Economic Substance Doctrine Analyzed by the Fifth Circuit Court of Appeals in Klamath Strategic Investment Fund
In Klamath Strategic Investment Fund, 103 AFTR 2d 2009-2220 (5th Cir. 2009), the Fifth Circuit adopted the same approach used by a majority of the other circuits by concluding that a taxpayer must, in order to avoid a lack of economic substance challenge, satisfy what is referred to as both a subjective test and an objective test that the transaction was entered into for profit. Meeting both parts or standards is challenging for the typical tax shelter in which the costs of entering into the transaction are substantially greater than the true economic gain that stands to be realized. that have concluded that a transaction lacks economic substance unless the taxpayer can satisfy both a subjective test and an objective test.
The case involved a series of complex transactions referred to as a "bond linked issue premium structure" or "BLIPS". BLIPS are basis type tax shelters which, like the SON of BOSS transactions, involve a transfer of assets and contingent liabilities to a partnership. The promoter contends that the transaction does not involve a shift of the liability to the partnership so that the transferor’s outside basis in his partnership interest is not reduced. In Klamath, two law partners, who received millions in legal fees as part of their representing plaintiffs against the tobacco industry, engaged in the BLIPS strategy after consulting with their accountants and then an investment advisory firm which specialized in foreign currency trading. The transaction involved a multi-stage structure over 7 years. The law partners funded the BLIPS strategy with $1.5M in their own funds as well as a borrowing from a bank where each was loaned $66.7M, which was comprised of $41.7M in principal and a "loan premium" of $25M. The interest rate was well above market, i.e., 18%. The lender wanted to lock in the exorbitant interest rate and negotiated a prepayment penalty at $25M subject to a sliding scale over seven years.
The loan premium, which was at the heart of the tax planning in this case, was given in exchange for the lawyers' payment of an above-market interest rate of 17.97%. To protect the lender from the possibility that the loans would be repaid early and the benefit of the higher interest rate would not be realized, the credit agreement further required a prepayment penalty if the loans were paid off early. The prepayment penalty started out at $25 million and decreased over the next seven years.
The lawyers then contributed the loan proceeds into the partnership and assigned their loan obligations as well. The two partnerships involved deposited the funds into accounts controlled the lender, and were used to purchase low risk contract trades in dollars and euros. The partnerships also made some small, short-term forward contract trades in foreign currencies. This was the only activity undertaken by the partnerships, which were liquidated at the end of 60 days, which was referred to as "stage I". The lawyers received the cash and euros upon liquidation of the partnerships.
Aside from the currency trades neither partnership engaged in an y business. Each lawyer claimed $25M in losses from their partnership which were allegedly realized since the taxpayers claimed that the loans were never assumed by the partnerships thereby generating the large capital loss reflective of the prepayment penalty of $25M. The lawyers-taxpayers argued that their loan premium obligations should not be treated as liabilities assumed by the partners. Upon audit, the IRS argued that the entire $66.7M loan amount should be treated as a liability that reduced basis or, in the alternative, the transactions were shames or lacked economic substance and should be disregarded for Federal income tax purposes. The Service also disallowed the deductions of fees and expenses claimed by the taxpayers, and asserted penalties with respect to the transaction.
The taxpayers paid the total tax assessed and after its claim for refund was denied, filed a refund suit in federal district court. Surprisingly, the lower court granted a motion for partial summary judgment that the loan premiums did not constitute liabilities for purposes of section 752 and therefore the lawyers-partners had properly determined their outside basis in their partnership interests. This proved to be a pyhrric victory for the duo. The district court ruled, after trial, that the taxpayers’ losses should be disregarded on the basis that the transactions were devoid of economic substance. It therefore side-stepped the controversial "contingent liability" question raised below. The lower court refused to assess penalties against the taxpayers and granted a refund to the extent that it allowed the taxpayers to deduct management fees paid to their accountants.
On appeal to the Fifth Circuit, the taxpayers argued there was in fact economic substance to the transactions. The government countered that the loan premiums were in fact liabilities that were assumed and that the operating fees and expenses could not be deducted. The Fifth Circuit was clearly aware of the split in the circuits on the issue of economic substance. The Fourth Circuit, in Rice's Toyota World, Inc., 752 F2d 89 (4th Cir., 1985) held that a transaction will not be given substance for tax purposes where and only if it lacks economic substance and the taxpayer's sole motive for the transaction was tax avoidance. In contrast, the majority of the appellate courts have developed a stricter test whereby a transaction can be invalidated for lack of economic substance regardless of whether the taxpayer has motives other than tax avoidance. See Coltec Industries, Inc., 454 F3d 1340 (Fed. Cir., 2006); United Parcel Service of America, Inc., 254 F3d 1014 (11th Cir., 2001); ACM Partnership, 157 F3d 231 (3rd Cir., 1998); James, 899 F2d 905 (10th Cir., 1990). In its prior decision in Compaq Computer Corp., , 277 F3d 778 (5th Cir., 2001), the Fifth Circuit did not expressly adopt either approach.
Citing the Supreme Court’s landmark case in Frank Lyon Co., 435 U.S. 561 (1978), the Fifth Circuit adopted the majority approach towards applying the economic substance doctrine. In Frank Lyon Co., supra, the Supreme Court held where there is a genuine multiple-party transaction with economic substance, which is in keeping with business or regulatory requirements and has an exchange of economic consideration independent of tax consequences and is not predominately driven by tax avoidance, the transaction needs to be respected for tax purposes. The Fifth Circuit stated that these factors are conjunctive, so that if any one of them is lacking the transaction is void for tax purposes. In analyzing the transactions before the court, it decided that the loan transactions were devoid of economic substance and eliminated the losses claimed.
On the issue of penalties, the Service appealed the lower court’s refusal to impose penalties on the basis that the partnerships acted in good faith and with reasonable cause. The Service disagreed and further argued that the trial court did not have jurisdiction to consider the penalties at the investor or partner level, i.e., the reasonable cause/good faith defense could only be considered in separate refund proceedings brought by the partners. The Fifth Circuit agreed that the entity level audit rules do not permit a partner to raise an individual defense during a partnership-level proceeding, but when considering whether penalties may be imposed at the partnership level, the court may consider the defenses of the partnership. See Temp. Reg. §301.6221-1T (reasonable cause is partner level defense).
In Klamath, the reasonable cause/good-faith defense was asserted on behalf of the partnerships by their managing partners, and the circuit court concluded that the district court had jurisdiction to consider the defenses. Having moved past the jurisdictional argument, the Fifth Circuit felt that reliance on a professional advisor alone is insufficient to constitute reasonable cause. Here the lawyers received detailed tax opinions that the issue complied with reasonable interpretations of the tax laws and their tax advisor testified that such opinions conformed with the requirements under Circular 230. The Court rule that the taxpayers, through the arguments of the partnerships, proved they relied in good faith on the advice of qualified tax counsel and accountants.
As to the expenses, the IRS challenged the lower court’s determination that the partnership were permitted to deduct "operational" expenses such as interest, management fees and professional fees. The IRS argued such fees were not deductible since they were incurred as part of a sham transaction. Indeed, where a transaction lacks economic substance deductions for costs expended in furtherance of the transaction are not permissible. Winn-Dixie Stores, Inc., 113 TC 254 (1999). The court agreed and rejected the taxpayers' argument that expenses incurred in connection with a sham transaction may be deducted as long as they are "separable" from the underlying transaction.
Deductions based on genuine debts incurred in connection with transactions that are found to lack economic substance have been allowed by the courts, but only if the debt was respected for tax purposes. In Klamath, the loans taken out by the lawyers were held by the trial court not to be loans at all. Accordingly, no deduction for interest was allowed. The Fifth Circuit also concluded that operating expenses and fees were not deductible based on the same rationale of the lack of economic substance.
