f the [Colgate] debt were 

 acquired at a premium or a discount, [Colgate] would 

 recognize a loss or gain, respectively, for income 

 statement purposes. It would be most reasonable for 

 the Partnership to sell the LIBOR Note . . . if[ABN] is 

 redeemed. Since the principal asset of the Partnership, 

 other than LIBOR Notes . . . is likely to be [Colgate] 

 debt and [Colgate] would be a 98% partner, the hedge 

 protection provided by the LIBOR Notes . . . is no 

 longer necessary." 

_________________________________________________________________ 

7. This item was designated "Step 7." "Step 6" addressed a possible 

investment in Colgate receivables as an alternative to the LIBOR notes. 

Because ACM did not invest in Colgate receivables, this aspect of the 

proposal is immaterial. 
 9 

 9) "After a period of years it might be advanta geous for 

 [Colgate] affiliates to purchase [Merrill Lynch's] 

 Partnership interest. Alternatively, the Partnership 

 might be liquidated with [Colgate] receiving[Colgate] 

 debt as proceeds of the liquidation." 

App. at 275-77. The final page of that document addressed 

the tax considerations of the arrangement and stated, 

 the liquidation of $200 million of Short-Term Notes in 

 exchange for approximately $140 million of cash and 

 $60 million market value of LIBOR notes should result 

 in approximately $106 million of gain to the

 Partnership. 15% of such gain, $16 million, will be 

 allocable to [Colgate]. If . . . LIBOR notes are 

 distributed to [Colgate], each $10 million market value 

 of the LIBOR notes distributed should have a tax basis 

 of approximately $28 million. In a succeeding tax year, 

 the Partnership will recognize a loss on sale or at 

 maturity of the remaining LIBOR Notes. 98% of such 

 loss will be allocable to [Colgate] because[Colgate] will 

 be a 98% partner at such time. Combined, losses on 

 sale of LIBOR Notes distributed to [Colgate] and losses 

 on sale of LIBOR Notes by the Partnership should 

 exceed $106 million. Accordingly, [Colgate] should 

 recognize a net loss of approximately $90 million. After 

 discounting and transactions costs . . . the transaction 

 produces over $20 million present value benefits to 

 [Colgate]. 

App. at 279. 

A representative of ABN's legal department testified that 

the partnership, as he understood it, was to: 

 enter into transactions that would create a capital gain 

 and in a later stage a capital loss, and that . . . 

 depending on the percentage of your participation, you 

 would either take part in the gain or the loss. So by 

 having us being the majority partner at the start, we 

 would take the majority of the gain, while in a later 

 stage one of the other partners would take the loss. 

App. at 1298. 

 10 

In a memorandum dated October 3, 1989, Pohlschroeder 
recommended the partnership to Colgate Treasurer Brian 

Heidtke. See App. at 310-21. Pohlschroeder outlined the 

advantages of repurchasing outstanding Colgate debt

through a partnership, and stated that "[t]he partnership 

would temporarily invest the funds in some short-term 

instruments and, at the same time, start the repurchasing 

program." App. at 312. The memorandum identified three 

sets of Colgate debt issues targeted for repurchase: 1) a set 

of 9.625% 30-year notes due in 2017 ("Long Bonds"); 2) a 

set of Eurodollar debentures due in 1996 ("Euro notes"); 

and 3) a set of 8.4% private placement notes held by 

Metropolitan Life Insurance Company ("Metropolitan") and 

due in 1998 ("Met Notes"). The memorandum stated that 

"pursuant to an inquiry to Metropolitan, we feel confident 

that the partnership can purchase sufficient Colgate debt" 

to carry out the proposed plan. App. at 313-14.8 

The memorandum's "Interest Rate Outlook" predicted 

that although the Federal Reserve Bank was not expected 

to "quickly lower interest rates in the near future," it was 

expected to "reduce the . . . rate" by late 1989 or early 1990 

to a level that would allow Colgate to "lock in attractive 

medium term interest rates." App. at 311. The 

memorandum then analyzed the impact of a one to two

percent interest rate increase or decrease on the LIBOR 

notes and the Colgate debt issues that the partnership 

expected to acquire. According to the analysis, a given 

decrease in interest rates would increase the value of the 

long-term Colgate debt and decrease the value of the LIBOR 

notes in roughly equal and offsetting amounts because the 

value of the LIBOR notes was directly dependent on interest 

rates whereas the value of the fixed-rate debt issues was 

inversely proportional to interest rates. See app. at 951-52, 

313. Thus, the memorandum concluded, "the LIBOR note is 

an effective hedge of fixed rate assets for the partnership." 

App. at 313. The memorandum stated that it would be

necessary to establish a "Desired Hedge Ratio" of LIBOR 

holdings to long-term debt holdings, so that the 

_________________________________________________________________ 

8. Pohlschroder testified that as of August 1989, he had received calls 

from traders indicating that the Long Bonds also were potentially 

available for purchase. See app. at 688. 

 11 

partnership's assets would be "fully hedged" against 

changes in value due to interest rate fluctuations. App. at 

314. 

The memorandum recommended that Colgate proceed 

with the partnership as a means "to actively manage its 
liability structure," and stated that the "Next Steps" after 

executing a partnership agreement, establishing the

partnership in a "Foreign Jurisdiction" and funding the 

partnership were the following: 

 -Short-term investment securities acquired. 

 - . . . . Disposition of short-term investment securities 

 to fund acquisition of Colgate debt. 

App. at 321. 

In a document marked "REVISED 9/1/89," Merrill Lynch 

provided Colgate a "Cost Component Analysis," which

estimated after-tax costs associated with the proposed 

acquisition and disposition of short-term notes and

acquisition of LIBOR notes. Merrill Lynch estimated that 

the short-term notes would entail an "origination" cost of 

$1.32 million, while the "remarketing" of the LIBOR notes 

would cost $1.29 million in addition to $.17 million in legal 

expenses and $1.32 million in Merrill Lynch advisory fees. 

See app. at 294. 

A September 20, 1989 document delineated the details of 

the proposed partnership transactions and their anticipated 

tax consequences under I.R.C. S 453 and the ratable basis 

recovery rule, Temp. Treas. Reg. S 15a.453. See app. at 

296-308. The document contemplated using the 

partnership's $200 million in cash investments to acquire 

short-term notes, see app. at 303, disposing of the shortterm notes in exchange for $140 million in cash and LIBOR 

instruments which would generate contingent payments 

with a present value of $60 million, and using the $140 

million in cash to purchase Colgate debt. App. at 300-01, 

304-05. Because the partnership was to receive payments 

on the exchange over the course of six years, the $200 

million basis in the short-term notes was to be recovered 

ratably over six tax years in equal increments of $33.3 

million per year pursuant to S 15a.453. Thus, according to 

 12 

this document, the transaction would result in significant 

capital gains in the first year, consisting of the $106.7 

million difference between the $140 million cash received 

that year and the $33.3 million basis recovered that year, 

and would result in capital losses in each of the ensuing 

years because the contingent payments received in each of 

those years considering imputed interest would fall short of 

the $33.3 million basis to be recovered in each of those 

years. See app. at 301. The aggregate projected capital 

losses in the ensuing years equaled precisely the amount of 
capital gains reported in the first year, and the document 

stated that the recognition of those losses "may be

accelerated in any year subsequent to 1989 by sale of the 

remaining LIBOR notes." App. at 301. 

The document also contemplates Colgate's increasing its 

share in the partnership from 15% to 97% after the 

partnership recognized the $106.7 million capital gain in 

year 1 but before it recognized the capital losses in the 

ensuing years. See app. at 305-08. According to the

document, the LIBOR notes eventually would be sold for a 

capital loss of $80 million, 97% of which would be allocated 

to Colgate based on its 97% partnership interest by the 

time the loss was incurred. See app. at 304, 308-09. 

At an October 12, 1989 meeting of Colgate's Board of 

Directors, the Directors considered the proposal and stated 

that it: 

 had originally been presented . . . with a view toward 

 minimizing the capital gains tax arising out of the 

 disposition of the Kendall business. However, major 

 changes were made . . . so that the program would 

 provide the important business advantages of

 accumulating [Colgate] debt in friendly hands and 

 permitting [Colgate] to obtain flexibility in managing 

 the ratio balance between short and long term debt 

 and the resulting interest exposure. Without these 

 treasury advantages, management would not have 

 recommended this transaction. 

 . . . . Over the life of the partnership, significant tax 

 benefits should be generated for Colgate, but even 

 without these benefits, Colgate would earn a pre-tax 

 return of approximately 6% on its investment. 

 13 

App. at 337. According to Steven Belasco, Colgate's Vice 

President of Taxation, the incorporation of Colgate's debt 

acquisition objectives into Merrill Lynch's initial proposal 

afforded sufficient business advantages to overcome

Colgate's hesitations about Merrill Lynch's initial proposal 

which served only the tax objectives of generating a capital 

loss to offset 1988 capital gains. See app. at 1235-36. 

B. The Partnership 

In late September and early October 1989, as Colgate 

was contemplating final approval of its participation in the 

proposed partnership, Merrill Lynch was finalizing 

arrangements for ABN's participation in the partnership. An 
ABN document dated October 11, 1989, stated that it

would agree to enter the partnership on the conditions that: 

1) "[t]he timing of the purchases and sales of the various 

securities be adhered to as proposed;" 2) "Colgate's 

obligation to purchase Kannex's interest in the partnership 

. . . is unconditional;" and 3) Merrill Lynch agrees to 

repurchase the securities "at par on November 29, 1989." 

73 T.C.M. at 2197; app. at 1061, 1064-65.9 

Between October 24 and October 27, 1989, ABN 

established Kannex, Colgate established Southampton, and 

Merrill Lynch established MLCS to participate in the ACM 

partnership. See 73 T.C.M. at 2197; app. at 81-84, 89-91. 

The October 27, 1989 partnership agreement among these 

newly created entities provided that Kannex was to receive 

a preferred return of the first $1.24 million in any 

partnership profits otherwise allocable to Southampton. See 

app. at 101; 73 T.C.M. at 2198-99.10 

_________________________________________________________________ 

9. The document referred to the securities as "MTNs" or medium-term 

notes. However, it is apparent from the November 29, 1989 date by 

which those notes were to be resold that these were the same securities 

which the partnership was to purchase initially and dispose of shortly 

thereafter in exchange for cash which would be used to purchase Colgate 

debt and for LIBOR notes. See app. at 321, 300-05. 

10. This "preferred return" provision was a component of the proposed 

partnership from its inception. In a document dated September 1, 1989, 

Merrill Lynch advised Colgate that this aspect of the partnership would 

cost Colgate $740,000. See app. at 294. 

 14 

On October 27, 1989, after executing the partnership 

agreement, the partners met and authorized Merrill Lynch 

to find willing sellers of Colgate debt issues, including the 

Euro Notes, Met Notes, and Long Bonds which had been 

identified in Pohlschroeder's October 3 memorandum. See 

app. at 313, 386. The partners resolved that "in order to 

maximize the investment return on its assets pending the 

acquisition" of these debt issues, Merrill Lynch was 

authorized "to arrange the purchase (in a private 

placement) of $205 million of . . . unsecured debt." App. at 

386-87. 

The minutes of the partnership meeting reported that 

Colgate's treasury department had contacted Metropolitan 

with a proposal to purchase $100,000,000 of the Met notes, 

and that Metropolitan "if interested, would come to

Bermuda on November 17, 1989 in order to negotiate and 

make final such transaction." App. at 387. 11 Earlier in the 
fall of 1989, Pohlschroeder had initiated discussions with 

Metropolitan about selling the notes after Metropolitan 

contacted him to express concern about certain terms in 

the notes. See app. 690-91, 742. Before the November 17 

meeting, a Metropolitan representative left Pohlschroeder a 

message indicating the price at which Metropolitan was 

prepared to sell the Met notes. Pohlschroeder did not 

respond to the call. See 73 T.C.M. at 2200; app. at 883. 

Pohlschroeder previously had conferred with Merrill Lynch's 

Henry Yordan about acquiring the Met Notes, Euro Notes, 

and Long Bonds. See app. at 117-18; 73 T.C.M. at 2200. 

Pohlschroeder's handwritten memorandum of the 

conversations regarding the Met notes concludes with a 

notation of the date November 17, while his notations 

regarding the acquisition of the Long Bonds and Euro Notes 

state that Kannex would instruct Merrill Lynch after 

purchase of Citicorp notes which, as discussed below, were 

to serve as the initial short-term investment contemplated 

in the partnership proposals. 73 T.C.M. at 2200; app. at 

880; 889-90. 

_________________________________________________________________ 

11. Pohlschroeder had contacted Metropolitan shortly after the first 

partnership meeting in October 1989 and had instructed Metropolitan to 

send a representative to the November 17 meeting if Metropolitan was 

interested in selling the Met notes. See app. at 743. 

 15 

C. The Transactions 

On November 2, 1989, Kannex contributed $169.4 

million, Southampton contributed $35 million, and MLCS 

contributed $0.6 million to the newly created ACM 

partnership for a total partnership capitalization of $205 

million. See app. at 98. Based on these contributions, 

Kannex held an 82.6% share of the partnership, 

Southampton held a 17.1% share, and MLCS held a 0.3% 

share. 73 T.C.M. at 2197; app. at 98. ACM deposited the 

$205 million in an account at ABN's New York branch

paying interest at an annual rate of 8.75%. ACM withdrew 

the funds the following day and purchased ten private 

placement Citicorp notes in an aggregate amount of $205 

million. The Citicorp notes paid interest monthly at a 

floating rate that was to be reset monthly. The initial rate 

was 8.78%, three basis points above the rate the funds 

were earning in the ABN account.12 On November 15, 1989, 

Citicorp made an interest payment and reset the interest 

rate to 8.65%. 73 T.C.M. at 2200. 

In late October 1989, before ACM's November 3 

acquisition of the Citicorp notes, Merrill Lynch had 
approached Bank of Tokyo ("BOT") and Banque Francaise 

du Commerce Exterieure ("BFCE") to negotiate selling them 

those notes.13 During the first week of November, Merrill 

Lynch forwarded BOT and BFCE specific terms of the 

proposed sale in which those two banks would purchase an 

aggregate of $175 million of the notes for $140 million in 

cash plus LIBOR notes providing for a five-year stream of 

quarterly payments with a net present value of 

approximately $35 million. See 73 T.C.M. at 2200; app. at 

107-08.14 On November 9, 1989, BOT representatives 

_________________________________________________________________ 

12. A basis point, a common unit of measure for interest rates, equals 

one one-hundredth of a percent. 

13. Pohlschroeder testified that ACM expected to sell the Citicorp notes 

for cash and LIBOR notes within several weeks to make the cash 

available to purchase Colgate debt. App. at 739-40. Pohlschroeder also 

stated that the Citicorp exchange was designed "to accomplish a tax 

aspect of the transaction." App. at 740. 

14. In negotiating the transactions with BOT and BFCE, Merrill Lynch 

also agreed to arrange a series of swaps which would hedge the banks' 

interest rate risks and provide them additional return on their purchase 

of the Citicorp notes. See 73 T.C.M. at 2206-10. 

 16 

requested approval from their head office, attaching 

documents which set forth "all details of the transaction." 

On November 10, 1989, Merrill Lynch confirmed that it 

would sell $125 million in Citicorp notes to BOT and $50 

million to BFCE. See app. at 111-14; 73 T.C.M. at 2200. 

On November 17, 1989, ACM convened its second 

partnership meeting in Bermuda. A Metropolitan 

representative attended pursuant to Pohlschroeder's

invitation to attend if interested in selling the Met Notes. 

After brief negotiations, ACM and Metropolitan agreed that 

ACM would purchase $100 million principal amount of Met 

Notes effective December 4, 1989. App. at 118-19, 390; 73 

T.C.M. at 2201. Pohlschroeder stated that ACM would need 

to raise cash by the time of the December 4 purchase and 

that the acquisition of long-term fixed-rate debt"would 

create a risk to the partnership in the event that interest 

rates increased." Accordingly, he recommended that ACM 

"hedge its risk by purchasing notional principal contracts 

with a floating rate of interest." App. at 391. ACM thus 

resolved "to arrange the sale of $175 million principal 

amount of Citicorp Notes" to BOT and BFCE "for cash and 

other LIBOR-based consideration, upon substantially the 

terms of a draft Installment Purchase Agreement presented 
to the meeting . . . in order to pay Metropolitan the 

amounts to be due . . . and to hedge . . . exposure to 

interest rate changes." App. at 391. 

ACM completed the sale of the Citicorp notes on 

November 27, 1989, in accordance with the terms which 

Merrill Lynch had negotiated by November 10 and which 

ACM had approved on November 17, selling $125 million of 

the notes to BOT and $50 million of them to BFCE for a 

total of $140 million in cash and eight LIBOR notes issued 

by BOT and BFCE. The LIBOR notes provided for a stream 

of 20 quarterly contingent payments commencing on March 

1, 1990, whose amount was derived from the three-month 

LIBOR multiplied by a notional principal amount of $97.76 

million.15 

_________________________________________________________________ 

15. The notional principal amount did not represent an amount owed, 

but rather was designated as a multiplier to determine the amount of the 

LIBOR-based contingent payments. 

 17 

In exchange for the $175,000,000 Citicorp notes, ACM 

received consideration totaling $174,410,814, which

represented the $175,000,000 value of the Citicorp notes, 

reduced by the $1,093,750 in transaction costs for 

arranging the sale of these illiquid private placement 

instruments, but increased by the $504,564 in interest that 

had accrued on the Citicorp notes during the 12 days since 

their last interest payment on November 15. Accordingly, 

the LIBOR notes effectively cost ACM $35,504,564, the 

difference between the $175,504,564 in value which ACM 

relinquished and the $140,000,000 in cash which ACM

received in return, but had a present value of $34,410,814 

to reflect the $1,093,750 in transaction costs. See 73 

T.C.M. 2201 02, 2206-10; app. at 751. The LIBOR notes 

issued by BOT accounted for $25,360,403 of the aggregate 

cost and $24,579,153 of the aggregate present value, while 

those issued by BFCE accounted for $10,144,161 of the 

aggregate cost and $9,831,661 of the aggregate present 

value of the LIBOR notes acquired in the exchange. See 73 

T.C.M. at 2201. 

Upon selling the Citicorp notes on November 27, ACM

invested the $140 million in cash proceeds in time deposits 

and certificates of deposit due seven days later on

December 4, 1989, and bearing interest at 8.15% to 8.20%. 

In several transactions between December 4 and 8, ACM 

purchased Colgate debt including $100 million of the Met 

Notes pursuant to the November 17 agreement, $5 million 

of the Euro Notes, and $31 million of the Long Bonds. See 
app. at 118-20. ACM purchased an additional $18.75 

million in Colgate long-term debt issues between June and 

October 1990. See 73 T.C.M. at 2205; app. at 119-20, 122- 

23. 

During the weeks preceding ACM's November 27 

acquisition of the LIBOR notes, Merrill Lynch began

arranging to sell a portion of them. In a November 13, 1989 

memorandum entitled "Analysis of Partnership Hedging 

Activity," Merrill Lynch stated that certain events would 

warrant a reduction in the desired amount of LIBOR 

holdings. Specifically, Merrill Lynch explained that if 

Southampton elected to increase its share of the 

partnership's interest rate risk, as it was entitled to do 

 18 

under a provision of the partnership agreement, see app. at 

101; 73 T.C.M. at 2198-99, or if ACM exchanged the Long 

Bonds for a new issue of five-year Colgate debt, ACM 

should reduce its LIBOR note holdings in light of its 

diminished need for their hedging function. See 73 T.C.M. 

at 2202. Merrill Lynch approached a major Danish bank, 

Sparekassen SDS ("Sparekassen"), offering it the BFCE 

LIBOR notes which totaled approximately $10 million, 

along with collateral swaps which provided Sparekassen 

risk protection and a return on its investment. On 

December 5, 1989, Sparekassen set aside a $10 million 

credit line in preparation for the transaction. See 73 T.C.M. 

at 2202. 

At ACM's third partnership meeting on December 12, 

1989, Southampton elected to increase its share of ACM's 

interest rate exposure and ACM exchanged a portion of the 

Long Bonds for shorter-term debt issues pursuant to"the 

terms of a Note Purchase Agreement presented to the

meeting." See app. at 101, 396-97; 73 T.C.M. at 2205. 

Merrill Lynch advised that ACM decrease its LIBOR note 

holdings in light of these factors reducing its interest rate 

exposure. App. at 397. ACM resolved to distribute the 

BFCE LIBOR notes to Southampton as a return of 

contributed capital, and executed Assignment Agreements 

conveying those notes to Southampton. See app. at 124, 

398. 

On December 22, 1989, Southampton sold the BFCE 

notes to Sparekassen for aggregate consideration of

$9,406,180, an amount $425,481 below the $9,831,661

present value of the notes when ACM acquired them on 

November 27. See app. at 125-26; 73 T.C.M. at 2201,

2202-03 & n.10. Of this discrepancy, $390,000 resulted 

from the transaction costs and bid-ask spread necessary to 
market the LIBOR notes, while the remaining shortfall 

resulted from the decreased value of the notes due to the 

decline in interest rates since November 27 and from a 

quarterly payment on the notes which reduced their 

remaining value. See 73 T.C.M. at 2202; app. at 1560-61, 

1628. 

On June 25, 1991, Colgate acquired a 38.31% share in 

ACM from Kannex for $85,897,203.60 and Southampton 

 19 

acquired an additional 6.69% share from Kannex for 

$15,000,000, giving Colgate-Southampton a majority 

interest in ACM. App. at 131-32, 414. Because it had 

acquired a majority interest in ACM, Colgate consolidated 

ACM's holdings with its own on its books, revealing its 

control of the debt issues which theretofore had remained 

outstanding on its books. See app. at 3249-50. ACM 

retained $30 million in Citicorp notes until October 16, 

1991, when it put them to Citicorp at par pursuant to an 

option provision. ACM earned $4,329,191 of interest on the 

portion of the Citicorp notes which it held until 1991. See 

app. at 507-67, 570-98. 

On November 27, 1991, ACM redeemed Kannex's 

remaining partnership interest for $100,775,915, leaving 

Colgate and Southampton with a combined 99.7% interest 

in ACM. App. at 137-38. At a December 5, 1991 

partnership meeting, Merrill Lynch stated that because 

Colgate owned virtually the entire partnership, its"net 

economic exposure to the risk of interest rate fluctuations 

in the value of the Colgate debt was effectively minimal, and 

the Partnership need not maintain its position in the 

[LIBOR notes] to hedge against such exposure." App. at 

408. Thus, Merrill Lynch explained, without the need for 

hedging, it was "unwise for the Partnership to hold" this 

"highly volatile investment" given the market's declining 

interest rates. ACM resolved to sell its remaining LIBOR 

notes, which were those issued by BOT, the BFCE LIBOR 

notes having been distributed to Southampton and 

subsequently sold to Sparekassen. App. at 409. On 

December 17, 1991, ACM sold the BOT LIBOR notes to 

BFCE for $10,961,581, a price that reflected a significant 

loss in value due to declining interest rates which had 

reduced the three-month LIBOR from 8.5% to 5.7% and

transaction costs of $440,000 arising from the bid-ask 

spread needed to remarket the notes. See 73 T.C.M. at 

2206; app. at 138. 

D. Tax and Financial Accounting of the Transactions
On its partnership return for the tax year ended 

November 30, 1989, ACM treated the November 27, 1989 

exchange of the Citicorp notes as an installment sale under 

 20 

I.R.C. S 453, as ACM was to receive part of the 

consideration for that exchange "after the close of the 

taxable year in which the disposition occurs" pursuant to 

S 453(b)(1). App. at 109. Because the quarterly LIBOR note 

payments would vary based on fluctuations in the LIBOR, 

there was no "stated maximum selling price" that could be 

identified "as of the close of the taxable year in which the 

. . . . disposition occurs." Thus, the transaction came within 

the terms of Temp. Treas. Reg. S 15a.453-1(c), whose 

ratable basis recovery rule provides that the taxpayer's 

basis "shall be allocated to the taxable years in which 

payment may be received under the agreement in equal 

annual increments." 

Accordingly, ACM divided its $175,504,564 basis in the 

Citicorp notes, consisting of their $175 million purchase 

price and $504,564 of accrued payable interest, equally 

among the six years over which payments were to be 

received in exchange for those notes, and thus recovered 

one sixth of that basis, or $29,250,761, during 1989.16 

Subtracting this basis from the $140 million in cash 

consideration for the Citicorp notes, ACM reported a 1989 

capital gain of $110,749,239.42 which it allocated among 

its partners according to their partnership shares, resulting 

in an allocation of $91,516,689 of the gain to Kannex, 

$18,908,407 to Southampton, and $324,144 to MLCS. See 

app. at 109, 144-66; 73 T.C.M. at 2203. Southampton and 

MLCS were subject to United States income tax on their 

respective shares of the gain, but Kannex as a foreign 

corporation was not. App. at 226-35.17 

Under the ratable basis recovery rule the tax basis

remaining to be recovered over the following five years 

became $146,253,803, representing the difference between 

_________________________________________________________________ 

16. ACM divided the basis across six years instead of five, although the 

LIBOR payments were to be received over 20 quarters commencing in 

1990, because it received the cash portion of the consideration three 

days before the end of the 1989 tax year, making 1989 a year "in which 

payment may be received" under S 15a.453. 

17. According to the Tax Court the share allocated to Kannex was not 

taxed in any jurisdiction but we, of course, are focusing only on the 

United States tax aspects of the transaction. 
 21 

the $175,504,564 value of the Citicorp notes which ACM 

relinquished to acquire those notes and the $29,250,761 in 

basis recovered during the first year of the transaction. See 

app. at 110. Of the $146,253,803 reported as the remaining 

unrecovered tax basis after 1989, $41,786,801 was 

attributable to the BFCE LIBOR notes, whose actual cost 

was $10,144,161, while $104,467,002 was attributable to 

the BOT LIBOR notes, whose actual cost was $25,360,403. 

See 73 T.C.M. at 2201, 2203 & n.11. 

On its 1989 tax return, Southampton reported its 

$18,908,407 share of the capital gain from the 

$140,000,000 cash received in exchange for the Citicorp 

notes, and reported a $32,429,839 capital loss from its 

December 22, 1989 sale to Sparekassen of the BFCE LIBOR 

notes which it had received in the December 12, 1989 

distribution from ACM.18 Because these capital losses 

completely offset the capital gains, Southampton reported a 

net 1989 capital loss of $13,521,432 and did not report any 

net tax liability on its share of ACM's gain from the 

disposition of the Citicorp notes. See 73 T.C.M. at 2203. 

ACM retained the Curacao office of Arthur Andersen & 

Co. as its accountants. In reviewing ACM's financial and 

tax accounting for 1989, the Arthur Andersen auditors 

noted that ACM's records were inconsistent in their

treatment of the $1,093,750 spread between the amount of 

consideration ACM had paid for the LIBOR notes and their 

market value at the time of acquisition. Specifically, the 

auditors noted, ACM had not accounted for this transaction 

cost in its income statement, but had included it in the 

book value of the LIBOR notes contrary to a provision in 

the partnership agreement requiring that assets be 

recorded at fair market value. Due to this discrepancy, 

ACM's records effectively overstated the market value of the 

LIBOR notes and understated the transaction costs 

involved in acquiring them through the contingent 

installment sale. See 73 T.C.M. at 2204. 

_________________________________________________________________ 

18. This $32,429,839 loss was computed based upon the $9,406,180 

cash proceeds from the sale, minus the $41,786,601 tax basis in the 

notes, minus $48,693 in accrued interest payable on the notes. See 73 

T.C.M. at 2203. 

 22 

The audit manager wrote the following memorandum in
February 1990 to his colleagues regarding the discrepancy: 

 Colgate does not want the cost to sell [the Citicorp 

 notes] of US $1,093,750 . . . in the . . . income 

 statement of ACM. The reasons are mainly tax driven, 

 as inclusion might set the IRS on top of the reasons 

 why the partnership was constructed in the first place 

 and thus the planned tax losses might be denied by 

 the IRS. We . . . were requested to think with Colgate 

 in order to keep the cost to sell out of the balance 

 sheet. 

Id.; see also app. at 141. Arthur Andersen proposed that to 

avoid accounting for the costs associated with the LIBOR 

notes, ACM could continue to record the transaction costs 

as part of the value of the LIBOR notes and could resolve 

the conflict with the market valuation provision of the 

partnership agreement by issuing "a side letter to the 

partnership agreement stating that the LIBOR notes are the 

one exception to the valuation rules which now state 

valuation at market and would . . . then state valuation at 

market increased by the cost to sell the original Citicorp 

notes." Id. 

At its February 28, 1990 partnership meeting, ACM 

adopted this approach and enacted special valuation rules 

which provided that the LIBOR notes, unlike other 

partnership assets, would be valued on ACM's books "at 

cost" rather than at market value and would be adjusted 

upon distribution of the note to a partner, redemption of 

the partnership interest of any partner, or liquidation of the 

partnership. See app. at 402, 407.19 This provision

effectively transferred the transaction costs associated with 

exchanging the Citicorp notes for LIBOR notes to the 

partner that eventually received the notes in a distribution, 

as the market value would be less than the reported value 

of the distribution. See 73 T.C.M. at 2204. Thus, ACM's 

December 12, 1989 distribution of the BFCE LIBOR notes 

_________________________________________________________________ 

19. The rules described the LIBOR notes as the "[c]ontingent payment 

notes with no stated principal value, with payments resulting from the 

product of a notional amount and a floating rate of interest." App. at 

407. 

 23 

effectively passed those transaction costs to Southampton 

in accordance with the partners' understanding that

Colgate and Southampton would bear the transaction costs 

associated with trading private placement notes. See app. 

at 1622-25. 
For its tax year ended December 31, 1991, ACM reported 

a capital loss of $84,997,111 from its December 17, 1991 

sale of the BOT LIBOR notes.20 This loss consisted of the 

difference between the $10,961,581 that ACM received for 

those notes and the remaining $95,958,692 basis in those 

notes. App. at 202-25. Of this amount of loss, $5.8 million 

resulted from a decline in the value of the LIBOR notes due 

to declining interest rates while $79,106,599 resulted from 

the application of the ratable basis recovery rule which 

effectively added to the tax basis of the LIBOR notes 5/6 of 

the $140 million value of the Citicorp notes which had been 

exchanged for cash. See 73 T.C.M. at 2206. 21 Because 

Colgate, together with its subsidiary Southampton, by that 

time owned 99.7% of the partnership, Colgate claimed 

99.7% of the $84,997,111 capital loss on its 1991 return 

for a total capital loss of $84,537,479. App. at 247-51. 

Colgate then filed an amended 1988 return reporting this 

_________________________________________________________________ 

20. This appeal concerns adjustments to ACM's 1989 and 1991 tax 

returns. Although the Commissioner's Final Partnership Administrative 

Adjustment and the Tax Court's decision made adjustments to ACM's 

1990 tax return, these adjustments affected only the basis in certain 

assets with no effect on net tax liability for 1990. See app. at 3444. 

Thus, we do not discuss the 1990 return further. 

21. Had it not applied the ratable basis recovery rule, ACM would have 

subtracted from the consideration it received upon disposition of the 

BOT LIBOR notes only the remaining portion of the LIBOR notes' 

aggregate $35,504,564 actual cost basis rather than the remaining 

portion of their aggregate $175,504,564 tax basis which ACM derived by 

aggregating the $140 million cash portion of the Citicorp note 

transaction with the $35 million LIBOR note portion of the transaction 

and adjusting the aggregate basis for accrued interest, yielding 

$95,958,692 in unrecovered basis at the time of the disposition of the 

BOT LIBOR notes. ACM also treated a portion of the proceeds from the 

notes as interest income rather than capital gains. See 73 T.C.M. at 

2206; app. at 3388. 

 24 

loss as a carryback pursuant to I.R.C. S 1212 to offset a 

portion of its 1988 capital gains. See app. at 252-62.22 

E. The Tax Court Decision 

On March 12, 1993, the Commissioner of Internal 

Revenue ("Commissioner") issued ACM a Notice of Final 

Partnership Administrative Adjustment ("FPAA") eliminating 

ACM's $110,749,239.42 installment gain from the sale of 

the Citicorp notes in November 1989, redetermining ACM's 
tax basis in the BFCE LIBOR notes distributed in December 

1989, and disallowing the $84,997,111 capital loss 

deduction which ACM reported in 1991. See app. at 28-42. 

In writing this opinion we primarily focus on the capital 

loss aspects of the case, though it should be understood 

that the gain and loss are part of a single integrated plan. 

The Commissioner asserted in the FPAA that the 

transactions involving the purchase and sale of the Citicorp 

notes in exchange for cash and LIBOR notes, "were shams 

in that they were prearranged and predetermined. . .. 

[S]aid transactions were devoid of economic substance 

necessary for recognition for federal income tax purposes 

and were totally lacking in economic reality. The 

transactions were created solely for tax motivated purposes 

without any realistic expectation of profit." App. at 39. On 

May 24, 1993, Southampton, in its capacity as ACM's tax 

matters partner, filed a petition in the Tax Court contesting 

the Commissioner's adjustments.23 ACM argued that its 

transactions 

 were bona fide arm's length transactions at fair market 

 value and had economic substance. . . . The purchase 

 of the Citicorp notes on November 3, 1989, and the 

 sale of a portion of the Citicorp notes on November 27, 

 1989, were not prearranged or predetermined, and 

 both had economic substance. . . . . The sale of the 

_________________________________________________________________ 

22. This capital loss of $84,537,479, combined with Colgate's reported 

1989 net capital loss of $13,521,432, gave rise to total reported capital 

losses of $98,058,911 over the course of Colgate's participation in ACM's 

transactions. See 73 T.C.M. at 2206. 

23. A designated tax matters partner represents the partnership in 

proceedings before the Tax Court. See I.R.C. SS 6231(a)(7), 6226(a). 

 25 

 Citicorp notes by ACM in exchange for fixed payments 

 and contingent payments under the LIBOR Notes 

 qualified for installment sale treatment under Treas. 

 Reg. S 15a.453-1(c)(3). 

App. at 25. 

The Tax Court tried the case over a month-long period in 

1996 and on March 5, 1997, issued a memorandum 

opinion upholding the Commissioner's adjustments on the 

grounds that "[a] taxpayer is not entitled to recognize a 

phantom loss from a transaction that lacks economic

substance." 73 T.C.M. at 2215. In reaching the conclusion 

that ACM was not entitled to deduct its claimed capital 
losses, the court examined the stated purposes and 

anticipated economic consequences of the transaction, and 

found that the claimed losses were "not economically 

inherent in" the transactions but rather were"created 

artificially" by machinations whose only purpose and effect 

was to give rise to the desired tax consequences. Id. On 

April 4, 1997, ACM moved for reconsideration of the court's 

opinion, arguing that the transactions had sufficient 

economic substance to be respected for tax purposes. See 

app. at 3311-47. The court denied the motion on June 9, 

1997. See app. at 3439-41. 

The parties filed memoranda, pursuant to Tax Court Rule 

of Practice and Procedure 155, regarding the computation 

of tax liability in accordance with the Tax Court's

memorandum opinion. See app. at 3385-444. ACM 

proposed a computation which disallowed deductions for 

the losses resulting from its application of the ratable basis 

recovery rule but which allowed the deduction of 

approximately $6,000,000 in actual economic losses 

resulting from the loss in value of the LIBOR notes. See 

app. at 3348-51, 3385-98. In a decision entered June 12, 

1997, the Tax Court rejected ACM's computations and

eliminated the entire $84,997,111 capital loss reported in 

1991 as well as the 1989 capital gains reported in the first 

year of the Citicorp note transaction. See app. at 3444. 

ACM filed a timely notice of appeal on September 8, 1997. 

See app. at 39-40. The Commissioner filed a protective 

cross appeal seeking to preserve the right to proceed on 

alternate theories for sustaining the adjustments in the 

 26 

event that the Tax Court's application of the economic 

substance doctrine were reversed. See app. at 3447.24 

III. DISCUSSION 

A. Economic Substance and the Sham Transaction 

Doctrine 

We must decide whether the Tax Court erred in 

disallowing ACM's claimed $110,749,239.42 capital gain in 

1989 and its $84,997,111 capital loss which the court 

characterized as a "phantom loss from a transaction that 

lacks economic substance." 73 T.C.M. at 2215. While we 

conduct plenary review of the Tax Court's legal conclusions, 

we review its factual findings, including its ultimate finding 

as to the economic substance of a transaction, for clear 

error. See Fredericks v. Commissioner, 126 F.3d 433, 436 

(3d Cir. 1997); Harbor Bancorp v. Commissioner, 115 F.3d 

722, 727 (9th Cir. 1997), cert. denied, 118 S. Ct. 1035 
(1998); Northern Indiana Pub. Serv. Co. v. Commissioner, 

115 F.3d 506, 510 (7th Cir. 1997); Ferguson v. 

Commissioner, 29 F.3d 98, 101 (2d Cir. 1994); Lukens v. 

Commissioner, 945 F.2d 92, 97 (5th Cir. 1991); Karr v. 

Commissioner, 924 F.2d 1018, 1022 (11th Cir. 1991); Rice's 

Toyota World, Inc. v. Commissioner, 752 F.2d 89, 92 (4th 

Cir. 1985).25 

ACM contends that, because its transactions on their 

face satisfied each requirement of the contingent 

_________________________________________________________________ 

24. Inasmuch as we agree with the Tax Court's decision sustaining the 

adjustments based on the lack of economic substance behind the 

transactions, we, like the Tax Court, need not consider the 

Commissioner's alternate theories. See 73 T.C.M. at 2190. In view of the 

elimination of the 1989 gain the parties apparently were spared from 

applying the complex mitigation provisions in the Internal Revenue Code. 

See Koss v. United States, 69 F.3d 705 (3d Cir. 1995), cert. denied, 117 

S.Ct. 54 (1996). 

25. We review findings of ultimate fact, like other findings of fact, only 

for 

clear error, contrary to our former practice of reviewing such findings de 

novo. See Geftman v. Commissioner, ___ F.3d ___, 1998 WL 460172, No. 

97-7313, slip op. at 11 n.9 (3d Cir. Aug. 10, 1998); Pleasant Summit 

Land Corp. v. Commissioner, 863 F.2d 263, 268 (3d Cir. 1988). 

 27 

installment sale provisions and regulations thereunder, it 

properly deducted the losses arising from its 

"straightforward application" of these provisions, which 

required it to recover only one sixth of the basis in the 

Citicorp notes during the first of the six years over which it 

was to receive payments. See Temp. Treas. Reg. S 15a.453- 

1(c).26 Thus, ACM contends, it properly subtracted the basis 

in the LIBOR notes to include the remaining five sixths of 

the basis in the Citicorp notes used to acquire them.27 

Consequently, ACM argues it properly subtracted the

approximately $96 million remaining unrecovered basis in 

the BOT LIBOR notes from the approximately $11 million 

consideration it received upon disposition of those notes, 

see br. at 32; app. at 202-03, and correctly recognized and 

reported the gains and losses arising from its sale or 

exchange of property in accordance with I.R.C. S 1001. 

While ACM's transactions, at least in form, satisfied each 

requirement of the contingent installment sale provisions 

and ratable basis recovery rule,28 ACM acknowledges that 

_________________________________________________________________ 
26. Although the LIBOR notes generated 20 quarterly payments 

spanning five years rather than six, ACM reported the "maximum period 

over which payments may be received under the contingent sale price 

agreement" as six years by including the year of the disposition in which 

it received the $140 million cash payment, although no quarterly 

payments were to be received before the tax year ended on November 30, 

1989, three days after the disposition. See 73 T.C.M. at 2200. 

27. The basis in the LIBOR notes was derived from the basis in the 

Citicorp notes which ACM exchanged for the LIBOR notes. See I.R.C. 

S 1031(d). Because ACM recovered one sixth of the basis of the Citicorp 

notes, or $29,250,761, during the first year of the transaction, the basis 

in the LIBOR notes after that year was $146,253,283. See app. at 110. 

While the actual cost basis of the LIBOR notes amounted to the 

$35,504,564 difference between the value of the Citicorp notes that ACM 

relinquished and the $140 million in cash that ACM received in return, 

under the ratable basis recovery rule, the cash portion of the transaction 

was aggregated with the contingent exchange portion of the transaction, 

effectively adding the $140 million in cash to the tax basis of the LIBOR 

notes. 

28. ACM exchanged the Citicorp notes, which as private placement 

securities were eligible for treatment under the contingent installment 

sale provisions, see I.R.C. S 453(k)(2)(A), for the LIBOR notes' stream of 

 28 

even where the "form of the taxpayer's activities 

indisputably satisfie[s] the literal requirements" of the 

relevant statutory language, the courts must examine 

"whether the substance of those transactions was 

consistent with their form," br. at 21, because a transaction 

that is "devoid of economic substance . . . simply is not 

recognized for federal taxation purposes." Lerman v. 

Commissioner, 939 F.2d 44, 45 (3d Cir. 1991). 

We begin our economic substance analysis with Gregory 

v. Helvering, 293 U.S. 465, 55 S.Ct. 266 (1935), the 

Supreme Court's foundational exposition of economic

substance principles under the Internal Revenue Code. In 

Gregory, as in this case, the transactions on their face 

satisfied "every element required by" the relevant statutory 

language. Gregory, 293 U.S. at 468, 55 S.Ct. at 267.29 The 

_________________________________________________________________ 

quarterly payments over 20 quarters so that "at least 1 payment" was to 

be "received after the close of the taxable year in which the disposition 

occurs." S 453(b). Because the amount of each quarterly payment would 

depend on the variable three-month LIBOR, the "maximum selling price" 

could "not be determined as of the close of the taxable year in which the 

. . . disposition occurr[ed]." Temp. Treas. Reg. S 15a.453-1(c). 

Accordingly, ACM's transactions satisfied the literal terms of each 
requirement necessary to trigger the application of the ratable basis 

recovery rule providing for recovery of the basis of the relinquished 

assets "in equal annual increments" over each of the "taxable years in 

which payment may be received." S 15a.453-1(c). 

29. We analyze the economic substance of ACM's transactions according 

to principles that were well established when the transactions occurred, 

but note that partnership transactions carried out on or after May 12, 

1994, also would be subject to Treasury Regulations which provide that 

partnership transactions "must be entered into for a substantial 

business purpose," that the "[t]he form of each partnership transaction 

must be respected under substance over form principles," and that "the 

tax consequences . . . to each partner of partnership operations . . . 

must accurately reflect the partners' income agreement." Treas. Reg. 

S 1.701-2(a). These regulations further provide that "if a partnership is 

formed or availed of in connection with a transaction a principal purpose 

of which is to reduce substantially the present value of the partners' 

aggregate federal tax liability . . . the Commissioner can recast the 

transaction for federal tax purposes" by determining that "[t]he 

partnership's items of income, gain, loss, deduction or credit should be 

 29 

taxpayer, instead of transferring stock from her whollyowned corporation directly to herself which would have 

generated taxable dividends, created a new corporation, 

transferred the stock to the new corporation, then 

liquidated the new corporation, transferred the stock to 

herself, and asserted that she had not recognized any 

taxable gain because she had received the stock"in 

pursuance of a plan of reorganization" within the meaning 

of I.R.C. S 112(g). Although the transactions satisfied each 

element of the statute, which defined "reorganization" as a 

transfer of assets between corporations under common 

control, the Court found that "[t]he whole undertaking, 

though conducted according to the [statutory] terms . . . 

was in fact an elaborate and devious form of conveyance 

masquerading as a corporate reorganization." Id. at 469, 55 

S.Ct. at 268. 

The Court stated that "if a reorganization in reality was 

effected" any "ulterior [tax avoidance] purpose . . . will be 

disregarded" and the transaction will be respected for tax 

purposes. Id., 55 S.Ct. at 267. The Court emphasized, 

however, that where the transactions merely "put on the 

form of a corporate reorganization as a disguise for 

concealing its real character" which was a "preconceived 

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reallocated . . . or [t]he claimed tax treatment should otherwise be 

adjusted or modified." Treas. Reg. S 1.701-2(b). 
The regulations set forth, as an example of a transaction whose tax 

consequences would be altered or disregarded thereunder, a transaction 

in which a foreign corporation, a domestic corporation, and a promoter 

form a partnership "[p]ursuant to a plan a principal purpose of which is 

to generate artificial losses and thereby shelter from federal taxation a 

substantial amount of income," and engage in a series of offsetting 

purchases and sales in which "any purported business purpose for the 

transaction is insignificant in comparison to the tax benefits that would 

result if the transaction were respected for federal tax purposes." Treas. 

Reg. S 1.701-2(d), Example 7. Because these regulations do not apply to 

ACM's transactions, which were completed well before the 1994 effective 

date of the regulations, we have no occasion to consider whether the 

economic substance analysis required under these regulations would 

differ from the analysis required under the judicially defined economic 

substance doctrines that we apply. 

 30 

plan . . . not to reorganize a business," but rather "to 

transfer . . . . shares to the [taxpayer]," the transaction was 

not, in reality, "the thing which the statute intended." 

Viewed according to their substance rather than their form, 

the Court found, the transactions fell "outside the plain 

intent of the statute" and therefore could not be treated in 

accordance with their form without "exalt[ing] artifice above 

reality." Id. at 469-70, 55 S.Ct. at 267-68. Thus, pursuant 

to Gregory, we must "look beyond the form of [the] 

transaction" to determine whether it has the"economic 

substance that [its] form represents," Kirchman v. 

Commissioner, 862 F.2d 1486, 1490 (11th Cir. 1989),

because regardless of its form, a transaction that is "devoid 

of economic substance" must be disregarded for tax 

purposes and "cannot be the basis for a deductible loss." 

Lerman, 939 F.2d at 45; accord United States v. Wexler, 31 

F.3d 117, 122 (3d Cir. 1994).30 

In applying these principles, we must view the 

transactions "as a whole, and each step, from the 

commencement . . . to the consummation . . . is relevant." 

Weller v. Commissioner, 270 F.2d 294, 297 (3d Cir. 1959); 

accord Commissioner v. Court Holding Co., 324 U.S. 331, 

334, 65 S.Ct. 707, 708 (1945). The inquiry into whether the 

taxpayer's transactions had sufficient economic substance 

to be respected for tax purposes turns on both the 

"objective economic substance of the transactions" and the 

"subjective business motivation" behind them. Casebeer v. 

Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990); accord 

Lerman, 939 F.2d at 53-54 (noting that sham transaction 

has been defined as a transaction that "has no business 

purpose or economic effect other than the creation of tax 

deductions" and holding that taxpayer was not entitled "to 

claim `losses' when none in fact were sustained"). However, 
these distinct aspects of the economic sham inquiry do not 

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30. The courts have distinguished between "shams in fact" where the 

reported transactions never occurred and "shams in substance" which 

"actually occurred but that lack the substance their form represents." 

Kirchman, 862 F.2d at 1492; accord Lerman, 939 F.2d at 49 n.6. 

Because it is undisputed that ACM's transactions actually occurred, we 

confine our inquiry to the question of whether their economic substance 

corresponds to their form. 

 31 

constitute discrete prongs of a "rigid two-step analysis," but 

rather represent related factors both of which inform the 

analysis of whether the transaction had sufficient 

substance, apart from its tax consequences, to be respected 

for tax purposes. Casebeer, 909 F.2d at 1363; accord 

James v. Commissioner, 899 F.2d 905, 908-09 (10th Cir. 

1990); Rose v. Commissioner, 868 F.2d 851, 854 (6th Cir. 

1989). For the reasons that follow, we find that both the 

objective analysis of the actual economic consequences of 

ACM's transactions and the subjective analysis of their 

intended purposes support the Tax Court's conclusion that 

ACM's transactions did not have sufficient economic

substance to be respected for tax purposes.31 

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31. While it is clear that a transaction such as ACM's that has neither 

objective non-tax economic effects nor subjective non-tax purposes 

constitutes an economic sham whose tax consequences must be 

disregarded, and equally clear that a transaction that has both objective 

non-tax economic significance and subjective non-tax purposes 

constitutes an economically substantive transaction whose tax 

consequences must be respected, it is also well established that where 

a transaction objectively affects the taxpayer's net economic position, 

legal relations, or non-tax business interests, it will not be disregarded 

merely because it was motivated by tax considerations. See, e.g., 

Gregory, 293 U.S. at 468-69, 55 S.Ct. at 267 ("if a reorganization in 

reality was effected . . . the ulterior purpose will be disregarded"), 

Northern Indiana Pub. Serv. Co., 115 F.3d at 512 (emphasizing that 

Gregory and its progeny "do not allow the Commissioner to disregard 

economic transactions . . . which result in actual, non-tax-related 

changes in economic position" regardless of "tax-avoidance motive" and 

refusing to disregard role of taxpayer's foreign subsidiary which 

performed a "recognizable business activity" of securing loans and 

processing payments for parent in foreign markets in exchange for 

legitimate profit); Kraft Foods Co. v. Commissioner, 232 F.2d 118, 127-28 

& n.19 (2d Cir. 1956) (refusing to disregard tax effects of debenture 

issue 

which "affected . . . legal relations" between taxpayer and its corporate 
parent by financing subsidiary's acquisition of venture used to further 

its 

non-tax business interests). In analyzing both the objective and 

subjective aspects of ACM's transaction in this case where the objective 

attributes of an economically substantive transaction were lacking, we 

do not intend to suggest that a transaction which has actual, objective 

effects on a taxpayer's non-tax affairs must be disregarded merely 

because it was motivated by tax considerations. 

 32 

1. Objective Aspects of the Economic Sham Analysis 

In assessing the economic substance of a taxpayer's

transactions, the courts have examined "whether the

transaction has any practical economic effects other than 

the creation of income tax losses," Jacobson v. 

Commissioner, 915 F.2d 832, 837 (2d Cir. 1990) (citations 

and internal quotations omitted), and have refused to 

recognize the tax consequences of transactions that were 

devoid of "nontax substance" because they"did not 

appreciably affect [the taxpayer's] beneficial interest except 

to reduce his tax." Knetsch v. United States, 364 U.S. 361, 

366, 81 S.Ct. 130, 135 (1960). In Knetsch, the taxpayer had 

purchased annuity savings bonds from an insurance 

company, borrowed virtually their entire value against 

them, made payments back to the insurance company, and 

characterized those payments as deductible interest. 

Because the borrowing against the bonds had reduced their 

value to a mere "pittance," leaving the taxpayer with 

nothing of value apart from tax deductions, the Court 

concluded that the net effect of the transfers between the 

taxpayer and the insurance company amounted only to

payment of a "fee for providing the facade of `loans' whereby 

the [taxpayers] sought to reduce their . . . taxes" and 

therefore could not be characterized as payment of interest 

on a debt. Id. at 366, 81 S.Ct. at 135 (citation and internal 

quotation omitted). 

In Weller, 270 F.2d 294, we examined a similar series of 

transactions in which the taxpayer purchased annuity 

policies, pledged them as collateral to borrow funds, used 

the borrowed funds to prepay future annual premiums on 

the policies, prepaid `interest' on an anticipated additional 

loans against the policies, then used the proceeds of the 

additional loans to repay the earlier loans, and sought to 

deduct the prepayments as interest. See id. at 295-96. 

Applying Gregory, we disallowed the deduction on the 

grounds that "transactions which do not vary control or 

change the flow of economic benefits are to be dismissed 

from consideration" if they "do not appreciably change the 

taxpayer's financial position." Id. at 297 (citations and 
internal quotations omitted). We therefore disregarded the 

transactions for tax purposes even though the taxpayer had 

 33 

made actual payments which satisfied the statutory 

definition of an "amount paid . . . on indebtedness incurred 

. . . to purchase a single premium life insurance contract," 

much as the Supreme Court had disregarded the 

transaction in Gregory despite the fact that the taxpayer 

had created "a real, valid, corporate entity" and carried out 

a transaction that was "within the terms of the statute." Id. 

at 296-98. 

In the context of property dispositions, the courts have 

applied the economic substance doctrine in a similar 

manner to disregard transactions which, although involving 

actual transactions disposing of property at a loss, had no 

net economic effect on the taxpayer's economic position, 

either because the taxpayer retained the opportunity to 

reacquire the property at the same price, or because the 

taxpayer offset the economic effect of the disposition by 

acquiring assets virtually identical to those relinquished. 

See, e.g., Lerman, 939 F.2d at 48; Merryman v. 

Commissioner, 873 F.2d 879 (5th Cir. 1989); Kirchman, 862 

F.2d at 1488, 1492-93; Yosha v. Commissioner, 861 F.2d 

494, 501 (7th Cir. 1988). Although the taxpayers in these 

cases actually and objectively disposed of their property, 

the courts examined the dispositions in their broader 

economic context and refused to recognize them for tax 

purposes where other aspects of the taxpayers' transactions 

offset the consequences of the disposition, resulting in no 

net change in the taxpayer's economic position. In light of 

these cases, we must determine whether the Tax Court 

erred in concluding that ACM's exchange of the Citicorp 

notes for contingent-payment LIBOR notes which gave rise 

to the tax consequences at issue generated only "a 

phantom loss" that was not "economically inherent in the 

object of the sale" and did not have "economic substance 

separate and distinct from economic benefit achieved solely 

by tax reduction." 73 T.C.M. at 2215. For the following 

reasons, we conclude that it did not. 

2. Objective Economic Consequences of ACM's 

Transactions 

While the Tax Court's analysis focused on the lack of 

non-tax purposes behind ACM's transactions rather than 

 34 
on their objective economic consequences, the court made 

numerous findings that were indicative of the lack of 

objective economic consequences arising from ACM's shortswing acquisition and disposition of the Citicorp notes 

between November 3 and November 27, 1989. The court

noted that ACM sold the Citicorp notes "for consideration 

equal to [their] purchase price" and thus did not realize any 

gain or loss in the notes' principal value. 73 T.C.M. at 2215 

n.19.32 Moreover, as the court observed, the lack of change 

in principal value was not merely coincidental, but was 

inherent in the terms of the notes and of the transactions 

in which they were traded. See id. at 2219-20. Likewise, the 

court found that the interest income generated by the notes 

could not have a material effect on ACM's financial position 

because the Citicorp notes paid interest at a rate that 

varied only nominally from the rate that ACM's cash

contributions "were already earning . . . in . . . deposit 

accounts before the notes were acquired," resulting in only 

a $3,500 difference in yield over the 24-day holding period, 

a difference which was obliterated by the transaction costs 

associated with marketing private placement notes to third 

parties. Id. at 2218, 2220-21. 

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32. As contemplated in transaction proposals drafted before ACM was 

formed, the Citicorp notes were sold for an amount equal to their 

purchase price. See app. at 275-77, 321, 300. 

 35