United States Court of Appeals For the First Circuit
No. 10-2421
FIDELITY INTERNATIONAL CURRENCY ADVISOR A FUND, LLC, by the Tax Matters Partner,
Plaintiff, Appellant,
v.
UNITED STATES OF AMERICA,
Defendant, Appellee.
APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF MASSACHUSETTS
[Hon. F. Dennis Saylor IV, U.S. District Judge]
Before Torruella, Boudin and Thompson, Circuit Judges.
William F. Nelson with whom Ronald L. Buch, Jr., David J. Curtin, Kiara L. Rankin and Bingham McCutchen LLP were on brief for appellant. Judith A. Hagley, Tax Division, Department of Justice, with whom Richard Farber, Tax Division, Department of Justice, Gilbert S. Rothenberg, Acting Deputy Assistant Attorney General, and Carmen M. Ortiz, United States Attorney, were on brief for appellee.
October 21, 2011 BOUDIN, Circuit Judge. Fidelity International Currency
Advisor A Fund ("Fidelity") seeks review of a district court
judgment resolving a controversy between Fidelity and the Internal
Revenue Service ("IRS"). In substance, the district court
sustained IRS adjustments to Fidelity's partnership returns for the
two tax years at issue and upheld a 40 percent penalty for tax
underpayment. Fid. Int'l Currency Advisor A Fund, LLC v. United
States, 747 F. Supp. 2d 49 (D. Mass. 2010).
The litigation arises out of the following events.
Richard Egan was the founder of EMC Corporation, a manufacturer of
computer storage devices, and in the early years of this ultimately
successful business, Egan received non-qualified options to acquire
EMC stock. When he exercised those options in 2001, they generated
$162 million of ordinary income for him and his wife; it was
estimated this could create a tax liability of over $63 million.
Prior to exercising the options, Egan met with various
accounting and law firms to discuss methods of reducing the
potential tax liability. Ultimately, the plan adopted and put into
effect required Egan to form a partnership with a foreign national;
that partnership would engage in transactions that would generate
largely offsetting gains and losses without net risk; the gain
component would be principally allocated to the foreign national;
the loss component would be principally allocated to Egan and used
-2- on his individual return to offset gains on his exercise of the EMC
stock options, virtually eliminating tax on those gains.
To this end, in July 2000 Egan formed Fidelity as a
limited liability company federally taxed as a partnership. Egan
was one partner; the other principal partner was Samuel Mahoney,
who was an Irish citizen. Common shares were initially assigned 93
percent to Mahoney and 5 percent to Egan; Egan contributed $2.7
million in cash and certain interest rate options valued at $1.6
million, and Mahoney contributed $651,000 in cash.
Then, in October 2001, Fidelity entered into a set of
transactions whereby it purchased and sold options, related to
foreign currency exchange rates and configured in pairs: the terms
set for each pair (as to premium, strike price, maturity dates, and
possible payout) assured that a loss on one option in a pair would
be offset by a corresponding gain on the other. In substance, the
transaction would provide virtually no opportunity for a net gain
but also no risk of a net loss.1
One week later, Fidelity terminated four of the options
that had gained in value due to fluctuations in the currency
exchange rates. The offsetting options in the pairs,
correspondingly reduced in value, were not terminated. Instead,
1 Imagine two bets placed on the temperature next Wednesday, such that the wagerer would earn $1 on the first bet but also pay $1 on the second if the temperature was above the date's historic average. If instead the temperature fell below that average, the wagerer would lose $1 on the first bet and win $1 on the second.
-3- the proceeds from the terminated options were used to purchase
replacement options that would ensure that the eventual losses
taken by the partnership when it terminated the original options
that had lost value and the replacement options would offset the
gains initially realized.
This generated net taxable gains on Fidelity's books of
about $174 million from the options that had been terminated. But
under the tax laws Fidelity pays no taxes; rather its gains and
losses are assigned to the partners in accordance with their
ownership shares in the partnership and taxed to the partners on
their own returns. 26 U.S.C. §§ 701-702 (2006). Because of the
then-existing 5 and 93 percent share allocation, Egan was assigned
$7.1 million net gain and Mahoney $163.3 million net gain.
Then, a week later, in early November 2001, Egan bought
88 percent of the common partnership interest from Mahoney for
$325,500 and so owned 93 percent with Mahoney being reduced to 5
percent. A month later, in early December, Fidelity terminated the
four remaining original foreign currency options as well as the
replacement options acquired immediately after the October
termination. Not surprisingly in light of the design of the option
pairs, the December loss ($178.1 million) only modestly exceeded
the original gain.
Fidelity now allocated the $178.1 million loss in
proportion to the reallocated ownership shares: Egan was allocated
-4- $165.8 million in loss and Mahoney $8.8 million. The net economic
loss to the partnership from all the offsetting foreign currency
options was just over half a million dollars; advisory fees brought
the total cost to $4.1 million--a cost dwarfed by the potential tax
benefits for Egan.
The gains and losses from the currency option
transactions were reported on the 2001 partnership return and the
associated forms allocating to Fidelity's partners the gains or
losses for the transactions. Almost all the losses were assigned
on the schedule to Egan. An attached schedule reflecting "Other
income (loss)" pertaining to each closed-out transaction--say, the
purchase and ultimate disposition of an option by Fidelity--showed
a "cost or other basis" for the option (such as the premium paid to
acquire it), the associated revenue generated (the price received
on its sale) and the difference (the net gain or loss on the
purchase and sale).
The ultimate effect of these 2001 currency option
transactions was to give Egan a net loss on paper of $158.6 million
(comprising 5 percent of the gain from the foreign currency
options, 93 percent of the loss, and fees) and Mahoney a net gain
of $154.5 million (including 93 percent of the gain, 5 percent of
the loss, and fees). Egan's net loss was reported on his 2001
personal return to offset gain on the nearly $163 million in income
realized from the exercise of his EMC options in the same year.
-5- These 2001 foreign currency options transactions were the
core means of generating the loss for Egan, but a related set of
transactions was also necessary. Under the tax laws, a partner may
deduct his share of a partnership's losses only to the extent of
his adjusted "outside" basis in the partnership at the end of the
year in which the loss occurred. 26 U.S.C. § 704(d). This outside
basis refers to the partner's investment in the partnership (as
opposed to the "inside" basis of investments made by the
partnership in carrying on its own business).
To establish this necessary large outside basis, Egan in
2000 had become a partner not only of Fidelity but of a second
vehicle called Fidelity World, which in early October 2001 entered
into two pairs of offsetting options keyed to interest rates.
Fidelity World contributed them to Fidelity, reporting as a capital
contribution by Egan the $150 million cost of premiums paid to
secure the future interest rates options (and ignoring largely
offsetting premiums received for the sale of the other two
options).
In 2001, Fidelity closed out the contributed interest
rate options by purchasing a set of offsetting options that locked
in any existing gain or loss to protect against any future changes.
When these options were all terminated in 2002, the transactions
produced a very modest net loss of $1.9 million, due primarily to
advisor fees; nearly $1.8 million was proportionally allocated to
-6- Egan on Fidelity's 2002 return and reported by him to shield other
income on his own 2002 tax return.
In 2005 and 2006, the IRS notified Fidelity that it was
making adjustments to Fidelity's 2001 and 2002 partnership tax
returns. Under the governing regime, the partnership return items
may be adjusted by the IRS and contested changes may be judicially
reviewed in a district court proceeding (or, the Tax Court or Court
of Federal Claims) addressed only to partnership items. 26 U.S.C.
§ 6226(a). These include "the proper allocation of such items
among the partners, and the applicability of any penalty . . .
which relates to an adjustment to a partnership item." Id. §
6226(f).
In this case, the IRS disallowed all of Egan's claimed
contributions to Fidelity, reduced Egan's claimed "outside
partnership basis" to zero for 2001 and--most importantly--
disallowed the losses on Fidelity option transactions that Egan had
used on his personal returns for 2001 and 2002 to shield his non-
Fidelity income. The adjustments rested on the IRS's determination
that the option transactions, and Egan's contribution, lacked
economic substance. The IRS also disregarded the partnership as a
sham and lacking in economic substance.
Tax considerations are permissibly taken into account by
taxpayers in structuring their financial transactions, but where a
transaction has no economic purpose other than to reduce taxes, the
-7- IRS may disregard the reported figures as fictions and look through
to the underlying substance.2 Here, the IRS found (and the
district court later agreed) that Fidelity's option transactions
were designed to cancel each other out and were merely reported to
generate paper losses to use on Egan's return. The shift in
partnership ownership part way through was a counterpart device to
allocate most losses to Egan and most gains to Mahoney.
Congress has adopted a graduated set of penalties for
overstating on a return the value or basis of property, and the IRS
invoked a provision adding a 40 percent penalty to the portion of
a tax underpayment that is "attributable to" a "gross valuation
misstatement." 26 U.S.C. § 6662(a), (b), (e), (h). A gross
valuation misstatement occurs when
the value of any property (or the adjusted basis of any property) claimed on any return of tax . . . is 400 percent or more of the amount determined to be the correct amount of such valuation or adjusted basis (as the case may be) . . . .
Id. § 6662(e)(1)(A), (h)(2)(A)(ii)(I). Under the regulations, a
gross valuation misstatement exists when the correct or adjusted
basis of property is zero. 26 C.F.R. § 1.6662-5(g) (2011).
The losses that Fidelity attributed to individual
transactions were calculated by assigning each option transaction
2 See 26 U.S.C.A. § 7701(o) (West 2011); Gregory v. Helvering, 293 U.S. 465 (1935); Dewees v. Comm'r, 870 F.2d 21, 29-30 (1st Cir. 1989).
-8- a cost basis or value to set against any revenue obtained from the
transaction. Absent a cost basis or value, the transaction could
not generate a loss. And when the IRS found that the transactions
lacked economic substance, it not only disallowed the loss but
invoked penalties for misstating the basis of the options.
To understand the target of the penalty, a simplified
example may help. Basis, in a typical business purchase and sale
transaction, equates to the cost (reduced by any depreciation).
Thus, a taxpayer might claim that the cost of a widget was $10--
when its actual cost was $1--and report its sale for $1.
Overstating the cost of the widget allowed the taxpayer to claim a
loss of $9, then used to reduce taxes on other income. So falsely
asserting, or increasing, a basis translates into reducing gain or
enlarging loss by the amount falsely asserted or increased.
Similarly, in this case, the reported basis in the
options transactions allowed Fidelity to report a loss (which it
allocated to Egan). An excerpt from a table attached to Fidelity's
Form 1065 to show "Other Income/(Loss)" read as follows (the line
below references a single option transaction):
Date Date Sold Gross Sales Cost or Gain/(Loss)
Acquired Price Other Basis 10/22/2001 12/03/2001 163,405,260 199,865,888 (36,460,628)
-9- The huge loss taken by Egan on his own return was comprised of the
sum of a number of such losses listed in the partnership return and
allocated to him.
Here, the IRS concluded that the 40 percent penalty
applied. On judicial review, the district court upheld this and
other determinations, making numerous factual findings and legal
determinations. Fid. Int'l, 747 F. Supp. 2d 49. Having agreed
with the IRS that the option transactions lacked economic
substance, the court held that the losses attributed to Egan were
properly disallowed. The 40 percent penalty rested on
determinations that the correct basis of those transactions was
zero, and that tax underpayments were attributable to those
overstatements. Id. at 239 ¶ 68k.
Fidelity's present appeal is narrow. Apart from a throw-
away line or so in its brief, Fidelity does not seriously contest
the district court's basis adjustment under the economic substance
doctrine. Nor does it appeal the applicability of alternative
lower penalties based on the spurious paper losses generated.
Instead, its arguments are directed only to the 40 percent penalty.
Although Fidelity is the nominal private party, this is effectively
a controversy between the Egan estate and the government.
The three issues Fidelity presents are legal and our
review is de novo. See Keller v. Commissioner, 556 F.3d 1056,
1058-59 (9th Cir. 2009). The first claim is that there was no
-10- "misstatement" of basis in the partnership returns. Second,
Fidelity argues that no underpayment of tax was "attributable to"
a basis misstatement, even if a misstatement existed. Finally,
Fidelity says that the 40 percent penalty is inconsistent with
congressional tax policy as evidenced by a new penalty provision.
The "No Misstatement" Claim. Fidelity's position on the
first issue has two separate strands. One is that there was no
improper statement of loss on the partnership return because the
net economic loss of $4.1 million reported on its 2001 return was
almost identical to the true net economic loss as computed by the
district court. But this is merely to say that any misstatements
of individual transactions might not have had any effect on
Fidelity's taxes if it were the taxpayer.
Here, the misstatements of concern are not the net effect
of the transactions taken together but the claimed bases on
individual options transactions. These bases, and the allocation
of the resulting losses to an individual partner, are themselves
partnership items subject to the IRS's adjustment power in
reviewing the partnership return.3 It was these individual
transactions that allowed Egan to offset ordinary income on his own
3 IRS regulations state that "[c]ontributions to the partnership" and a partner's share of "income, gain, [and] loss" are partnership items, 26 C.F.R. § 301.6231(a)(3)-1 (2011). See also Stobie Creek Invs. LLC v. United States, 608 F.3d 1366, 1380 (Fed. Cir. 2010).
-11- returns; and the individual transactions were just those that the
IRS found to lack economic substance.
The fact that gains and losses would inevitably balance
out is just what made the transactions lack economic substance for
Fidelity. There might or might not have been different counter-
parties to the individual transactions who could therefore suffer
"real" gains or losses themselves. But for Fidelity, the
transactions had no function but to create artificial paper gains
on some transactions (principally assigned to Mahoney) and losses
on others (principally assigned to Egan).
Fidelity's second-strand argument seeks to distinguish
between factually false transactions--ones that never occurred--and
the present case in which the transactions actually occurred but,
taken together, had no economic substance for Fidelity. In the
latter case, says Fidelity, the economic substance doctrine allows
the IRS to disregard the transactions but the reported figures
remain accurate recordations of each transaction and are not
misstatements, although (it says) a "legal dispute" might arise as
to their significance.
Congress singled out for stiff penalties a misstated
basis or value that improperly reduces taxes; the apparent reason
is that the misstated figures directly impair tax collections and
-12- prove difficult to resolve (and presumably are easy to fabricate).4
Here, the figures are misstatements precisely because the
transactions lacked any economic purpose for Fidelity other than to
generate purported losses to reduce Egan's taxes. Purpose, at
least in this case, is an issue of fact quite as much as whether an
option was bought or sold.
Relatedly, Fidelity argues that the valuation
misstatement penalty only applies in cases where the economic
substance doctrine is triggered because basis or value is
misstated, and not where the basis for the transaction is reduced
to zero after a finding of lack of economic substance. But this is
a distinction without a difference; and in any case, the statute by
its terms applies the penalty to a misstatement, and given the
policy concerns Congress had no reason to care about the nature of
the falsity.
The "Attributable To" Issue. Under the penalty statute,
the 40 percent penalty applies only to "a portion of the
underpayment . . . attributable to one or more gross valuation
misstatements." 26 U.S.C. § 6662(h)(1). Fidelity argues that the
underpayment of taxes by Egan--the partnership pays none for
itself--would have occurred without the misstatements of value and
4 See Todd v. Commissioner, 862 F.2d 540, 542 (5th Cir. 1988); Clearmeadow Investments, LLC v. United States, 87 Fed. Cl. 509, 531 n.27 (2009); H.R. Rep. No. 97-201, at 243 (1981).
-13- therefore cannot be "attributable to" any supposed gross valuation
misstatement.5
Fidelity says that even without the misstatements of
bases, the losses Fidelity claimed and allocated to Egan would have
been disallowed based on other determinations made by the IRS and
the district court. Specifically, these included determinations--
stemming from the same central finding that the transactions lacked
economic purpose and was designed purely for tax avoidance--that
Fidelity was not a true partnership, that Egan's outside basis was
zero, that Mahoney (the Irish national) was not a partner, and that
the transactions were not entered into for profit, 26 U.S.C. §
165(c)(2). Fid. Int'l, 747 F. Supp. 2d at 244.
Thus, given the lack of economic substance, the IRS had
various statutory grounds for disallowing the same losses. Dual
cause issues arise in various contexts throughout the law, e.g., W.
Page Keeton et al., Prosser and Keeton on Torts §§ 41-42 (5th ed.
1984), and the varying solutions depend primarily on context and
underlying policy. Here, Congress' phrase "attributable to" is
5 The district court only had jurisdiction over "the applicability of any penalty . . . which relates to an adjustment to a partnership item," 26 U.S.C. § 6226(f), and Egan's personal liability will be assessed in a separate, partner-level proceeding, but the IRS must issue a notice to the partnership before making assessments against individual partners. Id. § 6225(a). Courts seem willing to assume that a partnership adjustment is likely to produce an underpayment at the partner level. See, e.g., Am. Boat Co. v. United States, 583 F.3d 471, 473 (7th Cir. 2009).
-14- easily read to cover the role of the misstatements in lowering
Egan's taxes and that reading serves the underlying policy.
To repeat, the heavy penalty for gross misstatements of
value or basis reflects their resulting harm and difficulty in
detection. See note 4, above. The misstatements were the vehicle
for generating the spurious Fidelity losses carried over to Egan's
return to shield his income. That (in this case) alternative
grounds with lower or no penalties existed for disallowing the same
claimed losses hardly detracts from the need to penalize and
discourage the gross value misstatements.
Indeed, one might think that it would be perverse to
allow the taxpayer to avoid a penalty otherwise applicable to his
conduct on the ground that the taxpayer had also engaged in
additional violations that would support disallowance of the
claimed losses. Cf. Gilman v. Comm'r, 933 F.2d 143, 150 (2d Cir.
1991), cert. denied, 502 U.S. 1031 (1992). Most circuit courts
that have confronted variations on Fidelity's argument in the lack
of economic substance context have rejected it.6
The only unimpaired circuit precedents favoring
Fidelity's position are from the Fifth Circuit. In Todd v.
6 Compare Merino v. Comm'r, 196 F.3d 147 (3d Cir. 1999); Zfass v. Comm'r, 118 F.3d 184 (4th Cir. 1997); Illes v. Comm'r, 982 F.2d 163 (6th Cir. 1992), cert. denied, 507 U.S. 984 (1993); Gilman v. Comm'r, 933 F.2d 143 (2d Cir. 1991) cert. denied, 502 U.S. 1031 (1992); Massengill v. Comm'r, 876 F.2d 616, 619-20 (8th Cir. 1989) with Keller v. Comm'r, 556 F.3d 1056 (9th Cir. 2009); Heasley v. Comm'r, 902 F.2d 380 (5th Cir. 1990).
-15- Commissioner, 862 F.2d 540 (5th Cir. 1988), later summarily
followed by Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990),
the court accepted the position that an overvaluation underpinning
claimed tax benefits should go unpenalized because other grounds
also existed for imputing the same higher income to the taxpayer.
We think Todd rests on a misunderstanding of the sources relied on.
The court reached its result not by considering how the
"attributable to" language should be read in light of its purpose
(in fact, it admitted that its reading "ascribe[s] an intent to
Congress which might, at first blush, seem inequitable," Todd, 862
F.2d at 545) but rather because it glossed that requirement by
reading language in a congressional tax document generated to
explain the predecessor penalty to section 6662 passed in 1981.
This document's key language reads as follows:
The portion of a tax underpayment that is attributable to a valuation overstatement will be determined after taking into account any other proper adjustments to tax liability. Thus, the underpayment resulting from a valuation overstatement will be determined by comparing the taxpayer's (1) actual tax liability (i.e., the tax liability that results from a proper valuation and which takes into account any other proper adjustments) with (2) actual tax liability as reduced by taking into account the valuation overstatement. The difference between these two amounts will be the underpayment that is attributable to the valuation overstatement.
-16- Todd, 862 F.2d at 542-43 (quoting Staff of the Joint Committee on
Taxation, General Explanation of the Economic Recovery Tax Act of
1981, at 333 (Comm. Print 1981)).
In our view, that language is designed to avoid
attributing to a basis or value misstatement an upward adjustment
of taxes that is unrelated to the overstatement but due solely to
some other tax reporting error (for example, if Egan had also
falsely claimed a charitable contribution on his return). This is
surely what the quoted language means in excluding from the
overstatement penalty increased taxes due to "any other proper
adjustments." This is quite different from excusing an
overstatement because it is one of two independent, rather than the
sole, cause of the same under-reporting error.
Although the Ninth Circuit followed Todd's misreading in
Gainer v. Commissioner, 893 F.2d 225 (9th Cir. 1990), a later
decision of the court conceded that Gainer was a vulnerable
precedent in conflict with other circuits; but the panel felt
compelled to follow prior circuit precedent. Keller, 556 F.3d at
1061. We follow without hesitation the dominant view of the
circuits that have addressed this issue.
The Supposedly Conflicting Penalty Provisions. Fidelity
finally points to Congress' recent provision adding transactions
lacking economic substance to the list of tax underpayments to
which accuracy-related penalties apply. 26 U.S.C.A. § 6662(b)(6)
-17- (West 2011). This new provision, applying only to transactions
entered into after March 31, 2010, Health Care and Education
Reconciliation Act of 2010, Pub. L. No. 111-152, § 1409(e)(2), 124
Stat. 1029, 1070 (2010), applies a 40 percent penalty to those
transactions which are not disclosed and reduces it to 20 percent
for those that are, 26 U.S.C.A. § 6662(i) (West 2011).
Here, the individual Fidelity transactions at issue were,
in one sense at least, disclosed. On this premise, Fidelity
alleges a potential conflict created by reading the gross valuation
misstatement penalty to cover a disclosed transaction that lacks
economic substance: the incentive to disclose created by the new
provision is greatly reduced because the government could
presumably seek the 40 percent penalty under the gross valuation
misstatement provision for a fully disclosed transaction that
lacked economic substance.
The new statute was enacted after the transactions that
are in issue in this case, and Fidelity does not claim that it
governs those transactions. So this is not even a case in which
one can argue that two provisions apply simultaneously to the same
transaction and that one provision's language should be
reinterpreted to avoid an unreasonable result. Fidelity is in
effect arguing that the language in the earlier statute should be
re-read because of other changes by a later Congress.
-18- Anyway, the new provision is not limited solely to
misstatements of basis or value, which Congress earlier singled out
in imposing the higher penalty without regard to disclosure. And
the new penalty is a strict liability provision, while the gross
valuation misstatement penalty allows taxpayers to raise reasonable
cause and good faith defenses. 26 U.S.C. § 6664(c)(1)-(2) (West
2011). The two penalty provisions are designed differently but
create no such conflict as would lead us to tamper with
straightforward language of the 40 percent penalty provision.
Affirmed.
-19-