Opinion ID: 758343
Heading Depth: 2
Heading Rank: 4

Heading: Tax and Financial Accounting of the Transactions

Text: 61 On its partnership return for the tax year ended November 30, 1989, ACM treated the November 27, 1989 exchange of the Citicorp notes as an installment sale under I.R.C. § 453, as ACM was to receive part of the consideration for that exchange after the close of the taxable year in which the disposition occurs pursuant to § 453(b)(1). App. at 109. Because the quarterly LIBOR note payments would vary based on fluctuations in the LIBOR, there was no stated maximum selling price that could be identified as of the close of the taxable year in which the .... disposition occurs. Thus, the transaction came within the terms of Temp. Treas. Reg. § 15a.453-1(c), whose ratable basis recovery rule provides that the taxpayer's basis shall be allocated to the taxable years in which payment may be received under the agreement in equal annual increments. 62 Accordingly, ACM divided its $175,504,564 basis in the Citicorp notes, consisting of their $175 million purchase price and $504,564 of accrued payable interest, equally among the six years over which payments were to be received in exchange for those notes, and thus recovered one sixth of that basis, or $29,250,761, during 1989. 16 Subtracting this basis from the $140 million in cash consideration for the Citicorp notes, ACM reported a 1989 capital gain of $110,749,239.42 which it allocated among its partners according to their partnership shares, resulting in an allocation of $91,516,689 of the gain to Kannex, $18,908,407 to Southampton, and $324,144 to MLCS. See app. at 109, 144-66; 73 T.C.M. at 2203. Southampton and MLCS were subject to United States income tax on their respective shares of the gain, but Kannex as a foreign corporation was not. App. at 226-35. 17 63 Under the ratable basis recovery rule the tax basis remaining to be recovered over the following five years became $146,253,803, representing the difference between the $175,504,564 value of the Citicorp notes which ACM relinquished to acquire those notes and the $29,250,761 in basis recovered during the first year of the transaction. See app. at 110. Of the $146,253,803 reported as the remaining unrecovered tax basis after 1989, $41,786,801 was attributable to the BFCE LIBOR notes, whose actual cost was $10,144,161, while $104,467,002 was attributable to the BOT LIBOR notes, whose actual cost was $25,360,403. See 73 T.C.M. at 2201, 2203 & n. 11. 64 On its 1989 tax return, Southampton reported its $18,908,407 share of the capital gain from the $140,000,000 cash received in exchange for the Citicorp notes, and reported a $32,429,839 capital loss from its December 22, 1989 sale to Sparekassen of the BFCE LIBOR notes which it had received in the December 12, 1989 distribution from ACM. 18 Because these capital losses completely offset the capital gains, Southampton reported a net 1989 capital loss of $13,521,432 and did not report any net tax liability on its share of ACM's gain from the disposition of the Citicorp notes. See 73 T.C.M. at 2203. 65 ACM retained the Curacao office of Arthur Andersen & Co. as its accountants. In reviewing ACM's financial and tax accounting for 1989, the Arthur Andersen auditors noted that ACM's records were inconsistent in their treatment of the $1,093,750 spread between the amount of consideration ACM had paid for the LIBOR notes and their market value at the time of acquisition. Specifically, the auditors noted, ACM had not accounted for this transaction cost in its income statement, but had included it in the book value of the LIBOR notes contrary to a provision in the partnership agreement requiring that assets be recorded at fair market value. Due to this discrepancy, ACM's records effectively overstated the market value of the LIBOR notes and understated the transaction costs involved in acquiring them through the contingent installment sale. See 73 T.C.M. at 2204. 66 The audit manager wrote the following memorandum in February 1990 to his colleagues regarding the discrepancy: 67 Colgate does not want the cost to sell [the Citicorp notes] of U.S. $1,093,750 ... in the ... income statement of ACM. The reasons are mainly tax driven, as inclusion might set the IRS on top of the reasons why the partnership was constructed in the first place and thus the planned tax losses might be denied by the IRS. We ... were requested to think with Colgate in order to keep the cost to sell out of the balance sheet. 68 Id.; see also app. at 141. Arthur Andersen proposed that to avoid accounting for the costs associated with the LIBOR notes, ACM could continue to record the transaction costs as part of the value of the LIBOR notes and could resolve the conflict with the market valuation provision of the partnership agreement by issuing a side letter to the partnership agreement stating that the LIBOR notes are the one exception to the valuation rules which now state valuation at market and would ... then state valuation at market increased by the cost to sell the original Citicorp notes. Id. 69 At its February 28, 1990 partnership meeting, ACM adopted this approach and enacted special valuation rules which provided that the LIBOR notes, unlike other partnership assets, would be valued on ACM's books at cost rather than at market value and would be adjusted upon distribution of the note to a partner, redemption of the partnership interest of any partner, or liquidation of the partnership. See app. at 402, 407. 19 This provision effectively transferred the transaction costs associated with exchanging the Citicorp notes for LIBOR notes to the partner that eventually received the notes in a distribution, as the market value would be less than the reported value of the distribution. See 73 T.C.M. at 2204. Thus, ACM's December 12, 1989 distribution of the BFCE LIBOR notes effectively passed those transaction costs to Southampton in accordance with the partners' understanding that Colgate and Southampton would bear the transaction costs associated with trading private placement notes. See app. at 1622-25. 70 For its tax year ended December 31, 1991, ACM reported a capital loss of $84,997,111 from its December 17, 1991 sale of the BOT LIBOR notes. 20 This loss consisted of the difference between the $10,961,581 that ACM received for those notes and the remaining $95,958,692 basis in those notes. App. at 202-25. Of this amount of loss, $5.8 million resulted from a decline in the value of the LIBOR notes due to declining interest rates while $79,106,599 resulted from the application of the ratable basis recovery rule which effectively added to the tax basis of the LIBOR notes 5/6 of the $140 million value of the Citicorp notes which had been exchanged for cash. See 73 T.C.M. at 2206. 21 Because Colgate, together with its subsidiary Southampton, by that time owned 99.7% of the partnership, Colgate claimed 99.7% of the $84,997,111 capital loss on its 1991 return for a total capital loss of $84,537,479. App. at 247-51. Colgate then filed an amended 1988 return reporting this loss as a carryback pursuant to I.R.C. § 1212 to offset a portion of its 1988 capital gains. See app. at 252-62. 22