Opinion

ACM Partnership v. Commissioner IRS (Part II)

157 F.3d 231

Court: Court of Appeals for the Third Circuit
Filed: Oct 13, 1998
On the bench: Greenberg, Alito, McKee
Cited by: 1 cases
Authority: More cited than 40.0%

The opinion

Opinions of the United

1998 Decisions States Court of Appeals

for the Third Circuit

10-13-1998

ACM Partnership v. Commissioner IRS (Part II)

Precedential or Non-Precedential:

Docket 97-7484,97-7527

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Volume 2 of 2

Filed October 13, 1998

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

Nos. 97-7484 and 97-7527

ACM PARTNERSHIP,

SOUTHAMPTON-HAMILTON COMPANY,

TAX MATTERS PARTNER,

Appellant in No. 97-7484

COMMISSIONER OF INTERNAL REVENUE

ACM PARTNERSHIP,

SOUTHAMPTON-HAMILTON COMPANY,

TAX MATTERS PARTNER,

COMMISSIONER OF INTERNAL REVENUE

Appellant in No. 97-7527

On Appeal from the United States Tax Court

(Tax Court No. 10472-93)

Argued June 23, 1998

BEFORE: GREENBERG, ALITO, and McKEE,

Circuit Judges

(Filed October 13, 1998)

These findings, which are amply supported by the record,

demonstrate a lack of objective economic consequences

arising from ACM's offsetting acquisition and virtually

immediate disposition of the Citicorp notes.33 On November

3, 1989, ACM invested $175 million of its cash in private

placement Citicorp notes paying just three basis points

more than the cash was earning on deposit, then sold the

same notes 24 days later for consideration equal to their

purchase price, in a transaction whose terms had been

finalized by November 10, 1989, one week after ACM

acquired the notes.34 These transactions, which generated

the disputed capital losses by triggering the application of

the ratable basis recovery rule, offset one another with no

net effect on ACM's financial position. Examining the

sequence of ACM's transactions as a whole as we must in

assessing their economic substance, see Court Holding Co.,

324 U.S. at 334, 65 S.Ct. at 708; Weller, 270 F.2d at 297,

we find that these transactions had only nominal,

incidental effects on ACM's net economic position.

Viewed according to their objective economic effects

rather than their form, ACM's transactions involved only a

fleeting and economically inconsequential investment in

and offsetting divestment from the Citicorp notes. In the

course of this brief interim investment, ACM passed $175

million of its available cash through the Citicorp notes

before converting 80% of them, or $140 million, back into

cash while using the remaining 20%, or $35 million, to

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33. Because we find that the lack of objective economic consequences of

ACM's transactions, which is evident from the Tax Court's well-

supported factual findings, is essential to assessing whether the

transaction's tax consequences may be disregarded and lends significant

support to the court's ultimate finding that ACM's transactions did not

have sufficient substance to be recognized for tax purposes, we proceed

to conduct this portion of the economic substance analysis although the

Tax Court did not do so explicitly. See Northern Indiana Pub. Serv. Co.,

115 F.3d at 510 (holding that court of appeals may affirm Tax Court

decisions on any grounds found in the record regardless of Tax Court's

rationale).

34. The consideration consisted of $140 million in cash and LIBOR notes

whose present value was $34,410,814, or $35,000,000, reduced by the

transaction costs established by Merrill Lynch.

acquire an amount of LIBOR notes that was identical, apart

from transaction costs, to the amount of such notes that

ACM could have acquired by investing its $35 million in

cash directly into such assets. Thus, the transactions with

respect to the Citicorp notes left ACM in the same position

it had occupied before engaging in the offsetting acquisition

and disposition of those notes.

Just as the taxpayer in Gregory engaged in offsetting

transactions by creating a new corporation, transferring

stock to the corporation, transferring the stock back out of

the corporation and then liquidating the corporation, just

as the taxpayers in Knetsch and Weller engaged in

offsetting transactions by acquiring annuity policies and

borrowing back virtually their entire value, and just as the

taxpayers in Lerman and the other property disposition

cases engaged in inconsequential transactions by disposing

of property while retaining the opportunity to reacquire the

same or virtually identical property at the same price, so

ACM engaged in mutually offsetting transactions by

acquiring the Citicorp notes only to relinquish them a short

time later under circumstances which assured that their

principal value would remain unchanged and their interest

yield would be virtually identical to the interest yield on the

cash deposits which ACM used to acquire the Citicorp notes.35

Gregory requires us to determine the tax consequences of

a series of transactions based on what "actually occurred."

293 U.S. at 469, 55 S.Ct. at 267. Just as the Gregory Court

found that the intervening creation and dissolution of a

corporation and transfer of stock thereto and therefrom was

a "mere device which put on the form of a corporate

reorganization as a disguise for concealing its real

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35. The variable rate on the Citicorp notes presented a theoretical

possibility that the consequences of owning those notes would vary from

the consequences of leaving ACM's funds on deposit at a rate of interest

virtually identical to the initial rate on the Citicorp notes. However,

ACM's exposure to any fluctuation in the rate of return on its Citicorp

note investment was illusory, as the interest rates were scheduled to be

reset only once per month and ACM had arranged to hold the notes for

only 24 days, encompassing only one interest rate adjustment on

November 15 that would affect the notes for only 12 days before their

disposition. See 73 T.C.M. at 2200.

character" which amounts to a mere "transfer .. . of

corporate shares to the [taxpayer]," so we find that ACM's

intervening acquisition and disposition of the Citicorp notes

was a mere device to create the appearance of a contingent

installment sale despite the transaction's actual character

as an investment of $35 million in cash into a roughly

equivalent amount of LIBOR notes.36 Thus, the acquisition

and disposition of the qualifying private placement Citicorp

notes, based upon which ACM characterized its

transactions as a contingent installment sale subject to the

ratable basis recovery rule, had no effect on ACM's net

economic position or non-tax business interests and thus,

as the Tax Court properly found, did not constitute an

economically substantive transaction that may be respected

for tax purposes. See Gregory, 293 U.S. at 469-70, 55 S.Ct.

at 267-68; Knetsch, 364 U.S. at 366; Lerman, 939 F.2d 44;

Weller, 270 F.3d at 297.37

ACM contends that the Tax Court was bound to respect

the tax consequences of ACM's exchange of Citicorp notes

for LIBOR notes because, under Cottage Sav. Ass'n v.

Commissioner, 499 U.S. 554, 111 S.Ct. 1503 (1991), an

exchange of property for "materially different" assets is a

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36. ACM emphasizes that the total consideration it was to receive in

exchange for the Citicorp notes genuinely was contingent, in substance

as well as in form, because the amount depended on afluctuating

market variable "precisely [as] the statute and the regulations

anticipated." Br. at 31-32. However, the receipt of genuinely contingent

payments is necessary but not sufficient to trigger the application of the

ratable basis recovery rule which applies only in the context of a

contingent installment sale. Absent an economically substantive

disposition of qualifying property, the transactions do not constitute a

bona fide contingent installment sale within the meaning of the

provisions which ACM seeks to invoke. See I.R.C. SS 453(b), 453(k);

Temp. Treas. Reg. S 15a.453-1(c).

37. As discussed above, each of these cases involved objective acts which

satisfied the technical requirements of the Internal Revenue Code

provisions that the taxpayer sought to invoke, but which the courts

disregarded for tax purposes because they lacked any net effect on the

taxpayer's economic position or non-tax business interests. Accordingly,

we are unpersuaded by ACM's argument that its transactions must be

regarded as economically substantive because it actually and objectively

engaged in them. See br. at 21.

substantive disposition whose tax effects must be

recognized. We find Cottage Savings inapposite. The

taxpayer in that case, a savings and loan association,

owned fixed-rate mortgages whose value had declined as

interest rates had risen during the preceding decade. The

taxpayer simultaneously sold those mortgages and

purchased other mortgages which were approximately equal

in fair market value, but far lower in face value, than the

mortgages which the taxpayer relinquished. The Court

found that the exchange for different mortgages of

equivalent value afforded the taxpayer "legally distinct

entitlements," and thus was a substantive disposition

which entitled the taxpayer to deduct its losses resulting

from the decline in value of the mortgages during the time

that the taxpayer held them. Id. at 566, 111 S.Ct. at 1511.

The distinctions between the exchange at issue in this

case and the exchange before the Court in Cottage Savings

predominate over any superficial similarities between the

two transactions. The taxpayer in Cottage Savings had an

economically substantive investment in assets which it had

acquired a number of years earlier in the course of its

ordinary business operations and which had declined in

actual economic value by over $2 million from

approximately $6.9 million to approximately $4.5 million

from the time of acquisition to the time of disposition. See

Cottage Sav., 499 U.S. at 557-58, 111 S.Ct. at 1506. The

taxpayer's relinquishment of assets so altered in actual

economic value over the course of a long-term investment

stands in stark contrast to ACM's relinquishment of assets

that it had acquired 24 days earlier under circumstances

which assured that their principal value would remain

constant and that their interest payments would not vary

materially from those generated by ACM's cash deposits.38

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38. In Lerman, 939 F.2d at 55-56 & n.14, we observed that Cottage

Savings involved the relinquishment of assets whose value had declined

by over $2 million. Because the transaction in Cottage Savings brought

about the realization of a $2 million economic loss resulting from the

disposition of depreciated assets in which the taxpayer had an

economically substantive investment, we reject ACM's contention, see

reply br. at 15, that the case recognized as an economically substantive

loss any tax loss arising from a transaction in which the taxpayer

disposes of property in an arms'-length transaction. The Cottage Savings

Court had no occasion to address a transaction like that before us in

which the taxpayer relinquished property after a minimal holding period

with no intervening change in economic value.

While the dispositions in Cottage Savings and in this case

appear similar in that the taxpayer exchanged the assets

for other assets with the same net present value, beneath

this similarity lies the more fundamental distinction that

the disposition in Cottage Savings precipitated the

realization of actual economic losses arising from a long-

term, economically significant investment, while the

disposition in this case was without economic effect as it

merely terminated a fleeting and economically

inconsequential investment, effectively returning ACM to

the same economic position it had occupied before the

notes' acquisition 24 days earlier.39

As the Supreme Court emphasized in Cottage Savings,

deductions are allowable only where the taxpayer has

sustained a " `bona fide' " loss as determined by its

" `[s]ubstance and not mere form.' " 499 U.S. at 567-68, 111

S.Ct. at 1511 (quoting Treas. Reg. S 1.165-1(b)). According

to ACM's own synopsis of the transactions, the contingent

installment exchange would not generate actual economic

losses. Rather, ACM would sell the Citicorp notes for the

same price at which they were acquired, see app. at 275-

77, 321, 300, generating only tax losses which offset

precisely the tax gains reported earlier in the transaction

with no net loss or gain from the disposition. See app. at

301.40 Tax losses such as these, which are purely an

artifact of tax accounting methods and which do not

correspond to any actual economic losses, do not constitute

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39. ACM contends that its disposition of the Citicorp notes was

substantive because it "relinquished the benefits and burdens of owning

the Citicorp notes for the distinct benefits and burdens of owning $140

million of cash and the LIBOR notes." Br. at 28. This argument,

however, erroneously assumes that ACM had acquired the benefits and

burdens associated with the Citicorp notes in an economically

substantive sense, when in reality ACM's brief investment in and

offsetting divestment from these assets exposed ACM only to de minimis

risk of changes in principal value or interest rates.

40. The participation of a foreign partner that was impervious to tax

considerations and that claimed most of the reported gains while

allocating to Colgate virtually all of the losses allowed Colgate as ACM's

major U.S. partner to reap the benefits of the tax losses without

sustaining the burdens of the offsetting tax gains.

the type of "bona fide" losses that are deductible under the

Internal Revenue Code and regulations.

While ACM contends that "it would be absurd to

conclude that the application of the Commissioner's own

[ratable basis recovery] regulations results in gains or

losses that the Commissioner can then deem to be other

than `bona fide,' " reply br. at 14, its argument confounds

a tax accounting regulation which merely prescribes a

method for reporting otherwise existing deductible losses

that are realized over several years with a substantive

deductibility provision authorizing the deduction of certain

losses. In order to be deductible, a loss must reflect actual

economic consequences sustained in an economically

substantive transaction and cannot result solely from the

application of a tax accounting rule to bifurcate a loss

component of a transaction from its offsetting gain

component to generate an artificial loss which, as the Tax

Court found, is "not economically inherent in" the

transaction. 73 T.C.M. at 2215.41 Based on our review of

the record regarding the objective economic consequences

of ACM's short-swing, offsetting investment in and

divestment from the Citicorp notes, we find ample support

for the Tax Court's determination that ACM's transactions

generated only "phantom losses" which cannot form the

basis of a capital loss deduction under the Internal

Revenue Code.42

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41. Because the ratable basis recovery rule simply provides a method for

reporting otherwise existing economically substantive losses, we find it

irrelevant that the rule recognizes that its application could

"inappropriately defer or accelerate recovery of the taxpayer's basis,"

resulting in " `substantial distortion' " of the tax consequences realized

any particular year of a transaction. See ACM br. at 32-34 (quoting

Temp. Treas. Reg. SS 15a.453-1(c)(3), (c)(7)). While the rule contemplates

some distortion as to the timing of when actual gains or losses are

reported over the span of a contingent installment sale, it does not

contemplate the reporting of losses which are not the bona fide result of

an economically substantive transaction. Thus, contrary to ACM's

argument, the tax losses it reported are not "precisely what the

[regulations] intended." See br. at 33.

42. Having found ample support for the Tax Court's conclusion that

ACM's transactions lacked economic substance and thus cannot give rise

3. Subjective Aspects of the Economic Sham Analysis

In making its determination that it did "not find any

economic substance" in ACM's transactions, the Tax Court

relied extensively on evidence that the transactions were

not intended to serve any "useful non-tax purpose" and

were not reasonably expected to generate a pre-tax profit.

See 73 T.C.M. at 2215, 2229. ACM contends, br. at 34, that

the Tax Court improperly conducted a "generic tax-

independent" inquiry into the non-tax purposes and

potential pre-tax profitability of the transaction based on a

misapplication of Gregory, 293 U.S. at 469, 55 S.Ct. at 267.

According to ACM, the Tax Court mistook Gregory's

scrutiny of the "business or corporate purpose" behind the

transaction for a universally applicable aspect of the

economic substance analysis when in reality, ACM

contends, Gregory undertook this inquiry only because the

specific Internal Revenue Code provision there at issue

required that the transaction be effected "pursuant to a

plan of reorganization." See br. at 20-23 (citing Gregory,

293 U.S. at 469, 55 S.Ct. at 267). Thus, ACM argues, the

Tax Court erred in considering the intended purpose and

expected profitability of the transactions in this case where

the relevant provisions providing for the gain or loss on

sales or exchanges of property, I.R.C. S 1001, and for the

treatment of installment sales, I.R.C. S 453, do not require

a particular business purpose or profit motive. See id.

We disagree, and find that the Tax Court's analysis

properly rested on economic substance cases applying

provisions which, like those relevant in this case, do not by

their terms require a business purpose or profit motive. In

Goldstein v. Commissioner, 364 F.2d 734, 736 (2d Cir.

1966), the court analyzed the economic substance of a

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to taxable gains or deductible losses regardless of how those gains and

losses are allocated, we need not address the Commissioner's alternative

argument that the tax consequences of the transaction must be

disregarded because ACM's partnership structure artificially "bifurcat[ed]

the tax consequences of the transaction" by allocating taxable gains to

a foreign partner and offsetting tax losses to the taxpayer in a manner

which the relevant statute and regulations did not intend. See br. at 32-

34.

transaction under I.R.C. S 163(a), which provides, in purely

objective terms without reference to a business purpose or

profit motive, that "[t]here shall be allowed as a deduction

all interest paid or accrued within a taxable year on

indebtedness." The Goldstein court acknowledged that this

broad language did not require "that the deductible interest

serve a business purpose, that it be ordinary and

necessary, or even that it be reasonable," but found that

the language did not permit deductions arising from a

transaction that had "no substance or purpose aside from

the taxpayer's desire to obtain the tax benefit of an interest

deduction." Id. at 741-42. Thus, the court found, the

taxpayer was not entitled to deduct her substantial interest

charges, although they had accrued in an arms'-length

transaction, because she had incurred the underlying debt

for the sole purpose of generating a tax deduction to offset

other income.43

Likewise, in Wexler, 31 F.3d 117, we considered and

rejected the taxpayer's argument that a transaction need

not further any non-tax objectives or hold any profit

potential where the governing statutory provisions do not

"require that the deductions they provide for arise from

transactions having a business purpose or profit motive."

Id. at 122. Despite the broad statutory language allowing

the deduction of "all interest paid or accrued . . . on

indebtedness," I.R.C. S 163(a), we concluded that interest

charges were not deductible if they arose from a transaction

"entered into without expectation of economic profit and

[with] no purpose beyond creating tax deductions." Id. at

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43. ACM seeks to distinguish Goldstein on the grounds that it involved

a transaction which lacked objective economic effect because

"economically, [the taxpayer's] activities netted zero." However, contrary

to ACM's contention that it "bore all of the benefits and burdens of the

ownership of . . . the Citicorp Notes and then the cash and LIBOR Notes,

and stood to recognize true economic gain or loss from holding those

assets," reply br. at 5-6, we find that the critical parts of ACM's

transactions also "netted zero" because its acquisition and offsetting

disposition of the Citicorp notes had no net effect on its economic

position. Thus, we reject ACM's attempt to distinguish Goldstein which,

like the Tax Court opinion in this case, analyzed the taxpayer's intended

purposes as well as the transaction's economic effects.

123-24 (citations omitted). We emphasized that interest

payments "are not deductible where the underlying

transaction has no purpose other than tax avoidance" even

if the governing statutory language "had no express

business-purpose requirement." Id. at 124 (citations

omitted).44 Thus, we find no merit in ACM's argument that

the Tax Court erred as a matter of law by scrutinizing the

asserted business purposes and profit motives behind

ACM's transactions, and we turn to the question of whether

the court erred in finding that the transactions were not

intended to serve ACM's professed non-tax purposes and

were not reasonably expected to generate a pre-tax profit.

4. Intended Purposes and Anticipated Profitability of ACM's

Transactions

Before the Tax Court, ACM conceded that there were tax

objectives behind its transactions but contended that "tax-

independent considerations informed and justified each

step of the strategy." 73 T.C.M. at 2217. ACM asserted that

its transactions, in addition to presenting "a realistic

prospect that ACM would have made a profit" on a pre-tax

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44. Because the intended purposes behind a transaction are relevant in

assessing its economic substance even where the statute is drafted in

broad terms that do not require a particular intent or purpose, we are

unpersuaded by ACM's argument that its transactions must be

respected as economically substantive because I.R.C.S 1001, which

provides for the recognition of gain or loss "on the sale or exchange of

property" was intended to encompass "all exchanges." See br. at 23-25

(citing H.R. Rep. No. 179, 68th Cong., 1st Sess., at 13 (1924)). ACM

emphasizes, br. at 25-27, that the Supreme Court in Cottage Savings,

499 U.S. 554, 111 S.Ct. at 1503, recognized the tax effects of a

disposition that was motivated solely by tax considerations and was not

expected to generate a pre-tax profit. As discussed above, however, the

transaction in Cottage Savings had objective economic substance

because it resulted in the realization of actual economic losses arising

from a $2 million decline in market value of the property exchanged.

Where such objective economic effects are lacking, scrutiny of the

subjective intent behind the transactions becomes an important means

of determining whether the transactions constitute a scheme with "no

purpose other than tax avoidance" that may not give rise to deductible

losses even where the statute contains no express requirement that the

transaction serve a non-tax business purpose. Wexler, 31 F.3d at 124.

basis, also served the tax-independent purposes of

providing an interim investment until ACM needed its cash

to acquire Colgate debt and a hedge against interest rate

risk within the partnership. The Tax Court, however, found

that the record did not support ACM's assertions that the

transactions were designed either to serve these non-tax

objectives or to generate a pre-tax profit, see 73 T.C.M. at

2217-29, and for the following reasons, we agree.

a. Interim Investment

ACM contends that it invested in the Citicorp notes not

only because they qualified for treatment under the

contingent installment sale provisions and the ratable basis

recovery rule, but also because they served as an

appropriate interim investment until ACM could invest in

the Colgate debt whose acquisition, according to ACM, was

a central objective of the partnership. The Tax Court,

however, rejected this contention on the grounds that ACM

did not acquire the Citicorp notes as an interim investment

"to accommodate the timing of the acquisition of Colgate

debt; rather, it was the reverse: The acquisition of the

Colgate debt was timed so as to accommodate the

requirements of the section 453 investment strategy" which

required ACM to acquire and dispose of private placement

notes. 73 T.C.M. at 2227. This conclusion finds abundant

support in the record.

In May 1989, Merrill Lynch presented Colgate with an

initial proposal of partnership transactions intended to

generate capital losses which Colgate could use to offset

1988 capital gains. Although Merrill Lynch had not yet

incorporated the concept of using the partnership to

acquire Colgate debt issues as it did in its subsequent July

28 and August 17 proposals, its May proposal nonetheless

contemplated the acquisition and imminent disposition of

short-term securities, with no intervening change in their

economic value, in exchange for contingent installment

notes. See 73 T.C.M. at 2191; app. at 678-79, 275-77. The

fact that the acquisition and disposition of short-term notes

were central parts of the proposed partnership transactions

even before the formulation of non-tax partnership

objectives belies ACM's contention that its contingent

installment exchange of Citicorp notes was designed to

accommodate the timing of its debt acquisition strategy.

Moreover, as early as October 3, 1989, one month before

ACM was formed, Pohlschroeder reported that he had

identified the Met notes as targets for acquisition and that,

"pursuant to an inquiry to Metropolitan, we feel confident

that the partnership can purchase sufficient Colgate debt"

to serve the partnership's objectives. App. at 314. Yet,

despite this confidence that the debt was available for

purchase well in advance of ACM's formation,

Pohlschroeder did not recommend that the partnership

invest its funds directly in the identified debt issues or

finalize the terms of the anticipated debt purpose, but

rather identified as the "Next Steps" after formation of the

partnership "Short-term investment securities acquired. . . .

Disposition of short term investment securities to fund

acquisition of Colgate debt." App. at 321. In accordance

with this plan, ACM did not take any measures to pursue

the prompt purchase of these debt issues upon its receipt

of $205 million in cash contributions on November 2, 1989,

but rather, acting through Colgate, instructed Metropolitan

to attend a November 17 meeting to discuss the terms of

the sale. See 73 T.C.M. at 2227.45 Thus, we agree with the

Tax Court's finding that any delay preceding the

opportunity to acquire Colgate debt was of ACM's own

deliberate making and was intended so that ACM could

engage in the tax-motivated acquisition and disposition of

qualifying short-term notes in the contingent installment

sale that had been contemplated since before Merrill Lynch

and Colgate devised the concept of incorporating debt

acquisition objectives into Merrill Lynch's initial tax

reduction proposal.

Even if ACM had faced a delay before it could purchase

Colgate debt and thus needed to locate a suitable interim

_________________________________________________________________

45. Pohlschroeder's handwritten memorandum of October 19 indicating

that the Met Note acquisition would proceed on November 17 and that

the Long Bond and Euro Note acquisitions would proceed after

acquisition of the Citicorp notes further supports the Tax Court's

determination that ACM delayed the acquisition of the debt issues to

accommodate its tax-driven strategy of acquiring and disposing of private

placement notes in a contingent installment sale. See 73 T.C.M. at 2200.

investment, the Citicorp notes ill served the professed

purpose of holding cash assets in anticipation of an

impending purchase. The notes, which in order to qualify

for treatment in a contingent installment sale could not be

traded on an established market, see I.R.C. S 453(k)(2)(A),

were highly illiquid and thus could not be converted back

into the cash needed to purchase Colgate debt without

significant transaction costs in the form of the bid-ask

spread which Merrill Lynch deemed necessary to market

the notes to third parties. These transaction costs rendered

the illiquid Citicorp notes paying 8.78% significantly less

advantageous as an interim investment than the fully liquid

cash deposit account paying 8.75%. Accordingly, wefind no

error in the Tax Court's conclusion that ACM's brief

investment in the Citicorp notes was motivated by the

pursuit of the tax advantages of a contingent installment

sale rather than by a need for an interim investment

pending its acquisition of Colgate debt. See 73 T.C.M. at

2227-29.

b. Hedge Against Interest Rate Risk

The Tax Court also rejected ACM's contention that it

invested in LIBOR notes not only because they generated

the contingent payments necessary to trigger the

application of the ratable basis recovery rule, but also

because they were an appropriate hedge against the

interest rate exposure brought about by ACM's investment

in Colgate debt issues. As the court explained, ACM's

asserted rationale of hedging against other assets within

the partnership would "defeat [the] very purpose" which

Colgate had advanced for pursuing a debt acquisition

partnership in the first instance. 73 T.C.M. at 2222. The

court accurately noted that Colgate had entered into the

partnership based on a prediction of falling interest rates

and had justified its plan to acquire fixed-rate Colgate debt

issues on the grounds that as interest rates declined, these

issues would appreciate in value to ACM as the obligee,

thus offsetting, through Colgate's share in ACM, the

increased burdens that Colgate effectively would sustain as

the obligor on those instruments if market interest rates fell

further below the fixed rate established on these

obligations. See 73 T.C.M. at 2192-93, 2221-25; app. at

311, 666-68, 880-82, 2762-63, 2765, 2769-70.

While the acquisition of Colgate debt furthered this

professed goal of decreasing the exposure associated with

Colgate's fixed rate long term debt structure outside of the

partnership, the acquisition of the LIBOR notes, whose

value would decline as interest rates declined, conversely

increased ACM's exposure to falling interest rates, offsetting

the desired effect of the debt acquisition program which

purportedly was a fundamental partnership objective. See

T.C.M. at 2221; app. at 311. Accordingly, the LIBOR notes,

by hedging against the Colgate debt issues acquired within

the partnership, negated the potential benefit of ACM's

acquisition of these issues as a hedge against Colgate's

interest rate exposure outside the partnership.

The fact that the interest rate exposure resulting from the

LIBOR notes undermined rather than furthered the

partnership's purported debt management objectives is also

evident from the fact that Colgate reserved the option under

the partnership agreement to elect to increase its share in

changes in the value of the Colgate debt issues attributable

to fluctuations in market interest rates, and exercised this

option on several occasions. See app. at 101. Because the

value of the fixed-rate Colgate debt issues increased in

inverse proportion to interest rates, Colgate's exercise of

this option reflects a prediction of falling interest rates

which would result in risk to Colgate through its liabilities

outside the partnership but would benefit Colgate through

its interest in the assets held within the partnership. The

acquisition of LIBOR notes, whose value depended in direct

proportion on interest rates, effectively would dilute the

benefits which the partnership was intended to yield and

which Colgate sought to maximize by exercising its options

under the partnership agreement. Thus, we find

considerable support in the record for the Tax Court's

conclusion that the acquisition of the LIBOR notes operated

to "defeat [the] very purpose" which ACM had advanced as

a tax-independent justification for its sequence of

investments.

Although ACM meticulously set forth, in

contemporaneously recorded documents, tax-independent

rationales for each of its transactions with respect to the

Citicorp notes and LIBOR notes,46 these stated rationales

cannot withstand scrutiny in light of the stated purposes

behind the partnership itself, because the investment in the

Citicorp notes impeded rather than advanced ACM's

professed goal of making its cash available to acquire

Colgate debt issues, just as the investment in the LIBOR

notes impeded rather than advanced the professed goal of

acquiring partnership assets that would hedge against

Colgate's exposure to declining interest rates outside the

partnership.47 Accordingly, wefind no error in the Tax

Court's determination that the transactions "served no

useful non-tax purpose," 73 T.C.M. at 2229, and thus

constituted the type of scheme with "no purpose other than

tax avoidance" that lacks the economic substance

necessary to give rise to a deductible loss. Wexler, 31 F.3d

at 124.48

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46. See app. at 386-87 (authorizing investment in "private placement"

notes as an investment "pending the acquisition" of Colgate debt issues);

app. at 391 (recommending sale of Citicorp notes to generate cash

needed to acquire Colgate debt and acquisition of LIBOR notes to hedge

risks associated with Colgate debt); app. at 397 (advising reduction of

LIBOR note holdings in light of reduced need for hedging within

partnership); app. at 408-09 (recommending disposition of remaining

"highly volatile" LIBOR notes in light of Colgate's increased partnership

interest which eliminated need for hedge within partnership).

47. The rationales set forth in ACM's contemporaneous records are

particularly implausible in light of the documents prepared between May

and October 1989, before ACM's formation, which propose an identical

sequence of transactions far in advance of the events which, according

to memoranda and minutes recorded during the operation of the

partnership, prompted each ensuing step in the series of transactions.

See 71 T.C.M. at 2191; app. at 678-79, 275-79, 310-21, 296-308.

48. While ACM purported to combine the tax avoidance objectives of

Merrill Lynch's initial May 1989 proposal with the non-tax debt

acquisition objectives incorporated into subsequent proposals, ACM's

pursuit of these two distinct objectives within the same partnership

cannot obscure the fact that the contingent installment exchange, which

was solely responsible for the tax consequences at issue, was executed

independently of, did not further, and in fact impeded ACM's pursuit of

its non-tax debt acquisition objectives, because the Citicorp notes placed

the cash needed to acquire Colgate debt into illiquid instruments whose

c. Anticipated Profitability

In addition to rejecting ACM's asserted non-tax

justifications for its sequence of investments and

dispositions, the Tax Court also rejected ACM's contention

that its transactions were reasonably expected to yield a

pre-tax profit because the court found ACM had planned

and executed its transactions without regard to their pre-

tax economic consequences. See 73 T.C.M. at 2217-21. The

evidence in the record overwhelmingly supports this

conclusion.49 The documents outlining the proposed

transactions, while quite detailed in their explication of

expected tax consequences, are devoid of such detailed

projections as to the expected rate of return on the private

placement notes and contingent payment notes that were

essential components of each proposal. See 73 T.C.M. at

2191; app. at 678-79, 263-79, 296-308.50

Moreover, ACM's partners were aware before they entered

the partnership that the planned sequence of investments

would entail over $3 million in transaction costs. See app.

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disposition cost ACM several million dollars in transaction costs while

the purchase of the LIBOR notes increased exposure to falling interest

rates, diminishing the desired effects of the debt acquisition strategy.

Thus, the non-tax motivations behind ACM's debt purchase do not alter

the fact that the contingent installment sale was motivated only by tax

avoidance purposes.

49. ACM, citing Sacks v. Commissioner, 69 F.3d 982, 991 (9th Cir. 1995),

argues that a transaction need not be profitable in order to be respected

for tax purposes. See br. at 24 & n.30. Sacks, however, held that,

"[w]here a transaction has economic substance, it does not become a

sham merely because it is likely to be unprofitable on a pre-tax basis,"

and found that the transaction had economic substance because it

involved a sale and leaseback of equipment used for legitimate business

purposes and it resulted in concrete changes in the parties' economic

positions. See 69 F.3d at 990-92. Thus, Sacks is inapposite in this case

where the contingent installment exchange served no non-tax business

purposes and did not materially alter ACM's economic position.

50. According to these documents, the capital gains realized in the first

year of the transaction would equal the aggregate capital losses realized

in the ensuing years, reflecting no net economic change. See app. at 279,

300-301, 305-08.

at 294. Yet Colgate, which effectively bore virtually all of

these costs pursuant to the terms of the partnership

agreement, did not attempt to assess whether the

transactions would be profitable after accounting for these

significant transaction costs. See 73 T.C.M. at 2217-18,

2204. Furthermore, while ACM planned to dispose of the

Citicorp notes after a brief holding period for an amount

equal to their purchase price, see app. at 275-77, 300, 321,

its proposed transactions contemplated holding for two

years the LIBOR notes whose principal value would decline

in the event of the falling interest rates which ACM's

partners predicted. See app. at 311, 753-55.

Thus, while the Citicorp note investment which was

essential to structuring the transaction as a contingent

installment sale was economically inconsequential, the

LIBOR note investment which was equally essential to

achieving the desired tax structure was economically

disadvantageous under the market conditions which

Colgate predicted and which actually transpired. ACM's

lack of regard for the relative costs and benefits of the

contemplated transaction and its failure to conduct a

contemporaneous profitability analysis support the Tax

Court's conclusion that ACM's transactions were not

designed or reasonably anticipated to yield a pre-tax profit,

particularly in view of the significant transactions costs

involved in exchanging illiquid private placement

instruments. See Hines v. United States, 912 F.2d 736, 739

(4th Cir. 1990).51

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51. ACM, citing its expert's opinion that ACM could have earned a profit

at market interest rates of 8%, see br. at 38 & n.47, contends that the

Tax Court erred in concluding that ACM could not have expected to earn

a profit from its transactions "under any reasonable forecast of future

interest rates." 73 T.C.M. at 2219. However, in assessing the anticipated

profitability of a transaction, tax courts properly may disregard

computations, such as those presented by ACM's expert, that were

prepared in the context of the litigation and which "had not entered into

[the taxpayer's] calculations at the outset" of the transaction.

Goldstein,

364 F.2d at 740. Because nothing in the record resembles a profitability

calculation conducted at the inception of the transaction, we find no

error in the Tax Court's determination that ACM's transactions were not

designed to generate a profit.

In light of the Tax Court's well-founded conclusion that

Colgate and ACM expected interest rates to decline,

rendering the proposed transactions unprofitable, we find it

immaterial whether, as ACM contends, the court overstated

the degree to which interest rates would have had to rise in

order for ACM to recover its transaction costs. See br. at

42-43. Even accepting ACM's assertion that it could have

recovered its costs upon a significantly smaller rise in

interest rates than that calculated by the Tax Court, this

assertion is immaterial in the event of falling interest rates

and at best demonstrates a prospect of a nominal,

incidental pre-tax profit which would not support a finding

that the transaction was designed to serve a non-tax profit

motive. See Sheldon v. Commissioner, 94 T.C. 738, 768

(1990).52

Furthermore, we find no merit in ACM's assertion that

the Tax Court improperly based its determination that the

transactions were unprofitable for Colgate on the erroneous

assumption that Colgate, directly and through

Southampton, "would continue to own only 17 percent of

ACM's assets," causing it to understate the profits Colgate

would receive toward the end of the transactions when it

would own 99.7% of the partnership. See br. at 39.53 As

_________________________________________________________________

52. Similarly, the evidence that neither Colgate nor ACM reasonably

expected to gain any pretax profit from the transaction or even

attempted to formulate a profitability projection compels us to reject

ACM's contention that the Tax Court's profitability analysis improperly

rested on a finding that ACM could have made greater profits with less

risk by pursuing alternative investments. See br. at 46. While Lemmen

v. Commissioner, 77 T.C. 1326, 1346 n.29 (1981), on which ACM relies,

emphasized that a business venture may constitute an activity engaged

in for profit within the meaning of I.R.C. S 183 even when other types of

ventures may have been more profitable, this proposition does not

preclude the Tax Court from considering, in its analysis of whether there

was a profit motive behind ACM's transactions, that the decision to

exchange Citicorp notes for LIBOR notes involved substantial transaction

costs, entailed significant risks given the anticipated falling interest

rates, and compared unfavorably to the higher profitability and lower

risk of the 8.75% cash deposit accounts which ACM affirmatively

relinquished to pursue this strategy.

53. ACM contends that the Tax Court erred by examining the

transactions' anticipated profitability from Colgate's perspective,

contrary

discussed above, however, neither ACM nor any of its

partners reasonably anticipated any profits resulting from

the relevant transactions, which entailed an economically

inconsequential investment in Citicorp notes and a

decidedly unprofitable investment in LIBOR notes whose

value would be expected to decline under

contemporaneously predicted market conditions. Because

the contingent installment exchange transaction, as

contemplated and as actually executed, yielded no

partnership profits in any amount, Colgate's percentage

share of those non-existent profits is immaterial.54

Even assuming, however, that ACM and its partners

expected to earn some measure of profits upon disposition

of the BOT LIBOR notes, any additional portion of these

profits that would redound to Colgate's benefit due to its

increased share in the partnership cannot be characterized

as an additional return on Colgate's investment in

_________________________________________________________________

to the principle that the expected profitability of partnership

transactions

must be determined "at the partnership level, rather than at the level of

the partners." Br. at 36. However, as we explained in Simon v.

Commissioner, 830 F.2d 499, 507 (3d Cir. 1987),

[a]lthough the existence of a profit objective of a partnership is

determined at the partnership level, . . . a partnership is merely

formal entity, and a determination of profit objective can only be

made with reference to the actions of those . . . who manage the

partnership affairs. . . . . [Therefore] the Tax Court did not

misapply

the profit objective test at the partnership level by looking to

the

motives and actions of those individuals that organized, structured

and conducted [partnership] operations.

In this case where ACM and its transactions were structured around

Colgate's objectives and where Colgate was to hold a 99.7% stake in any

eventual partnership profits, see 73 T.C.M. at 2190-97, 2217-19, 2221,

we find no error in the Tax Court's examination of Colgate's prospects for

profit as a means of analyzing ACM's prospects for profit.

54. ACM argues, br. at 9, that each of ACM's partners realized a positive

pre-tax return on its investment in ACM. However, we reject ACM's

attempt to equate net partnership profits with profits resulting from the

contingent installment exchange which gave rise to the tax consequences

at issue and which the Tax Court properly found, based on ample

evidence in the record, was not reasonably anticipated to generate a

profit. See 73 T.C.M. at 2218-19.

partnership assets because Colgate, directly and through

Southampton, paid well over $100 million to acquire its

increased partnership interest. See app. at 137, 769-70.55

These additional contributions far exceeded Colgate's initial

partnership investment of $35 million, undermining ACM's

assertion that any additional returns attributable to

Colgate's increased stake in the partnership properly may

be characterized as further returns on Colgate's interest in

the partnership's investments. Thus, we are unpersuaded

by ACM's contention that the Tax Court distorted its

profitability analysis by failing to account for Colgate's

increased partnership interest.

ACM also argues that the Tax Court's profitability

analysis was flawed because the court adjusted the income

expected to be generated by the LIBOR notes to its net

present value. See br. at 43. In support of its assertion that

this net present value adjustment constitutes reversible

error, ACM cites Estate of Thomas v. Commissioner, 84 T.C.

412 (1985), which noted that the issue of present value

adjustments was "not raised or briefed by the parties" and

held that absent some statutory guidance, it would not

discount the residual value of obsolete partnership assets

at the time of obsolescence to their equivalent present

values at the time the partnership was formed. The court

reasoned that discounting to present value effectively would

require that the taxpayer's investment yield a rate of return

exceeding the discount rate which, the court found, would

contravene the admonition in Treas. Reg. S 1.183-2(b)(9)

that "the availability of other investments which would yield

a higher return, or which would be more likely to be

profitable, is not evidence that an activity is not engaged in

for profit" within the meaning of I.R.C. S 183. See 84 T.C.

at 440 n.52.

We reject ACM's contention that Estate of Thomas, which

_________________________________________________________________

55. On June 25, 1991, Colgate paid Kannex $85,897,203 and

Southampton paid Kannex $15 million to purchase a portion of Kannex's

share in the partnership. On November 27, 1991, ACM redeemed

Kannex's remaining partnership interest at a cost of $100,775,915 which

Colgate borrowed against the partnership assets it was to acquire. See

app. at 137, 769-70.

construed Treasury Regulations under I.R.C. S 183,

precludes present value adjustments in the prospect-for-

profit analysis under the judicially created economic

substance doctrine.56 In transactions that are designed to

yield deferred rather than immediate returns, present value

adjustments are, as the courts have recognized, an

appropriate means of assessing the transaction's actual

and anticipated economic effects. See, e.g., Hilton v.

Commissioner, 671 F.2d 316, 317 (9th Cir. 1982) (affirming

economic substance determination based on present value

analysis of taxpayer's investments); Citizens & Southern

Corp. v. Commissioner, 91 T.C. 463, 498 (1988) (noting that

value of an acquired asset may be determined based on

future income likely to be generated that by that asset

discounted to present value), aff'd, 919 F.2d 1992 (11th

Cir. 1990); Gianaris v. Commissioner, 64 T.C.M. (CCH)

1229, 1234 (1992) ("we have consistently discounted . . .

income streams produced by [an investment] in

determining whether the taxpayer had a profit objective")

(citations omitted).

We find no basis in the law for precluding a tax court's

reliance on a present value adjustment where such an

adjustment, under the surrounding circumstances, will

serve as an accurate gauge of the reasonably expected

economic consequences of the transaction. In this case

where ACM's transactions essentially converted readily

available cash, with only a brief interim investment in the

Citicorp notes, into a stream of deferred payments, we find

that the present value adjustment played an appropriate

_________________________________________________________________

56. ACM also cites City of New York v. Commissioner, 103 T.C. 481, 487

(1994), aff 'd, 70 F.3d 142 (D.C. Cir. 1995), which analyzed whether

I.R.C. S 141, in setting forth statutory distinctions based on the amount

of bond proceeds forwarded to private parties, referred to these amounts

in absolute terms or as adjusted to present value. The court concluded

that "time value of money concepts can be applied only in the presence

of a legislative directive to do so" and found no indication that Congress

intended to refer to adjusted amounts. Id. (citation omitted). Because the

issue of whether to imply a net present value adjustment in an amount

specified in the Internal Revenue Code is distinct from the issue of

whether to consider net present value as a variable in a profitability

analysis under the economic substance doctrine, wefind City of New

York inapposite.

role in the Tax Court's analysis of the potential profitability

of the transactions. We accordingly find no error in this

aspect of the court's analysis.

ACM also avers that the Tax Court erred in excluding

from its profitability analysis "the pre-tax income resulting

from the investment of $140 million of cash received as

part of the consideration for the Citicorp Notes." Br. at 44.

We disagree. The Tax Court properly analyzed the

profitability of the transactions whose economic substance

is at issue, namely the contingent installment exchange of

Citicorp notes for LIBOR notes which gave rise to the

disputed tax consequences. Any profits arising from ACM's

investment of $140 million in cash into Colgate debt issues

did not result from the contingent installment exchange

whose economic substance is in issue. Because this sum of

cash in fact represents the portion of the proceeds from the

Citicorp notes which ACM did not invest in the contingent

installment exchange of the other $35 million in Citicorp

notes for contingent-payment LIBOR notes, any profits

derived from these funds cannot be characterized as profits

arising from the contingent installment exchange. Thus, the

Tax Court properly excluded these profits from its analysis

of the profitability of the contingent installment sale which

gave rise to the disputed capital losses.57 We find ample

_________________________________________________________________

57. For similar reasons, we reject ACM's contention, see br. at 45, that

the Tax Court erroneously excluded from its profitability analysis the

gains derived from the portion of the Citicorp notes which ACM held

until October 1991 instead of exchanging them for LIBOR notes. These

notes, like the $140 million cash proceeds of the Citicorp note

disposition, were not involved in the exchange for contingent-payment

notes. Thus, any profits generated thereby may not be considered to be

profits arising from the contingent installment sale. In fact, the

profitability of holding the Citicorp notes until 1991 when they could be

tendered to the issuer at par, ensuring recovery of their principal value,

only highlights the lack of reasonably anticipated profitability in

exchanging these notes for the LIBOR notes whose principal value was

at risk in the projected declining interest rate market. We also are

unpersuaded by ACM's contention, see id., that the Tax Court, having

excluded from its profitability analysis the gains from the Citicorp notes

held until 1991, erred by failing to exclude from its calculations a

portion of the transaction costs arising from the partnership transactions

support in the record for the Tax Court's conclusion that

ACM and its partners did not reasonably anticipate that its

contingent installment sale would generate a pre-tax profit.

Because ACM's acquisition and disposition of the Citicorp

notes in a contingent installment exchange was without

objective effect on ACM's net economic position or non-tax

objectives, and because its investments in the Citicorp

notes and LIBOR notes did not rationally serve ACM's

professed non-tax objectives or afford ACM or its partners

a reasonable prospect for pre-tax profit, we will affirm the

Tax Court's determination that the contingent installment

exchange transactions lacked economic substance and its

resulting decision providing that the capital gain and loss

at issue will not be recognized and thus disallowing

deductions arising from the application of the contingent

installment sale provisions and the ratable basis recovery

rule.

B. Actual Economic Losses

Following the entry of the Tax Court's opinion holding

that ACM's contingent installment sale did not have

sufficient economic substance to be recognized for tax

purposes, the parties submitted memoranda pursuant to

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as a whole. See id. Even if we were to subtract the 15% pro rata portion

of the transaction costs that ACM suggests were attributable to the 15%

of ACM's $205 million in Citicorp notes which were not exchanged in the

contingent sale, the resulting increase in the net yield from ACM's

transactions, totaling under $0.5 million, would not support the

conclusion that these transactions portended a reasonable prospect for

profit, particularly in light of the evidence that ACM and its partners

made no attempt to assess the transactions' profitability after

transaction costs. In any event, the Tax Court properly declined to

allocate a pro rata portion of the overall transaction costs to the

portion

of the Citicorp notes which were put to Citicorp at par in 1991, because

the most significant portion of the transaction costs arose in the course

of negotiating the structured transaction and bid-ask spread required to

market the illiquid private placement notes to third parties in the

contingent installment exchange and to remarket the LIBOR notes, and

thus was not properly attributable to the notes which ACM retained and

put to Citicorp in 1991.

Tax Court Rule 155 regarding the proper computation of

tax liabilities to be allocated by ACM pursuant to that

opinion. ACM argued that even if it was not entitled to

deduct the entire $84,997,111 in tax losses it had reported,

it was entitled to deduct the approximately $6 million

"portion of its loss that is not attributable to the installment

sale accounting and that reflects the actual economics of

the transactions in issue." App. at 3386; see also app. at

3348-51, 3385-98. The court rejected ACM's argument and

entered a final decision disallowing all deductions arising

from ACM's transactions as well as the 1989 capital gain.

See app. at 3444. ACM contends that the Tax Court

erroneously failed to recognize that ACM's ownership of the

LIBOR notes had economic substance even if the

contingent installment sale did not, and thus improperly

disallowed deductions arising from its ownership of those

notes, resulting in inconsistent tax treatment in light of

ACM's reporting of the income generated by those notes.58

We agree.

In Lerman, 939 F.2d at 45, we held that a transaction

that lacks economic substance "simply is not recognized for

federal taxation purposes, for better or for worse," and we

are not aware of any cases applying the economic

substance doctrine selectively to recognize the

consequences of a taxpayer's actions for some tax purposes

but not others. Rather, the courts have applied economic

substance principles to "give effect either to both the cost

and the income functions [of a transaction], or to neither."

Seykota v. Commissioner, 62 T.C.M. (CCH) 1116, 1118

(1991); accord Sheldon, 94 T.C. at 762 (denying interest

deduction and accordingly holding that income items

should not be recognized); Arrowhead Mountain Getaway,

_________________________________________________________________

58. Contrary to the Commissioner's suggestion, br. at 49, ACM

adequately raised before the Tax Court its contention that, as gain from

the LIBOR notes was recognized, it was entitled to deduct the

corresponding economic losses on those notes. See app. at 3386

("[d]isallowing the loss from the sale of the LIBOR Notes would be

inconsistent with recognizing the income from the payments under the

Notes"); id. at 3390 (arguing that Commissioner "should not be permitted

to . . . cause the recognition of . . . income and then disregard the same

transactions in order to deny a loss").

Ltd. v. Commissioner, 69 T.C.M. (CCH) 1805, 1822 (1995)

(holding that because transactions were economic shams

that could not give rise to deductions, amounts received in

the course of those transactions could not be characterized

as taxable income), aff'd, 119 F.3d 80 (9th Cir. 1997)

(table). Thus, we must set aside the Tax Court's decision to

the extent that it disallowed the deduction of all losses,

including actual economic losses, associated with the

LIBOR notes without adjusting for the taxes paid on the

approximately $2.3 million of interest income generated by

the same notes. See app. at 3444, 3390.

While it is clear that the income and loss aspects of the

LIBOR notes must be treated consistently with one another,

this proposition does not resolve whether the consistency

should be achieved by disregarding the tax consequences of

the income generated by the notes or by permitting the

deduction of actual economic losses associated with the

notes. ACM urges us to adopt the latter position and in

support thereof invokes Wexler, 31 F.3d at 127, in which

we held that "in some circumstances, a sham transaction

may have separable, economically substantive, elements

that give rise to deductible interest obligations." According

to ACM, br. at 48, its ownership of the BOT LIBOR notes

and its 1991 disposition thereof for an actual economic loss

gave rise to a separable, economically substantive loss that

is properly deductible under Wexler because it is distinct

from the losses resulting from the ratable basis recovery

rule. The Commissioner, on the other hand, contends that

Wexler does not permit the deduction of ACM's economic

losses on the LIBOR notes because, according to the

Commissioner's interpretation of Wexler, a separable item

of loss is not deductible unless the underlying transaction

had a potential non-tax benefit. See br. at 48-49.

For the following reasons, we find ACM's contentions to

be more persuasive. In Wexler, the taxpayer invoked Rice's

Toyota, 752 F.2d at 95-96, which disallowed depreciation

and interest deductions arising from a transaction that was

a sham in that the taxpayer "subjectively lacked a business

purpose and the transaction objectively lacked economic

substance." The court found, however, that one discrete

portion of the transaction, which entailed the exchange of

a recourse note for "something of economic value," had

sufficient economic substance to give rise to an interest

deduction. Id. at 95-96. Distinguishing Rice's Toyota, we

found that the claimed deductions in Wexler did not

constitute such a "separable, economically substantive"

item that was distinct from the sham aspects of the

transaction, but rather constituted "the principal tax

benefits of the transaction." Wexler, 31 F.3d at 125. Thus,

we found, allowance of the deduction would have permitted

the taxpayer "to reap the entire benefit of its sham

transaction" by allowing him the deduction "that was the

centerpiece of the whole scheme." Id. at 127.

Such is not the case here. The actual economic losses

associated with ACM's ownership of the LIBOR notes are

both economically substantive and separable from the

sham aspects of the underlying transaction. Far from being

the "centerpiece" or "principal tax benefit" of the underlying

transaction, the approximately $6 million in economic

losses which ACM seeks to deduct were separate and

distinct from the $87 million tax loss that did not

correspond to any actual economic loss but rather was an

artifact of the ratable basis recovery rule which inflated the

tax basis of the LIBOR notes well above their actual cost

basis. In contrast to its economically inconsequential

acquisition and disposition of the Citicorp notes, ACM's

ownership of the BOT LIBOR notes, which extended over

two years under circumstances that posed an actual risk to

the principal value of that investment, had an economically

substantive impact on ACM's net financial position. In

these circumstances, recognition of both the income and

the loss aspects of ACM's investment in those notes will

result in consistent tax treatment which accurately reflects

the economic reality of ACM's transactions and will allow

deduction only of a "separable, economically substantive"

item that is not the "centerpiece" of the transactions,

consistently with our holding in Wexler.

While the Commissioner, br. at 48, urges us to read

Wexler more broadly to preclude any deductions associated

with an underlying transaction found to be a sham, we

decline to do so. We recognize that Wexler not only

distinguished Rice's Toyota on its facts, but also criticized

its reasoning. In doing so, however, Wexler did not criticize

Rice's Toyota's essential holding that "in some

circumstances, a sham transaction may have separable,

economically substantive elements that give rise to

deductible" liabilities, see 31 F.3d at 127, but rather

disagreed with the Rice's Toyota court'sfinding that the

recourse note portion of the transaction, which the court

had described as "a `fee' for purchase of expected tax

benefits," had economic substance. As we explained in

Wexler, by the Rice's Toyota court's own description, that

transaction had no non-tax consequences and served no

non-tax purposes and thus could not be considered

economically substantive even if it was separable from the

central aspects of the underlying sham. See Wexler, 31

F.3d at 125 (quoting Rice's Toyota, 752 F.2d at 94).

ACM's possession of the LIBOR notes, although not

intended to serve non-tax purposes, had significant non-tax

economic effects, consisting of several million dollars in

actual economic losses. As we acknowledged in Wexler,

even where a transaction is not intended to serve business

purposes, it may give rise to a deduction to the extent that

it has objective economic consequences apart from tax

benefits. See 31 F.3d at 126 (citing Jacobson, 915 F.2d at

849); see also Gregory, 293 U.S. at 469, 55 S.Ct. at 267

(holding that if the transaction "in reality was effected" in

substance as well as in form, "the ulterior [tax avoidance]

purposes . . . will be disregarded); Northern Indiana Pub.

Serv. Co., 115 F.3d at 512 (holding that Gregory and its

progency "do not allow the Commissioner to disregard

economic transactions . . . which result in actual, non-tax-

related changes in economic position" regardless of "tax-

avoidance motive"). Thus, we are unpersuaded by the

Commissioner's assertion that Wexler requires us to

disregard actual, objective economic losses merely because

they are incidental to a broader series of transactions that

are found to constitute an economic sham whose principal

tax benefits must be denied. See br. at 48-49. Because

ACM's possession and disposition of the LIBOR notes was

distinct from the contingent installment exchange which

constituted the underlying sham transaction and because

this distinct portion of the transaction had sufficient non-

tax economic effect to be recognized as economically

substantive, we find that this aspect of ACM's transactions

gave rise to the type of "separable, economically

substantive" loss that is deductible even when incurred in

the context of a broader transaction that constitutes an

economic sham. Wexler, 31 F.3d at 127. Accordingly, we

will reverse the Tax Court's decision to the extent that it

disallowed the deductions arising from the actual economic

losses which ACM sustained upon its disposition of the

LIBOR notes.

IV. CONCLUSION

For the foregoing reasons, we will affirm the Tax Court's

application of the economic substance doctrine and its

resulting decision eliminating the capital gains and losses

attributable to ACM's application of the contingent

installment sale provisions and the ratable basis recovery

rule. The Commissioner's cross appeal is moot and thus

will be dismissed. We will, however, reverse the Tax Court's

decision insofar as it disallowed the deductions arising from

the actual economic losses associated with ACM's

ownership of the LIBOR notes, and will remand to the Tax

Court for entry of a decision consistent with this opinion.

The parties will bear their own costs on this appeal.

McKEE, Circuit Judge, dissenting.

By finding that ACM's sales of the Citicorp notes for cash

and LIBOR Notes "satisfied each requirement of the

contingent installment sales provisions and the ratable

basis recovery rule," Maj. Op. at 28, yet, simultaneously

subjecting these transactions to an economic substance

and sham transaction analysis, the majority has ignored

the plain language of IRC S 1001, and controlling Supreme

Court precedent. We have injected the "economic

substance" analysis into an inquiry where it does not

belong. Therefore, I respectfully dissent.

ACM, like all taxpayers, has the absolute right to

decrease or to avoid the payment of taxes so long as that

goal is achieved legally. Gregory v. Helvering, 293 U.S. 465,

468 (1935). Id. In Gregory, the taxpayer wanted to transfer

stock from her wholly-owned corporation to herself, but

realized that a direct distribution of those shares would be

a taxable event. Therefore, in an attempt to avoid a taxable

event, the taxpayer created a new corporation, transferred

the stock to that new corporation, and then caused the new

corporation to distribute the stock to her in liquidation. The

taxpayer owned all of the stock of United Mortgage

Corporation, and that corporation owned 1000 shares of

the Monitor Securities Corporation that the taxpayer

wanted to obtain. In order to do so without paying the taxes

that would clearly be due on a direct transfer, she

engineered a purported reorganization of United Mortgage

Corporation. The Supreme Court described her scheme as

follows:

To that end, she caused the Averill Corporation to be

organized under the laws of Delaware on September

18, 1928. Three days later, the United Mortgage

Corporation transferred to the Averill Corporation the

1,000 shares of Monitor stock, for which all the shares

of the Averill Corporation were issued to the petitioner.

On September 24, the Averill Corporation was

dissolved, and liquidated by distributing all its assets,

namely, the Monitor shares, to the petitioner. No other

business was ever transacted, or intended to be

transacted, by that company. The petitioner

immediately sold the Monitor shares. . . .

Gregory, 293 U.S. at 467 (emphasis added). At the time, 26

USCA S 112 (g) exempted the gain realized from a corporate

reorganization "[i]f there is distributed, in pursuance of a

plan of reorganization, to a shareholder, . . . stock . . . in

such corporation." Id. at 468. Most significantly for our

purposes, the Court stated the issue as follows: "[b]ut the

question for determination is whether what was done, apart

from the tax motive, was the thing which the statute

intended." Id. at 469. The Court concluded that what was

done was not what the statute intended because the

liquidation was not a plan of reorganization at all, but "a

transfer of assets by one corporation to another in

pursuance of a plan having no relation to the business of

either. . . ." Id. Accordingly, the Court disregarded the

transaction, even though the form of the transaction

satisfied the literal requirements of the IRC's reorganization

provisions, because it found that the entire transaction was

nothing but "an elaborate and devious form of conveyance

masquerading as a corporate reorganization, and nothing

else." Id. at 470. In other words, the transaction was one

which "upon its face lies outside the plain intent of the

statute." Id. Consequently, "the rule which excludes from

consideration the motive of tax avoidance" did not apply. Id.

Accordingly, I am not as persuaded as my colleagues that

Gregory should guide our inquiry into these transactions.

Here, the sales of the Citicorp Notes for cash and LIBOR

Notes were clearly "legitimate" sales in the nontax sense.

Under IRC S 1001, the tax consequences of a gain or loss in

the value of property are deferred until the taxpayer realizes

the gain or loss. Cottage Savings Assoc. v. Commissioner,

499 U.S. 554, 559 (1991). The concept of "realization" is

implicit in IRC S 1001(a), Id., and the realized gain is

recognized when the property is sold or exchanged. IRC

S 1001(c).1 In Cottage Savings, the Court held that a sale or

exchange of property is a realization event "so long as the

exchanged properties are `materially different' -- that is, so

_________________________________________________________________

1. IRC S 1001(c) provides: "(c) Recognition of Gain or Loss. -- Except as

otherwise provided in this subtitle, the entire amount of the gain or

loss,

determined under this section, on the sale or exchange of property, shall

be recognized."

long as they embody legally distinct entitlements.' Id. at

566.

Cottage Savings sold 90% participation in 252

mortgages to four S&L's. It simultaneously purchased

90% participation interests in 305 mortgages held by

these S&L's. All of the loans involved in the transaction

were secured by single-family homes. . . .

On its 1980 federal income tax return, Cottage

Savings claimed a deduction . . . which represented the

adjusted difference between the face value of the

participation interests that it traded and the fair

market value of the participation interests it received.

. . .

Cottage Savings, 499 U.S. at 557. It was not disputed that

"[t]he . . . acknowledged purpose [of the transfers] was to

facilitate transactions that would generate tax losses but

that would not substantially affect the economic position of

the transacting S&L's". Id. at 556. In allowing the taxpayer

to deduct the resulting loss the Court reasoned that S 1001

did not recognize exchanges "commonly known as `like

kind', and that Congress therefore intended to afford tax

recognition of gains and losses resulting from exchanges of

property that was materially different." Id., at 564. The

Court held "[u]nder our interpretation of S 1001(a), an

exchange of property gives rise to a realization event so long

as the exchanged properties are `materially different' -- that

is, so long as they embody legally distinct entitlements." Id.

That is what happened here, and I believe that, under

Cottage Savings, the tax loss here should have been

allowed.

ACM's sales of the Citicorp Notes for cash and LIBOR

Notes resulted in the exchange of materially different

property with "legally distinct entitlements.". Consequently,

the sales were substantive dispositions, and the tax effects

of those transactions should be recognized. Cottage

Savings, as well as the plain language of IRC S 1001,

demands that result.

Thus, I do not think that the many cases decided before

Cottage Savings that the majority relies upon are helpful.

e.g., Maj. Op. at 26-34. Similarly, I do not believe our

inquiry is furthered by discussing United States v. Wexler,

31 F.3d 117 (3rd Cir. 1994). See Maj. Op. at 45. There, we

were not addressing the issue of sham transactions in the

context presented here, nor did we cite Cottage Savings. We

did cite Lerman v. Commissioner, 939 F.2d 44, 45 (3d Cir.

1991), and we noted that, in Lerman, we said " `economic

substance is a prerequisite to any Code provision allowing

deductions.' " 31 F.3d at 127 (quoting Lerman, 939 F.2d at

48 & n. 6, 52). However, it is the definition of "economic

substance" that is the sticking point. Here, the "economic

substance" inquiry must be governed by the "material

difference requirement" of Cottage Savings, not by the tax

avoidance intent of the taxpayers.

In this regard, I believe the majority mischaracterizes the

appellant's argument. The majority states: "ACM

acknowledges that even where the `form of the taxpayer's

activities indisputably satisfie[s] the literal requirements' of

the statutory language, the courts must examine `whether

the substance of those transactions was consistent with

their form' ". Maj. Op. at 29 (quoting Appellant's Br. at 21).

However, ACM is referring to the issue as posed by Gregory

v. Helvering. In referring to the facts of that case, ACM

argues:

The form of the taxpayer's activities indisputably

satisfied the literal requirements of the Code's

reorganization provisions, but the question was

whether the substance of those transactions was

consistent with their form. As he does here, the

Commissioner argued in Gregory that the taxpayer's

ulterior purpose should be disregarded. . . .

In other words, the focus should be on the substance

of what was done, and not on why it was done. The

Supreme Court then analyzed the specific statutory

language concerning reorganizations and concluded

that the taxpayer's actions lay outside the plain intent

of the statute.

Appellant's Br. at 21.

As recited earlier, ACM's sales of the Citicorp Notes for

cash and LIBOR Notes resulted in the exchange of

materially different property. I believe our inquiry should

proceed no further, and reverse the holding of the Tax

Court eliminating the capital gains and losses attributable

to ACM's application of the contingent installment sale

provisions and the ratable basis recovery rule to its

disposition of the Citicorp Notes.

I can't help but suspect that the majority's conclusion to

the contrary is, in its essence, something akin to a"smell

test." If the scheme in question smells bad, the intent to

avoid taxes defines the result as we do not want the

taxpayer to "put one over." However, the issue clearly is not

whether ACM put one over on the Commissioner, or used

LIBOR notes to "pull the wool over his eyes." The issue is

whether what ACM did qualifies for the tax treatment it

seeks under S 1001. The fact that ACM may have"put one

over" in crafting these transactions ought not to influence

our inquiry. Our inquiry is cerebral, not visceral. To the

extent that the Commissioner is offended by these

transactions he should address Congress and/or the

rulemaking process, and not the courts.2

Accordingly I must dissent from what I admit is a very

finely crafted opinion by my colleague, Judge Greenberg.

A True Copy:

Teste:

Clerk of the United States Court of Appeals

for the Third Circuit

_________________________________________________________________

2. As the majority notes, the Commissioner apparently realized the

possible "loophole" in the regulations and enacted Treas. Reg. S 1.701-

2(a) in an apparent effort to curb such tax driven transactions as the

ones here. See Maj. Op. at 29-30, n. 29.

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.