The opinion
United States Court of Appeals
FOR THE DISTRICT OF COLUMBIA CIRCUIT
Argued October 19, 1999 Decided February 1, 2000
No. 98-1583
ASA Investerings Partnership, et al.,
Appellants
v.
Commissioner of Internal Revenue,
Appellee
Appeal from the United States Tax Court
(No. TAX-27320-96)
Jerome B. Libin argued the cause for appellants. With
him on the briefs was Steuart H. Thomsen.
Edward T. Perelmuter, Attorney, U.S. Department of Jus-
tice, argued the cause for appellee. With him on the brief
were Loretta C. Argrett, Assistant Attorney General, and
Richard Farber, Attorney.
Before: Williams, Sentelle and Henderson, Circuit
Judges.
Opinion for the Court filed by Circuit Judge Williams.
Williams, Circuit Judge: In January 1990 AlliedSignal, a
company manufacturing aerospace and automotive products,
decided to sell its interest in Union Texas Petroleum Hold-
ings, Inc., an oil, gas, and petrochemical company. Anticipat-
ing a large capital gain, it sought to reduce the resulting tax
burden by entering into a set of transactions via a partner-
ship with several foreign corporations. The transactions took
advantage of provisions of the Internal Revenue Code (and
related regulations) designed to yield reasonable results when
property is sold on an installment basis and the value of the
installment payments cannot be known in advance. With the
help of these provisions, transactions that in substance added
up to a wash were transmuted into ones generating tax losses
of several hundred million dollars; the offsetting gains were
allocated to foreign entities not subject to United States
income tax at all.
The Commissioner of Internal Revenue in 1996 issued a
notice of final partnership administrative adjustment, reallo-
cating to AlliedSignal much of the capital gain accrued by the
partnership. ASA, via its "Tax Matters Partner," Allied-
Signal, petitioned for relief in the Tax Court, which agreed
with the Commissioner that AlliedSignal had not entered into
a bona fide partnership and upheld the Commissioner's deter-
mination. ASA Investerings Partnership, AlliedSignal, Inc.,
Tax Matters Partner v. Commissioner, 76 T.C.M. (CCH) 325
(1998) ("Tax Court Decision"). We affirm.
* * *
The hardest aspect of this case is simply getting a handle
on the facts. To make them manageable, we first discuss the
principal tax provisions in question and then show their
application through a series of examples, ending with a
simplified version of the transactions here. Only then do we
lay out the exact transactions themselves.
Under the general provisions of the Internal Revenue Code
("IRC"), gains and losses are generally "realized" in the year
that they are received or incurred. See 26 U.S.C. s 1001
(1994). A sale for future payments, however, presents sever-
al difficulties, among them that the deferred payment may be
contingent in amount or otherwise not susceptible to accurate
valuation. Section 453 of the Internal Revenue Code, 26
U.S.C. s 453, provides methods for taxation of such an "in-
stallment sale," defined as "a disposition of property where at
least 1 payment is to be received after the close of the taxable
year in which the disposition occurs." Id. s 453(b)(1). It
specifies the "installment method" for such a sale, providing
that "the income recognized for any taxable year from a
disposition is that proportion of the payments received in that
year which the gross profit ... bears to the total contract
price." Id. s 453(c). Thus, if A owns a building with a basis
of $100, and sells it for $300 to be paid in five $60 annual
installments, A recognizes a taxable gain of $40 each year.
The proportion of "gross profit" to "total contract price" is
200/300 or two thirds, so the income recognized for each year
is two thirds of the receipts of that year.
In 1980 Congress expanded s 453, authorizing the Secre-
tary to make the installment method available to deferred
payment transactions for which the sales price is indefinite, or
subject to a contingency. Section 453(j) (previously s 453(i))
mandates that the Secretary shall promulgate regulations
"providing for ratable basis recovery in transactions where
the gross profit or the total contract price (or both) cannot be
readily ascertained." In response, the Treasury promulgated
Temp. Treas. Reg. s 15A.453-1(c)(3)(i) (1981), which provides
that in contingent payment sales (and subject to irrelevant
exceptions), "the taxpayer's basis ... shall be allocated to the
taxable years in which payment may be received under the
agreement in equal annual increments."
Under these regulations, the taxpayer will have a recog-
nized gain in years when payment from the sale exceeds the
basis recovered; in years when payment is less than the basis
recovered, "no loss shall be allowed unless the taxable year is
the final payment year under the agreement or unless it is
otherwise determined ... that the future payment obligation
under the agreement has become worthless." Id.
The following examples should illustrate the ratable basis
recovery rule. Property owner, A, sells a house with a basis
and current value of $1 million in exchange for an instrument
that will pay unpredictable amounts (e.g., a share of the
property's gross profits) over a five-year period. In any year
in which the payout equals or exceeds $200,000, A will recover
$200,000 in basis under the ratable basis recovery rule and
will have a taxable gain equal to the difference between the
amount received from the note and $200,000. In a year in
which the payout is less than $200,000, A will not report a
loss, but instead will recover a portion of the basis equal to
the payout; the unused basis will then be carried forward to
the next year. See id. s 15a.453-1(c)(3), example (2). Under
the rule just quoted above, unused basis would be recovered
only in the last year of scheduled payout.
The rule works similarly when the seller receives both an
instrument with indefinite value and an immediate payment
of cash. In a variation on the preceding case, for example,
suppose A sells the property for a $500,000 cash payment and
an indefinite five-year instrument. Once again, the basis is
recovered over the course of five years. In the first year, A
recovers $200,000 in basis; because he has received $500,000
that year, he must report a gain of $300,000. If A sells the
note in Year 2 for $500,000, he can report a loss of $300,000,
equal to the difference between the remaining basis in the
note ($800,000) and the $500,000 he has received in exchange
for the note.1 In this example, of course, the results are
rather unappealing to the taxpayer: although he had no real
gain, he recognized a nominal one early, offset by an equal
tax loss--but one that was deferred and therefore not a
complete offset. Because of the rule against any recovery of
__________
1 The regulation does not appear to provide expressly that in
the event that the taxpayer completely liquidates the instrument
before the end of scheduled payout he may recover all unused basis
in that year. Both parties agree, however, that this is the case.
basis in excess of gross receipts in any year except the last,
the taxpayer cannot manipulate the timing in his favor.
But suppose A finds a way of allocating the nominal tax
gain to a tax-free entity, reserving for himself a nominal tax
loss? Here is how he might do it: He forms a partnership
with a foreign entity not subject to U.S. tax, supplying the
partnership with $100,000 and inducing the "partner" to
supply $900,000. The "partnership" buys for $1,000,000 prop-
erty eligible for installment sale treatment under s 453, and,
as the ink is drying on the purchase documents, sells the
property, as in the last example, for $500,000 in cash and an
indefinite five-year debt instrument. The cash payment pro-
duces a gain of $300,000, 90% of which goes to the nontaxable
foreign entity. Then ownership adjustments are made so
that A owns 90% of the partnership. In year 2 the instru-
ment is sold, yielding a tax loss of $300,000, 90% of which is
allocable to A. Presto: A has generated a tax loss of
$240,000 ($270,000 loss in Year 2, offset by $30,000 gain in
Year 1), with no material change in his financial position--
other than receipt of the valuable tax loss. This example is
AlliedSignal's case, stripped to its essentials.
Now for the specifics of this case: In 1990, AlliedSignal
anticipated that it would soon realize a capital gain of over
$400 million from the sale of its interest in Union Texas
Petroleum Holdings, Inc. In February, AlliedSignal ap-
proached Merrill Lynch & Co. to discuss a set of transactions
that Merrill had developed to create tax losses to shelter
anticipated capital gains.
Under the plan AlliedSignal would form a partnership with
a foreign entity, which in turn would supply the majority of
the capital for and assume a majority stake in the partner-
ship. In Year 1, the partnership would purchase short-term
private placement notes ("PPNs"), which can be sold under
the installment method of accounting provided for in IRC
s 453. See 26 U.S.C. s 453(k)(2)(A) (implying that the sale
of "stock or securities which are [not] traded on an estab-
lished securities market" would be subject to the installment
method). Several weeks later, the partnership would sell the
instruments for 80% cash and 20% debt instruments, which
would pay out over several years and thus would be subject to
the ratable basis recovery rule. As in the example above, the
partnership would report a large gain in the first year, equal
to the difference between the substantial cash payment and
the small share of basis recovered that year. The gain would
be allocated according to each partner's interest, with the tax-
exempt foreign partner receiving the lion's share.
The next year, AlliedSignal would acquire a majority inter-
est in the partnership, and sell the debt instruments. The
sale would create a large tax loss because the basis available
for recovery would far exceed the value of the instruments.
Merrill would serve as the partnership's financial adviser
and, for a $7 million fee, would recruit the foreign partner
and arrange for the subsequent investments. Tax Court
Decision, 76 T.C.M. at 326. Merrill would also "structure and
enter into the requisite swap transactions" with the banks,
"[t]o ensure a market for [the] issuance and sale" of the
PPNs and the debt instruments to be received on their sale.
Id. In exchange for serving as the partnership's financial
intermediary, Merrill would receive roughly $1 to 2 million on
the initial sale of PPNs, and $200,000 to $400,000 on the sale
of the subsequent debt instruments. Id. The foreign part-
ner would receive the greater of $2,850,000 or 75 basis points
(1 basis point = .01%) over the London International Bank
Offering Rate ("LIBOR") on any funds contributed to the
partnership, as well as reimbursement of all partnership
expenses incurred. Id.
AlliedSignal and Merrill followed the proposal to the letter.
Merrill contacted Algemene Bank Netherlands N.V. ("ABN"),
one of the Netherlands' largest commercial banks. Id. at 327.
ABN had previously participated in similar Merrill transac-
tions, and anticipated that this partnership would strengthen
its preexisting lending relationship with AlliedSignal. Id.
On April 5, 1990 Johannes den Baas, Vice President of
Corporate Finance for ABN New York, an ABN affiliate,
requested authorization to enter into this venture. Id. Den
Baas recommended the creation of two "special purpose
corporations" ("SPCs"), to which ABN would lend $990 mil-
lion, and which would then contribute this money to the
venture. Id. The purpose of this structure, den Baas said,
was (1) to permit ABN, which would otherwise be a general
partner in the venture with AlliedSignal, to limit its exposure
to liability, and (2) to facilitate ABN's shifting part of the loan
to other banks for various reasons.
On April 17 and 18, den Baas and another representative of
an ABN affiliate met in Bermuda with a representative of
AlliedSignal. Id. Both sides agreed that AlliedSignal would
pay all partnership expenses, as well as ABN's costs funding
the requisite loans to the partnership (approximately
LIBOR), plus 75 basis points. Id. at 328.2 The precise
amount, of course, would depend on the amount that ABN
contributed and how long the partnership, to be known as
ASA Investerings, held those funds. In response to den
Baas's request that AlliedSignal pay $5 million up-front, the
parties agreed that AlliedSignal would instead periodically
make "premium" payments upon the occurrence of certain
events. Id. The agreements reached during these negotia-
tions were referred to by the Tax Court as the "Bermuda
Agreement."
ABN's Risk Management Division expressed concern that a
loss might arise out of the sale of the PPNs. Id. at 327. Den
Baas responded by assuring these officials that any such loss
would be added to the value of the subsequent debt instru-
ments, and would in turn be borne by AlliedSignal on liqui-
dation of those instruments. But there could be no written
agreement to this effect, explained den Baas, because "in that
case it would not be a matter of a general partnership." Id.;
__________
2 Petitioner acknowledges that ABN might have "had in mind a
target return of LIBOR plus 75bp on the amount it invested,"
Petitioner's Initial Br. at 59, but argues that the Tax Court erred in
finding that the parties actually entered into such an agreement.
Petitioner points to the fact that AlliedSignal's payments were
negotiated rather than specified in advance, and were not based on
a LIBOR plus 75 basis points return. This dispute is, however,
immaterial. See infra pp. 16-17.
Memo from den Baas to Jos Albers, 4/22/90, Joint Appendix
("J.A.") 676. Den Baas nonetheless assured the authorities at
ABN of his confidence that AlliedSignal would bear any such
loss:
[T]he fact that the client is the only one who is interested
in such a sale and wants to obtain the installment note,
whereby the SPCs have a right of veto during the entire
procedure--as is, in fact, set forth in the partnership
document--makes ABN NY Corporate Finance more
than confident that the client will continue to have this
loss charged to his account in the future as well.
Id. The loan-approving committees later authorized ABN's
participation.
On April 19 ASA Investerings Partnership was formed.
Tax Court Decision, 76 T.C.M. at 328. It consisted of Allied-
Signal, AlliedSignal Investment Corporation ("ASIC"), a
wholly-owned subsidiary of AlliedSignal, and the two SPCs,
Barber Corp. N.V. and Domniguito Corp. N.V., which were
controlled by foundations in turn controlled by ABN. Barber
and Dominguito entered into revolving credit agreements
with ABN. The foundations which owned the SPCs granted
ABN an irrevocable option to buy shares of the respective
SPCs at par value. Id.
On April 19th and 24th, the partners contributed a total of
$850 million, with each partner receiving a partnership inter-
est in accordance with its contribution. AlliedSignal's share
was 10%, the SPCs' 90%. In May 1990, the parties supple-
mented their contributions (in the same ratio), bringing the
total contribution to $1.1 billion.
On April 25, 1990 ASA purchased from two Japanese banks
$850 million of 5-year floating rate notes which were not
traded on an established securities market--the planned
PPNs. Id. at 329. On May 8, the partnership met in
Bermuda and decided to sell the PPNs for 80% cash and 20%
LIBOR notes. Id. Between May 17 and May 24 (i.e., within
one month of purchase), ASA sold the PPNs to two banks in
exchange for a little under $700 million in cash and 11 notes.
(With the cash it bought time deposits and 30-day commercial
paper.) These notes each made 20 quarterly payments con-
sisting of the 3-month LIBOR rate, calculated at the begin-
ning of each payment period, applied to 25% of the notional
principal amount, which in this case was $434,749,000. Id.
The LIBOR notes did not require a return of principal at
maturity; rather, the quarterly payments of interest on the
"notional amount" can be seen as both interest and return of
actual principal. ABN entered into swap transactions with
Merrill, Barber and Dominguito to hedge ABN's interest rate
risk relating to the LIBOR notes. Merrill also entered into
swap transactions with the banks from whom it bought the
LIBOR notes (as it had with the PPNs) to induce their
participation. Merrill's transaction costs in selling the PPNs
were $6.375 million. Id. This was added to the value of the
LIBOR notes in ASA's partnership books, so that Allied-
Signal would bear the costs of the sale when it acquired the
LIBOR notes from the partnership. Id. at 329-330.
Because the LIBOR notes provided for 20 quarterly pay-
ments at a variable rate, and the PPNs were not sold on an
established securities market, the sale of the PPNs qualified
for use of the installment method. For the taxable year
ending May 31, 1990, ASA recovered 1/6 of the basis in the
PPNs (because the completion of the scheduled payout would
occur in the sixth tax year after the sale, and reported
$549,443,361 in capital gains (= $681,300,000 in cash minus
1/6($851,139,836)).3 Id. at 331. The gain was allocated ac-
cording to partnership interest, 90% to the SPCs and 10% to
AlliedSignal and ASIC. Id.
On August 2, 1990, AlliedSignal issued $435 million in
commercial paper, and with the proceeds purchased Barber's
entire interest in ASA for about $400 million and a 13.43%
interest in ASA from Dominguito for about $150 million.
Between November 1991 and April 1992, ASA further re-
duced Dominguito's interest to 25%. AlliedSignal also paid a
$4.4 million "premium" payment, representing a portion of
__________
3 The parties stipulated in the Tax Court that ASA had erred in
calculating the gain on its 1990 tax return and that the correct
amount was $539,364,656.
the $5 million requested by den Baas. After this purchase,
AlliedSignal and ASIC entered into several swaps with Mer-
rill to hedge their interest in the LIBOR notes. Id. at 330.
Between August 31 and September 28 AlliedSignal borrowed
$435 million from ASA, using the proceeds to repay the debt
incurred August 2; this indebtedness was paid off May 1,
1992.
On August 21 the partnership authorized a distribution of
the LIBOR notes to AlliedSignal and ASIC, and about $116
million in cash and commercial paper to Dominguito. Id. at
331. During 1990, AlliedSignal and ASIC sold a fraction of
the LIBOR notes with a basis of $246,520,807, for a total of
$50,454,103, and reported a capital loss equal to the differ-
ence, $196,066,704. Id. That year, AlliedSignal also reported
a capital gain of $53,926,336, its share of ASA's capital gain
from the sale of the PPNs. Id.
On December 5, 1991, AlliedSignal made a direct payment
of $1,631,250 to Dominguito, representing: the difference
between ABN's funding costs and the SPCs' combined income
allocations; interest on $92 million of ABN's funds that
remained in ASA beyond the agreed upon date; and the
difference (plus interest) between the $5 million up-front
payment that ABN had requested and the $4.4 million it had
previously paid. Id.
Prior to liquidation, ABN and AlliedSignal agreed that
ABN would refund $315,000, reflecting excesses of the SPCs'
income allocations over funding costs, and of ASA's returns
from November 22, 1991 through April 30, 1992 over LIBOR.
Id. at 332. On June 1, 1992, the partners liquidated ASA.
On November 31, AlliedSignal sold its remaining LIBOR
notes for $33,431,000, and recovered the remainder of the
basis, $429,655,738, taking a capital loss of $396,234,738. Id.
In a notice of final partnership administrative adjustment
the Commissioner disallowed ASA's capital gain, reallocating
it to AlliedSignal and ASIC and thus in substance cancelling
out the tax losses otherwise enjoyed by AlliedSignal. Id. at
333. The Commissioner relied on alternative grounds: first,
ASA was not a bona fide partnership, and Barber and Domin-
guito were not correctly deemed partners; and second, the
transactions lacked "economic substance." Id.
* * *
The Tax Court agreed with the Commissioner that ASA
was not a valid partnership for tax purposes, and thus did not
reach the economic substance argument. At the outset, the
court disregarded Barber and Dominguito "[f]or purposes of
[its] analysis," Tax Court Decision, 76 T.C.M. at 333, finding
that they were merely ABN's agents. First, they were thinly
capitalized, and created just for purposes of the venture.
Second, the parties themselves treated ABN as the partner,
disregarding Barber and Dominguito. Third, Barber and
Dominguito were "mere conduits," to whom ABN lent funds
and in whom ABN owned options to purchase shares for a de
minimis amount.
Having found ABN to be the relevant party, the Tax Court
turned its attention to the question whether AlliedSignal and
ABN entered into a bona fide partnership. Although the
Internal Revenue Code provides that "the term 'partnership'
includes a syndicate, group, pool, joint venture, or other
unincorporated organization through or by means of which
any business, financial operation, or venture is carried on," 26
U.S.C. s 761, the court set out to determine whether the
formal partnership had substance, quoting the Supreme
Court's language in Commissioner v. Culbertson, 337 U.S.
733, 742 (1949), which said that the existence of the partner-
ship (for tax purposes) would depend on whether, "consider-
ing all the facts ... the parties in good faith and acting with a
business purpose intended to join together in the present
conduct of the enterprise." Applying this test, the Tax Court
concluded that AlliedSignal and ABN did not have "the
requisite intent to join together for the purpose of carrying
on a partnership." 76 T.C.M. at 335.
* * *
We review decisions of the Tax Court "in the same manner
and to the same extent as decisions of the district courts in
civil actions tried without a jury." 26 U.S.C. s 7482. Factual
findings are reviewed for clear error, see Commissioner v.
Duberstein, 363 U.S. 278, 291 (1960), and determinations of
law de novo. See United States v. Popa, 187 F.3d 672, 674
(D.C. Cir. 1999). We have held that in tax cases mixed
questions of law and fact are to be treated like questions of
fact. See Fund for the Study of Economic Growth and Tax
Reform v. IRS, 161 F.3d 755, 759 (D.C. Cir. 1998) (citing
Duberstein, 363 U.S. at 289 n.11). Petitioner poses chal-
lenges to all three types of decisions constituting the Tax
Court judgment.
Much of petitioner's opening brief is directed to an attack
on the Tax Court's reasoning. We confess that some of that
reasoning seems misdirected. For example, the court
seemed to believe that because ABN and AlliedSignal had
"divergent business goals," 76 T.C.M. at 333, they were
precluded from having the requisite intent to form a partner-
ship. We agree with petitioner that partners need not have a
common motive. In fact, the desirability of joining comple-
mentary interests in a single enterprise is surely a major
reason for creating partnerships. But we see no reason to
think that this view, mentioned only in the opinion's initial
summary and concluding paragraph, was essential to the
court's conclusion.
Some of petitioner's argument seems an exercise in seman-
tic ju jitsu. It argues that we may not consider whether the
partnership was a "sham" because the Tax Court (a) explicitly
refused to consider that, and (b) never used the word "sham."
The first point is false, the second irrelevant. Although the
Tax Court said that it would not consider whether the trans-
actions at issue lacked "economic substance," id., its decision
rejecting the bona fides of the partnership was the equivalent
of a finding that it was, for tax purposes, a "sham."
Getting to the controlling issue, petitioner argues that
under the standard established in Moline Properties, Inc. v.
Commissioner, 319 U.S. 436 (1943), the partnership cannot be
regarded as a sham. The Court there said that a corporation
remains a separate taxable entity for tax purposes "so long as
[its] purpose is the equivalent of business activity or is
followed by the carrying on of business by the corporation."
319 U.S. at 439. The Tax Court has since applied Moline to
partnership cases. See Bertoli v. Commissioner, 103 T.C.
501, 511-12 (1994).
Petitioner views Moline as establishing a two-part test,
under which a tax entity is accepted as real if either: (1) its
purpose is "the equivalent of business activity" (not tax
avoidance), or (2) it conducts business activities. Moline, 319
U.S. at 439. Because ASA "engaged in more than sufficient
business activity to be respected as a genuine entity," peti-
tioner argues that ASA was a partnership under the second
alternative. Petitioner's Reply Br. at 12. We agree if engag-
ing in business activity were sufficient to validate a partner-
ship ASA would qualify. It was infused with a substantial
amount in capital ($1.1 billion), and invested it in PPNs,
LIBOR notes, and other short-term notes over a period of
two years. In fact, however, courts have understood the
"business activity" reference in Moline to exclude activity
whose sole purpose is tax avoidance. This reading treats
"sham entity" cases the same way the law treats "sham
transaction" cases, in which the existence of formal business
activity is a given but the inquiry turns on the existence of a
nontax business motive. See Knetsch v. United States, 364
U.S. 361, 364-66 (1960). Thus, what the petitioner alleges to
be a two-pronged inquiry is in fact a unitary test--whether
the "sham" be in the entity or the transaction--under which
the absence of a nontax business purpose is fatal.4
Shortly after Moline the Second Circuit held per Judge
Learned Hand in National Investors Corp. v. Hoey, 144 F.2d
466 (2d Cir. 1944), that the retention and sale of securities,
after the date when the corporate holding had served its
__________
4 Indeed, one might logically enough place the Tax Court's
findings here under the "sham transaction" heading, viewing the
formation of the partnership as the transaction. Because of the
ultimate unity of the tests, however, there is no need to address this
formulation.
nontax goals, could not be considered for tax purposes.
There an investment trust corporation proposed to merge
with its subsidiaries. To this end it created a new corpora-
tion into which it transferred its interests in the subsidiaries
in exchange for 10 shares of stock. But the stockholders
decided to reject the plan to unify the four corporations. The
investment trust then liquidated the new corporation, starting
with an exchange of 10% of the new corporation's shares and
taking a deduction based on the difference between the value
of 10% of the shares when originally issued to the trust, and
10% of their reduced value a year later. In initiating even
this 10% liquidation, however, it delayed for some time after
the shareholders' vote. The court held that the trust was
entitled to a deduction only for value decreases incurred from
the time of the original transfer of assets to the corporation
to "a reasonable time" after the stockholders rejected the
plan. Id. at 468. Thereafter, "there was no longer any
business for [the corporation] to do." Id. Retention of the
corporation merely for the purpose of tax minimization was
not enough. The court explicitly read the cases as saying
that "the term 'corporation' will be interpreted to mean a
corporation which does some 'business' in the ordinary mean-
ing, and that escaping taxation is not 'business' in the ordi-
nary meaning." Id. So too, for ASA: Although its invest-
ment in LIBOR notes might have had a business purpose, the
prior three-week investment in and subsequent sale of PPNs
was, like the retention of assets in Hoey, a business activity
merely conducted for tax purposes.5 Moreover, as discussed
later, AlliedSignal's interest in any potential gain from the
partnership's investments was in its view at all times dwarfed
by its interest in the tax benefit.
__________
5 The PPNs cost $850 million. When an expert was later
engaged by AlliedSignal to evaluate the partnership's gains and
losses, AlliedSignal asked that he assign to the LIBOR notes a
value which, together with the cash, would bring the total value of
the proceeds of the PPNs to $850 million. See J.A. 1343. Allied-
Signal evidently did not believe that the initial investment in PPNs
increased the return from the transactions in the aggregate.
The Ninth Circuit has similarly held that "business activi-
ty" is inadequate in the absence of a nontax business purpose.
In Zmuda v. Commissioner, 731 F.2d 1417 (9th Cir. 1984),
the taxpayers argued that the Tax Court incorrectly applied
the "economic substance" rule rather than the "business
purpose" rule. The court found that the taxpayer's argument
"attempts to create a distinction where none exists. There is
no real difference between the business purpose and the
economic substance rules. Both simply state that the Com-
missioner may look beyond the form of an action to discover
its substance." Id. at 1420. The court went on to say:
The terminology of one rule may appear in the context of
the other because they share the same rationale. Both
rules elevate the substance of an action over its form.
Although the taxpayer may structure a transaction so
that it satisfies the formal requirements of the Internal
Revenue Code, the Commissioner may deny legal effect
to a transaction if its sole purpose is to evade taxation.
Id. at 1421. At issue was the validity of certain trusts, so the
court's equation of the "transaction" test and the "entity" test
was clearly a holding.
We note that the "business purpose" doctrine is hazardous.
It is uniformly recognized that taxpayers are entitled to
structure their transactions in such a way as to minimize tax.
When the business purpose doctrine is violated, such struc-
turing is deemed to have gotten out of hand, to have been
carried to such extreme lengths that the business purpose is
no more than a facade. But there is no absolutely clear line
between the two. Yet the doctrine seems essential. A tax
system of rather high rates gives a multitude of clever
individuals in the private sector powerful incentives to game
the system. Even the smartest drafters of legislation and
regulation cannot be expected to anticipate every device.
The business purpose doctrine reduces the incentive to en-
gage in such essentially wasteful activity, and in addition
helps achieve reasonable equity among taxpayers who are
similarly situated--in every respect except for differing in-
vestments in tax avoidance.
Thus the Tax Court was, we think, sound in its basic
inquiry, trying to decide whether, all facts considered, the
parties intended to join together as partners to conduct
business activity for a purpose other than tax avoidance. Its
focus was primarily on ABN, curiously. As we shall discuss
later, the absence of a nontax business purpose was even
clearer for AlliedSignal. Nonetheless, given ABN's protec-
tion from risk, and even from the borrowing costs of provid-
ing its capital contribution, there was no clear error in the
finding that its participation was formal rather than substan-
tive.6 Petitioner alleges two primary ways in which the Tax
Court erred in this regard.
First, petitioner says that the Tax Court incorrectly found
that Barber and Dominguito were mere agents of ABN
rather than partners in their own right. But this issue of
classification makes no material difference. Once the court
decided that the SPCs were mere conduits for ABN, it shifted
its focus to whether AlliedSignal and ABN (rather than the
SPCs) formed a bona fide partnership. There was certainly
no clear error in the court's view of the SPCs as being within
the complete control of ABN, and there is no indication as to
how the SPCs' intent as to the "partnership" differed from
that of ABN.
Second, petitioner argues that the Tax Court erred by
finding that ABN did not share in profits and losses because
it received a specified return from AlliedSignal and hedged
against risk through swap transactions with Merrill. On the
profit side, we find no clear error in the court's findings that
the direct payments made to ABN were to compensate it
merely for its funding costs. Petitioner says that there was
no explicit agreement that ABN would receive a return of
LIBOR plus 75 basis points, pointing to the fact that the
payments actually made by AlliedSignal to ABN did not
__________
6 Although petitioner argues that ABN's purpose was not tax-
avoidance, but rather "included a desire to enhance its business
relationship with AlliedSignal," Petitioner's Initial Br. at 41 n.19,
the desire to aid another party in tax avoidance is no more a
business purpose than actually engaging in tax avoidance.
produce such a return. See Petitioner's Brief at 59; supra
note 2. But petitioner makes no argument that these pay-
ments were related to the success of the partnership's invest-
ments (i.e., the PPNs and LIBOR notes), and under the
circumstances it is reasonable to infer that they were made
pursuant to a pre-arranged agreement to compensate ABN
for its funding costs (plus some amount above LIBOR, even if
not 75 basis points).
Den Baas's testimony, moreover, confirms that ABN could
make no profit from the transaction: any potential profit
from the LIBOR notes would be offset by losses from the
concomitant swap transactions. Petitioner cites Hunt v.
Commissioner, 59 T.C.M. (CCH) 635 (1990), for the proposi-
tion that a guaranteed return is not inconsistent with partner-
ship status. In Hunt, however, both parties had a bona fide
business purpose for entering into the partnership, and unlike
in the case at hand, the guaranteed return created a floor but
not a ceiling. See id. at 648.
Turning to the risk of loss, we agree with the Tax Court
that any risks inherent in ABN's investment were de minimis.
As a preliminary matter, the court did not err by carving out
an exception for de minimis risks, as no investment is entirely
without risk. Unless one posited a particular asset (such as
the dollar) as the sole standard, its value could change in
relation to the values of other assets, and treating one--even
the dollar--as the sole standard would be arbitrary. The Tax
Court's decision not to consider ABN's "de minimis" risk is
also consistent with the Supreme Court's view, albeit in the
"sham transaction" context, that a transaction will be disre-
garded if it did "not appreciably affect [taxpayer's] beneficial
interest except to reduce his tax." Knetsch, 364 U.S. at 366
(emphasis added) (quoting Gilbert v. Commissioner, 248 F.2d
399, 411 (2d Cir. 1957) (Hand, C.J., dissenting)).
There was no clear error in the Tax Court's determination
that at no point during the transaction did ABN assume
greater than de minimis risk. The PPNs were essentially
risk free: not only were they issued by banks with the
highest credit ratings but they were held for a mere three
weeks. Moreover, because of the side agreement under
which any loss on the PPNs would be embedded in the value
of the LIBOR notes, AlliedSignal would bear any shortfall
over the brief period in which PPNs were held. Petitioner
argues that ABN was subject to the risk that AlliedSignal
would ultimately decide not to acquire the LIBOR notes.
This seems unlikely to the point of triviality, however, for two
reasons: first, this step was integral to AlliedSignal's tax
objective, and to the entire transaction; and second, at the
point when the LIBOR notes would be distributed, Domingui-
to still owned over 40% of ASA, and according to the partner-
ship agreement, any act of the partnership committee would
require the consent of partners whose interest equaled or
exceeded 95%. Nor was there any real hazard that Allied-
Signal might agree to distribute the LIBOR notes but refuse
to make the adjustment for any loss on the PPNs: as den
Baas had stated in a memorandum to ABN officials, the SPCs
could counter by refusing consent for the distribution of the
notes altogether.
The LIBOR notes certainly had greater inherent risk than
the short-term PPNs; ABN, however, entered into hedge
transactions outside the partnership to reduce the risk to a de
minimis amount. In fact, the correlation between the swaps
and the LIBOR notes was 99.999%, i.e., the company succeed-
ed in hedging all but a de minimis amount of the risk
associated with the LIBOR notes. Petitioner concedes that
"the hedges provided the ABN parties with substantial pro-
tection from fluctuations in LIBOR Note value due to move-
ments in interest rates." Petitioner's Reply Br. at 18. But
ASA nevertheless contends that ABN still bore the credit risk
associated with the issuers of the LIBOR notes and with
Merrill, which provided the hedges. Once again, we find that
the Tax Court correctly found the risk to be de minimis: the
LIBOR notes were issued by banks having a credit rating of
AAA and AA+, and were held by ASA for only three months.
So too, the risk associated with the swaps with Merrill (a
single-A rated institution) was de minimis. Finally, there was
little, if any, risk associated with the commercial paper that
ASA held at this point, which although unhedged, was found
by the Tax Court to be "AAA-rated, short-term, and from
multiple issuers." Tax Court Decision, 76 T.C.M. at 335.
Petitioner argues that ABN's side-transactions should not
be considered in deciding whether a bona fide partnership
was formed. It draws an analogy to a partnership which
owns an uninsured building later destroyed by fire; this
partnership is bona fide even if one partner had insured
against his portion of the loss. The analogy, though imagina-
tive, is not very telling. The insurance in the hypothetical is
comparatively narrow, leaving a considerable range of poten-
tial business hazards and opportunities for profit. Contrast
den Baas's observation at the outset of the present plan:
"Credit risk: The structure demands that virtually no credit
risk will be taken in the partnership since any defaults on the
principal of the investments will jeopardize the objective....
Market interest rate risk: ABN New york [sic] will take care
of perfect hedges in order to protect the bank from the
changes in the value of the underlying securities.... due to
interest rate fluctuations." J.A. 680-81. We note, moreover,
that petitioner directs us to no evidence that ABN even bore
the cost of these hedges. Given that Merrill, which had
orchestrated the entire transaction and to whom AlliedSignal
had paid a substantial sum, engaged in the swap transactions,
it is likely that AlliedSignal assumed the costs of the swaps.
A partner whose risks are all insured at the expense of
another partner hardly fits within the traditional notion of
partnership.
Petitioner argues that the Tax Court also erred in deter-
mining that ABN's capital contribution constituted a loan.
We need not pass on this question because it is quite periph-
eral to the central issue of whether the parties entered into a
bona fide partnership.
We noted earlier that the Tax Court's focus on ABN's
intentions was a little puzzling. AlliedSignal, after all, was
the driving force and AlliedSignal focused on tax minimization
to the virtual exclusion of ordinary business goals. Of course
no one wants to pay more than necessary, even for a very
profitable tax minimization scheme, and the petitioner argues
that even with the very substantial transaction costs associat-
ed with the partnership, AlliedSignal had grounds for expect-
ing that it would come out more than $15 million ahead. As it
proved, transaction costs were almost $25 million rather than
the roughly $12 million it anticipated, Tax Court Decision, 76
T.C.M at 326, 332, so the ultimate financial gain, according to
the parties, was actually about $3.6 million. The expected
gain turned on the belief of Roger Matthews, AlliedSignal's
assistant treasurer--which proved correct--that interest
rates would shift in such a way that, when all the swaps were
taken into account, AlliedSignal would benefit. But this
evidence says nothing about AlliedSignal's use of the elabo-
rate partnership--with a pair of partners concocted for the
occasion. There is no reason to believe that AlliedSignal
could not have realized Matthews's interest rate play without
the partnership at far, far lower transactions costs. For the
deal overall, the most telling evidence is the testimony of
AlliedSignal's Chairman and CEO, who could not "recall any
talk or any estimates of how much profit [the transaction]
would generate." The Tax Court concluded that none of the
supposed partners had the intent to form a real partnership,
a conclusion that undoubtedly encompasses AlliedSignal.
And the record amply supports that finding.
The decision of the Tax Court is
Affirmed.