Opinion ID: 758343
Heading Depth: 3
Heading Rank: 4

Heading: Intended Purposes and Anticipated Profitability of ACM's

Text: Transactions 103 Before the Tax Court, ACM conceded that there were tax objectives behind its transactions but contended that tax independent considerations informed and justified each step of the strategy. 73 T.C.M. at 2217. ACM asserted that its transactions, in addition to presenting a realistic prospect that ACM would have made a profit on a pre-tax basis, also served the tax-independent purposes of providing an interim investment until ACM needed its cash to acquire Colgate debt and a hedge against interest rate risk within the partnership. The Tax Court, however, found that the record did not support ACM's assertions that the transactions were designed either to serve these non-tax objectives or to generate a pre-tax profit, see 73 T.C.M. at 2217-29, and for the following reasons, we agree. 104
105 ACM contends that it invested in the Citicorp notes not only because they qualified for treatment under the contingent installment sale provisions and the ratable basis recovery rule, but also because they served as an appropriate interim investment until ACM could invest in the Colgate debt whose acquisition, according to ACM, was a central objective of the partnership. The Tax Court, however, rejected this contention on the grounds that ACM did not acquire the Citicorp notes as an interim investment to accommodate the timing of the acquisition of Colgate debt; rather, it was the reverse: The acquisition of the Colgate debt was timed so as to accommodate the requirements of the section 453 investment strategy which required ACM to acquire and dispose of private placement notes. 73 T.C.M. at 2227. This conclusion finds abundant support in the record. 106 In May 1989, Merrill Lynch presented Colgate with an initial proposal of partnership transactions intended to generate capital losses which Colgate could use to offset 1988 capital gains. Although Merrill Lynch had not yet incorporated the concept of using the partnership to acquire Colgate debt issues as it did in its subsequent July 28 and August 17 proposals, its May proposal nonetheless contemplated the acquisition and imminent disposition of short-term securities, with no intervening change in their economic value, in exchange for contingent installment notes. See 73 T.C.M. at 2191; app. at 678-79, 275-77. The fact that the acquisition and disposition of short-term notes were central parts of the proposed partnership transactions even before the formulation of non-tax partnership objectives belies ACM's contention that its contingent installment exchange of Citicorp notes was designed to accommodate the timing of its debt acquisition strategy. 107 Moreover, as early as October 3, 1989, one month before ACM was formed, Pohlschroeder reported that he had identified the Met notes as targets for acquisition and that, pursuant to an inquiry to Metropolitan, we feel confident that the partnership can purchase sufficient Colgate debt to serve the partnership's objectives. App. at 314. Yet, despite this confidence that the debt was available for purchase well in advance of ACM's formation, Pohlschroeder did not recommend that the partnership invest its funds directly in the identified debt issues or finalize the terms of the anticipated debt purpose, but rather identified as the Next Steps after formation of the partnership Short-term investment securities acquired.... Disposition of short term investment securities to fund acquisition of Colgate debt. App. at 321. In accordance with this plan, ACM did not take any measures to pursue the prompt purchase of these debt issues upon its receipt of $205 million in cash contributions on November 2, 1989, but rather, acting through Colgate, instructed Metropolitan to attend a November 17 meeting to discuss the terms of the sale. See 73 T.C.M. at 2227. 45 Thus, we agree with the Tax Court's finding that any delay preceding the opportunity to acquire Colgate debt was of ACM's own deliberate making and was intended so that ACM could engage in the tax-motivated acquisition and disposition of qualifying short-term notes in the contingent installment sale that had been contemplated since before Merrill Lynch and Colgate devised the concept of incorporating debt acquisition objectives into Merrill Lynch's initial tax reduction proposal. 108 Even if ACM had faced a delay before it could purchase Colgate debt and thus needed to locate a suitable interim investment, the Citicorp notes ill served the professed purpose of holding cash assets in anticipation of an impending purchase. The notes, which in order to qualify for treatment in a contingent installment sale could not be traded on an established market, see I.R.C. § 453(k)(2)(A), were highly illiquid and thus could not be converted back into the cash needed to purchase Colgate debt without significant transaction costs in the form of the bid-ask spread which Merrill Lynch deemed necessary to market the notes to third parties. These transaction costs rendered the illiquid Citicorp notes paying 8.78% significantly less advantageous as an interim investment than the fully liquid cash deposit account paying 8.75%. Accordingly, we find no error in the Tax Court's conclusion that ACM's brief investment in the Citicorp notes was motivated by the pursuit of the tax advantages of a contingent installment sale rather than by a need for an interim investment pending its acquisition of Colgate debt. See 73 T.C.M. at 2227-29. 109
110 The Tax Court also rejected ACM's contention that it invested in LIBOR notes not only because they generated the contingent payments necessary to trigger the application of the ratable basis recovery rule, but also because they were an appropriate hedge against the interest rate exposure brought about by ACM's investment in Colgate debt issues. As the court explained, ACM's asserted rationale of hedging against other assets within the partnership would defeat [the] very purpose which Colgate had advanced for pursuing a debt acquisition partnership in the first instance. 73 T.C.M. at 2222. The court accurately noted that Colgate had entered into the partnership based on a prediction of falling interest rates and had justified its plan to acquire fixed-rate Colgate debt issues on the grounds that as interest rates declined, these issues would appreciate in value to ACM as the obligee, thus offsetting, through Colgate's share in ACM, the increased burdens that Colgate effectively would sustain as the obligor on those instruments if market interest rates fell further below the fixed rate established on these obligations. See 73 T.C.M. at 2192-93, 2221-25; app. at 311, 666-68, 880-82, 2762-63, 2765, 2769-70. 111 While the acquisition of Colgate debt furthered this professed goal of decreasing the exposure associated with Colgate's fixed rate long term debt structure outside of the partnership, the acquisition of the LIBOR notes, whose value would decline as interest rates declined, conversely increased ACM's exposure to falling interest rates, offsetting the desired effect of the debt acquisition program which purportedly was a fundamental partnership objective. See T.C.M. at 2221; app. at 311. Accordingly, the LIBOR notes, by hedging against the Colgate debt issues acquired within the partnership, negated the potential benefit of ACM's acquisition of these issues as a hedge against Colgate's interest rate exposure outside the partnership. 112 The fact that the interest rate exposure resulting from the LIBOR notes undermined rather than furthered the partnership's purported debt management objectives is also evident from the fact that Colgate reserved the option under the partnership agreement to elect to increase its share in changes in the value of the Colgate debt issues attributable to fluctuations in market interest rates, and exercised this option on several occasions. See app. at 101. Because the value of the fixed-rate Colgate debt issues increased in inverse proportion to interest rates, Colgate's exercise of this option reflects a prediction of falling interest rates which would result in risk to Colgate through its liabilities outside the partnership but would benefit Colgate through its interest in the assets held within the partnership. The acquisition of LIBOR notes, whose value depended in direct proportion on interest rates, effectively would dilute the benefits which the partnership was intended to yield and which Colgate sought to maximize by exercising its options under the partnership agreement. Thus, we find considerable support in the record for the Tax Court's conclusion that the acquisition of the LIBOR notes operated to defeat [the] very purpose which ACM had advanced as a tax-independent justification for its sequence of investments. 113 Although ACM meticulously set forth, in contemporaneously recorded documents, tax-independent rationales for each of its transactions with respect to the Citicorp notes and LIBOR notes, 46 these stated rationales cannot withstand scrutiny in light of the stated purposes behind the partnership itself, because the investment in the Citicorp notes impeded rather than advanced ACM's professed goal of making its cash available to acquire Colgate debt issues, just as the investment in the LIBOR notes impeded rather than advanced the professed goal of acquiring partnership assets that would hedge against Colgate's exposure to declining interest rates outside the partnership. 47 Accordingly, we find no error in the Tax Court's determination that the transactions served no useful non-tax purpose, 73 T.C.M. at 2229, and thus constituted the type of scheme with no purpose other than tax avoidance that lacks the economic substance necessary to give rise to a deductible loss. Wexler, 31 F.3d at 124. 48 c. Anticipated Profitability 114 In addition to rejecting ACM's asserted non-tax justifications for its sequence of investments and dispositions, the Tax Court also rejected ACM's contention that its transactions were reasonably expected to yield a pre-tax profit because the court found ACM had planned and executed its transactions without regard to their pretax economic consequences. See 73 T.C.M. at 2217-21. The evidence in the record overwhelmingly supports this conclusion. 49 The documents outlining the proposed transactions, while quite detailed in their explication of expected tax consequences, are devoid of such detailed projections as to the expected rate of return on the private placement notes and contingent payment notes that were essential components of each proposal. See 73 T.C.M. at 2191; app. at 678-79, 263-79, 296-308. 50 115 Moreover, ACM's partners were aware before they entered the partnership that the planned sequence of investments would entail over $3 million in transaction costs. See app. at 294. Yet Colgate, which effectively bore virtually all of these costs pursuant to the terms of the partnership agreement, did not attempt to assess whether the transactions would be profitable after accounting for these significant transaction costs. See 73 T.C.M. at 2217-18, 2204. Furthermore, while ACM planned to dispose of the Citicorp notes after a brief holding period for an amount equal to their purchase price, see app. at 275-77, 300, 321, its proposed transactions contemplated holding for two years the LIBOR notes whose principal value would decline in the event of the falling interest rates which ACM's partners predicted. See app. at 311, 753-55. 116 Thus, while the Citicorp note investment which was essential to structuring the transaction as a contingent installment sale was economically inconsequential, the LIBOR note investment which was equally essential to achieving the desired tax structure was economically disadvantageous under the market conditions which Colgate predicted and which actually transpired. ACM's lack of regard for the relative costs and benefits of the contemplated transaction and its failure to conduct a contemporaneous profitability analysis support the Tax Court's conclusion that ACM's transactions were not designed or reasonably anticipated to yield a pre-tax profit, particularly in view of the significant transactions costs involved in exchanging illiquid private placement instruments. See Hines v. United States, 912 F.2d 736, 739 (4th Cir.1990). 51 117 In light of the Tax Court's well-founded conclusion that Colgate and ACM expected interest rates to decline, rendering the proposed transactions unprofitable, we find it immaterial whether, as ACM contends, the court overstated the degree to which interest rates would have had to rise in order for ACM to recover its transaction costs. See br. at 42-43. Even accepting ACM's assertion that it could have recovered its costs upon a significantly smaller rise in interest rates than that calculated by the Tax Court, this assertion is immaterial in the event of falling interest rates and at best demonstrates a prospect of a nominal, incidental pre-tax profit which would not support a finding that the transaction was designed to serve a non-tax profit motive. See Sheldon v. Commissioner, 94 T.C. 738, 768, 1990 WL 69233 (1990). 52 118 Furthermore, we find no merit in ACM's assertion that the Tax Court improperly based its determination that the transactions were unprofitable for Colgate on the erroneous assumption that Colgate, directly and through Southampton, would continue to own only 17 percent of ACM's assets, causing it to understate the profits Colgate would receive toward the end of the transactions when it would own 99.7% of the partnership. See br. at 39. 53 As discussed above, however, neither ACM nor any of its partners reasonably anticipated any profits resulting from the relevant transactions, which entailed an economically inconsequential investment in Citicorp notes and a decidedly unprofitable investment in LIBOR notes whose value would be expected to decline under contemporaneously predicted market conditions. Because the contingent installment exchange transaction, as contemplated and as actually executed, yielded no partnership profits in any amount, Colgate's percentage share of those non-existent profits is immaterial. 54 119 Even assuming, however, that ACM and its partners expected to earn some measure of profits upon disposition of the BOT LIBOR notes, any additional portion of these profits that would redound to Colgate's benefit due to its increased share in the partnership cannot be characterized as an additional return on Colgate's investment in partnership assets because Colgate, directly and through Southampton, paid well over $100 million to acquire its increased partnership interest. See app. at 137, 769-70. 55 These additional contributions far exceeded Colgate's initial partnership investment of $35 million, undermining ACM's assertion that any additional returns attributable to Colgate's increased stake in the partnership properly may be characterized as further returns on Colgate's interest in the partnership's investments. Thus, we are unpersuaded by ACM's contention that the Tax Court distorted its profitability analysis by failing to account for Colgate's increased partnership interest. 120 ACM also argues that the Tax Court's profitability analysis was flawed because the court adjusted the income expected to be generated by the LIBOR notes to its net present value. See br. at 43. In support of its assertion that this net present value adjustment constitutes reversible error, ACM cites Estate of Thomas v. Commissioner, 84 T.C. 412, 1985 WL 15324 (1985), which noted that the issue of present value adjustments was not raised or briefed by the parties and held that absent some statutory guidance, it would not discount the residual value of obsolete partnership assets at the time of obsolescence to their equivalent present values at the time the partnership was formed. The court reasoned that discounting to present value effectively would require that the taxpayer's investment yield a rate of return exceeding the discount rate which, the court found, would contravene the admonition in Treas. Reg. § 1.183-2(b)(9) that the availability of other investments which would yield a higher return, or which would be more likely to be profitable, is not evidence that an activity is not engaged in for profit within the meaning of I.R.C. § 183. See 84 T.C. at 440 n. 52. 121 We reject ACM's contention that Estate of Thomas, which construed Treasury Regulations under I.R.C. § 183, precludes present value adjustments in the prospect-for profit analysis under the judicially created economic substance doctrine. 56 In transactions that are designed to yield deferred rather than immediate returns, present value adjustments are, as the courts have recognized, an appropriate means of assessing the transaction's actual and anticipated economic effects. See, e.g., Hilton v. Commissioner, 671 F.2d 316, 317 (9th Cir.1982) (affirming economic substance determination based on present value analysis of taxpayer's investments); Citizens & Southern Corp. v. Commissioner, 91 T.C. 463, 498, 1988 WL 90987 (1988) (noting that value of an acquired asset may be determined based on future income likely to be generated that by that asset discounted to present value), aff'd, 919 F.2d 1492 (11th Cir.1990); Gianaris v. Commissioner, 64 T.C.M. (CCH) 1229, 1234 (1992) (we have consistently discounted ... income streams produced by [an investment] in determining whether the taxpayer had a profit objective) (citations omitted). 122 We find no basis in the law for precluding a tax court's reliance on a present value adjustment where such an adjustment, under the surrounding circumstances, will serve as an accurate gauge of the reasonably expected economic consequences of the transaction. In this case where ACM's transactions essentially converted readily available cash, with only a brief interim investment in the Citicorp notes, into a stream of deferred payments, we find that the present value adjustment played an appropriate role in the Tax Court's analysis of the potential profitability of the transactions. We accordingly find no error in this aspect of the court's analysis. 123 ACM also avers that the Tax Court erred in excluding from its profitability analysis the pre-tax income resulting from the investment of $140 million of cash received as part of the consideration for the Citicorp Notes. Br. at 44. We disagree. The Tax Court properly analyzed the profitability of the transactions whose economic substance is at issue, namely the contingent installment exchange of Citicorp notes for LIBOR notes which gave rise to the disputed tax consequences. Any profits arising from ACM's investment of $140 million in cash into Colgate debt issues did not result from the contingent installment exchange whose economic substance is in issue. Because this sum of cash in fact represents the portion of the proceeds from the Citicorp notes which ACM did not invest in the contingent installment exchange of the other $35 million in Citicorp notes for contingent-payment LIBOR notes, any profits derived from these funds cannot be characterized as profits arising from the contingent installment exchange. Thus, the Tax Court properly excluded these profits from its analysis of the profitability of the contingent installment sale which gave rise to the disputed capital losses. 57 We find ample support in the record for the Tax Court's conclusion that ACM and its partners did not reasonably anticipate that its contingent installment sale would generate a pre-tax profit. Because ACM's acquisition and disposition of the Citicorp notes in a contingent installment exchange was without objective effect on ACM's net economic position or non-tax objectives, and because its investments in the Citicorp notes and LIBOR notes did not rationally serve ACM's professed non-tax objectives or afford ACM or its partners a reasonable prospect for pre-tax profit, we will affirm the Tax Court's determination that the contingent installment exchange transactions lacked economic substance and its resulting decision providing that the capital gain and loss at issue will not be recognized and thus disallowing deductions arising from the application of the contingent installment sale provisions and the ratable basis recovery rule.