A Disguised Sale and Lack of Economic Substance
A disguised sale and lack of economic substance prevented losses from being claimed on utility receivables.
BDO Siedman marketed “tax solutions” from 2000 through 2003.
It strongly encouraged its employees and partners to help sell them by sending firmwide emails every time such a product was sold announcing the sale, the accountants who made the sale and the fees earned. Bonuses were paid based on such sales.
One of the products was a highly-structured distressed debt product. BDO teamed up with Gramercy, a fund manager that specialized in distressed sovereign and major corporate debt. Its funds were focused on debt that is distressed but likely to be restructured. It holds the debt expecting to profit from reselling it before or after the restructuring. It dealt only in debt that is dollar denominated, issued in international capital markets, and is subject to New York or UK law and is issued by a government or a major corporation that the country has a strong interest in seeing survive.
Two BDO clients, who were executives of a company that Eastman Kodak was acquiring, had large amounts of income that they wanted to shelter from taxes.
The BDO product focused on customer receivables. BDO arranged to refer its clients interested in the product to Gramercy. In the particular transaction, OAO Saratovenergy, the electric utility for the Saratov region in Russia, contributed receivables from 46 commercial customers to a “master” LLC with Gramercy as a 1% managing member. The receivables were denominated in rubles, had a face amount equivalent to $368.8 million and were at least four years overdue. The master LLC contributed them to sub 1 LLC that was owned 99% by the master LLC and 1% by Gramercy, again as managing member.
The parties recorded a tax basis in the receivables of the face amount. The actual value was far less: about $3.9 million.
Nothing was ever collected on them.
The BDO clients acquired 90% of the sub 1 LLC by paying the master LLC 90% of the actual value, and the master LLC distributed the money to the Russian utility. Sub 1 LLC then dropped the receivables into sub 2 LLC and exchanged sub 2 LLC with Gramercy for assets equivalent in actual value, triggering the loss.
The US Tax Court denied the losses in a decision in November. The cases are UniteBuyuk LLC v. Commissioner and Beyazit, LLC v. Commissioner.
The court said the transaction was a disguised sale of the receivables by the utility to the master LLC. The master LLC is a partnership. IRS regulations make clear there is a presumption that a partner who contributes property and is distributed cash by the partnership within two years made a sale of the property.
This meant the partnership took 90% of the receivables with a basis equal to their actual value so that the later exchange could not have triggered a loss.
The court also said the entire transaction lacked economic substance. The two executives claiming the losses had no possibility of earning a profit on the receivables. Gramercy worked out an agreement for the utility to continue trying to collect, but Gramercy was to receive the first $37 million in collections and then split any additional collections 25% for Gramercy and 75% for the utility. The court said the utility had no incentive under this arrangement to spend time trying to collect. The court saw no business purpose for the investment by the two BDO clients other than to generate a tax loss.
The IRS slapped a 40% penalty on the taxpayers, not the usual 20% penalty, due to a “gross valuation misstatement.” The tax basis claimed on the property was at least 400% more than the amount the IRS considered correct. The court said the penalty was warranted.
By Keith Martin