Salina Partnership L.P. v. Commissioner
Opinion
*421 Decision will be entered under Rule 155.
In 1991, FPL incurred a substantial capital loss on the
sale of a subsidiary. In December 1992, GS, an investment bank,
persuaded FPL to invest in a domestic limited partnership, S,
newly formed at GS's request by two affiliates of ABN, an
international bank based in The Netherlands. S, at GS's
suggestion, took a substantial short position in U.S. Treasury
bills. FPL purchased a 98-percent limited partnership interest
in S to take advantage of desired tax benefits and to enhance
its return on its short-term, fixed-income investments.
Immediately following FPL's investment, S closed its short
position in U.S. Treasury bills.
Relying on a series of complex partnership basis adjustment
provisions, S concluded that it realized a $ 344 million short-
term capital gain, of which $ 337 million was allocated to FPL.
FPL thereupon claimed a capital loss carryover from 1991 to
offset nearly all of its distributive share of S's capital gain.
During 1993 and most of 1994, S pursued a sophisticated
*422 investment strategy. S was liquidated in 1994. FPL, which had
increased its outside basis in its interest in S by the $ 337
million gain it had reported in 1992, claimed large ordinary
losses attributable to its interest in S for the taxable years
1994 through 1997.
R issued a notice of final partnership administrative
adjustment to S determining that S did not realize a $ 344
million short-term capital gain for the period ended Dec. 31,
1992, on the alternative grounds that: (1) FPL's initial
investment in S was a sham in substance; and/or (2) S failed to
properly compute its substituted basis (from its partners)
pursuant to
readjustment in its capacity as a notice partner of S.
HELD: FPL's investment in S was not a sham in substance
inasmuch as FPL invested in S in order to achieve legitimate
business objectives independent of purported tax benefits and
FPL's investment produced objective economic consequences. HELD,
FURTHER, R's adjustments are*423 sustained on the ground that S's
short position in Treasury bills generated a partnership
"liability", within the meaning of
liability S failed to account for in computing its substituted
basis (from its partners) in its assets.
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*421 Decision will be entered under Rule 155.
In 1991, FPL incurred a substantial capital loss on the
sale of a subsidiary. In December 1992, GS, an investment bank,
persuaded FPL to invest in a domestic limited partnership, S,
newly formed at GS's request by two affiliates of ABN, an
international bank based in The Netherlands. S, at GS's
suggestion, took a substantial short position in U.S. Treasury
bills. FPL purchased a 98-percent limited partnership interest
in S to take advantage of desired tax benefits and to enhance
its return on its short-term, fixed-income investments.
Immediately following FPL's investment, S closed its short
position in U.S. Treasury bills.
Relying on a series of complex partnership basis adjustment
provisions, S concluded that it realized a $ 344 million short-
term capital gain, of which $ 337 million was allocated to FPL.
FPL thereupon claimed a capital loss carryover from 1991 to
offset nearly all of its distributive share of S's capital gain.
During 1993 and most of 1994, S pursued a sophisticated
*422 investment strategy. S was liquidated in 1994. FPL, which had
increased its outside basis in its interest in S by the $ 337
million gain it had reported in 1992, claimed large ordinary
losses attributable to its interest in S for the taxable years
1994 through 1997.
R issued a notice of final partnership administrative
adjustment to S determining that S did not realize a $ 344
million short-term capital gain for the period ended Dec. 31,
1992, on the alternative grounds that: (1) FPL's initial
investment in S was a sham in substance; and/or (2) S failed to
properly compute its substituted basis (from its partners)
pursuant to
readjustment in its capacity as a notice partner of S.
HELD: FPL's investment in S was not a sham in substance
inasmuch as FPL invested in S in order to achieve legitimate
business objectives independent of purported tax benefits and
FPL's investment produced objective economic consequences. HELD,
FURTHER, R's adjustments are*423 sustained on the ground that S's
short position in Treasury bills generated a partnership
"liability", within the meaning of
liability S failed to account for in computing its substituted
basis (from its partners) in its assets.
MEMORANDUM FINDINGS OF FACT AND OPINION
JACOBS, JUDGE: Respondent issued a notice of final partnership administrative adjustment (FPAA) to Caraville Corporation, N.V., the tax matters partner (TMP) of Salina Partnership, LP (hereinafter, Salina or the partnership), setting forth adjustments to the partnership's tax return for its taxable year ended December 31, 1992. Respondent subsequently mailed a copy of the FPAA to FPL Group, Inc. (FPL or petitioner), a Salina notice partner. FPL, in its capacity as a partner other than the TMP, filed a timely petition for readjustment contesting the FPAA. 1 See sec. 6226(b).
*424 The issue for decision is whether the partnership realized a short-term capital gain of $ 344,234,365 for the taxable year ended December 31, 1992. 2 (The situation presented in this case is one in which "normal" roles of the parties appear to be reversed inasmuch as FPL is defending Salina's reporting of the $ 344 million gain against respondent's assertion that Salina realized a short- term capital gain of only $ 334,214.) Respondent's determination is based on alternative grounds, including arguments that: (1) FPL's purchase of a 98-percent partnership interest in Salina was a sham in substance; and (2) Salina erred in failing to apply
Unless otherwise indicated, section references are to the Internal*425 Revenue Code in effect for 1992, and Rule references are to the Tax Court Rules of Practice and Procedure. All dollar amounts are rounded.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulated facts and exhibits are incorporated herein by this reference. I. FPL
FPL, the stock of which is publicly traded, is a holding company and the parent of various wholly owned subsidiaries including Florida Power and Light Co. (Florida Power), the largest electric public utility in the State of Florida, and FPL Capital Group (FPL Capital). FPL filed consolidated returns with its various subsidiaries during the period in question.
Paul Evanson assumed the position of chief financial officer of FPL on December 7, 1992. Prior to joining FPL, Mr. Evanson's professional experience included 6 years as a tax specialist at Arthur Andersen, a large firm of certified public accountants, and 5 years as president and chief operating officer of Lynch Corp. Prior to his employment at Arthur Andersen, Mr. Evanson was awarded a juris doctor degree from Columbia University School of Law and an LL.M. in taxation degree from New York University.
James Higgins, *426 FPL's vice president for taxes, was responsible for all income tax planning, research, and compliance. Dilek Samil, FPL's corporate treasurer, was responsible for financial forecasting and analysis. In addition, Ms. Samil was responsible for managing FPL's long-term and short-term funding needs. FPL's long- term funding needs normally were satisfied by issuing debt and equity securities, while FPL's short-term funding needs were met through the company's normal cash-flow and the issuance of commercial paper. Jeffrey Holtzman, FPL's assistant treasurer, was primarily responsible for bank relations and assessing FPL's investments. Michael Wynn, an FPL financial analyst, was responsible for various cash management activities and special projects.
In early 1991, FPL decided to restructure its operations by selling noncore businesses and focusing on its utility businesses, particularly Florida Power. Between 1991 and 1999, FPL sold a number of its subsidiary businesses including Colonial Penn Group (CPG) -- an insurance holding company, Telesat -- a cable television operation, Alandco -- a real estate subsidiary, Turner Foods -- a citrus producer, *427 and a separate banking business.
During 1992, FPL raised cash through a secondary stock offering. FPL also had excess cash-flow from normal operations. FPL usually held its short-term investments in commercial paper with rates of return averaging 3.25 percent.
On its consolidated income tax return for 1991, FPL reported a capital loss of $ 581,921,987 attributable to its sale of CPG. FPL carried back approximately $ 131 million of the CPG loss to taxable years prior to 1991. On its consolidated income tax return for 1992, FPL claimed a loss carryover of approximately $ 311 million attributable to its CPG loss.
Respondent issued a notice of deficiency to FPL for, among other years, 1991 and 1992. Respondent determined, in pertinent part, that FPL had understated the amount of its CPG loss subject to disallowance pursuant to
FPL was a client of Goldman Sachs & Co. (Goldman Sachs), a large investment bank. Goldman Sachs had advised FPL with regard to both the purchase of CPG in 1985 and the sale of the company in 1991. At all relevant times, David A. Ackert was a vice president at Goldman Sachs.
In 1992, Mr. Ackert developed an investment strategy called Special Treasury and Mortgage Partnership Units (STAMPS). The STAMPS strategy employed leveraged and hedged investments in short- term U.S. Treasury securities, mortgage-backed securities, and other arbitrage positions in fixed-income securities, in an effort to provide a cash investment vehicle for corporate or institutional clients seeking above-market returns.
The STAMPS strategy was*429 designed not only as an investment strategy, but also involved accounting, tax, and legal considerations. Mr. Ackert concluded that it would be preferable for corporate investors to pursue the STAMPS investment strategy through a partnership that would allow the investor the possibility of "off balance sheet" accounting treatment. Mr. Ackert believed that off balance sheet accounting treatment was essential to making the STAMPS strategy appealing to potential investors because, to the extent that the program required a leveraged position, the investor's balance sheet would reflect the net amount of its investment without showing any related debt.
In conjunction with the creation of the STAMPS investment strategy, Mr. Ackert approached Mark Silverstein, vice president and portfolio manager at BEA Associates (BEA), an investment advisory and cash management firm based in New York, to inquire whether BEA would be interested in serving as the investment adviser and portfolio manager for potential investors in the STAMPS strategy. Mr. Silverstein agreed to work with Mr. Ackert's clients on the understanding that BEA would be compensated for its services through*430 management fees computed as a percentage of the assets under its direction.
BEA, recognized as a leading fixed-income portfolio manager, utilized an investment strategy with similarities to STAMPS known as mortgage arbitrage partners or MAPS. The MAPS strategy included leveraged and hedged investments in U.S. Treasury securities, asset-backed securities, mortgaged-backed securities, and international and corporate bonds. Though comparable in some respects with the STAMPS strategy, the MAPS strategy contemplated investments in a broader array of securities with maturities (approximately 3 to 6 months) of shorter duration.
Mr. Ackert was aware that FPL had incurred a substantial capital loss on its sale of CPG in 1991. In early October 1992, Mr. Ackert met with FPL representatives in Florida and proposed that FPL purchase a 98-percent limited partnership interest in a preexisting domestic limited partnership controlled by an international bank for the purpose of investing in the STAMPS strategy. Mr. Ackert promoted the STAMPS strategy as a means to increase the return on FPL's short- term, fixed-income investments. At the same time, Mr. Ackert informed*431 FPL that it should rely upon its own independent accounting, legal, and tax advisers regarding the consequences of the STAMPS investment strategy. During a private meeting with Mr. Higgins, Mr. Ackert suggested that the partnership's investments could be arranged so that, upon entry into the partnership, FPL would recognize a capital gain for Federal income tax purposes and simultaneously create a built-in loss in its partnership interest.
In late October 1992, Mr. Ackert introduced Mr. Silverstein to FPL's representatives. Mr. Silverstein took the opportunity to explain the MAPS investment strategy and to offer BEA's investment services to FPL. In mid-November 1992, FPL representatives met with Mr. Silverstein at BEA's New York office. At FPL's request, Mr. Silverstein presented FPL with several analyses of the financial risks and rewards associated with the MAPS investment strategy under a variety of economic scenarios. Using Treasury bills (with a then 3 percent annual rate of return) as a benchmark, Mr. Silverstein projected that the MAPS strategy would allow FPL to earn between 4 and 7 percent over current Treasury bill yields. However, Mr. Silverstein cautioned that he could*432 not guarantee a specific return inasmuch as FPL's investment would be subject to market risks. FPL's representatives concluded that the company could earn a higher return under the MAPS strategy relative to historic returns that it had earned investing in short-term commercial paper.
FPL began preparations to enter into the proposed partnership in early December 1992. On December 9, 1992, Mr. Silverstein issued a memorandum to Mr. Wynn at FPL stating that he was in the process of arranging credit with certain securities dealers and requesting information from FPL regarding the partnership. On December 14, 1992, Margaret Watson, a vice president for Chemical Bank (Chemical), forwarded a memorandum to Mr. Wynn stating that Chemical had assigned an account number to a multi- currency master custody account for a partnership identified as New Coral Partnership. Upon receipt of the memorandum, Mr. Wynn struck the reference to New Coral Partnership, entered the name "Salina Partnership", and forwarded the memorandum to Mr. Silverstein at BEA.
ABN AMRO Bank, N.V. (ABN) is a large bank based in The Netherlands with international operations. During 1992, Jaap Van Burg, *433 an attorney, served as an assistant managing director at two ABN affiliates known as ABN AMRO Trust Co., N.V. (ABN Trust) and N.V. Fides.
In October 1992, concurrent with his discussions with FPL, Mr. Ackert informed Mr. Van Burg that he had a client that might be interested in pursuing the STAMPS investment strategy and inquired whether ABN would be interested in forming a partnership for use in connection with that strategy. Mr. Ackert informed Mr. Van Burg that the partnership would be most marketable to his client if the partnership held a $ 350 million short position in Treasury bills. Mr. Van Burg obtained approval for ABN to participate in the transaction as outlined by Mr. Ackert.
On July 16, 1992, and October 22, 1992, ABN formed two limited liability companies, Caraville Corporation, N.V. (Caraville), and Pallico Corporation, N.V. (Pallico). Caraville and Pallico initially were each capitalized with $ 6,001. ABN controlled Caraville and Pallico through ABN Trust and N.V. Fides, as managing directors, respectively (both of which were in turn owned by ABN). As foreign entities, ABN, Caraville, and Pallico were not subject to U.S. income tax.
Caraville*434 owned the stock of Aldershot Corp. On August 17, 1992, Aldershot Corp. paid a dividend of $ 1,928,669 to Caraville.
On December 16, 1992, Caraville and Pallico formed Salina as a limited partnership under the laws of the State of Delaware. The Salina partnership agreement stated in pertinent part that the partnership was organized to invest in "Permitted Investments", a term defined as obligations of the United States and obligations of any agency that are backed by the full faith and credit of the United States with remaining terms to maturity of no more than 10 years, mortgaged-backed securities with a stated maturity of no more than 7 years, and certain repurchase and reverse repurchase contracts.
On December 17, 1992, Caraville contributed $ 750,000 in exchange for a 1-percent general partnership interest in Salina, while Pallico contributed $ 74,250,000 in exchange for a 99-percent limited partnership interest. The funds that Pallico contributed to Salina were transferred to Pallico through a revolving credit agreement between ABN and Escorial Corporation, N.V., an ABN affiliate managed by ABN Trust. Mr. Van Burg assumed that ABN also was the*435 source of Caraville's contribution to Salina.
The partnership agreement stated that the partnership would pay a quarterly management fee of $ 125,000 to Caraville.
On December 17, 1992, Salina opened a custodial account with ABN's New York office. On December 17, 1992, Salina purchased, through ABN, U.S. Treasury notes with a face value of $ 140 million for a price of $ 139,891,953 (net of $ 320,192 accrued interest). The Treasury notes each bore an interest rate of 4.625 percent and were due to mature on November 30, 1994. Salina financed approximately one-half of the purchase price of the Treasury notes through a master repurchase agreement with Goldman Sachs (the Salina/Goldman Sachs master repurchase agreement) under which Salina borrowed $ 70,087,500 from Goldman Sachs and collateralized the loan with a portion of the Treasury notes it had purchased. 4 Salina treated the Goldman Sachs loan as a liability on its opening balance sheet as of December 28, 1992.
*436 On December 17, 1992 (consistent with Mr. Ackert's earlier request to Mr. Van Burg), Salina entered into a short sale of U.S. Treasury bills with a face value of $ 350 million for a price of $ 344,066,593. 5 The Treasury bills were due to mature on June 17, 1993. Salina completed the short sale transaction described above to the extent of $ 175 million executed through Goldman Sachs and $ 175 million executed through ABN. To complete delivery of the Treasury bills, Salina entered into a master repurchase agreement with ABN (the Salina/ABN master repurchase agreement) under which Salina lent $ 343,875,000 to ABN, and ABN collateralized the loan with the Treasury bills that Salina sold short. Salina treated the amount it was due from ABN under the Salina/ABN master repurchase agreement ($ 343,875,000) and accrued interest thereon ($ 278,921) as assets on its opening balance sheet. Salina treated the amount of the Treasury bills that it sold short ($ 344,447,250) as a liability on its opening balance sheet.
*437 For the period December 17 through 27, 1992, Salina earned $ 398,292 on its investments for an annualized return of 17.62 percent.
On December 14, 1992, Mr. Evanson obtained authorization from FPL's board of directors to invest in the Salina partnership. The minutes of the December 14, 1992, board of directors' meeting state in pertinent part:
[The Chairman] reported that the officers of the Corporation
were considering investing approximately $ 75 million of the
funds raised from the sale of common stock in 1992 for future
capital requirements in an investment partnership. These funds
were not needed immediately and were currently invested in
short-term securities yielding a little more than 3% per annum.
Investing in the partnership would increase the return on the
funds substantially and still keep them available for capital
expenditures as needed. In addition, the partnership could
engage in certain transactions that could utilize certain of the
tax losses from the sale of Colonial Penn. Mr. Evanson then
explained the proposed investment activities*438 of the partnership.
FPL conditioned its participation in the partnership upon Salina's agreements to: (1) Appoint Mr. Silverstein as its investment manager, and (2) liquidate its investments by December 30, 1992. Salina agreed to FPL's conditions. On December 28, 1992, Salina executed a "Financial Advisory Agreement" appointing BEA to serve as its financial adviser "with respect to all securities and property with an initial value of $ 75,398,292.47" held by Chemical Bank.
On December 28, 1992, Caraville, Pallico, and FPL executed an amended partnership agreement that included an expanded list of permitted investments. The partnership agreed to pay quarterly management fees to Caraville (totaling $ 750,000) during 1993 and 1994. The partnership agreement states that the partnership would be obliged to redeem FPL's partnership interest or dissolve and liquidate at FPL's request.
On December 28, 1992, Goldman Sachs issued a letter to FPL stating that FPL did not rely upon Goldman Sachs for advice or information relating to the financial, legal, tax, accounting, or other matters in connection with FPL's investment in Salina.
On December 28, 1992, FPL transferred $ 76,540,327 to Pallico*439 in exchange for a 98-percent limited partnership interest in Salina. FPL treated $ 73,890,327 of its $ 76,540,327 payment to Pallico as capital invested in the partnership. The $ 73,890,327 includes $ 390,327 representing Pallico's share of Salina's net partnership gain during the period December 17 to 27, 1992.
Pallico retained $ 50,000 of the $ 76,540,327 payment that it received from FPL. Pallico transferred $ 73,890,327 to ABN -- the same amount that FPL treated as its capital contribution to Salina -- in partial repayment of the loan that ABN provided to Pallico in connection with the formation of Salina. In addition, Pallico made the following payments on behalf of FPL:
Payee Amount Purpose
Andrews & Kurth, LLP $ 350,000 Legal fees
ABN AMRO Bank 1,000,000 Fees
Goldman Sachs 1,250,000 Brokerage fees
Ms. Samil recalled negotiating the $ 1,250,000 fee paid to Goldman Sachs. None of FPL's representatives specifically recalled negotiating the fees paid to Andrews & Kurth, LLP, or ABN. The $ 1 million amount paid to ABN represented ABN's*440 fee for forming the Salina partnership, arranging the partnership's investments to satisfy FPL's tax planning objectives, and allowing ABN's affiliates to remain in the partnership so that FPL could pursue its short-term investment objectives.
FPL did not deduct the fees that it paid to ABN, Goldman Sachs, and Andrews & Kurth, LLP on its 1992 tax return, nor did it include the amount of these fees in its Salina capital account. The parties agree that FPL's adjusted basis in Salina as of December 28, 1992, should be increased by the amount of these fees.
On December 28, 1992, Mr. Silverstein recommended that Salina liquidate its existing investments so that Mr. Silverstein could reinvest the proceeds pursuant to the MAPS investment strategy. On the same day, Salina provided BEA with written authorization to liquidate its investments. On December 30, 1992, Mr. Silverstein closed Salina's short position in Treasury bills by directing the purchase of Treasury bills with a face value of $ 350 million for a price of $ 344,675,333. On December 31, 1992, Mr. Silverstein sold Salina's long position in Treasury notes for $ 140,408,750 and repaid*441Goldman Sachs approximately $ 70 million representing the amount borrowed under the Salina/Goldman Sachs repo agreement. The proceeds of these transactions were held in bank deposits pending Mr. Silverstein's reinvestment of those amounts under the MAPS strategy after January 1, 1993. For financial reporting purposes, Salina realized a book gain of $ 334,214 for the period December 17 through 31, 1992.
After January 1, 1993, Mr. Silverstein actively managed Salina's investments pursuant to the MAPS strategy. Mr. Silverstein executed approximately 2,000 trades on behalf of Salina between January 1, 1993, and November 30, 1994, earning management fees of approximately $ 1,500,000 in the process.
During the period January 1993 to November 1994, BEA prepared monthly transaction and performance summaries detailing all of Salina's transactions for the particular month. In addition, Mr. Silverstein routinely communicated with Salina's partners in order to apprise them of market developments and BEA's strategy.
Salina conducted regular partnership meetings attended by representatives of FPL, Caraville, and Pallico. At Salina's August 26, 1993 partnership*442 meeting, the partners decided to direct BEA to decrease the leverage in Salina's portfolio in order to reduce the partnership's level of risk.
During 1993, Salina earned a gross return of approximately 10 percent under the MAPS strategy. After paying BEA's fee, Caraville's management fee, and other partnership fees, Salina's net return was approximately 8 percent.
During 1994, the MAPS strategy was hindered by rising interest rates. During 1994, Salina had no earnings under the MAPS strategy.
On November 22, 1994, FPL requested that Caraville liquidate Salina. Accordingly, on November 30, 1994, Salina was liquidated, and its assets were distributed to its partners. FPL received a total distribution of $ 79,888,748, consisting of $ 63,175,099 in cash and $ 16,713,749 in mortgage-backed securities. The record does not reflect the specific amounts distributed to Caraville and Pallico or the ultimate disposition of those distributions.
In July 1993, Salina filed a U.S. Partnership Income Tax Return (Form 1065) for the short tax year December 17 to December 27, 1992, reporting investment income*443 of $ 467,110, investment expenses of $ 327,812, and unrealized trading profits of $ 314,526.
In July 1993, Salina filed a Form 1065 for the short tax year December 28 to December 31, 1992, reporting portfolio income of $ 700,713, investment expenses of $ 19,469, and a net short-term capital gain of $ 344,234,365. On Schedule K-1, Partner's Share of Income, Credits, Deductions, Etc., attached to the return, Salina allocated $ 337,343,455 of its short-term capital gain to FPL.
Salina concluded that it realized a $ 344,234,365 net short- term capital gain following the December 30, 1992, liquidation of its investments based upon a complex set of partnership basis adjustment rules that were purportedly invoked upon FPL's purchase of its 98-percent Salina partnership interest. In particular, relying on
Salina filed a Form 1065 for 1993 reporting income of $ 6,177,300. FPL's distributive share of Salina's 1993 net income was $ 6,053,754. Salina filed a Form 1065 for 1994 reporting a loss of $ 12,163.
On its original 1992 consolidated income tax return, FPL reported a $ 337,343,455 capital gain attributable to its distributive share of the capital gain that Salina purportedly realized upon the liquidation of its investments on December 30, 1992. FPL*445 offset a substantial portion of the aforementioned capital gain by reporting a loss carryover attributable to its 1991 sale of CPG. After accounting for the loss carryover, FPL reported and paid additional income tax of $ 5,904,046 (attributable to its Salina investment) on its 1992 income tax return.
In May 1993, FPL filed an amended return for 1992 reporting an increase in the amount of its CPG loss available for carryover from 1991 and claiming a refund of $ 5,904,046. FPL claimed that it was entitled to a greater loss carryover from 1991 on the ground that the loss disallowance rules prescribed in section 1.1502- 20, Income Tax Regs., are invalid.
After reporting $ 337,343,455 as its distributive share of Salina's net short-term capital gain for the period December 28 through 31, 1992, FPL added that amount to its original capital investment in Salina ($ 73,890,327) to arrive at a total outside basis in the partnership of $ 411,804,596. FPL later adjusted its basis to account for its distributive share of Salina's items of income and expense for the taxable years 1993 and 1994, as well as the value of the cash and mortgaged-backed securities that Salina distributed to FPL in*446 liquidation of its interest in November 1994. As of November 30, 1994, FPL claimed an adjusted tax basis in Salina of $ 339,631,665, which it allocated to the mortgage-backed securities. As FPL received payments on the mortgage-backed securities during 1994, 1995, 1996, and 1997, FPL reported ordinary losses (determined by computing the excess of its basis in those assets over the amount realized) in the amounts of $ 1,101,833, $ 14,107,759, $ 212,280,777, and $ 112,000,000, respectively.
As previously stated, respondent issued an FPAA setting forth adjustments to Salina's partnership return for the period ending December 31, 1992. Relying on alternative theories, respondent disallowed $ 343,900,151 of the $ 344,234,365 net short-term capital gain that Salina reported for the taxable year ending December 31, 1992, leaving a corrected net short-term capital gain of $ 334,214. Petitioner filed a timely petition for readjustment contesting the FPAA.
OPINION
Salina computed its short-term capital gain for its taxable year ended December 31, 1992, pursuant to a complex set of tax basis adjustment provisions contained in subchapter K, Partners and Partnerships, of*447 subtitle A of the Internal Revenue Code (the Code). We begin our analysis with a review of the statutory provisions in question.
Pursuant to
The regulations underlying
(iv) If a partnership is terminated by a sale or exchange
of an interest, the following is deemed to occur: The
partnership distributes its properties to the purchaser and the
other remaining partners in proportion to their respective
interests in the partnership properties; and, immediately
thereafter, the purchaser and the other remaining partners
contribute the properties to*449 a new partnership, either for the
continuation of the business or for its dissolution and winding
up.
Following a deemed distribution pursuant to section 1.708- 1(b)(1)(iv),
The basis of property (other than money) distributed by a
partnership to a partner in liquidation of the partner's
interest shall be an amount equal to the adjusted basis of such
partner's interest in the partnership reduced by any money
distributed in the same transaction.
Pursuant to
Based upon these provisions, Salina concluded that its assets were deemed distributed to FPL, Caraville, and Pallico, and, immediately thereafter, deemed recontributed to the partnership with bases equal to the partners' outside bases in the partnership. Respondent determined that Salina is not entitled to rely upon the provisions outlined*450 above, citing several alternative grounds.
1. ECONOMIC SUBSTANCE
Respondent first contends that FPL's investment in Salina during the period December 28 through 31, 1992, should be disregarded for tax purposes as a sham in substance. In so arguing, respondent asserts that the Court should segregate FPL's investment in Salina into two parts: (1) FPL's investment in Salina during the period December 28 through 31, 1992, and (2) FPL's investment in Salina during the period January 1, 1993, through the dissolution and liquidation of the partnership in November 1994. Although respondent concedes that FPL had a valid business purpose for investing in Salina during the latter period, respondent contends that FPL's entry into the partnership was structured solely to provide the company with a perceived tax benefit. Respondent argues in pertinent part:
In effect, there were two partnerships as a matter of
economic substance. The first partnership's destiny was to
accomplish a specific tax purpose in its predetermined life span
of 48 hours. This partnership is an economic sham. In contrast,
the second partnership had the legitimate role of*451 implementing
Mr. Silverstein's investment strategy commencing on January 1,
1993. The economic substance of this partnership is not
disputed.
Respondent contends that Goldman Sachs, fully aware that FPL had incurred a large capital loss on the sale of CPG, arranged for ABN to form Salina and orchestrated Salina's $ 350 million short position in Treasury bills so that, following FPL's investment in the partnership and the immediate liquidation of the partnership's investments, Salina would realize a substantial (paper) capital gain. Continuing, respondent maintains that FPL would be able to use its CPG capital loss carryover to offset its distributive share of the Salina capital gain while simultaneously creating an equivalent built-in loss in its Salina partnership interest -- a loss that FPL would be able to realize at will through its control of Salina. In this regard, respondent maintains that FPL improperly used its investment in Salina to avoid the 5-year limitation on the use of loss carryovers set forth in section 1212(a).
Respondent argues that FPL's investment in Salina during the initial investment period lacked economic substance because FPL had*452 no intention to profit from Salina's investments under the STAMPS strategy inasmuch as FPL always intended for those investments to be immediately liquidated and reinvested under the MAPS strategy. Respondent further asserts that (1) there is no evidence of significant negotiations between FPL and ABN prior to FPL's investment in Salina, and (2) the $ 2.25 million in fees paid to Goldman Sachs and ABN are nothing more than fees for the perceived tax benefits underlying the transaction.
Petitioner counters by claiming that Salina was formed and operated as a legitimate investment partnership and that FPL invested in Salina solely to enhance the returns on its short-term investments. Petitioner maintains that, although FPL understood that Salina would realize a substantial capital gain upon the liquidation of its investments in late 1992, FPL viewed any such transaction as tax neutral insofar as FPL had a large capital loss carryover (the CPG loss) to offset any gain.
It is well settled that taxpayers generally are free to structure their business transactions as they please, even if motivated by tax avoidance considerations. See
"A sham transaction is one which, though it may be proper in form, lacks economic substance beyond the creation of tax benefits."
A taxpayer may establish that a transaction was entered into for a valid business purpose if the transaction is "rationally related to a useful nontax purpose that is plausible in light of the taxpayer's conduct and * * * economic situation."
Contrary to respondent's position, we decline to analyze the economic substance of the disputed transaction by focusing solely on events occurring during the period December 28 through 31, 1992. Segregating FPL's investment in Salina into two parts, as respondent suggests, would violate the principle that the economic substance of a transaction turns on a review of the entire transaction. See
Considering all the facts and circumstances, we conclude that FPL entered into the Salina transaction to achieve a valid business purpose independent of tax benefits. The record demonstrates that FPL entered into the Salina partnership for the primary purpose of enhancing the return on its short-term investments. Each of FPL's representatives testified convincingly on this point. Moreover, their testimony was bolstered by their detailed review and consideration of the proposed investment and the minutes of the board of director's meeting approving the investment. 6
We need not dwell on respondent's contention*458 that FPL failed to evaluate fully the STAMPS investment strategy. We are convinced that FPL evaluated the STAMPS strategy in sufficient detail to determine that the strategy presented greater market risk than it was willing to accept. FPL invested in Salina on the condition that Salina's STAMPS portfolio would be promptly liquidated and reinvested under the MAPS strategy. There is no dispute that FPL carefully evaluated the potential risks and rewards of the MAPS strategy. FPL's "due diligence" included two meetings with Mr. Silverstein. Moreover, at FPL's request, Mr. Silverstein presented FPL with several analyses of the financial risks and rewards associated with the MAPS investment strategy under a variety of economic scenarios.
We are convinced that FPL's investment in Salina provided a reasonable opportunity for FPL to earn profits independent of tax benefits. As previously discussed, FPL carefully evaluated the potential risks and rewards of the MAPS strategy. Mr. Silverstein projected that under normal market conditions, the MAPS strategy would allow FPL to earn between 4 and 7 percent over Treasury bills which were then yielding approximately 3 percent. In fact, respondent*459 concedes that Mr. Silverstein's projections were reasonable.
Relying upon
Respondent's view of the potential tax benefit associated with FPL's Salina investment is significantly inflated. The record reveals that FPL was in the process of restructuring its operations by selling noncore businesses in order to concentrate on its utility businesses. FPL's sale of CPG was undertaken as part of this restructuring. We are convinced that, as of late 1992, FPL reasonably anticipated that it would realize substantial*460 capital gains over the next several years on the sale of various subsidiaries (including Telesat, Alandco, Turner Foods, and a separate banking business). On the basis of the record presented, we conclude that FPL would have used most, if not all, of its CPG loss within the 5-year period for reporting loss carryovers under section 1212(a). Accordingly, although we shall not attempt to precisely quantify the potential value of the tax benefit associated with FPL's investment in Salina, we are satisfied that the potential profits associated with the investment were not de minimis relative to the perceived tax benefit.
2. SECTION 752
Having concluded that FPL's investment in the Salina partnership was not a sham in substance, we now review the disputed transaction on its merits. Respondent maintains that Salina substantially overstated the amount of its short-term capital gain by failing to treat its obligation to return the Treasury bills that it sold short as a "liability" under
(a) Increase In Partner's Liabilities. -- Any increase in a
partner's share*461 of the liabilities of a partnership, or any
increase in a partner's individual liabilities by reason of the
assumption by such partner of partnership liabilities, shall be
considered as a contribution of money by such partner to the
partnership.
Assuming that Salina's obligation to close its short sale constituted a partnership liability under
Respondent relies upon
*463The various provisions of subchapter K of the Code blend two approaches, the entity and the aggregate approaches, for taxation of partnerships and partners. See
In an effort to avoid distortions in income tax reporting associated with the blending of the entity and aggregate approaches within subchapter K, Congress enacted a number of provisions that generally are intended to equate the aggregate of the partnership's inside bases in its*464 assets with the aggregate of its partners' outside bases in their partnership interests. See 1 McKee et al., Federal Taxation of Partnerships and Partners, par. 6.01, at 6-3 (3d ed. 1997) (McKee). The carryover-basis rules contained in section 722, which provide that a partner's basis in his partnership interest equals the amount of money plus the adjusted basis of property contributed to a partnership, generally results in a matching of inside and outside bases upon the formation of a partnership. See
Under
If a partnership borrows money, the basis of its assets
increases by the amount of cash received, even though the
receipt of the borrowed funds is not income. By treating the
partners as contributing cash in an amount equal to their shares
of the debt, inside/outside basis equality is preserved and
distortions are avoided. If a liability for borrowed money were
not added to the partners' bases, they could be taxed on a
distribution of the borrowed cash even though there is no gain
inherent in*466 the partnership's assets. A similar result could
occur if a partnership incurs a purchase money liability to
acquire property, since the liability is added to the
partnership's basis in the property.
McKee, supra, par. 7.01[1], at 7-2; see
In the instant case, the parties disagree whether Salina's obligation to close out its short sale transaction by returning the Treasury bills that it borrowed from ABN and Goldman Sachs represents a liability within the meaning of
In
*469 Under P's method of accounting, P's obligations to pay
amounts incurred for interest and services are not deductible
until paid. For purposes of
"liabilities of a partnership" and "partnership liabilities"
include an obligation only if and to the extent that incurring
the liability creates or increases the basis to the partnership
of any of the partnership's assets (including cash attributable
to borrowings), gives rise to an immediate deduction to the
partnership, or, under section 705(a)(2)(B), currently decreases
a partner's basis in the partner's partnership interest. [Rev. Rul. 88-77,
A few months after issuing
(g) Liability defined. -- Except as otherwise provided in
the regulations under
*470 of the obligor of purposes of
thereunder to the extent, but only to the extent, that incurring
or holding such obligation gives rise to --
(1) The creation of, or an increase in, the basis of
any property owned by the obligor (including cash
attributable to borrowings);
(2) A deduction that is taken into account in
computing the taxable income of the obligor; or
(3) An expenditure that is not deductible in computing
the obligor's taxable income and is not properly chargeable
to capital.
For reasons that are unclear, the final regulations under
In
On these facts, the Commissioner concluded that the short sale created a partnership liability within the meaning of
Petitioner first asserts that
We are not convinced that the treatment of a short sale as an open transaction for income tax purposes under
Further, we are not persuaded that the Commissioner's position in
the deferred income of 100x dollars as of December 31, 1971
(representing progress payments on the contract), represents
"liabilities of a partnership" within the meaning of section
752(a) of the Code and, as such, additions to basis of the
partnership interests of the partners. [
C.B. 216.]
The Commissioner concluded that the progress payments*476 qualified as "unrealized receivables" under section 751(c), as opposed to liabilities within the meaning of
In
During the years in issue, the taxpayers received payments directly from the third party pursuant to the option agreement -- amounts that the partnership listed as distributions to the taxpayers on its books and tax returns. During the years in issue, the taxpayers received partnership distributions, and had the partnership pay personal expenses, in excess of their adjusted bases in the partnership. The Commissioner determined that, although the option payments qualified as deferred income at the partnership level, the taxpayers nevertheless were subject to income tax to the extent that they had received distributions from the partnership in excess of their adjusted bases in their partnership interests. In response, the taxpayers argued that their adjusted bases in their partnership interests should be increased by their pro rata shares of the option payments, which they characterized as partnership liabilities under
*478 The Court agreed with the Commissioner that no liability within the meaning of
We are not convinced that either
Petitioner attempts to draw an analogy between the option payments that the partnership received in
As an alternative to its "open transaction" *481 argument, petitioner cites Deputy v. du
In Deputy v. du
Petitioner's interpretation of Deputy v. du
Although petitioner asserts that Salina's short sale of Treasury bills did not result in a partnership liability within the meaning of
Black's Law Dictionary 925 (7th ed. 1999), defines the term "liability" in pertinent part as follows:
1. The quality or state of being legally*484 obligated or
accountable; legal responsibility to another or to society,
enforceable by civil remedy or criminal punishment. * * * 2. A
financial or pecuniary obligation * * *.
Based upon the aforementioned meaning of the term "liability", and consistent with the policy underlining
Consistent with the preceding discussion, we sustain respondent's adjustment to Salina's tax return inasmuch as Salina's partners were required to increase their outside bases in their partnership interests to reflect their pro rata shares of the aforementioned liability.
A final matter. Petitioner observes that section 1.708- 1(b)(1)(iv), Income Tax Regs., was amended effective May 8, 1997, to*485 eliminate the basis adjustment provision underlying the present dispute. 13 Because the regulation was amended prospectively, it is of no aid to this Court in deciding the question presented in this case. See, e.g.,
Under the circumstances, we need not consider the parties' remaining arguments. To reflect the foregoing, and the agreement of the parties, see supra note 2,
Decision will be entered under Rule 155.
Footnotes
1. The parties stipulated that venue for purposes of appeal is to the U.S. Court of Appeals for the Eleventh Circuit. See sec. 7482(b)(2).↩
2. The parties agree that if petitioner prevails, the amount of the partnership's interest income is $ 700,713 for the period in question, whereas if respondent prevails, the amount of the partnership's interest income is $ 147,252.↩
3.
Sec. 1.1502-20(a), Income Tax Regs.↩ , states the general rule that no deduction is allowed for any loss recognized by a member of the affiliated group with respect to the disposition of stock of a subsidiary.4. Repurchase agreements (repos) and reverse repurchase agreements (reverse repos) are frequently used by dealers in government securities, financial institutions, and others as methods for temporary cash management, interest rate arbitrage, or the borrowing of securities used in the course of a dealer's business. In a repo transaction, the first party (e.g., a dealer) sells securities (generally U.S. Treasury and Federal agency securities) to a second party (e.g., a customer) and simultaneously agrees to repurchase a like amount of the same securities at a stated price (generally greater than the original sales price) on a fixed, future date. Repo transactions, from the viewpoint of the seller (such as a dealer), provide financing to acquire newly issued government securities or other portfolio assets; from the viewpoint of the purchaser, a repo transaction provides a means by which funds can be invested for a desired period while holding as collateral a virtually risk-free asset in the event the seller breaches its agreement to repurchase. See
Price v. Commissioner, 88 T.C. 860, 864↩ n.9 (1987) 5. One commentator has described a short sale as follows:
More completely, a short sale may be defined as consisting of
two transactions: (1) the taxpayer's sale of property
(typically, securities) borrowed from another person (typically,
a broker), and (2) the subsequent closing out of the short
position by the taxpayer's delivery of securities to the person
who loaned the securities that were sold.
In the absence of statutory guidance, the treatment of * * *
[short sale] transactions would be unclear because the first
transaction is in form a sale but gain or loss cannot be
computed because the taxpayer's cost for the securities is
unknown, whereas the second transaction is in form the repayment
of a loan. [Fn. ref. omitted.] 2 Bittker & Lokken, Federal
Taxation Of Income, Estates And Gifts, par. 54.3.1, at 54-21 (2d
ed. 1990).
The strategy of a short sale is that by the time the security is covered, the seller will have acquired the security by purchasing it on the open market at a price lower than that for which it was sold, thereby making a profit. Another way to cover a short position is to use the security obtained in a reverse repo transaction. Reverse repo transactions are the mirror images of repo transactions -- securities are purchased by the first party subject to the obligation of the second party to repurchase them. Notwithstanding the first party's obligation to sell (in a reverse repo transaction) a like amount of the same securities back to the second party, the first party generally is entitled to use the securities in transactions with third parties. See
Price v. Commissioner, supra at 864-865↩ nn.9, 11.6. Although the minutes also mention a potential tax benefit associated with the investment, we infer that FPL did not consider the tax benefit to be paramount to the transaction, rather merely ancillary or collateral thereto.↩
7. The portion of the preamble to
sec. 1.752-1T, Temporary Income Tax Regs. ,53 Fed. Reg. 53143 (Dec. 30, 1988), that respondent relies upon states in pertinent part:The allocation of partnership liabilities among the
partners serves to equalize the partnership's basis in its
assets ("inside basis") with the partners' bases in their
partnership interests ("outside basis"). The provision of
additional basis to a partner for the partner's partnership
interest will permit the partner to receive distributions of the
proceeds of partnership liabilities without recognizing gain
under section 731, and to take deductions attributable to
partnership liabilities without limitation under section 704(d)
(which limits the losses that a partner may claim to the basis
of the partner's interest in the partnership). By equalizing
inside and outside basis,
section 752 simulates the taxconsequences that the partners would realize if they owned
undivided interests in the partnership's assets, thereby
treating the partnership as an aggregate of its partners. [T.D.
8237,
1989-1 C.B. 180↩, 182 .]8. On the other hand,
sec. 752(b)↩ provides that a decrease in a partner's share of partnership liabilities is considered a distribution of cash to the partner, which results in a decrease in the partner's outside basis in his partnership interest.9. In
Rev. Rul. 60-345, 1960-2 C.B. 211 , the Commissioner concluded (with no analysis) that, in computing the adjusted basis of a partner's interest in a partnership using the cash method of accounting, for purposes of determining the extent to which the partner would be allowed a deduction for his distributive share of the partnership's loss for the year pursuant to sec. 704(d), the term "liabilities" undersec. 752↩ includes the partnership's obligation to pay outstanding trade accounts, notes, and accrued expenses.10. Sec. 357(c) generally provides that a taxpayer who transfers property to a corporation with liabilities in excess of adjusted basis is considered to have realized a gain. Sec. 357(c)(3)(A) generally provides that, for purposes of a sec. 351 exchange, liabilities in excess of adjusted basis are excluded from consideration if the liability would give rise to a deduction or if it would be considered a distributive share or guaranteed payment under sec. 736(a). Sec. 357(c)(3)(B) provides that subparagraph (A) shall not apply to a liability to the extent that the incurrence of the liability resulted in the creation of, or an increase in, the basis of any property.↩
11. A short sale of securities is treated as an open transaction for income tax purposes because the taxpayer's ultimate gain or loss on the transaction cannot be determined until the taxpayer purchases securities to replace those that were borrowed (and sold) in the first leg of the transaction. See
sec. 1.1233-1(a), Income Tax Regs.↩ 12. Neither petitioner nor respondent argues that the current regulations provide insight on the question presented.↩
13. Pursuant to an amendment to
sec. 1.708-1(b)(1)(iv), Income Tax Regs.↩ , effective May 8, 1997, constructive partnership terminations are no longer treated as deemed distributions of partnership assets. Pursuant to the amendment, the new partnership is now required to take a carryover basis from the old partnership.
2000 T.C. Memo. 352 (Salina Partnership L.P. v. Commissioner) — published by Counsel Stack Legal Research, free access to 12M+ legal documents.