BEMONT INVESTMENTS, L.L.C., by and through its TAX MATTERS PARTNER, Plaintiff-Appellee—Cross-Appellant, v. UNITED STATES of America, Defendant-Appellant—Cross-Appellee. BPB Investments, L.C., by and through its Tax Matters Partner, Daniel Beal, BPB Investments, L.L.C. Tax Matters Partner, Plaintiffs-Appellees—Cross-Appellants, v. United States of America, Defendant-Appellant—Cross-Appellee.
No. 10-41132
United States Court of Appeals, Fifth Circuit
April 26, 2012
VII.
We AFFIRM the district court in full, its reporting requirement terminating January 11, 2013, two years from the date of judgment below.
Roy Theodore Englert, Jr. (argued), Gary A. Orseck, Robbins, Russell, Englert, Orseck, Untereiner & Sauber, L.L.P., Washington, DC, Michael Todd Welty, Laura L. Gavioli, Lezlie Brooke Willis, SNR Denton US, L.L.P., Dallas, TX, Steven Merouse, SNR Denton US, L.L.P.,
Judith Ann Hagley (argued), Richard Bradshaw Farber, Supervisory Atty., Gilbert Steven Rothenberg, Dep. Asst. Atty. Gen.,
Before REAVLEY, DAVIS and PRADO, Circuit Judges.
W. EUGENE DAVIS, Circuit Judge:
These consolidated cases sought judicial review of notices of final partnership administrative adjustment (FPAA) issued to Bemont Investments, L.L.C. (Bemont) and BPB Investments, L.C. (BPB). Following that review in the district court, the government appeals two aspects of the district court‘s judgment: (1) the ruling on the partnerships’ motion for partial summary judgment disallowing the 40% valuation misstatement penalty, and (2) the ruling post trial holding that the FPAA issued to Bemont for the 2001 tax year was time-barred. The partnerships appeal the district court‘s judgment upholding the imposition of the 20% substantial understatement and negligence penalties. We affirm in part and reverse in part.
I.
On October 13, 2006, the Commissioner of the Internal Revenue issued FPAAs to Bemont and BPB for tax years 2001 and 2002. An FPAA is the partnership equivalent of a statutory notice of deficiency to an individual or non-partnership entity. The FPAAs disallowed losses from a foreign currency hedging transaction claimed
Before trial, the court granted the partnerships’ motion for partial summary judgment, holding that the government was foreclosed from imposing the valuation misstatement penalties (items (1) and (4) above). The remainder of the case proceeded to trial. After a bench trial, the court determined that the FPAA issued to Bemont for 2001 was time-barred, precluding the tax assessment and penalties related to that tax year. The court upheld the disallowance of losses reported by the partnerships and the imposition of penalties against them (items (2) and (3) above) for 2002. Both sides appeal.
The transaction underlying this dispute is described by the IRS as a classic Son of BOSS tax shelter. This type of shelter creates tax benefits in the form of deductible losses or reduced gains by creating an artificially high basis in partnership interests. Ordinarily under the Internal Revenue Code, when a partner contributes property to a partnership, the partner‘s basis in his partnership interest increases.
Taxpayers who purchase and entities who promote listed transactions have certain disclosure requirements to the IRS. In general, the taxpayer must file a disclosure statement with any tax return that includes gains or losses from a listed transaction.
To combat the problem of taxpayers and promoters who fail to comply with the disclosure requirements, Congress extended the usual three-year statute of limitations for issuance of a deficiency notice or FPAA in cases involving undisclosed listed transactions until one year after the taxpayer or his tax-shelter advisor has complied with the notice requirements.
The particular shelter in this case took the following form. Andrew Beal formed BPB and contributed to BPB $5 million in cash and stock with a cost basis of $4 million in Solution 6, an Australian company. Beal‘s purported plan was to takeover Solution 6 in a transaction requiring substantial sums of Australian dollars. To hedge the risk that the Australian dollar would appreciate (relative to the U.S. dollar) prior to closing on a takeover bid for Solution 6, BPB entered into a digital currency swap transaction with Deutsche Bank. The swaps included two long positions that required BPB to pay Deutsche Bank a fee of $202.5 million. Two short positions required Deutsche Bank to pay BPB a fee of $197.5 million. BPB only paid Deutsche Bank the net difference between the long and short positions, i.e. $5 million. In addition, the swaps required BPB and Deutsche Bank to make offsetting fixed payments to each other—under which term Deutsche Bank paid BPB approximately $2.5 million. Thus, BPB‘s net cost of these transactions was $2.5 million.
Shortly after Beal formed BPB, BPB formed a partnership called Bemont with Montgomery. BPB contributed the swaps contracts and Solution 6 stock to Bemont. The partnerships reported that the tax basis of the swaps contributed was $202.5 million, ignoring the $197.5 million offset represented by the short swaps.
After the swaps terminated in November 2001, Montgomery left the Bemont partnership with BPB, causing Bemont to terminate for tax purposes. Once Montgomery exited, Bemont‘s only asset was the Australian currency, which was deemed distributed to BPB. In late 2001, Beal and Montgomery decided not to pursue the takeover of Solution 6 and BPB sold most of the Australian currency at its fair market value. Using the inflated basis of $202.5 million, Bemont reported a $151 million foreign-currency loss on its 2001 return, which was allocated to Beal. In 2002, after the deemed distribution from Bemont, BPB sold the remainder of the Australian currency and reported a
In adopting this tax treatment, Beal and Montgomery relied on the advice of tax accountant, Matt Coscia, that the tax treatment using the inflated tax bases was likely correct. Neither Beal nor the partnerships filed the disclosure statements required by Notice 2000-44 and
In April 2005, the IRS audited Beal‘s 2002 tax return and inquired about the $46 million loss allocated from BPB. Beth Montgomery, the accountant who had prepared Beal‘s return, gave the IRS agent a copy of the agreement assigning BPB‘s rights under the swaps to Bemont. The agreement listed all four swaps—two long and two short. She also provided copies of the confirmation letters for the long swaps but did not provide further detail on the short swaps. No adjustments were made by the IRS to Beal‘s return for that year.
On October 13, 2006, after the ordinary three-year statute of limitations for examining Beal‘s and the partnerships’ 2001 returns had expired, the IRS issued FPAAs to BPB and Bemont. The FPAA the IRS issued to Bemont covered the 2001 tax year, disallowing the losses from the swaps and determining that Bemont‘s partners had no basis in the partnership. The FPAA the IRS issued to BPB dealt with the 2002 tax year, and disallowed the losses from the swaps and determined that the BPB partners had no basis. Thus this case deals with the 2001 losses reported by Bemont and the 2002 losses reported by BPB.
II.
The district court‘s findings of fact are reviewed for clear error and legal conclusions are reviewed de novo. Klamath Strategic Inv. Fund v. United States, 568 F.3d 537, 543 (5th Cir. 2009).
III.
Ordinarily, the IRS must assess taxes within three years after a taxpayer files his return.
The district court found that subpart (A) of
The regulation promulgated under the authority granted in
A list may be maintained on paper, card file, magnetic media, or in any other form, provided the method of maintaining the list enables the Internal Revenue Service to determine without undue delay or difficulty the information required by A-17 of this section.
Question 17 asks what information must be included on the list. The requirement provided in Answer A-17 is quoted in the margin.2
Although the parties present arguments addressing whether the information was provided to the IRS as a
In 2004, the IRS issued a series of summons to Deutsche Bank. The summonses were never disclosed in this litigation. However, Deutsche Bank‘s cover letters and responses to the IRS provide insight into what the IRS requested. A May 2005 letter states that the disclosure relates to “In re Matter of the Liability of Taurus Corporation and Deutsche Bank, AG for Penalties under I.R.C. Section 6707/6708, Summonses dated October 20, 2004.”4 The letter discloses that the bank had made previous productions of documents in January, March and April of 2005. Those submissions included 123 CDs that captured approximately 1,100,000 pages of documents. The May 2005 submission included an additional 103 CDs that captured approximately 1,090,000 pages of documents. The information on Bemont and BPB was included on 21 CDs labeled “Transaction: FX Digital Options” responsive to the IRS‘s summons headed “Son of Boss/Digital Options.” The letter also indicates that Deutsche Bank expected to make an additional submission of documents.
The partnerships at issue in this case are identified on three of those pages in charts attached to internal Deutsche Bank emails. One email has the subject line “September Commissions” with a one page attachment that includes a list of clients and commissions due. The list includes BPB for a transaction labeled “SWAP.” The second email has a subject line reading “Sell cad please” and has a 15 page chart attached. One page of the chart includes a reference to Beal and BM Investments LLC (the entity referred to as Bemont in this opinion), related account numbers, a reference to Australian dollars and an “FX Amount” of $4,849,660. An-
Regardless of whether the information on the three discrete pages meets or does not meet the requirements of Question and Answer A-17 of the regulation, we find that the disclosure as a whole does not meet the regulations requirement in A-16 that the information be provided in a form that enables the IRS to determine the information required by A-17 without undue delay or difficulty. First, the references to BPB and Bemont were on three pages buried in over 2 million pages of documents. Second, the references were in charts attached to internal Deutsche Bank emails. Neither the emails or the chart titles give any hint that the attachments contained lists of advisees engaging in tax shelter transactions. Rather BPB and Bemont were listed in emails containing calculations of commissions due and in a list of sales orders. The taxpayer does not explain and it is not apparent to us how the IRS would be expected to locate these references within the volume of documents or how the IRS could easily determine from this information that any of the listed entities participated in abusive tax shelter transactions.
Accordingly, we conclude that the 2005 disclosures by Deutsche Bank did not trigger the one year limitations period in
IV.
The government appeals the disallowance of the 40% gross valuation misstatement penalty. The taxpayer cross appeals the negligence penalty and also argues that the substantial understatement penalty should not apply.
A.
The government argues that the district court erred in holding that the 40% penalty for basis valuation misstatements in
First, in Todd v. Comm‘r, 862 F.2d 540 (5th Cir. 1988), this court construed
In other words, where the deductions and credits for these [assets] were inappropriate altogether, the Todds’ valuation of the property supposedly generating the tax benefits had no impact whatsoever on the amount of tax actually owed. Id. This court was persuaded that the Tax Court‘s approach was proper.
In Heasley v. Comm‘r, 902 F.2d 380 (5th Cir. 1990), this court addressed again a valuation overstatement penalty in
Whenever the I.R.S. totally disallows a deduction or credit, the I.R.S. may not penalize the taxpayer for a valuation overstatement included in that deduction or credit.... In this case, the Heasleys’ actual tax liability does not differ one cent from their tax liability without the valuation overstatement included. In other words, the Heasleys’ valuation overstatement does not change the amount of tax actually owed.
Id. at 383. Consistent with Todd, we found that the valuation overstatement penalty did not apply.
In this case, the IRS gave a number of reasons to disallow the losses reported by the partnerships. As described by the district court, the deductions were not disallowed because of a substantial valuation misstatement. Rather the IRS determined that the transactions which generated the purported losses were created for no business purpose other than tax avoidance, lacked economic substance and were an economic sham. Accordingly, the IRS disregarded the transactions in full. Because the IRS treated the transactions as a sham, and disallowed all tax attributes flowing from the transactions in full, any valuation misstatement was irrelevant to
The district court properly disallowed the 40% penalty for basis valuation misstatements.
B.
In its cross-appeal, the partnerships argue that the district court erred in imposing the 20% negligence penalty and also argue that the 20% substantial understatement penalty should not apply. As outlined above,
The partnerships argue that the district court erred by ignoring their al-
The most important factor is the extent of the taxpayer‘s effort to assess his proper liability in light of all the circumstances.
In Klamath, the district court found that the taxpayers had sought legal advice from qualified accountants and tax attorneys concerning the legal implications of their investments and the resulting tax deductions. They hired attorneys to write a detailed tax opinion, providing the attorneys with access to all relevant transactional documents. This tax opinion concluded that the tax treatment at issue complied with reasonable interpretations of the tax laws. At trial, the Partnerships’ tax expert concluded that the opinion complied with standards established by
The IRS also imposed a 20% penalty for a substantial understatement of income tax. This penalty may be avoided if the taxpayer can show that he had “substantial authority” for the tax treatment of an item.
The taxpayer‘s reliance on Streber is misplaced. In Streber, two sisters in their twenties received over a million dollars each and hired an attorney to advise them on their potential tax liability. Id. at 217. The IRS charged them with negligence and substantial understatement penalties (under statutes that are very similar to the ones applicable to this case) for treating the funds as a gift. Id. at 218. As in this case, the taxpayers appealed only the penalties. Id. at 218-19.
Addressing the substantial authority defense, this court stated that substantial authority could rest on factual matters.
In a recent decision, the Eleventh Circuit explained that where the substantial authority issue turns on evidence going both ways, “there is substantial authority from a factual standpoint for the taxpayer‘s position. Only if there was a record upon which the Government could obtain a reversal under the clearly erroneous standard could it be argued that from an evidentiary standpoint, there was not substantial authority....” Osteen v. Commissioner, 62 F.3d 356, 359 (11th Cir. 1995). Apart from trying to confine Osteen to its facts, an untenable position, I.R.S. does not demonstrate how its principle is inapt here. The government makes no effort to assert that the only rational tax treatment of the transaction was as a gift made before 1985.
Id. at 223 (emphasis added). The taxpayers argue that their factual defenses (that the swaps had profit potential and the takeover bid for Solution 6 was not abandoned prior to the swaps) were supported by credible evidence. Thus the taxpayers in this case assert that the district court‘s fact findings against them do not preclude their reliance on the rejected factual assertions for purposes of the substantial authority defense. They argue that this is true even though the district court rejected their factual assertions.
We conclude that Streber is inapplicable to this case for several reasons. First, in Streber, the facts “were complex, largely undisputed, and not materially affected by the Tax Court‘s assessment of the sisters’ lack of credibility.” Id. The facts in this case were greatly disputed, particularly on the critical issue of whether the underlying transaction was a sham. Second, in Streber, neither the IRS or the Tax Court argued “that ‘substantial authority’ means only legal, not factual authority.” Id. n. 14. In this case, the government points to
V.
For the above reasons, we reverse the judgment of the district court that the FPAA as to the 2001 tax year was untimely; we affirm the judgment of the district court in all other respects including disallowing the 40% valuation misstatement penalty and upholding the 20% negligence penalty for both 2001 and 2002. We remand this case to the district court for entry of judgment consistent with this opinion.
REVERSED in part; AFFIRMED in part; REMANDED.
EDWARD C. PRADO, Circuit Judge, concurring:
Under this circuit‘s precedent, the 40% penalty for a tax underpayment attributable to a substantial valuation misstatement does not apply when the relevant deduction has been totally disregarded because the underlying transaction lacked economic substance. See Todd v. Comm‘r, 862 F.2d 540, 542-45 (5th Cir. 1988); Heasley v. Comm‘r, 902 F.2d 380, 383 (5th Cir. 1990); see also
I.
In Todd, we relied on the 1981 “Blue Book“—the name for a post-enactment summary of a major tax law prepared by the staff of the Joint Committee on Taxation—to interpret
This example makes sense of the Blue Book‘s statement that the portion of tax underpayment attributable to a valuation overstatement will be determined “after taking into account any other proper adjustments to tax liability.” According to the Blue Book, if a filing suffers from two unrelated sources of deficiency—e.g., one improper deduction stemming from a valuation overstatement of a particular asset, and another improper deduction stemming from a false charitable contribution—one should isolate the effect of the valuation-related deduction by (i) calculating the actual tax liability after correcting each improper deduction, (ii) calculating the tax liability reduced by counting the valuation-related deduction, and (iii) taking the difference. The Blue Book‘s formula and example are expressing a straightforward principle in mathematical terms: Do not apply the valuation overstatement penalty to a tax infraction, such as an improper charitable deduction, that is unrelated to (i.e., incapable of being attributed to) the valuation overstatement.
Yet, the Todd court misread the Blue Book‘s elementary guidance. In Todd, the defendant-investors overvalued their property and consequently claimed improper deductions and credits, which the Tax Court totally denied because the property had not been placed in service—a requirement for those deductions and credits. Id. at 540-41. We found support in the Blue Book to hold that the valuation overstatement penalty should not apply, because there was no difference between the investors’ actual tax liability (which excluded the overvaluation-generated tax benefit that was conditioned on placing the property in service) and their tax liability reduced by taking into account the overvaluation (which, we concluded, would still not have included the tax benefit, as the deduction was denied because the property had not been placed in service). Id. at 542-43. As noted, however, the Blue Book only explains that the overvaluation penalty should not apply to an improper tax benefit that is unrelated to the valuation overstatement. The Blue Book only covers the case of two unrelated deductions, one of which is caused by overvaluation. Accordingly, the Blue Book does not suggest that the overvaluation penalty should not apply if overvaluation is one of two possible grounds for denying the same deduction and the ground explicitly chosen is not overvaluation. No language in the Blue Book counsels against applying the penalty in such a case; the tax underpayment could still be “attributable to” the overvaluation. But we inferred otherwise, despite the Blue Book‘s silence, and begged the question.
What is more, we exacerbated Todd‘s misinterpretation in Heasley, holding that “[w]henever the IRS totally disallows a
To be sure, a routine application of the Todd/Heasley rule decides this case. If an overvaluation generates an improper deduction, and the deduction is totally disallowed on the ground that the underlying transaction is a sham, we are bound to hold that the tax underpayment is not “attributable to” the valuation overstatement. In so reasoning, however, we have strayed from the Blue Book‘s text.1 Penalizing Defendants for the valuation misstatement would not flout the Blue Book‘s warning not to apply the valuation-misstatement penalty to a tax infraction that is unrelated to the overvaluation.2
II.
Arguably, if the Todd/Heasley rule did not bind us, tax underpayment in this case would be “attributable to” a valuation overstatement. Defendants made a valuation misstatement when they asserted that the basis in the Australian currency was $202.5 million. In reality, the basis in the Australian currency was about $5 million. To create this anomaly, Defendants engaged in two sham, offsetting transactions; they moved the “long” and “short” swaps into the partnership; they recognized the $202.5 million increase in basis from the “long” swap assets, but ignored the $197.5 million decrease in basis from the “short” swap liabilities; and they dissolved the partnership, leaving behind a fake basis of about $202.5 million in the Australian currency. Defendants then sold the Australian currency, which was actually worth about $5 million, in the marketplace for its fair market value—presumably close to $5 million. They should not have reported much loss, if any. As we know, however, Defendants made a valuation misstatement. They asserted that the Australian currency had a basis of $202.5 million. Thus, Defendants claimed a loss of about $200 million from the sale, because they had sold an item worth $202.5 million for much less. Consequently, when Defendants paid their taxes, they did not pay tax on about $200 million. But as we know, the loss was artificial. As a result of their
After analyzing the anatomy of Defendants’ scheme, it becomes clear that the basis misstatement and the transaction‘s lack of economic substance are inextricably intertwined. The basis misstatement was the engine of the vehicle behind the sham transaction. By misstating the basis in Australian currency, Defendants claimed an artificial loss when they sold the currency; by claiming the artificial loss, Defendants underpaid their tax. Misstating the basis thereby generated an improper tax benefit in direct proportion to the amount of the misstatement. Although that deduction was disregarded because the transaction lacked economic substance, attributing the tax underpayment only to the artificiality of the transaction and not to the basis overvaluation is making a false distinction. The basis misstatement is an essential element of the transaction‘s artificiality; in fact, disregarding the deduction for a lack of economic substance pulls the correct basis to zero, which eliminates the claimed loss, and renders the tax underpaid. Therefore, disregarding the transaction for a lack of economic substance does not alter the reality that the tax underpayment was ultimately “attributable to” the basis misstatement—or so one could argue, in a world without Todd/Heasley.
III.
The near-unanimous opposition to the Todd/Heasley rule is worth highlighting. Except for the Ninth Circuit, every sister circuit that has considered the issue has concluded that the valuation misstatement penalty may apply even if the deduction is totally disallowed because the underlying transaction lacked economic substance. See Fidelity Int‘l Currency Advisor A Fund, LLC v. United States, 661 F.3d 667, 673-74 (1st Cir. 2011) (rejecting Todd/Heasley rule for “misreading” the Blue Book and following “without hesitation the dominant view of the circuits“); Merino v. Comm‘r, 196 F.3d 147, 158 (3d Cir. 1999) (declining to apply Todd/Heasley and affirming valuation overstatement penalty because overvaluation was “an essential component of the tax avoidance scheme“); Zfass v. Comm‘r, 118 F.3d 184, 191 (4th Cir. 1997) (rejecting Todd/Heasley and affirming valuation overstatement penalty because value overstatement was “primary reason” for disallowance due to lack of economic substance); Illes v. Comm‘r, 982 F.2d 163, 167 (6th Cir. 1992) (“The tax benefit ... was directly dependent upon the valuation overstatement, and the amount of the tax benefit was actually determined by the amount of the overvaluation. The entire artifice of the [tax] shelter was constructed on the foundation of the overvaluation of its assets. Plainly, then, [the tax] underpayment was attributable to [the] valuation overstatement.“); Gilman v. Comm‘r, 933 F.2d 143, 151 (2d Cir. 1991) (“The lack of economic substance was due in part to the overvaluation, and thus the underpayment was attributable to the valuation overstatement.“); Massengill v. Comm‘r, 876 F.2d 616, 619-20 (8th Cir. 1989) (“When an underpayment stems from disallowed depreciation deductions or investment credit due to lack of economic substance, the deficiency is attributable to overstatement of value, and subject to penalty [for valuation overstatement].“).
In addition, the Federal Court of Claims and the Tax Court, when not bound by corresponding circuit precedent, have sided with the majority. See Clearmeadow Invs., LLC v. United States, 87 Fed. Cl. 509, 535-36 (Fed. Cl. 2009) (siding with majority and criticizing Todd/Heasley rule); Petaluma FX Partners, LLC v. Comm‘r, 131 T.C. 84, 104-05 (2008)
Although the Ninth Circuit has not joined the majority because it is bound by its own precedent to follow the Todd/Heasley rule, it has questioned the rule‘s wisdom. Keller v. Comm‘r, 556 F.3d 1056, 1060-61 (9th Cir. 2009) (holding that the Ninth Circuit is “constrained by” Gainer v. Comm‘r, 893 F.2d 225 (1990), which “rested in large part” on Todd, but recognizing the “sensible” approach of “many other circuits“). Only we remain completely out of step.
IV.
As a policy matter, the Todd/Heasley rule could incentivize improper tax behavior. If a taxpayer claims a benefit that is improper only due to a basis misstatement, then the valuation-misstatement penalty may apply. But by crafting a more extreme scheme and generating a deduction that is improper not only due to a basis misstatement, but also for some other reason (e.g., a lack of economic substance), the taxpayer increases his chance of avoiding the valuation-misstatement penalty—because, per the Todd/Heasley hierarchy whereby the overvaluation penalty is subordinated to any other proper adjustment, disallowing the deduction on the other ground could block the penalty. Amplifying the egregiousness of the scheme—to the point where the transaction is an utter sham—could thus, perversely, shield the taxpayer from liability for overvaluation. See Fidelity, 661 F.3d at 673 (recognizing this perverse policy result); Gilman, 933 F.2d at 150 (same); see also Keller, 556 F.3d at 1061 (same, though following circuit precedent not to apply penalty). A taxpayer could generate an enormous improper tax benefit by overstating an asset‘s basis, but then could escape the overvaluation penalty by strategically conceding a deficiency on the ground of economic substance. See Clearmeadow, 87 Fed. Cl. at 536 (recognizing the risk of such “gamesmanship“). By creating this perverse incentive structure, the Todd/Heasley rule frustrates the purpose of the valuation-misstatement penalty, which is to deter taxpayers from inflating values and bases to generate large, improper tax benefits—such as a deduction to the tune of $200 million.
V.
Still, I understand that our hands are tied. Additionally, I am not convinced that
Judges REAVLEY and W. EUGENE DAVIS concur in Judge PRADO‘S special concurrence.
UNITED STATES of America, Plaintiff-Appellee, v. Shirley A. CUNNINGHAM, Jr. (09-5987) and William J. Gallion (09-5998), Defendants-Appellants.
Nos. 09-5987, 09-5998
United States Court of Appeals, Sixth Circuit
May 1, 2012
Rehearing and Rehearing En Banc* Denied June 27, 2012
Argued: Jan. 17, 2012.