04 - Fourth and Eleventh Circuits Find CARDs Transaction Lacked Economic Substance

Transcription

1 04 - Fourth and Eleventh Circuits Find CARDs Transaction Lacked Economic Substance Curtis Investment Company, LLC, v. Comm., (CA11 12/6/2018) 122 AFTR 2d ; Baxter, et ux v. Comm., (CA4, 12/7/2018) 122 AFTR 2d The Courts of Appeals for the Eleventh and Fourth Circuits, affirming the Tax Court, have held that a Custom Adjustable Rate Debt Structure (CARDS) transaction entered into by an LLC and two individuals associated with the LLC lacked economic substance and that losses stemming from the transaction weren't deductible. The Courts found that the transaction-which was designed and entered into for the purpose of generating a tax loss-presented no real opportunity for profit and that the taxpayers had no valid non-tax reasons for participating in it. Background economic substance. To determine whether a transaction has economic substance, courts usually make a two-pronged factual inquiry: (1) Was the taxpayer motivated by no business purpose (other than getting tax benefits) in entering into the transaction? (subjective test) (2) Did the transaction have objective economic substance, i.e., was there a reasonable possibility of a profit? (objective test) (Frank Lyon Co v. U.S., (S Ct 1978) 41 AFTR 2d ) The economic substance doctrine allows the government to look beyond technical compliance with the Code to ascertain the real nature of the transaction at issue. The Circuits have differed in their application of the two-prong test. A number of Circuits, including the Eleventh Circuit (United Parcel Service of America Inc, (CA ) 87 AFTR 2d ), require that a transaction have both a subjective business purpose and objective economic substance in order to be respected (the conjunctive test). On the other hand, the Fourth Circuit requires only that a transaction have either a subjective business purpose or objective economic substance in order to be respected (the disjunctive test). (Rice's Toyota World Inc v. Comm., (CA ) 55 AFTR 2d ) In these cases, Curtis Investment (an LLC organized in Georgia) appealed the Tax Court's decision to the Eleventh Circuit, while Guy and Lonnie Baxter (residents of South Carolina) appealed to the Fourth Circuit. Therefore, in determining whether the transaction had economic substance, the Courts applied 10

2 the conjunctive test with respect to Curtis Investment and the disjunctive test with respect to the Baxters. Observation: For transactions entered into after Mar. 30, 2010 i.e., after the time period involved in this case the Health Care and Education Reconciliation Act (P.L , 3/30/2010) added Code Sec. 7701(o). Under a conjunctive two-prong test, it provides that a transaction is treated as having economic substance only if, apart from Federal income tax effects, both: (1) the transaction changes the taxpayer's economic position in a meaningful way; and (2) the taxpayer has a substantial purpose for entering into the transaction. That is, the taxpayer's non-federal-income-tax purpose for entering into a transaction must be "substantial." Background CARDS transactions. A CARDS transaction is, in effect, a complex transaction designed to create an artificial capital loss to offset an unrelated capital gain. As previously described by the Third Circuit in Cirpin v. Comm., (CA ) 111 AFTR 2d , which involved a transaction similar to the one in this case: "A CARDS transaction is a tax-avoidance scheme that...purports to generate, through a series of pre-arranged steps, large "paper" losses deductible from ordinary income. First, a tax-indifferent party...borrows foreign currency from a foreign bank (a "CARDS Loan"). Then, a United States taxpayer purchases a small amount...of the borrowed foreign currency by assuming liability for a an equal amount of the CARDS Loan. The taxpayer also agrees to be jointly liable with the foreign borrower for the remainder of the CARDS Loan and so the taxpayer purports to establish a basis equal to the entire borrowed amount. Finally, the taxpayer exchanges the foreign currency he purchased for United States dollars. That exchange is a taxable event, and the taxpayer claims a loss equal to the full amount of his supposed basis in the CARDS Loan, less the proceeds of the relatively small amount of currency actually exchanged. The taxpayer uses that loss to shelter unrelated income." The CARDS strategy was targeted by IRS in August of 2000 in Notice , CB 255. That Notice warned taxpayers that noneconomic losses produced by certain basis-inflating transactions aren't allowable as tax deductions. Background accuracy-related penalty. Taxpayers are subject to a 20% accuracy-related penalty for an underpayment of tax required to be shown on a return that is attributable to a substantial valuation misstatement. (Code Sec. 6662(a), Code Sec. 6662(b)(3)) The penalty is 40% of the portion of an underpayment of tax attributable to one or more substantial valuation misstatements that meet the requirements for a "gross valuation misstatement" i.e., one where the value or adjusted basis of any property claimed on a tax return is 200% or more of the amount determined to be the correct amount of 11

3 such value or adjusted basis. (Code Sec. 6662(h)) The accuracy-related penalty does not apply, however, with respect to any portion of the underpayment for which the taxpayer shows that there was reasonable cause and that he or she acted in good faith. (Code Sec. 6664(c)) The Supreme Court in U.S. v. Woods, (S Ct 2013) 112 AFTR 2d , resolving a split in the circuits, held that the valuation misstatement penalty could be imposed where the underlying transaction lacked economic substance. Facts. Curtis Investment Company LLC (Curtis Investment), a holding company formed by the Curtis family, owned approximately 30% of the stock of American Business Products, Inc. (ABP), as well as other assets. Mrs. Baxter, a member of the Curtis family, became managing member of Curtis Investment in '86, and her son, Mr. Bird, assumed that role in '98. In late '99 or early 2000, ABP received a tender offer for the purchase of the company, which its board accepted. In February 2000, Curtis Investment sold ABP stock, generating approximately $28.6 million in long-term capital gain. Mrs. Baxter also sold ABP stock generating approximately $2.4 million in long-term capital gain and $19,000 in short-term capital gain. In the fall of 2000, knowing that the sales of ABP stock would generate substantial tax liabilities, an accountant recommended a CARDS transaction to Curtis Investment and Mrs. Baxter. Mr. Bird had various legal and financial advisors, some of whom were also promoters of the transaction, review the transaction. He received a model opinion letter drafted by a law firm concluding that the transaction would "more likely than not" have economic substance. While none of the advisors actually provided their own opinion letters, they generally concurred with the model opinion letter as to the tax consequences of the transaction. Mr. Bird himself also researched the investment potential of the CARDS transaction and concluded that it would be profitable. They decided to participate. The CARDS transaction resulted in a purported $28 million loss for Curtis Investment and a $2.3 million loss for Mr. and Mrs. Baxter. Both Curtis Investment and the Baxters reported these losses, as well as the long- and shortterm gains from the ABP stock sale, on their 2000 returns. IRS, however, determined that they were not entitled to a capital loss deduction as a result of the CARDS transaction because it lacked economic substance. IRS also found that they were liable for gross valuation misstatement penalties. Tax Court decision. The Tax Court concluded that the transaction lacked economic substance under both the subjective and objective tests. (Curtis Investment Company, LLC, TC Memo ) The Tax Court explained that, to satisfy the objective test, a transaction must be objectively likely to produce economic benefits other than the generation of a tax 12

4 deduction. (Glass, (1986) 87 TC 1087) Curtis Investment and the Baxters argued that the Court should consider the profit potential from returns on investments that were purchased with proceeds of the CARDS transaction, but the Court rejected this argument, focusing instead on the transaction itself that gave rise to the tax loss. The Court then concluded that the CARDS transaction in this case, like prior ones it had considered, did not provide an objectively reasonable possibility of profit. Rather, the transaction was purposefully entered to create tax losses, and the Court found that "any testimony to the contrary is simply not credible." The Court noted that its conclusion that the CARDS transaction failed the objective test was enough for it to conclude that, with respect to Curtis Investment, the CARDS transaction lacked economic substance. However, it continued to apply the subjective test, satisfaction of which was also required to reach a similar conclusion with respect to the Baxters. The subjective test looks to whether there was a business purpose for a transaction or, put otherwise, whether the transaction would have occurred absent tax avoidance reasons. The Baxters claim that their business purpose was to obtain proceeds for investment, but the Court found that this claim was belied by the facts of the transaction, including the high financing costs incurred, the overall timing, and the fact that the Baxters didn't explore less expensive financing arrangements or attempt to obtain any other loan or maximize the amount they could borrow. Finally, the Tax Court upheld IRS's imposition of a 40% gross valuation misstatement penalty, citing Woods. The Court noted that the Tax Court had previously found that a taxpayer acted with reasonable cause and good faith when (a) a deficiency was the result of an issue of first impression and the taxpayer's position was reasonably debatable; or (b) a taxpayer took a position on an initial interpretation of a statute and the statutory text was unclear. However, the Court rejected the argument that the CARDS transaction presented novel issues, finding that IRS had already taken an unfavorable position with regard to CARDS transactions in Notice (and that this Notice was discussed in the model opinion letter concerning the transaction); and even if it had presented novel issues, the facts of the case otherwise weighed against a finding of reasonable cause and good faith. Notably, any claimed reliance on tax advisors was belied by the fact that they had an inherent conflict of interest, and the Baxters, as well as Mr. Bird, were all financially sophisticated. Eleventh Circuit decision. The Eleventh Circuit found that the Tax Court did not err in concluding that Curtis Investment's CARDS transaction lacked economic substance or a business purpose, nor in finding that Curtis Investment was liable for a 40% gross valuation misstatement penalty for its 2000 tax return. It also determined that the Tax Court did not clearly err in determining that Curtis Investment lacked reasonable cause and good faith in making an understatement on its 2000 tax return 13

5 The Eleventh Circuit found that the Tax Court properly focused on the CARDS transaction as the specific transaction generating the tax benefit the artificial loss at issue in Curtis Investment's 2000 tax returns. The Court rejected Curtis Investment's argument that it was motivated by a business purpose and its transaction had economic effects other than tax consequences because it planned to make a net profit from investments with proceeds of the interest-free loan it obtained in its CARDS transaction. The Court found that these investments were collateral to the CARDS transaction and did not contribute to Curtis Investment's ability to claim a tax benefit; thus, they were not considered to be part of the specific transaction. The Eleventh Circuit concluded that the Tax Court's finding of facts and credibility did not constitute clear error. The Tax Court determined that the CARDS transactions reduced the taxpayers' wealth by over 2 million and would have cost even more after one year. Accordingly, there was no reasonable possibility of profit. While Curtis Investment may have had a business purpose to borrow funds for long-term investment, it had no legitimate business purpose for choosing this particular financing plan, which left considerably less money for investment than conventional financing. Moreover, the Tax Court found that Curtis Investment did not consider financing alternatives and made no attempt to reduce its cost of borrowing to maximize funds available for investment. Instead, Curtis Investment used a new bank and paid financing costs of approximately 45% of the proceeds of its loan. The Tax Court discussed further evidence, including multiple one-year time frames in documents related to the transaction, suggesting that Curtis Investment did not truly enter into the CARDS transaction for long-term investment purposes and did not reasonably believe that it had taken on a genuine enforceable obligation to repay the full debt. Thus, the Tax Court concluded that Curtis Investment's CARDS transaction objectively lacked economic substance and subjectively lacked a non-tax business purpose. In evaluating the reasonableness of Curtis Investment's reliance and good faith with respect to the position that it took on its 2000 tax return, the Eleventh Circuit noted that the Tax Court determined that Curtis Investment's managers were not as "unsophisticated" as they claimed to be. The Tax Court also noted how Curtis Investment's managers had considerable experience in financing transactions but did not investigate alternative financing options despite the high cost of the CARDS transaction. Ultimately, the Tax Court concluded that Curtis Investment did not reasonably rely on professional advice in drafting its 2000 tax returns. The Eleventh Circuit rejected the taxpayer's contention that it took a reasonable position given the unclear nature of the law. Although CARDS was a new tax structure in 2000, the underlying legal theory was already established: transactions lacking economic substance are disregarded for tax purposes. Fourth Circuit decision. The Fourth Circuit determined that the Tax Court did not clearly err in finding that the taxpayers' CARDS transaction failed both the 14

6 subjective and objective prongs of the economic substance test. Accordingly, the Court rejected the taxpayers' claim that the Tax Court reversibly erred in finding that the CARDS transaction was a sham. The Tax Court found that the taxpayers failed the prong of the economic substance test which required a subjective showing that the tax consequences were not the only purpose for entering into the transaction. The Fourth Circuit held that the findings by the Tax Court in this regard were supported by facts in the record, and reflected reasonable inferences from those facts, and so were not subject to reversal under the applicable clear error standard of review. The Tax Court found that: (1) the taxpayers' claimed purpose of obtaining the loans so as to engage in leveraged investment was not credible in light of the extremely high fees and the high costs of borrowing, which would constitute a long-term drain on investment profitability; (2) the taxpayers expected the loan proceeds to be available for 30 years which was essential to their expectation of profitability given that the taxpayers would pay the high fees up front was not credible in light of the structure of the various short-term elements of the transaction; (3) Mrs. Baxter's testimony as to her non-tax-avoidance purpose in engaging in the transaction was not credible; and (4) the taxpayers were aware of the substantial tax liabilities associated with the sale of Mrs. Baxter's ABP shares and considered several other tax shelters before choosing CARDS. The Fourth Circuit also recognized that, as in this case, "promotion materials" distributed to market the tax consequences of a purported investment transaction could constitute strong evidence of intent when such materials evidence that the transaction was designed as a tax avoidance transaction. The Fourth agreed with the Tax Court that the taxpayers failed to meet the other prong of the economic substance test which required an objective determination of whether a reasonable possibility of profit from the transaction existed apart from the tax benefits. The Fourth Circuit rejected the taxpayers' contention that the Tax Court was required to consider the "whole undertaking" i.e. the taxpayers' planned investment of the loan proceeds, not just the loan transaction itself in determining whether a reasonable possibility of profit from the transaction existed apart from the tax benefits. The Fourth Circuit found that the Tax Court's decision to disregard the potential profitability of the taxpayers' investment plan for the loan proceeds was consistent with other courts' focus on the "transaction" that gave rise to the loss. The taxpayers also argued that, even with the high-cost of financing, they expected the transaction to be profitable over the long-term. However, under the Tax Court's well-supported factual finding, the taxpayers' testimony that they anticipated that the loan proceeds would be available for more than a year was not credible, and so, the taxpayers could not have expected to profit from the 15

7 transaction, given the high upfront fees. Accordingly, no reasonable possibility of profit from the transaction existed apart from the tax benefits. In determining that the taxpayers could not show reasonable cause and good faith reliance on professional advice, the Fourth Circuit found that the taxpayers reliance on the opinion of the tax shelter promoter s attorneys suffered from an obvious conflict of interest. Further, taxpayers could not and did not reasonably rely on their legal and tax advisors' "independent review of the transaction because those advisors relied solely on the model opinion letter from the promoter s attorneys in formulating their opinion. In addition, the Fourth Circuit noted that the Tax Court emphasized that given Mrs. Baxter's twenty-year tenure as assistant manager and manager of Curtis Investment and service on its investment committee, she should have known that the tax benefits of the transaction were too good to be true. The Fourth Circuit concluded that the well-established body of case law dealing with the economic substance doctrine, IRS's notice, and the record evidence as to the subjective and objective economic substance of the taxpayers' CARDS transaction provided ample basis to support the Tax Court's ultimate finding that, at the time the taxpayers claimed the loss, their position was not reasonably debatable and they did not prove that they acted with reasonable cause and in good faith. As to the taxpayers' argument that the tax issues raised by Mrs. Baxter's CARDS transaction were "novel" and "unsettled" at the time the taxpayers claimed losses attributable to the transaction, the Fourth Circuit stated that it was wellestablished that transactions lacking economic substance must be disregarded for tax purposes. Further, as the Tax Court correctly noted, just months before Mrs. Baxter entered into her CARDS transaction, IRS issued a formal notice in Notice on "Tax Avoidance Using Artificially High Basis." 16