In August 2001, Calloway ("Petitioner") entered into an agreement with Derivium Capital, LLC whereby Petitioner transferred 990 shares of his IBM common stock to Derivium in exchange for the sum of $93,586.23. The agreement recited that the transaction was a loan of 90% of the value of the IBM stock pleged as collateral. The program was promoted by a company that engaged in some 1,700 similar transactions involving approximately $1 .25 billion. More on Derivium below.
The purported loan was nonrecourse and precluded Petitioner from making any payments of interest or principal during the 3 year term of the loan arrangement. Under the agreement Derivium was permitted to sell the stock, which it did as soon as the transaction was entered into. The loan's terms were as follows: nonrecourse as to borrower (recourse against collateral only); dividends to be received as cash payments against interest due, with the balance of interest owed to accrue until maturity date; noncallable before maturity; no prepayment allowed before maturity; interest at 10.5% compounded annually; balloon payment at loan maturity equal to the loan principal plus accrued interest. At maturity of the "loan", Petitioner Calloway was granted the option of: (i) paying the balance due on the note and having an equivalent amount of IBM stock returned to him; (ii) renewing the purported loan for an additional term; or (iii) satisfy the "loan" by surrendering any right to receive IBM stock. At maturity in August 2004 the balance due was $40,924.57 in excess of the then value of the IBM stock. Petitioiner elected to satisfy his purported loan by surrendering any right to receive IBM stock. P was not required to and did not make any payments toward either principal or interest on the purported loan.
Prior to entering into the loan arrangement, the Petitioner relied upon the advises of Robert Nagy, who was purportedly a certified public accountant to the president of Derivium. Nagy claimed that while there was no guaranty the transaction would be treated as a "sale", there was a "solid basis for the position that these transactions are, in fact, loans." Calloway testified that a loan versus a sale transaction made economic sense to him because the loan proceeds given to him were 90% of the value of the IBM stock whereas if he had sold the stock he would have had to pay 20% capital gains taxes under the then applicable rate. The taxpayer did not report the transaction on his 2001 return holding the belief that the transaction was a loan. The Service disagreed and asserted a failure to timely file penalty as well as an accuracy related penalty.
In the opinion of the Court authored by Judge Ruwe, the proposed assessment of income tax of $30,911 by the Internal Revenue Service in its notice of deficiency was upheld. The Court found that the transaction, in substance, was a sale of Petitioner’s IBM stock to Derivium in August 2001 for the "loan" amount of $93,586.23. resulting from the transfer of all of the burdens and benefits of ownership. The Court distinguished the facts at bar to the securities lending arrangement described in Rev. Rul 57-451, 1957-2 CB. 295 or otherwise equivalent to a securities lending arrangement under §1058. The Petitioner was further held liable for a late filing penalty of $6,583 under §6651(a)(1) as well as an accuracy-related penalty of $6,182 under §6662.
The central issue in the case was whether the Derivium "master agreement" loan was to be treated as a loan or instead as a sale for Federal income tax purposes. It is somewhat universally accepted that a "sale" for Federal income tax purposes is given its ordinary meaning as a transfer of property for money or a promise to pay money." Grodt & McKay Realty, Inc. v. Comm’r, 77 T.C. 1221, 1237 (1981) (citing Comm’r v. Brown, 380 U.S. 563, 570-571 (1965)). Since the economic substance of a transaction, rather than its form, controls for tax purposes, the question for the court to determine at bar was whether the benefits and burdens of ownership of the IBM stock passed from petitioner to Derivium. This is a question of fact for which generally the taxpayer has the burden of proving by a preponderance of the evidence. See §7491. See also Arevalo v. Comm’r, 124 T.C. 244, 251-252 (2005), affd. 469 F.3d 436 [98 AFTR 2d 2006-7676] (5th Cir. 2006). Factors the courts have considered in making this determination include: (1) whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity interest in the property is acquired; (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments; (5) whether the right of possession is vested in the purchaser; (6) which party pays the property taxes; (7) which party bears the risk of loss or damage to the property; and (8) which party receives the profits from the operation and sale of the property.
In the majority opinion by Ruwe, in which 10 judges joined and one additional judge concurring in result only, the Tax Court was critical of the taxpayer’s "loan" position on various grounds, including:
- Petitioner did not treat the transaction consistent as a loan. For example, he did not include dividends pain on the stock as income from 2001 through 2004. He failed to report the "sale" of the shares on his 2004 return and further failed to alternatively report any cancellation from indebtedness income in 2004 for the balance of the "loan" left unpaid and discharged.
- Petitioner did not retain any property interest in the stock. He retained, in the eyes of the Court, no more than an option to purchase an equivalent number of IBM shares after 3 years at a price equivalent to $93,586 plus "interest." The effectiveness of the option depended on Derivium's ability to acquire and deliver the required number of IBM shares in 2004.
- Derivium obtained title to, possession of, and complete control of the IBM stock from Calloway. It immediately exercised those rights and sold the stock.
- Upon receipt of the $93,586.23 from Derivium in 2001, Calloway bore no risk of loss in the event that the value of the IBM stock decreased. He was entitled to retain all the funds transferred to him regardless of the performance of the IBM stock in the financial marketplace.
The Court opined that at best the agreement with Derivium provided the Petitioner with an option to repurchase IBM stock at the end of 3 years however this option depended on Derivium’s ability to acquire IBM stock at that time. The Tax Court pointed out that two other Federal courts recently considered whether the transfer of securities to Derivium under its 90%-stock-loan program was a sale for Federal tax purposes (one case, dealing with Mr. Nagy, dealt with §6700 promoter penalties; the other, dealing with Mr. Cathcart, enjoined him from marketing the 90% stock loan program). In those cases, the courts, using essentially the same facts and applying the same legal standards that are found in well established cases, found that the 90%-stock-loan-program transactions were sales of securities and not bona fide loans.
The Tax Court also held that the transaction was not analogous to the securities lending arrangement in Rev Rul 57-452, 1957-2 CB 295 , nor was it equivalent to a securities lending arrangement under Code Sec. 1058 .
Petitioner was held liable for the accuracy related penalty under §6662 because he was found not to have acted with reasonable cause and in good faith because he didn't report the transaction on his returns consistent with his characterization of it. He couldn't avoid liability for the penalty by showing reliance on a competent professional adviser (i.e., his financial adviser) because he made no effort to establish that adviser's credentials or qualifications nor did he establish whether the adviser had any relations to Derivium. Finally, Calloway admitted that he knew nothing about Mr. Nagy other than that he apparently wrote an opinion letter addressed to Mr. Cathcart concerning another 90%-stock-loan transaction. In like manner there the Petitioner failed to establish "reasonable cause" or the absence of "willful neglect" in not timely filing his 2001 return which was filed more than 21 month after its due date.
On November 24, 2009, Judge Phyllis J. Hamilton, for the U.S. District Court for the Northern district of California, ordered a permanent injunction against the principal of Derivium, Charles Cathcart of Tuxedo Park, N.Y., from promoting a complex tax scheme involving numerous entities located around the globe and sales of over $1.25 billion in securities, the Justice Department announced today. The record indicated that Cathcart, a Ph.D. economist, developed a scheme called the "90% Loan Program" and promoted it throughout the United States through companies he controlled-including Derivium Capital LLC and Derivium USA.The 90% Loan Program falsely claimed customers could exchange their appreciated stock for loan payments equal to 90% of the stocks’ value without paying income tax on their capital gains. It also purported to allow the tax-free return of those customers’ stocks at maturity if the customers repaid the "loans." The customers’ stocks were sold immediately, with 90% of the sale proceeds going to make the purported "loans" to the customers, and the other 10% being retained by the promoters. Customers were told the loans were made by independent third-party lenders, but in fact the supposed loans were made through sham companies that Cathcart created and controlled. The sham companies never functioned as genuine lenders, never held or maintained any assets or reserves, and were located throughout the world in such far-flung places as the Isle of Man, Ireland and Hong Kong.
The Federal district court record reflected that Cathcart, through the 90% Loan Program, sold more than $1.25 billion worth of customers’ stock in some 3,100 transactions, leaving more than $100 million for himself and the other promoters after payment of 90% of the sale proceeds to customers as purported loans. The government complaint in the case alleged that the scheme cost the U.S. Treasury an estimated $230 million or more. Judge Hamilton previously ruled that Cathcart’s customers were not receiving loans, because the transactions were in fact sales. Thus, Cathcart’s representations to customers that they were receiving loans were false statements about the scheme’s tax benefits. The same court earlier barred Cathcart’s son, Scott, Robert Nagy, and other members of the team from promoting the 90% Loan program. A representative of the Department of Justice stated that the government wanted to shut down complex tax schemes that falsely claim to eliminate income tax on capital gains, a scheme directed towards the more affluent.
By the time that Mr. Calloway had his 2001 case heard and decided by the Tax Court, the numerous legal proceedings and investigative efforts undertaken by the Department of Justice working with the SEC and IRS made the outcome to this civil tax case before the Tax Court forseeable as well as anticlimactic. One can't help but wonder why the Petitioner still pressed forward with his case and furthermore, why it took the full Court to decide it. Perhaps the answer to the latter question was to prevent other adventurous and predatory "lenders" from falsely promoting a bad tax scheme employing a "loan" strategy.
Promoters and Principals of Derivium Subsequently Face SEC and IRS Charges
Tax Court’s Underlying Analysis
The Tax Court Finds in Favor of the Service