Tax shelter lacked nontax business purpose.

In 1990, M approached AHP (as it had also approached other Fortune 500 companies) with a scheme to shelter large capital gains. The scheme essentially allowed a newly formed foreign partnership to claim a massive tax gain, which is allocated to the nontaxable foreign partner, and a massive tax loss, which the U.S. corporate partner (AHP) keeps for itself. After meeting with M's representatives, AHP's vice-president for taxes prepared a memorandum that outlined the proposal, including the relevant portions below:

1. Formation of partnership The partnership will be formed in a favorable tax jurisdiction (e.g., the Netherlands Antilles) under the New York general partnership law. The partnership members will be S, an AHP domestic subsidiary and XYZ, an unrelated foreign financial institution. S will contribute $110 million (representing a 10% ownership); XYZ will contribute $990 million. Under the partnership agreement, all of the partnership's income, gain, expense and loss will be allocated among the members in proportion to their capital accounts.

2. Purchase of corporate bonds. The partnership will invest $1.057 billion in corporate bonds.

3. Installment sale. The partnership will sell the bonds to a financial institution for $898.5 million in cash and $158.5 million at fair market value (FMV), five-year London Interbank Offering Rate (LIBOR) installment notes.

4. Increase of S's partnership interest. Following Step 3, S will purchase a 45.5% interest in the partnership from XYZ for $500 million, bringing its total interest to 55.5% and XYZ's interest down to 44.5%.

5. Contribution of assets to partnership. S will then contribute assets with a FMV of $200 million to the partnership, further increasing its partnership interest to 62%.

6. Partial redemption of partnership interest. The partnership will distribute a $159 million FMV installment note to S and $96 million to XYZ.

7. Sale of installment note. S will sell the note for $159 million, resulting in a $723.2 million capital loss.

AHP decided to accept the proposal. In late May 1990, the partnership sold over $1 billion of the bonds for $880 million in cash and indefinite debt instruments (LIBOR notes).This sale generated transaction costs of $13 million to AHP; the partnership received less than $7 million in interest on its $1.1 billion investment.

The partnership treated the transaction as an installment sale under Sec. 453(b), and claimed a short-term capital gain of over $721 million, calculated by subtracting the ratably recovered basis from the $880 million in cash generated by the bond sales. Ten percent of the gain was allocated to AHP and S; the remaining 90% was allocated to the foreign partners, who were not subject to U.S. tax on the gain. A, a Netherlands bank that controlled the foreign partnerships, entered into interest-rate swaps with M and the foreign partners to hedge the interest-rate risk on the LIBOR notes. A was also involved in Saba Partnerships, 273 F3d 1135 (DC Cir. 2001) and ASA Investerings Partnership, 201 F3d 505 (DC Cir. 2000).

The IRS ruled that the foreign entities had not entered into a valid partnership with AHP, and thus recognized the transaction for tax purposes, but allocated all the gains and losses reported by the partnership to AHP. Under a second theory, that the transaction was an economic sham, the IRS eliminated any gains and losses reported by the partnership resulting from the transaction. A district court determined that the IRS erred in proposing the adjustments and the Service appealed to the DC Circuit.

Analysis

The district court erred in determining that this case was materially different from ASA Investerings, in which a very similar partnership between AlliedSignal and ABN Bank was held to be a sham under the business-purpose doctrine. While the similarity of facts in the two cases does not, in itself, invalidate the district court's finding that the partnership was not a sham, the district court's misapplication of ASA Investerings' instructions for interpreting transactions such as these is a reversible error. As noted in Saba Partnership, ASA Investerings makes clear that "the absence of a nontax business purpose is fatal to the argument that the Commissioner should respect an entity for federal tax purposes."

The business-purpose doctrine applied in ASA Investerings establishes that while taxpayers can structure their business transactions so as to minimize their tax, these transactions must have a legitimate, nontax-avoidance business purpose to be recognized as legitimate for tax purposes.

In the current case, the district court never made a finding of fact as to the need for AHP to acquire foreign partners to engage in the transactions. No official testified that AHP needed a partnership with a foreign corporation to invest in LIBOR notes or bonds. AHP's participation in the partnership defies common sense from an economic standpoint; it could have purchased the bonds and the LIBOR notes directly and avoided millions in transaction costs, including the $7 million fee it paid to M and the "premiums" paid to the foreign partners for their ownership interests.

To satisfy the legal test for this type of partnership, the district court would have to have found a nontax business purpose for the partnership to accomplish the partners' goals. The district court concluded that the transactions financing the purchase and sale of the bonds had economic substance, were not prearranged or predetermined and had a legitimate purpose. Because the record does not support a finding that the partnership form served any nontax business purpose, this conclusion is unsupported, inconsistent with ASA Investerings, and is a reversible error.

BOCA INVESTERINGS PARTNERSHIP, DC CIR., 1/10/03