Opinion ID: 614511
Heading Depth: 2
Heading Rank: 2

Heading: The tax plan

Text: At the same time he was researching the profit potential of an investment in Chinese NPLs, Montgomery also began researching the potential tax benefits that could be created by such an investment. In May of 2002, Deutsche Bank introduced Montgomery to the law firm of De Castro, West, Chodorow, Glickfeld & Nass, Inc. (De Castro). Montgomery sought De Castro's advice on how to structure an acquisition of Chinese NPLs so that it would create tax benefits for Beal. In a series of memoranda that it sent to Montgomery in June and July of 2002, De Castro laid out its plan for such a transaction structure. In short, De Castro proposed to Montgomery that, once he had identified the portfolio of NPLs he was going to recommend that Beal acquire, he form a partnership with Cinda and have Cinda contribute the NPLs to the partnership. By purchasing a portion of Cinda's interest in the partnership to which it had contributed the NPLs instead of purchasing the NPLs directly from Cinda, Beal would be able to generate a paper loss that he could claim as a deduction on his individual tax return. Understanding why De Castro proposed this structure requires a brief review of the relevant provisions of the Internal Revenue Code and its implementing regulations. The Code treats a taxpayer's sale or other disposition of a piece of property in the ordinary course of his business as a taxable transaction. If the amount realized on the sale is less than the taxpayer's adjusted basis in the property, then the taxpayer is entitled to deduct that loss from his taxable income. [5] Basis is the amount that the seller has invested in the property; ordinarily, the taxpayer takes a cost basis in a piece of property equal to the property's purchase price. [6] The amount of the loss is determined by subtracting the taxpayer's adjusted basis in the property from the amount realized on the sale. [7] For example, assume a taxpayer purchases a piece of property for $60 and later sells it for $20. The taxpayer's cost basis is $60, and he has suffered a loss of $40 on the sale; that loss, when incurred in the ordinary course of the taxpayer's business, is deductible against the taxpayer's income. By contrast, if a taxpayer purchases a piece of property for $60 and later sells it for $100, he has realized a gain of $40. He would be required to pay tax on that gain. This latter example describes, in the most simplified terms, the structure and tax consequences of the Bank's early 2002 purchase of a portfolio of Jamaican NPLs. These rules apply to purchases of property. De Castro's plan for the Chinese NPL transaction was designed to take advantage of the fact that different rules apply to sales of partnership interests, with the result that purchasing an interest in a partnership that owns property can offer big tax advantages compared to purchasing the property directly. When a partner acquires an interest in a partnership by contributing property to the partnership, the contribution is generally not a taxable disposition of the property. [8] Instead, the partner's basis in the property transfers, or carries over, to the partnership. [9] The partnership's basis in the transferred property is often referred to as inside basis, and the partnership has the same inside basis in the property that the partner had before the contribution. [10] If, at the time of the transfer, the property's fair market value is lower than the partner's adjusted basis in the property, the property has a built-in loss. [11] Ordinarily, if a partner transfers property with a built-in loss to the partnership, any loss the partnership incurs when it sells that property must be allocated back to the contributing partner; the other partners cannot share in the loss. [12] For example, suppose that A and B form a partnership, agreeing to a 50-50 split of profits. B contributes $10 in cash to the partnership, and A contributes built-in-loss property with a fair market value of $10 and in which A's basis is $100. A and B each receive a capital-account credit of $10, [13] and the partnership takes a carryover inside basis in the property of $100. If the partnership later sells the property for $10, the partnership has realized a $90 loss on the sale. Under § 704(c)(1)(C)(ii) of the Internal Revenue Code, the entirety of that $90 loss must be allocated to A. [14] In this way, the normal operation of § 704(c) ensures that tax value follows book value. In other words, when property is sold for a loss, the sale creates a tax benefit in the form of a deduction. The purpose of § 704(c) is to allocate that benefit to the person who has actually suffered a real economic loss due to the property's diminution in value: the partner who paid $100 for property that is now only worth $10. A wrinkle arises when the contributing partner sells his partnership interest to a new partner before the partnership sells the property with the built-in loss. In that circumstance, Treasury Regulation 1.704-3(a)(7) requires the built-in loss to be allocated to the partner who purchased the partnership interest in the same manner that it would have been allocated to the contributing partner. [15] This rule enables the benefit of claiming the loss as a tax deduction to be separated and transferred away from the person who suffered the real, economic loss of the property's diminution of value. [16] To continue with the prior example, suppose that after A and B formed their partnership, A sold her partnership interest to C for $10. If the partnership later sold the property contributed by A for $10, the partnershipwhose inside basis in the property is $100would suffer a loss of $90. Regulation 1.704-3(a)(7) would require that $90 loss to be allocated to C. [17] Thus, even though the transaction was revenue-neutral for C in real economic terms (the partnership sold the property for the same amount of money that C spent to purchase his partnership interest), for tax purposes C has suffered a $90 loss, which C is then eligible to deduct against his other income. [18] By contrast, if C had simply purchased the property directly from A, C would have taken a cost basis of $10, and his later resale of the property for $10 would have been income-tax neutral. The real economic consequences to C of the two transactions are identical. But by running the acquisition through the partnership structure instead of consummating a direct purchase, C receives an income-tax windfall despite not being the party who suffered real economic loss as a result of the property's diminution in value. This example describesagain in highly simplified termsthe transaction structure that De Castro proposed to Montgomery for Beal's acquisition of a portfolio of Chinese NPLs. Cinda was an ideal partner for such a transaction. Because the Chinese government had required Cinda to purchase its NPLs at face value, Cinda had a cost basis in its NPLs that far exceeded the loans' fair market value; the NPLs had a huge built-in loss. As a foreign corporation not subject to U.S. income taxation, Cinda was a tax-indifferent party, unable to obtain any economic benefit from claiming the built-in loss as a deduction on an American tax return. If Beal were to purchase the NPLs directly from Cinda, that built-in loss would evaporate, and Beal would take a cost basis in the NPLs equal to their purchase price. If Cinda instead contributed to the NPLs to a partnership and Beal then purchased Cinda's interest in the partnership, the built-in loss would be preserved and transferred to Beal. Any loss realized on the partnership's sale of the NPLs would be allocated to Beal for tax purposes.