Opinion ID: 489931
Heading Depth: 1
Heading Rank: 5

Heading: Deductibility of Interest on the Anglo Dutch Loans

Text: 23 Bail Bonds contends that the tax court erred as a matter of law in upholding the Commissioner's denial of the deduction for the interest on the Anglo Dutch loans. Bail Bonds does not appeal the determination that the Farila transactions were shams; rather, it argues that the Anglo Dutch loans were not shams. Bail Bonds claims that it borrowed money from Anglo Dutch, was legally obligated to repay it, and did in fact repay it with interest. Bail Bonds concludes that the cost of the use of funds in this transaction is deductible. We disagree. A. Standard of Review 24 The tax court's determination that the Anglo Dutch loans were shams is a finding of fact which will not be overturned on appeal unless it is clearly erroneous. Karme v. Commissioner, 673 F.2d 1062, 1065 (9th Cir.1982). The standards of law employed by the tax court in making its sham determination are reviewed de novo. See United States v. McConney, 728 F.2d 1195, 1201 (9th Cir.), cert. denied, 469 U.S. 824, 105 S.Ct. 101, 83 L.Ed.2d 46 (1984). B. Analysis 25 Pursuant to I.R.C. Sec. 163(a), an income tax deduction may be taken for interest paid on indebtedness. However, interest on sham indebtedness is not deductible. See, e.g., Goldberg v. United States, 789 F.2d 1341, 1342-43 (9th Cir.1986); Beck v. Commissioner, 678 F.2d 818, 821 (9th Cir.1982). A transaction is a sham if it has no purpose or economic effect other than the creation of tax deductions. See Neely v. United States, 775 F.2d 1092, 1094 (9th Cir.1985); Zmuda v. Commissioner, 731 F.2d 1417, 1421 (9th Cir.1984). 26 When the deductibility of interest is at issue, we focus on the substance of the loan transaction rather than its form. See Knetsch v. United States, 364 U.S. 361, 365-66, 81 S.Ct. 132, 134-35, 5 L.Ed.2d 128 (1960); Goldberg, 789 F.2d at 1343. Where, as here, the Commissioner has made a deficiency determination, the taxpayer has the burden of producing enough evidence to rebut the deficiency determination and the burden of persuasion in substantiating a claimed deduction. Valley Title Co. v. Commissioner, 559 F.2d 1139, 1141 (9th Cir.1977). 1. Rice's Toyota 27 In support of its argument that the tax court's decision was an error of law, Bail Bonds relies primarily on Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir.1985). That case reversed a determination by the tax court that the interest on a recourse debt undertaken to finance a sham sale-leaseback arrangement was not deductible. The tax court had disregarded the transaction in its entirety, effectively determining that the recourse debt was a sham because the underlying sale-leaseback transaction was a sham. 28 In reversing, the Fourth Circuit stated that the Internal Revenue Code does not limit deductibility of interest depending upon the item purchased by the taxpayer. Id. at 96. The court concluded that the sham nature of the sale-leaseback agreement did not support the trial court's conclusion that the recourse loan was not genuine debt. Id. Rather, the recourse loan had created a genuine legal obligation on the part of the taxpayer, and possessed sufficient economic substance to justify the taxpayer's interest deductions. Id. 29 Rice's Toyota is relevant to the case at issue because the court below basically relied on the sham nature of the underlying Farila transaction in concluding that the Anglo Dutch loans were shams. We read Rice's Toyota to hold that, as a factual matter, indebtedness undertaken to fund a sham transaction is not necessarily a sham. 6 Consequently, a transaction involving use of loans to fund a tax avoidance scheme cannot be disregarded in its entirety unless the loans themselves have been separately examined and found to be shams. 2. Sham nature of Anglo Dutch loans 30 In the instant case, the tax court did not err in determining that the loans at issue were shams. The court did not rely simply on the sham nature of the underlying Farila transaction in determining that the Anglo Dutch loans were shams. Rather, it relied on the close relationship, and, more important, the close similarity between the Farila and Anglo Dutch transactions, concluding that both transactions occurred only on paper and operated simply to circulate money among various participants in the Margolis system. The court then proceeded to make a separate finding that the loans operated solely to create interest deductions and to circulate funds from Bail Bonds to Nelson. 31 The record does not support Bail Bonds' contention that the Anglo Dutch loans were not shams. In determining whether a transaction is a sham, courts typically focus on two related factors: 1) has the taxpayer shown that it had a business purpose for engaging in the transaction other than tax avoidance? 2) has the taxpayer shown that the transaction had economic substance beyond the creation of tax benefits? See, e.g., Frank Lyon Co. v. United States, 435 U.S. 561, 583-84, 98 S.Ct. 1291, 1303, 55 L.Ed.2d 550 (1978); Zmuda, 731 F.2d at 1421; Salley v. Commissioner, 464 F.2d 479, 482, 485 (5th Cir.1972); Hilton v. Commissioner, 74 T.C. 305, 349-50 (1980), aff'd per curiam, 671 F.2d 316 (9th Cir.), cert. denied, 459 U.S. 907, 103 S.Ct. 211, 74 L.Ed.2d 168 (1982). The business purpose factor often involves an examination of the subjective factors which motivated a taxpayer to make the transaction at issue. The economic substance factor involves a broader examination of whether the substance of a transaction reflects its form, and whether from an objective standpoint the transaction was likely to produce economic benefits aside from a tax deduction. See generally Packard v. Commissioner, 85 T.C. 397, 417 (1985). In the instant case, Bail Bonds has failed to demonstrate that the Anglo Dutch transaction had either a business purpose or economic substance. 32 It is clear from the record that the $25,000 loan was basically a fictitious transfer which circulated $25,000 from Anglo Dutch to Bail Bonds and back to Anglo Dutch. The loan was then paid off by another fictitious transfer which circulated approximately $27,000 from ABC (a system entity effectively controlled by Margolis) to Bail Bonds and back to Anglo Dutch (a system entity directly controlled by Margolis). 33 The $25,000 loan was a sham for two related reasons. First, it is clear that the transaction between Bail Bonds and Anglo Dutch was motivated and shaped solely by tax avoidance concerns. Second, because both the loan and the repayment of the loan consisted of nothing more than circulations of funds through the Margolis system, Bail Bonds did not actually secure the use of or pay for the use of the $25,000. See Karme v. Commissioner, 73 T.C. 1163, 1186-87 (1980), aff'd, 673 F.2d 1062 (9th Cir.1982); see also Beck, 678 F.2d at 821 (interest deduction may be taken only where taxpayer pays for the use or forbearance of money); Norton v. Commissioner, 474 F.2d 608, 610 (9th Cir.1973) (same). In sum, the $25,000 loan had neither a business purpose nor economic substance. Consequently, the interest on the loan is not deductible. See Salley, 464 F.2d at 485. 34 The nature of the $15,000 loan is somewhat less clear. The tax court found that the loan operated to create tax benefits for Bail Bonds and to circulate funds from Bail Bonds to Nelson. But the tax court did not spell out how the loan was repaid, beyond stating that repayment to Anglo Dutch occurred in three installments. 35 Nevertheless, Bail Bonds has failed to meet its burden of proving that the $15,000 loan was not a sham. See Goldberg, 789 F.2d at 1343; Karme, 673 F.2d at 1065; Thompson v. Commissioner, 66 T.C. 1024, 1052-53 (1976), aff'd, 631 F.2d 642 (9th Cir.1980), cert. denied, 452 U.S. 961, 101 S.Ct. 3110, 69 L.Ed.2d 972 (1981). Indeed, at trial Nelson testified that he was unable to recall the Anglo Dutch loans. Specifically, as with the $25,000 loan, there is no evidence that Bail Bonds had a business purpose for making the $15,000 loan; the loan was shaped solely by tax avoidance concerns. Nor is there evidence that the loan had economic substance. There is no evidence that Bail Bonds could have benefited economically from the transaction, aside from obtaining tax deductions. See Rice's Toyota, 752 F.2d at 94; Packard, 85 T.C. at 417. Funds derived from one system entity (Anglo Dutch) were simply designated as a premium payment on a sham reinsurance agreement with another system entity (Farila). In light of Bail Bonds' failure to prove that the $15,000 loan had a business purpose or economic substance, and in light of the close similarity between the Anglo Dutch transactions and the sham Farila transactions, we conclude that the district court's determination that the $15,000 loan was a sham is not clearly erroneous. The interest on the $15,000 loan is not deductible. 36 Our determination that the interest on both Anglo Dutch loans is not deductible is not affected by Bail Bonds' contention that it had a legal obligation to repay the Anglo Dutch loans. Beyond the bare assertion that it had such an obligation, Bail Bonds has supplied no evidence demonstrating that this obligation was genuine. Rather, the complete absence of arm's length dealings in the Anglo Dutch transactions indicates that Bail Bonds' purported legal obligation to repay the loans was purely formal. The obligation may therefore be disregarded. See Goldberg, 789 F.2d at 1343; Norton, 474 F.2d at 610.