No economic substance was a problem in two recent transactions.

A US district court in Florida held in March that a transaction that KPMG and Bricolage, a consultancy, marketed to wealthy individuals to help shelter capital gains from taxes lacked economic substance. The transaction was called FOCus for family office customized partnership.

KPMG identified the founder of a computer company called American Megatrends that had sold a division at a gain of approximately $80.9 million, creating a tax obligation of about $16 million. KPMG brought in Bricolage. The two pitched the idea of using a FOCus partnership to the client.

Bricolage set up three tiers of partnerships. The lowest-tier partnership entered into a foreign currency straddle. In a straddle, an investor goes long and short in the same currency. One leg will show a gain and the other leg will show a roughly equivalent loss. The partnership closed out the gain leg of the straddle and realized the gain, but left the loss leg outstanding.

The client then bought 99% of the top two partnerships in the chain for $6.1 million in December 2001 and agreed to pay Bricolage a separate “strategic consulting fee” of $4.3 million. The fee was calculated as a function of the loss that the client wanted to generate. Bricolage retained a 1% interest in each of the partnerships in the chain.

Still in December but 15 days later, the middle partnership sold the third-tier partnership to another Bricolage entity causing the client to realize the loss on the loss leg of the straddle. Shortly before the sale, the middle partnership borrowed money from a bank and entered into a yen carry trade structured as a deep-in-the-money call spread on which it earned $200,000, but the court said a collar in place on the trade “severely limited both risk and reward.”

The client continued to have a relationship with Bricolage through 2005 and eventually made money off other transactions conducted through the partnerships. This was a pre-planned step in the FOCus shelter: slides KPMG used to pitch the transaction to the client said participation in the transaction had to last at least three years.

In early 2002, the IRS said in Announcement 2002-2 that it would waive some penalties for anyone who disclosed his involvement in a tax shelter. The client disclosed the transaction. The IRS began looking into the transaction in 2008.

A US district court denied the tax loss from the straddle on grounds that the transaction lacked economic substance. The court applied a two-prong test. It said the transaction had to have an economic effect on the taxpayer other than producing tax benefits, and the taxpayer had to have a real business purpose, other than reducing his federal income taxes, for entering into the transaction. It could find neither in this case.

It focused on the effort to push the loss leg of the straddle to the client while ignoring other trades in which the partnerships engaged.

The case is Kearney Partners Fund, LLC v. United States.

The US Tax Court held another transaction lacked economic substance in March in a case called Humboldt Shelby Holding Corporation v. Commissioner.

The promoter of the second transaction, James Haber, is a tax professional in New York who marketed tax shelters to third parties. He formed a corporation and had it pay $86 million in 2003 to acquire two other corporations with combined assets of $90 million, but the target companies had appreciated assets on which they would have to pay about $25 million in taxes eventually. Thus, the net asset value of the companies was only about $65 million after taxes. Haber overpaid figuring he could enter into a separate transaction to shelter the gains on the appreciated assets.

He had each of the target companies both buy and sell digital options and contribute the options to a partnership. The long and short positions were largely offsetting. For example, a company buying a digital option might receive $20 if the S&P 500 index is above 450 on X date. If the index is below 450 on that date, then the company would receive nothing. A company selling such an option would pay $20 if the index is below 450 on X date, but pay nothing if the index is above 450. No one buys and sells exactly at the same strike price. There is a slight spread, such as buying an option with a strike price of 450 and selling one with a strike price of 450.03.

One of the two target companies bought an option for $70 million and sold a largely offsetting one for $69.7 million. When it contributed the options to the partnership, it took an “outside basis” in its partnership interest of $70 million (for the long option and nothing for the sold option). The other company bought an option for $4.4 million and sold a largely offsetting one for $4.38 million.

One set of options was linked to the S&P 500 index. The other was linked to the NASDAQ 100 index.

All of the options expired three months later with no payment on either side. The two corporations then liquidated their partnership interests and claimed their outside bases as capital losses.

The companies would have had large gains in theory if the options had expired while the stock indexes were within the sweet spot, but the Tax Court said the most that could have been earned in practice was between $320,000 and $510,000. The Tax Court said this amount of potential profit was inconsequential compared to the $25 million in capital losses that the options were guaranteed to generate. The existence of some potential for profit does not foreclose a finding of no economic substance. The only way Haber could have paid $86 million for two companies worth $65 million after taxes was by figuring out a way to eliminate the taxes.

The Tax Court said any appeal of its decision would go to the US appeals court for the 2d circuit. That appeals court has no rigid formulation of the economic substance test but would look more broadly at whether the digital options trades and use of the partnership had any purpose other than the creation of tax losses.

The court upheld the IRS assessments of back taxes of $25.6 million and a penalty of $10.2 million. IRS regulations allow penalties of up to 40% in the case of a gross valuation misstatement.

By Keith Martin