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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 Appellantand 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 Uni ted States Tax Court dated June 12, 1997. The Tax Court 's jurisdiction rested on I.R.C. SS 7442, 6213 and 622 6 based

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on appellant's timely filing of a petition seeking redetermination of a deficiency and review of a Fin al 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 t his circuit at the time it filed its petition. For the reasons that follow, we will affirm in part, reverse in part, di smiss the Commissioner of Internal Revenue's cross appeal, an d remand for further proceedings.

II. FACTUAL AND PROCEDURAL HISTORY

This appeal concerns the tax consequences of a seri es of

transactions executed between November 1989 and December 1991 by appellant ACM, a partnership forme d on October 27, 1989, with its principal place of busin ess in Curacao, Netherlands Antilles. Each of ACM's three partners was created as a subsidiary of a larger en tity several days before ACM's formation. Southampton wa s incorporated under Delaware law on October 24, 1989 , asa wholly-owned subsidiary of Colgate-Palmolive Comp any

("Colgate"), an international consumer products com pany. 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 Ly nch MLCS, Inc. ("MLCS"), was incorporated under Delawar e law on October 27, 1989, as a wholly owned subsidiary o f 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 i n a proposal which Merrill Lynch presented to Colgate i n May 1989. During the previous year, Colgate had reporte d $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"). S ee

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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 gener ate capital losses which Colgate could use to offset so me of its 1988 capital gains. App. at 674-76, 784, 965.1

Pohlschroeder related the plan to Colgate's Vice Pr esident of Taxation Steven Belasco, who expressed reservati ons because the plan entailed substantial costs, might not be recognized for tax purposes, and did not seem to se rve 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. Immediatel y thereafter, ABC invests $100 in short-term s ecurities which it sells on December 30, 1989, to an u nrelated party. The fair market value and face amount of the

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

cash and an installment note that provides f or six semiannual payments . . . Each payment equal s the sum of a notional principal amount multiplie d by the London Interbank Offering Rate (LIBOR) at th e start of the semiannual period.2 ABC uses the $70 cas h 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), w hich permits a taxpayer to carry back a capital loss to offset cap ital gains recognized within the preceding three years.

2. The LIBOR [London Interbank Offering Rate] is th e primary fixed income index reference rate used in [Europeanfinanc ial] markets. (Footnote is by Tax Court.)

4

73 T.C.M. at 2191.

The law firm advised that the sale of the short-ter m securities would be reported as a contingent instal lment sale under the installment method which governs "dispositions[s] of property where at least 1 payme nt 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 ye ar in which the sale or other disposition occurs, but th e maximum period over which payments may be received u nder the contingent sale price agreement is fixed, th e 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 incremen ts.

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 wou ld recognize gain to the extent that the payments rece ived in any year exceeded the $25 or loss to the extent tha t the payments fell below the $25, but only if the loss w ere carried over to a year with sufficient reported gai ns 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, discus sedColgate's concerns about the proposed partnership

transaction, including its costs and its potential to serve Colgate's business purposes. Pohlschroeder's handwr itten

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 T reasury regulations with respect to both this case and the cases we cit e 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 m ajority ownership.

App. at 634, 791.

Colgate was interested in the concept of using the proposed partnership to invest in its own debt beca use of recent developments which had weighted Colgate's de bt portfolio toward fixed-rate long-term debt, leaving Colgate

vulnerable to a decline in interest rates.4 Moreove r, 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 prof ile, thus decreasing its exposure to falling interest rates, by acquiring its long-term debt issues at their presen tly 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 obj ectives. The acquisition of its own debt issues would decrea se Colgate's exposure to falling interest rates becaus e by acquiring those debt issues as an asset, Colgate ef fectively would reap the benefits of receiving the above-mark et interest payments due on those issues, thus hedging against the burdens associated with owing those pay ments. See 73 T.C.M. at 2193. Acquiring the debt through t he partnership instead of directly would keep the acqu isitions off Colgate's books, thus permitting Colgate to car ry out its

___________________________________________________ ______________4. The elevated proportion of long-term debt in Col gate's debt structure

arose in part from Colgate's use of the proceeds fr om the Kendall sale to retire significant amounts of short-term debt and i ts issuance of longterm debt to finance an employee retirement plan. S ee 73 T.C.M. at 2192; app. at 77-78, 669-70, 2761, 2764-70. This hi gh proportion of long-term fixed-rate debt exposed Colgate to risk i n the event of declining interest rates, as Colgate would receive diminished returns from its cash balances and short-term deposits, but would continu e to owe interest on its debts at the higher fixed rate.

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debt acquisition strategy without alerting potentia l acquirors to the internal accumulation of debt issu es which, by increasing the capacity for internal leve rage, 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 mo re favorable. In the interim, the debt effectively wou ld be retired because Colgate would not owe the obligatio ns thereon to third parties, yet the debt would remain outstanding for accounting purposes, reducing Colga te's vulnerability to potential acquirors. See app. at 6 73; 73

T.C.M. at 2193.

On July 28, 1989, Merrill Lynch presented a propose d 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 M errill Lynch. Merrill Lynch explained to ABN that the part nership would invest in Colgate long-term debt to serve Col gate's debt management objectives, would engage in a conti ngent installment sale, and would require ABN's participa tion for no more than 2-3 years. ABN agreed to meet with Col gate 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 transact ions 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 t ransaction, as Merrill

Lynch had approached ABN in early 1989 while it was developing the proposal and had sought ABN's participation in a si milar partnership arranged on behalf of another Merrill Lynch client. See 73 T.C.M. at 2194; app. at 1670-75, 1103.

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Partnership Transaction Summary," see app. at 263-6 7, set forth the following proposal incorporating both the contingent installment sales transaction which Merr ill Lynch initially had proposed in May 1989 and the de bt acquisitions which Merrill Lynch had incorporated i n its July 28 proposal:6

1) A Colgate subsidiary contributes $30 mill ion, A BN contributes $169.3 million and Merrill Lynch contributes $.7 million.

2) The partnership invests its entire $200 m illion 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 commerc ial paper or bank deposits."

3) The partnership sells the short-term note s for a

combination of cash and LIBOR-based notes an d uses the cash to acquire Colgate debt. "The purpo se of the LIBOR notes will be to partly hedge the inte rest rate sensitivity of long-term [Colgate] debt acqu ired by the Partnership."

4) The partnership exchanges a portion of th e long - term Colgate debt for newly issued medium-te rm 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 ho ldings. 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 Partners hip assets. Alternatively, if a substantial amount of lo ng-term [Colgate] debt is exchanged, the Partnership would

___________________________________________________ ______________

6. The August 17 transaction summary referred to Co lgate 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 ofthem played in the ensuing transactions and from Po hlschroeder's

testimony. See app. at 685. Except where there are direct quotations we have paraphrased the summary.

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likely reduce its holding of LIBOR notes. Su ch a reduction would be necessary because the Med ium- Term Debt, received in exchange for long-ter m [Colgate] debt, is less interest rate sensitive than t he long-term [Colgate] debt. LIBOR Notes may either be so ld directly

or distributed to one or more Partners in a non- liquidating distribution."

6) If the partnership has not invested all o f its capital in Colgate debt and LIBOR instruments, the partnership "may liquidate some or all of th e remaining Short-Term Notes and distribute the proceeds to one or more of the partners."7

7) "Possible redemption of [ABN's] Partne rs hip 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 c ash. For example, assuming no change in asset values, the Partnership could borrow $169.3 million coll ateralized by its assets and use the proceeds to redeem [ABN]."

8) "If [ABN] is redeemed, the Partnership m ust be consolidated with [Colgate] for financial re porting purposes. Accordingly, all assets, including [Colgate] debt . . . will appear on the [Colgate] cons olidated balance sheet. The [Colgate] debt will be ef fectively retired at that time. . . . [I]f the [Colgat e] debt were acquired at a premium or a discount, [Colgat e] would recognize a loss or gain, respectively, for income statement purposes. It would be most reasona ble for the Partnership to sell the LIBOR Note . . . if[ABN] is redeemed. Since the principal asset of the P artnership, other than LIBOR Notes . . . is likely to be [Colgate] debt and [Colgate] would be a 98% partner, t he hedge protection provided by the LIBOR Notes . . . is no longer necessary."

___________________________________________________ ______________

7. This item was designated "Step 7." "Step 6" addr essed 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 adva nta geous for [Colgate] affiliates to purchase [Merrill Ly nch's] Partnership interest. Alternatively, the Par tnership might be liquidated with [Colgate] receiving [Colgate] debt as proceeds of the liquidation."

App. at 275-77. The final page of that document add ressed the tax considerations of the arrangement and state d,

the liquidation of $200 million of Short-Ter m Notes in exchange for approximately $140 million of c ash and $60 million market value of LIBOR notes shou ld 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 m arket value

of the LIBOR notes distributed should have a tax basis of approximately $28 million. In a succeedin g tax year, the Partnership will recognize a loss on sal e or at maturity of the remaining LIBOR Notes. 98% o f such loss will be allocable to [Colgate] because[ Colgate] will be a 98% partner at such time. Combined, los ses on sale of LIBOR Notes distributed to [Colgate] and losses on sale of LIBOR Notes by the Partnership sh ould exceed $106 million. Accordingly, [Colgate] should recognize a net loss of approximately $90 mi llion. After discounting and transactions costs . . . the transaction produces over $20 million present value bene fits to [Colgate].

App. at 279.

A representative of ABN's legal department testifie d 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 tha t . . . depending on the percentage of your particip ation, you would either take part in the gain or the lo ss. So by having us being the majority partner at the start, we would take the majority of the gain, while i n a later stage one of the other partners would take t he loss.

App. at 1298.

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In a memorandum dated October 3, 1989, Pohlschroede rrecommended the partnership to Colgate Treasurer Br ian

Heidtke. See App. at 310-21. Pohlschroeder outlined the advantages of repurchasing outstanding Colgate debt through a partnership, and stated that "[t]he partn ership would temporarily invest the funds in some short-te rm instruments and, at the same time, start the repurc hasing program." App. at 312. The memorandum identified th ree 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 not es"); and 3) a set of 8.4% private placement notes held b y Metropolitan Life Insurance Company ("Metropolitan" ) and due in 1998 ("Met Notes"). The memorandum stated th at "pursuant to an inquiry to Metropolitan, we feel co nfident that the partnership can purchase sufficient Colgat e 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 expe cted 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 att ractive 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 L IBOR notes and the Colgate debt issues that the partners hip expected to acquire. According to the analysis, a g iven

decrease in interest rates would increase the value of the long-term Colgate debt and decrease the value of th e LIBOR notes in roughly equal and offsetting amounts becau se the value of the LIBOR notes was directly dependent on interest

rates whereas the value of the fixed-rate debt issu es was inversely proportional to interest rates. See app. at 951-52, 313. Thus, the memorandum concluded, "the LIBOR not e is an effective hedge of fixed rate assets for the par tnership." App. at 313. The memorandum stated that it would be necessary to establish a "Desired Hedge Ratio" of L IBOR holdings to long-term debt holdings, so that the

___________________________________________________ ______________

8. Pohlschroder testified that as of August 1989, h e had received calls from traders indicating that the Long Bonds also we re potentially available for purchase. See app. at 688.

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partnership's assets would be "fully hedged" agains t 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 itsliability structure," and stated that the "Next Ste ps" 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 investme nt securities to fund acquisition of Colgate debt.

App. at 321.

In a document marked "REVISED 9/1/89," Merrill Lync h provided Colgate a "Cost Component Analysis," which estimated after-tax costs associated with the propo sed 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 millio n in legal expenses and $1.32 million in Merrill Lynch advisor y fees. See app. at 294.

A September 20, 1989 document delineated the detail s of the proposed partnership transactions and their ant icipated 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 a cquire 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 payment s with a present value of $60 million, and using the $140 million in cash to purchase Colgate debt. App. at 3 00-01, 304-05. Because the partnership was to receive paym ents on the exchange over the course of six years, the $ 200

million basis in the short-term notes was to be rec overed ratably over six tax years in equal increments of $ 33.3 million per year pursuant to S 15a.453. Thus, accor ding to

12

this document, the transaction would result in sign ificant capital gains in the first year, consisting of the $106.7 million difference between the $140 million cash re ceived that year and the $33.3 million basis recovered tha t year, and would result in capital losses in each of the e nsuing years because the contingent payments received in e ach 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 cap ital losses in the ensuing years equaled precisely the a mount ofcapital gains reported in the first year, and the d ocument

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 g ain 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 o f Directors, the Directors considered the proposal an d stated

that it:

had originally been presented . . . with a v iew 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 hand s and permitting [Colgate] to obtain flexibility i n managing the ratio balance between short and long ter m debt and the resulting interest exposure. Without these treasury advantages, management would not ha ve recommended this transaction.

. . . . Over the life of the partnership, si gnificant tax benefits should be generated for Colgate, bu t even without these benefits, Colgate would earn a pre-tax return of approximately 6% on its investment

.

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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 Colgat e was contemplating final approval of its participati on in the proposed partnership, Merrill Lynch was finalizing arrangements for ABN's participation in the partner ship. AnABN document dated October 11, 1989, stated that it

would agree to enter the partnership on the conditi ons 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 par tnership . . . is unconditional;" and 3) Merrill Lynch agree s to repurchase the securities "at par on November 29, 1 989." 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 th e ACM partnership. See 73 T.C.M. at 2197; app. at 81-84, 89-91. The October 27, 1989 partnership agreement among th ese newly created entities provided that Kannex was to receive a preferred return of the first $1.24 million in an y partnership profits otherwise allocable to Southamp ton. 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 compone nt of the proposed partnership from its inception. In a document dated September 1, 1989, Merrill Lynch advised Colgate that this aspect of t he partnership would cost Colgate $740,000. See app. at 294.

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On October 27, 1989, after executing the partnershi p agreement, the partners met and authorized Merrill Lynch to find willing sellers of Colgate debt issues, inc luding the Euro Notes, Met Notes, and Long Bonds which had bee n identified in Pohlschroeder's October 3 memorandum. See app. at 313, 386. The partners resolved that "in or der to maximize the investment return on its assets pendin g the acquisition" of these debt issues, Merrill Lynch wa s 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 tha t Colgate's treasury department had contacted Metropo litan 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 Earli er in thefall of 1989, Pohlschroeder had initiated discussio ns with

Metropolitan about selling the notes after Metropol itan contacted him to express concern about certain term s in the notes. See app. 690-91, 742. Before the Novembe r 17 meeting, a Metropolitan representative left Pohlsch roeder a message indicating the price at which Metropolitan was prepared to sell the Met notes. Pohlschroeder did n ot 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 No tes, and Long Bonds. See app. at 117-18; 73 T.C.M. at 22 00.

Pohlschroeder's handwritten memorandum of the conversations regarding the Met notes concludes wit h a notation of the date November 17, while his notatio ns regarding the acquisition of the Long Bonds and Eur o Notes state that Kannex would instruct Merrill Lynch afte r purchase of Citicorp notes which, as discussed belo w, were to serve as the initial short-term investment conte mplated in the partnership proposals. 73 T.C.M. at 2200; ap p. at 880; 889-90.

___________________________________________________ ______________

11. Pohlschroeder had contacted Metropolitan shortl y after the first partnership meeting in October 1989 and had instruc ted Metropolitan to send a representative to the November 17 meeting if Metropolitan was interested in selling the Met notes. See app. at 74 3.

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C. The Transactions

On November 2, 1989, Kannex contributed $169.4 million, Southampton contributed $35 million, and M LCS 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 contributio ns, 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 wit hdrew the funds the following day and purchased ten priva te placement Citicorp notes in an aggregate amount of $205 million. The Citicorp notes paid interest monthly a t a floating rate that was to be reset monthly. The ini tial rate was 8.78%, three basis points above the rate the fu nds were earning in the ABN account.12 On November 15, 1989, Citicorp made an interest payment and reset the int erest

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 ha dapproached Bank of Tokyo ("BOT") and Banque Francai se

du Commerce Exterieure ("BFCE") to negotiate sellin g them those notes.13 During the first week of November, M errill Lynch forwarded BOT and BFCE specific terms of the proposed sale in which those two banks would purcha se an aggregate of $175 million of the notes for $140 mil lion in cash plus LIBOR notes providing for a five-year str eam of quarterly payments with a net present value of approximately $35 million. See 73 T.C.M. at 2200; a pp. at 107-08.14 On November 9, 1989, BOT representatives

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12. A basis point, a common unit of measure for int erest rates, equals one one-hundredth of a percent.

13. Pohlschroeder testified that ACM expected to se ll the Citicorp notes

for cash and LIBOR notes within several weeks to ma ke 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 BF CE, Merrill Lynch also agreed to arrange a series of swaps which woul d hedge the banks' interest rate risks and provide them additional ret urn on their purchase of the Citicorp notes. See 73 T.C.M. at 2206-10.

16

requested approval from their head office, attachin g documents which set forth "all details of the trans action." On November 10, 1989, Merrill Lynch confirmed that it would sell $125 million in Citicorp notes to BOT an d $50 million to BFCE. See app. at 111-14; 73 T.C.M. at 2 200.

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 M et Notes. After brief negotiations, ACM and Metropolitan agre ed that ACM would purchase $100 million principal amount of Met Notes effective December 4, 1989. App. at 118-19, 3 90; 73

T.C.M. at 2201. Pohlschroeder stated that ACM would need to raise cash by the time of the December 4 purchas e and that the acquisition of long-term fixed-rate debt"w ould 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 co ntracts with a floating rate of interest." App. at 391. ACM thus resolved "to arrange the sale of $175 million princ ipal 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 pre sentedto the meeting . . . in order to pay Metropolitan t he

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 whi ch Merrill Lynch had negotiated by November 10 and whi ch ACM had approved on November 17, selling $125 milli on of the notes to BOT and $50 million of them to BFCE fo r a total of $140 million in cash and eight LIBOR notes issued by BOT and BFCE. The LIBOR notes provided for a str eam of 20 quarterly contingent payments commencing on M arch 1, 1990, whose amount was derived from the three-mo nth LIBOR multiplied by a notional principal amount of $97.76

million.15

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15. The notional principal amount did not represent an amount owed, but rather was designated as a multiplier to determ ine the amount of the LIBOR-based contingent payments.

17

In exchange for the $175,000,000 Citicorp notes, AC M 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 placem ent instruments, but increased by the $504,564 in inter est that had accrued on the Citicorp notes during the 12 day s since their last interest payment on November 15. Accordi ngly, the LIBOR notes effectively cost ACM $35,504,564, t he 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 not es issued by BOT accounted for $25,360,403 of the aggr egate cost and $24,579,153 of the aggregate present value , while those issued by BFCE accounted for $10,144,161 of t he aggregate cost and $9,831,661 of the aggregate pres ent 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, A CM purchased Colgate debt including $100 million of th e Met Notes pursuant to the November 17 agreement, $5 mil lion of the Euro Notes, and $31 million of the Long Bond s. Seeapp. at 118-20. ACM purchased an additional $18.75

million in Colgate long-term debt issues between Ju ne 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 Hedgin g Activity," Merrill Lynch stated that certain events would

warrant a reduction in the desired amount of LIBOR holdings. Specifically, Merrill Lynch explained tha t if Southampton elected to increase its share of the partnership's interest rate risk, as it was entitle d 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, AC M should reduce its LIBOR note holdings in light of i ts diminished need for their hedging function. See 73 T.C.M. at 2202. Merrill Lynch approached a major Danish ba nk, Sparekassen SDS ("Sparekassen"), offering it the BF CE LIBOR notes which totaled approximately $10 million

, along with collateral swaps which provided Sparekas sen risk protection and a return on its investment. On December 5, 1989, Sparekassen set aside a $10 milli on 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 220 5. Merrill Lynch advised that ACM decrease its LIBOR n ote holdings in light of these factors reducing its int erest rate exposure. App. at 397. ACM resolved to distribute t he BFCE LIBOR notes to Southampton as a return of contributed capital, and executed Assignment Agreem ents conveying those notes to Southampton. See app. at 1 24,

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 o n November 27. See app. at 125-26; 73 T.C.M. at 2201, 2202-03 & n.10. Of this discrepancy, $390,000 resul ted from the transaction costs and bid-ask spread neces sary tomarket the LIBOR notes, while the remaining shortfa ll

resulted from the decreased value of the notes due to the

decline in interest rates since November 27 and fro m a quarterly payment on the notes which reduced their remaining value. See 73 T.C.M. at 2202; app. at 156 0-61,

1628.

On June 25, 1991, Colgate acquired a 38.31% share i n 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 ha d acquired a majority interest in ACM, Colgate consol idated ACM's holdings with its own on its books, revealing its

control of the debt issues which theretofore had re mained outstanding on its books. See app. at 3249-50. ACM retained $30 million in Citicorp notes until Octobe r 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 1 991. See app. at 507-67, 570-98.

On November 27, 1991, ACM redeemed Kannex's remaining partnership interest for $100,775,915, le aving Colgate and Southampton with a combined 99.7% inter est in ACM. App. at 137-38. At a December 5, 1991 partnership meeting, Merrill Lynch stated that beca use Colgate owned virtually the entire partnership, its "net economic exposure to the risk of interest rate fluc tuations in the value of the Colgate debt was effectively mi nimal, and the Partnership need not maintain its position in t he [LIBOR notes] to hedge against such exposure." App. at 408. Thus, Merrill Lynch explained, without the nee d for hedging, it was "unwise for the Partnership to hold " this "highly volatile investment" given the market's dec lining interest rates. ACM resolved to sell its remaining LIBOR notes, which were those issued by BOT, the BFCE LIB OR 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 sign ificant 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 TransactionsOn its partnership return for the tax year ended

November 30, 1989, ACM treated the November 27, 198 9 exchange of the Citicorp notes as an installment sa le 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" pursu ant to S 453(b)(1). App. at 109. Because the quarterly LIB OR note payments would vary based on fluctuations in the LI BOR, there was no "stated maximum selling price" that co uld 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), whos e ratable basis recovery rule provides that the taxpa yer's basis "shall be allocated to the taxable years in w hich payment may be received under the agreement in equa l

annual increments."

Accordingly, ACM divided its $175,504,564 basis in the Citicorp notes, consisting of their $175 million pu rchase price and $504,564 of accrued payable interest, equ ally among the six years over which payments were to be received in exchange for those notes, and thus reco vered one sixth of that basis, or $29,250,761, during 198 9.16 Subtracting this basis from the $140 million in cas h 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 Kann ex, $18,908,407 to Southampton, and $324,144 to MLCS. S ee app. at 109, 144-66; 73 T.C.M. at 2203. Southampton and MLCS were subject to United States income tax on th eir respective shares of the gain, but Kannex as a fore ign 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 y ears became $146,253,803, representing the difference be tween

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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 c onsideration three days before the end of the 1989 tax year, making 19 89 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 fo cusing 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 transa ction. See app. at 110. Of the $146,253,803 reported as the re maining 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 attributabl e 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 Citi corp notes, and reported a $32,429,839 capital loss from its December 22, 1989 sale to Sparekassen of the BFCE L IBOR notes which it had received in the December 12, 198 9 distribution from ACM.18 Because these capital loss es completely offset the capital gains, Southampton re ported a net 1989 capital loss of $13,521,432 and did not re port any net tax liability on its share of ACM's gain from t he 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 financia l and tax accounting for 1989, the Arthur Andersen audito rs noted that ACM's records were inconsistent in their treatment of the $1,093,750 spread between the amou nt of consideration ACM had paid for the LIBOR notes and their market value at the time of acquisition. Specifical ly, the auditors noted, ACM had not accounted for this tran saction cost in its income statement, but had included it i n the book value of the LIBOR notes contrary to a provisi on in the partnership agreement requiring that assets be recorded at fair market value. Due to this discrepa ncy, ACM's records effectively overstated the market val ue 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.

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18. This $32,429,839 loss was computed based upon t he $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 inFebruary 1990 to his colleagues regarding the discr epancy:

Colgate does not want the cost to sell [the Citicorp notes] of US $1,093,750 . . . in the . . . i ncome 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 f irst place and thus the planned tax losses might be den ied by the IRS. We . . . were requested to think wi th 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 r esolve 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 stat e valuation at market and would . . . then state valu ation at market increased by the cost to sell the original C iticorp

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 adju sted upon distribution of the note to a partner, redempt ion of the partnership interest of any partner, or liquida tion of the partnership. See app. at 402, 407.19 This provision effectively transferred the transaction costs assoc iated with exchanging the Citicorp notes for LIBOR notes to th e partner that eventually received the notes in a dis tribution, as the market value would be less than the reported value of the distribution. See 73 T.C.M. at 2204. Thus, A CM's December 12, 1989 distribution of the BFCE LIBOR no tes

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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 South ampton in accordance with the partners' understanding that Colgate and Southampton would bear the transaction costs associated with trading private placement notes. Se e app. at 1622-25.For its tax year ended December 31, 1991, ACM repor ted

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 receive d 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 n otes due to declining interest rates while $79,106,599 resul ted from the application of the ratable basis recovery rule which effectively added to the tax basis of the LIBOR not es 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 Becau se Colgate, together with its subsidiary Southampton, by that time owned 99.7% of the partnership, Colgate claime d 99.7% of the $84,997,111 capital loss on its 1991 r eturn for a total capital loss of $84,537,479. App. at 24 7-51. Colgate then filed an amended 1988 return reporting this

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20. This appeal concerns adjustments to ACM's 1989 and 1991 tax returns. Although the Commissioner's Final Partners hip Administrative Adjustment and the Tax Court's decision made adjust ments to ACM's 1990 tax return, these adjustments affected only th e 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 r ule, ACM would have subtracted from the consideration it received upon disposition of the BOT LIBOR notes only the remaining portion of the L IBOR notes' aggregate $35,504,564 actual cost basis rather than the remaining portion of their aggregate $175,504,564 tax basis w hich ACM derived by aggregating the $140 million cash portion of the Ci ticorp note transaction with the $35 million LIBOR note portion of the transaction and adjusting the aggregate basis for accrued inter est, 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 of fset 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 Fin al Partnership Administrative Adjustment ("FPAA") elim inating ACM's $110,749,239.42 installment gain from the sal e of the Citicorp notes in November 1989, redetermining ACM'stax basis in the BFCE LIBOR notes distributed in De cember

1989, and disallowing the $84,997,111 capital loss deduction which ACM reported in 1991. See app. at 2 8-42. In writing this opinion we primarily focus on the c apital loss aspects of the case, though it should be under stood that the gain and loss are part of a single integra ted 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 s hams in that they were prearranged and predetermined. .

.. [S]aid transactions were devoid of economic substan ce necessary for recognition for federal income tax pu rposes 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 i ts

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, a nd the sale of a portion of the Citicorp notes on N ovember 27, 1989, were not prearranged or predetermined, and

both had economic substance. . . . . The sal e of the

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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 623 1(a)(7), 6226(a).

25

Citicorp notes by ACM in exchange for fixed payments and contingent payments under the LIBOR Note s qualified for installment sale treatment und er Treas. Reg. S 15a.453-1(c)(3).

App. at 25.

The Tax Court tried the case over a month-long peri od 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 recog nize a phantom loss from a transaction that lacks economic substance." 73 T.C.M. at 2215. In reaching the conc lusion that ACM was not entitled to deduct its claimed cap itallosses, the court examined the stated purposes and

anticipated economic consequences of the transactio n, and

found that the claimed losses were "not economicall y inherent in" the transactions but rather were"creat ed artificially" by machinations whose only purpose an d effect was to give rise to the desired tax consequences. I d. On April 4, 1997, ACM moved for reconsideration of the court's opinion, arguing that the transactions had sufficie nt economic substance to be respected for tax purposes . See app. at 3311-47. The court denied the motion on Jun e 9, 1997. See app. at 3439-41.

The parties filed memoranda, pursuant to Tax Court Rule of Practice and Procedure 155, regarding the comput ation 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 ra table 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 Jun e 12, 1997, the Tax Court rejected ACM's computations and eliminated the entire $84,997,111 capital loss repo rted 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 protect ive cross appeal seeking to preserve the right to proce ed on alternate theories for sustaining the adjustments i n the

26

event that the Tax Court's application of the econo mic 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 g ain in 1989 and its $84,997,111 capital loss which the cou rt 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 con clusions, we review its factual findings, including its ultim ate 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. Commissi oner,

115 F.3d 506, 510 (7th Cir. 1997); Ferguson v. Commissioner, 29 F.3d 98, 101 (2d Cir. 1994); Luken s 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 thei r face satisfied each requirement of the contingent

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24. Inasmuch as we agree with the Tax Court's decis ion sustaining the adjustments based on the lack of economic substance behind the transactions, we, like the Tax Court, need not cons ider 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 I nternal Revenue Code. See Koss v. United States, 69 F.3d 705 (3d Cir. 199 5), 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 rev iewing such findings de novo. See Geftman v. Commissioner, ___ F.3d ___, 19 98 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 C ir. 1988).

27

installment sale provisions and regulations thereun der, 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 ov er which it was to receive payments. See Temp. Treas. Reg. S 15 a.453- 1(c).26 Thus, ACM contends, it properly subtracted the basis in the LIBOR notes to include the remaining five si xths of the basis in the Citicorp notes used to acquire the m.27 Consequently, ACM argues it properly subtracted the approximately $96 million remaining unrecovered bas is in the BOT LIBOR notes from the approximately $11 mill ion consideration it received upon disposition of those notes, see br. at 32; app. at 202-03, and correctly recogn ized and reported the gains and losses arising from its sale or exchange of property in accordance with I.R.C. S 10 01.

While ACM's transactions, at least in form, satisfi ed each requirement of the contingent installment sale prov isions 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 t he "maximum period over which payments may be received under the conti ngent sale price agreement" as six years by including the year of th e disposition in which it received the $140 million cash payment, although no quarterly payments were to be received before the tax year en ded 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 t he basis in the Citicorp notes which ACM exchanged for the LIBOR no tes. See I.R.C. S 1031(d). Because ACM recovered one sixth of the b asis 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 amou nted to the $35,504,564 difference between the value of the Cit icorp notes that ACM relinquished and the $140 million in cash that ACM received in return, under the ratable basis recovery rule, the cash por tion 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 priv ate placement securities were eligible for treatment under the co ntingent 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 examin e "whether the substance of those transactions was consistent with their form," br. at 21, because a t ransaction 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 Grego ry v. Helvering, 293 U.S. 465, 55 S.Ct. 266 (1935), th e Supreme Court's foundational exposition of economic substance principles under the Internal Revenue Cod e. 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

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quarterly payments over 20 quarters so that "at lea st 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 quart erly payment would depend on the variable three-month LIBOR, the "maxi mum selling price"

could "not be determined as of the close of the tax able year in which the . . . disposition occurr[ed]." Temp. Treas. Reg. S 15a.453-1(c). Accordingly, ACM's transactions satisfied the liter al terms of eachrequirement necessary to trigger the application of the ratable basis

recovery rule providing for recovery of the basis o f the relinquished assets "in equal annual increments" over each of th e "taxable years in which payment may be received." S 15a.453-1(c).

29. We analyze the economic substance of ACM's tran sactions according to principles that were well established when the t ransactions 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 par tnership transaction must be respected under substance over form princip les," and that "the tax consequences . . . to each partner of partnersh ip operations . . . must accurately reflect the partners' income agreem ent." Treas. Reg. S 1.701-2(a). These regulations further provide tha t "if a partnership is

formed or availed of in connection with a transacti on a principal purpose of which is to reduce substantially the present val ue of the partners' aggregate federal tax liability . . . the Commissio ner can recast the transaction for federal tax purposes" by determinin g that "[t]he partnership's items of income, gain, loss, deductio n or credit should be

29

taxpayer, instead of transferring stock from her wh ollyowned corporation directly to herself which would h ave generated taxable dividends, created a new corporat ion, transferred the stock to the new corporation, then liquidated the new corporation, transferred the sto ck to herself, and asserted that she had not recognized a ny taxable gain because she had received the stock"in pursuance of a plan of reorganization" within the m eaning of I.R.C. S 112(g). Although the transactions satis fied each element of the statute, which defined "reorganizati on" as a transfer of assets between corporations under commo n control, the Court found that "[t]he whole undertak ing, though conducted according to the [statutory] terms

. . . was in fact an elaborate and devious form of convey ance masquerading as a corporate reorganization." Id. at 469, 55

S.Ct. at 268.

The Court stated that "if a reorganization in reali ty 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 emphasize d, however, that where the transactions merely "put on the form of a corporate reorganization as a disguise fo r concealing its real character" which was a "preconc eived

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reallocated . . . or [t]he claimed tax treatment sh ould otherwise be adjusted or modified." Treas. Reg. S 1.701-2(b).The regulations set forth, as an example of a trans action whose tax

consequences would be altered or disregarded thereu nder, a transaction in which a foreign corporation, a domestic corporat ion, and a promoter form a partnership "[p]ursuant to a plan a principa l purpose of which is to generate artificial losses and thereby shelter f rom federal taxation a substantial amount of income," and engage in a seri es of offsetting purchases and sales in which "any purported busines s purpose for the transaction is insignificant in comparison to the t ax benefits that would result if the transaction were respected for federa l tax purposes." Treas. Reg. S 1.701-2(d), Example 7. Because these regulat ions do not apply to ACM's transactions, which were completed well befor e the 1994 effective date of the regulations, we have no occasion to con sider whether the economic substance analysis required under these re gulations would differ from the analysis required under the judicia lly defined economic substance doctrines that we apply.

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plan . . . not to reorganize a business," but rathe r "to transfer . . . . shares to the [taxpayer]," the tra nsaction was not, in reality, "the thing which the statute inten ded." Viewed according to their substance rather than the ir form, the Court found, the transactions fell "outside the plain

intent of the statute" and therefore could not be t reated in accordance with their form without "exalt[ing] arti fice 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"econom ic 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. Wex ler, 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 rel evant." 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 whe ther the taxpayer's transactions had sufficient economic sub stance to be respected for tax purposes turns on both the "objective economic substance of the transactions" and the "subjective business motivation" behind them. Caseb eer v. Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990); accord Lerman, 939 F.2d at 53-54 (noting that sham transac tion

has been defined as a transaction that "has no busi ness purpose or economic effect other than the creation of tax deductions" and holding that taxpayer was not entit led "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 thei r 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 ac tually occurred, we confine our inquiry to the question of whether thei r economic substance corresponds to their form.

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constitute discrete prongs of a "rigid two-step ana lysis," but rather represent related factors both of which info rm the analysis of whether the transaction had sufficient substance, apart from its tax consequences, to be r espected for tax purposes. Casebeer, 909 F.2d at 1363; accor d James v. Commissioner, 899 F.2d 905, 908-09 (10th C ir. 1990); Rose v. Commissioner, 868 F.2d 851, 854 (6th Cir. 1989). For the reasons that follow, we find that bo th the objective analysis of the actual economic consequen ces of ACM's transactions and the subjective analysis of t heir intended purposes support the Tax Court's conclusio n 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 AC M's that has neither objective non-tax economic effects nor subjective n on-tax purposes constitutes an economic sham whose tax consequences must be disregarded, and equally clear that a transaction t hat has both objective non-tax economic significance and subjective non-ta x purposes constitutes an economically substantive transaction whose tax consequences must be respected, it is also well est ablished that where a transaction objectively affects the taxpayer's ne t economic position, legal relations, or non-tax business interests, it will not be disregarded merely because it was motivated by tax consideratio ns. 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 wil l be disregarded"), Northern Indiana Pub. Serv. Co., 115 F.3d at 512 (e mphasizing that Gregory and its progeny "do not allow the Commissio ner to disregard economic transactions . . . which result in actual, non-tax-related changes in economic position" regardless of "tax-av oidance motive" and refusing to disregard role of taxpayer's foreign su bsidiary which performed a "recognizable business activity" of sec uring loans and processing payments for parent in foreign markets i n exchange for legitimate profit); Kraft Foods Co. v. Commissioner , 232 F.2d 118, 127-28 & n.19 (2d Cir. 1956) (refusing to disregard tax ef fects of debenture

issue which "affected . . . legal relations" between taxp ayer and its corporateparent by financing subsidiary's acquisition of ven ture used to further

its non-tax business interests). In analyzing both the objective and subjective aspects of ACM's transaction in this cas e where the objective attributes of an economically substantive transacti on were lacking, we do not intend to suggest that a transaction which h as actual, objective effects on a taxpayer's non-tax affairs must be dis regarded merely because it was motivated by tax considerations.

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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 othe r than the creation of income tax losses," Jacobson v. Commissioner, 915 F.2d 832, 837 (2d Cir. 1990) (cit ations 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 inte rest except to reduce his tax." Knetsch v. United States, 364 U .S. 361, 366, 81 S.Ct. 130, 135 (1960). In Knetsch, the taxp ayer had purchased annuity savings bonds from an insurance company, borrowed virtually their entire value agai nst 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 wi th nothing of value apart from tax deductions, the Cou rt

concluded that the net effect of the transfers betw een the taxpayer and the insurance company amounted only to payment of a "fee for providing the facade of `loan s' 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 an d internal quotation omitted).

In Weller, 270 F.2d 294, we examined a similar seri es of transactions in which the taxpayer purchased annuit y policies, pledged them as collateral to borrow fund s, 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 so ught to deduct the prepayments as interest. See id. at 295- 96. Applying Gregory, we disallowed the deduction on th e grounds that "transactions which do not vary contro l or change the flow of economic benefits are to be dism issed from consideration" if they "do not appreciably cha nge the taxpayer's financial position." Id. at 297 (citatio ns andinternal quotations omitted). We therefore disregar ded the

transactions for tax purposes even though the taxpa yer had

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made actual payments which satisfied the statutory definition of an "amount paid . . . on indebtedness incurred . . . to purchase a single premium life insurance c ontract," much as the Supreme Court had disregarded the transaction in Gregory despite the fact that the ta xpayer had created "a real, valid, corporate entity" and c arried out

a transaction that was "within the terms of the sta tute." Id.

at 296-98.

In the context of property dispositions, the courts have applied the economic substance doctrine in a simila r manner to disregard transactions which, although in volving actual transactions disposing of property at a loss , had no net economic effect on the taxpayer's economic posi tion, either because the taxpayer retained the opportunit y to reacquire the property at the same price, or becaus e the taxpayer offset the economic effect of the disposit ion by acquiring assets virtually identical to those relin quished. See, e.g., Lerman, 939 F.2d at 48; Merryman v. Commissioner, 873 F.2d 879 (5th Cir. 1989); Kirchma n, 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 pr operty, the courts examined the dispositions in their broad er economic context and refused to recognize them for tax purposes where other aspects of the taxpayers' tran sactions offset the consequences of the disposition, resulti ng in no net change in the taxpayer's economic position. In light of these cases, we must determine whether the Tax Cour t erred in concluding that ACM's exchange of the Citi corp 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 i n the object of the sale" and did not have "economic subs tance separate and distinct from economic benefit achieve d solely by tax reduction." 73 T.C.M. at 2215. For the follo wing 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 t han

34on 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 n otes between November 3 and November 27, 1989. The court noted that ACM sold the Citicorp notes "for conside ration equal to [their] purchase price" and thus did not r ealize 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 o f change in principal value was not merely coincidental, but was inherent in the terms of the notes and of the trans actions in which they were traded. See id. at 2219-20. Like wise, the court found that the interest income generated by t he 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 holdin g period, a difference which was obliterated by the transacti on costs associated with marketing private placement notes t o third parties. Id. at 2218, 2220-21.

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32. As contemplated in transaction proposals drafte d before ACM was formed, the Citicorp notes were sold for an amount equal to their purchase price. See app. at 275-77, 321, 300.

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