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Written by the judges who cited it.
The opinion
Case: 15-30577 Document: 00513508751 Page: 1 Date Filed: 05/17/2016
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
United States Court of Appeals
Fifth Circuit
FILED
No. 15-30577 May 17, 2016
Lyle W. Cayce
CHEMTECH ROYALTY ASSOCIATES, L.P., Clerk
As Tax Matters Partner Real Party in Interest Dow Europe, S.A.,
Plaintiff–Appellant,
versus
UNITED STATES OF AMERICA,
Defendant–Appellee.
* * * * *
CHEMTECH ROYALTY ASSOCIATES, L.P.,
By Dow Europe, S.A., as Tax Matters Partner,
Plaintiff–Appellant,
versus
UNITED STATES OF AMERICA,
Defendant–Appellee.
* * * * *
CHEMTECH II, L.P.,
Plaintiff–Appellant,
versus
UNITED STATES OF AMERICA,
Defendant–Appellee.
* * * * *
CHEMTECH II, L.P., BY IFCO, INCORPORATED,
As Tax Matters Partner,
Plaintiff–Appellant,
versus
UNITED STATES OF AMERICA,
Defendant–Appellee.
Case: 15-30577 Document: 00513508751 Page: 2 Date Filed: 05/17/2016
No. 15-30577
Appeal from the United States District Court
for the Middle District of Louisiana
Before DAVIS, SMITH, and HIGGINSON, Circuit Judges.
JERRY E. SMITH, Circuit Judge:
In a prior appeal of this tax case, we affirmed the district court’s decision
to disregard the partnership form of Chemtech Royalty Associates, L.P.
(“Chemtech I”), and Chemtech II, L.P. (“Chemtech II”), for tax purposes but
vacated and remanded as to the penalty award. On remand, the court re-
instated the vacated penalty award and further held that a tax penalty for
gross-valuation misstatement applied to Chemtech II. Through its wholly-
owned subsidiary Dow Europe, S.A., which was the tax matters partner for
Chemtech I, real party in interest The Dow Chemical Company (“Dow”) now
appeals the penalty award solely as to Chemtech I. We find no error and
affirm.
I.
The underlying facts are set out in detail in the opinions of this court and
the district court, 1 so we only summarize the most relevant facts. In the early
1990s, Dow decided to engage in a tax shelter transaction that became Chem-
tech I. After forming Chemtech I as a limited partnership, Dow contributed
seventy-three patents, which it then leased back in return for royalty
payments.
1Chemtech Royalty Assocs., L.P. v. United States, 766 F.3d 453 (5th Cir. 2014); Chem-
tech Royalty Assocs., L.P. v. United States, Nos. 05-944-BAJ-DLD, 06-258-BAJ-DLD, 07-405-
BAJ-DLD, 2013 WL 70437 (M.D. La. Feb. 26, 2013).
2
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Dow took valuable tax deductions on its royalty payments to Chemtech I.
Dow, however, was allocated only a small fraction of Chemtech I’s taxable
income, which instead was allocated mainly to Chemtech I’s tax-exempt inves-
tors, foreign banks 2 that invested $200 million in return for a priority return
of interest-like payments of 6.947% per year. In theory, the foreign banks had
minimal participation (1%) in Chemtech I’s residual profits. But Dow was able
to control the extent of the foreign banks’ profit participation through a con-
tractual provision that enabled it to remove profitable patents from Chem-
tech I’s patent portfolio. See Chemtech, 766 F.3d at 464. Other provisions also
insulated the foreign banks from almost all risk of loss by effectively
guaranteeing that they would receive their investment back regardless of
Chemtech I’s financial performance. See id.
In 1998, Dow terminated Chemtech I in response to changes in U.S. tax
laws. Dow bought out the shares of the foreign banks, then reorganized the
partnership as Chemtech II. The details of Chemtech II are irrelevant for
purposes of this appeal.
After conducting a partnership-level audit, the Internal Revenue Service
issued Final Partnership Administrative Adjustments (“FPAAs”) to the tax
matters partner for Chemtech I for tax years 1993 through 1997 and to the tax
matters partner for Chemtech II for tax years 1998 through 2006. The FPAAs
asserted adjustments for tax years 1993 through 2006, resulting in the dis-
allowance of $1 billion of tax deductions to Dow and also asserted accuracy-
related penalties for tax years 1997 through 2006 under 26 U.S.C. § 6662. 3
2Bank of Brussels Lambert; Dresdner Bank A.G.; Kredietbank, N.V.; National West-
minster Bank Plc; and Rabo Merchant Bank N.V. (collectively, “the foreign banks”).
3 The FPAAs did not assert accuracy-related penalties for 1993–1996 (the first four
years of Chemtech I) because the law applicable to those years does not allow penalties to be
determined at the partnership level. See Taxpayer Relief Act of 1997, P.L. 105-34, § 1238(c),
3
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Through the tax matters partners for Chemtech I and Chemtech II,
which are both Dow subsidiaries, Dow filed a partnership-level proceeding in
district court under the Tax Equity and Fiscal Responsibility Act of 1982
(“TEFRA”), challenging the FPAAs. After a bench trial, the court affirmed the
FPAAs’ adjustments of partnership items, basing its decision on three grounds:
(1) The alleged partnerships were shams; (2) the contribution-leaseback trans-
actions at the heart of Chemtech I and Chemtech II lacked economic substance;
and (3) the banks’ interests in Chemtech I and Chemtech II were debt rather
than equity. The court then held that the 20% accuracy-related penalties for
negligence and substantial understatement applied but that substantial-
valuation and gross-valuation misstatement penalties were foreclosed under
Todd v. Commissioner, 862 F.2d 540 (5th Cir. 1988), and Heasley v. Commis-
sioner, 902 F.2d 380 (5th Cir. 1990).
In our 2014 opinion, we affirmed the district court’s decision to disregard
the partnership form of Chemtech I and Chemtech II for tax purposes, rea-
soning that they were sham partnerships. Despite that affirmance, however,
we vacated and remanded as to the penalty award in light of the intervening
decision in United States v. Woods, 134 S. Ct. 557, 564 (2013), which effectively
overruled Todd and Heasley. We instructed the district court to reconsider the
applicability of the substantial-valuation and gross-valuation misstatement
penalties and to “consider the extent to which imposing [the negligence and
substantial-understatement] penalties remains consistent with this opinion.”
Chemtech, 766 F.3d at 465. 4
111 Stat. 788, 1027 (1997) (amending 26 U.S.C. § 6221). The government states that the
penalties for 1993–1996 will be determined in partner-level proceedings.
4 In a partnership-level proceeding, the court technically determines only the applica-
bility of accuracy-related penalties. The penalties themselves are imposed only at the partner
level, which may require further, partner-specific determinations. See Woods, 134 S. Ct.
4
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On remand, the district court amended its final judgment. It held that
the gross-valuation misstatement penalty applied to Chemtech II and that the
substantial-understatement and negligence penalties vacated in the first
appeal applied to both Chemtech I (tax years 1997 through mid-1998) and
Chemtech II (tax years mid-1998 through 2006). Because penalties under Sec-
tion 6662 do not stack, 5 the result of the district court’s decision was to hold
applicable a 20% penalty for tax years 1997 to mid-1998 and a 40% penalty for
tax years mid-1998 to 2006.
II.
Section 6662 of the Internal Revenue Code (“IRC”) imposes a penalty of
20% of the portion of any underpayment of tax attributable to, inter alia, negli-
gence and substantial understatement of income. Negligence “includes any
failure to make a reasonable attempt to comply with the provisions” of the IRC.
26 U.S.C. § 6662(c). A substantial understatement occurs when the amount by
which a corporate taxpayer understates its tax obligation exceeds the lesser of
$10,000,000 or 10% of the tax actually owed. Id. § 6662(d)(1)(B).
At issue here is whether, on remand, the district court erred in holding
that penalties for negligence and substantial understatement applied to the
last year and a half of Chemtech I, i.e., tax years 1997 through mid-1998. Dow
asserts that the answer is yes, for essentially two reasons. 6 First, it maintains,
at 564. But, as the quotation from our prior opinion demonstrates, we have not always
observed that terminological distinction.
5 26 C.F.R. § 1.6662-2(c).
6Dow also posits that it had a reasonable basis and substantial authority for its posi-
tions that the contribution-leaseback transactions in Chemtech I possessed economic sub-
stance and that the foreign banks’ interests in Chemtech I were equity rather than debt. We
need not address those theories, however, because we conclude that Dow lacked a reasonable
basis and substantial authority for its position that Chemtech I was a valid partnership and
because negligence and substantial-understatement penalties are applicable as long as Dow
5
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No. 15-30577
our mandate from the first appeal required the district court to justify any tax
penalty solely on the ground that Chemtech I was a sham partnership. Second,
penalties for negligence and substantial understatement cannot be justified on
the basis that Chemtech I was a sham partnership, because Dow had a reason-
able basis and substantial authority for its contrary position that Chemtech I
was a valid partnership. A taxpayer may reduce or eliminate the negligence
penalty by establishing that it had a “reasonable basis” for its tax treatment of
an item, 26 C.F.R. § 1.6662-3(b)(1), and may reduce or eliminate the
substantial-understatement penalty by showing that it had “substantial
authority,” id. § 1.6662-3(b)(3). 7
A.
We review a district court’s interpretation of a remand order de novo. 8
Review of a determination that the negligence penalty applies as a factual
matter is for clear error, 9 and whether the reasonable-basis defense applies as
lacks a defense to any one of the three disputed tax positions.
7 Not at issue here is whether Dow had “reasonable cause” and acted in “good faith”
with respect to its underpayment of tax, see 26 U.S.C. § 6664(c)(1), because reasonable cause
is a partner-level defense that should generally be reserved for a partner-level proceeding
rather than litigated in a partnership-level proceeding such as this one. See Klamath
Strategic Inv. Fund ex rel. St. Croix Ventures v. United States, 568 F.3d 537, 548 (5th Cir.
2009) (permitting reasonable cause to be litigated in a partnership-level proceeding where it
is presented as a defense on behalf of the partnership). Reasonable cause differs from both
the reasonable-basis defense to the negligence penalty and the reasonable-belief requirement
for the substantial-authority defense.
8 Gene & Gene, L.L.C. v. BioPay, L.L.C., 624 F.3d 698, 702 (5th Cir. 2010); United
States v. Carales-Villata, 617 F.3d 342, 344 (5th Cir. 2010).
9 See Streber v. Comm’r, 138 F.3d 216, 219 (5th Cir. 1998).
6
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a legal matter is reviewed de novo. 10 Where the facts are essentially un-
disputed, the applicability of the substantial-authority defense is a question of
law reviewed de novo. 11
B.
In the first appeal, we vacated the penalties for negligence and substan-
tial understatement and directed the district court to “consider the extent to
which imposing those penalties remains consistent with this opinion.” Chem-
tech, 766 F.3d at 465. On remand, the court readopted “the factual findings
and conclusions of law [from its original opinion] on the issues of negligence
and substantial-understatement penalties,” then reinstated the negligence
and substantial-understatement penalties. 12 It gave two reasons: (1) The
underlying facts remained unchanged; and (2) the “imposition of those
penalties does not contravene the Fifth Circuit’s opinion in this matter.” 13
Dow contends that the district court failed to implement our mandate.
According to Dow, we vacated that court’s original penalty determinations in
light of the “narrow” ground for our affirmance of tax deficiency in the first
appeal. Whereas the district court gave three grounds for affirming the defi-
ciencies assessed by the IRS, we affirmed the deficiency determinations on only
one ground, namely, that Chemtech I was a sham partnership. Dow maintains
that we vacated and remanded as to the tax penalties so that the district court
could reconsider whether the negligence and substantial-understatement
10 See Stanford v. Comm’r, 152 F.3d 450, 455 (5th Cir. 1998).
11 NPR Invs., LLC ex rel. Roach v. United States, 740 F.3d 998, 1011 (5th Cir. 2014).
12 Chemtech Royalty Assocs., L.P. v. United States, Nos. 05-00944-BAJ-SCR, 06-cv-
258-BAJ-SCR, 07-cv-405-BAJ-SCR, 10-cv-791-BAJ-SCR, 2015 WL 2183807, at *1 (M.D. La.
May 8, 2015).
13 Id.
7
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penalties could be justified on the basis of our sham-partnership holding, an
inquiry that the district court never undertook. Again according to Dow, in its
original order the district court justified the negligence penalty based solely on
the finding that the “artificial tax benefits [of Chemtech I and Chemtech II]
would seem ‘too good to be true’ to a reasonable and prudent person, let alone
to a highly sophisticated Fortune 100 company and its numerous lawyers and
tax professionals.” Chemtech, 2013 WL 704037, at *28. The district court did
not consider whether Dow had a reasonable basis for any of its tax positions,
and it considered Dow’s substantial-authority defense only with regard to
Dow’s economic-substance position. 14
We reject Dow’s theory that our mandate required the district court to
consider whether Dow had a reasonable basis and substantial authority for its
sham-partnership position. As stated at the beginning of our opinion in the
first appeal, we vacated and remanded as to the penalty award in light of
Woods, which overruled the line of cases on which the district court had pre-
cluded substantial-valuation and gross-valuation misstatement penalties. Al-
though Woods did not directly pertain to the penalties for negligence and
substantial understatement, we nevertheless deemed it appropriate to vacate
those penalties in case, on remand, the district court determined that applica-
tion of Woods might indirectly affect the applicability of negligence and
substantial-understatement penalties. We stated that we were “express[ing]
no opinion on whether the [district] court erred in imposing the negligence and
substantial-understatement penalties.” Chemtech, 766 F.3d at 465. Dow’s
14 Chemtech, 2013 WL 704037, at *30 (“The Court has already held the Chemtech
transactions lack any underlying economic substance, and were entered into solely for the
purpose of creating tax benefits. As such, the facts of this case fall in line with cases from
other circuits and courts where a finding of no substantial authority accompanied a finding
of lack of economic substance.”).
8
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suggestion that our vacatur of those penalties reflects some disapproval of or
dissatisfaction with the district court’s original grounds for finding them
applicable is therefore untenable.
C.
The district court did not err in failing to justify the negligence and
substantial-understatement penalties on the basis of our sham-partnership
holding, but it could have done so. We affirm the applicability of the negligence
and substantial-understatement penalties on the ground that the district court
would have been correct to do so. 15 Dow lacked substantial authority for its
position that Chemtech I was a valid partnership. And Dow lacked a reasona-
ble basis for the same reasons that its substantial-authority defense fails: The
cited authorities are materially distinguishable on their facts. 16
1.
The government contends that Dow may not assert the substantial-
authority defense because it made no attempt to show that it “reasonably
believed” its tax treatment of Chemtech I was “more likely than not correct.”
For years before 2004, the IRC prohibited corporate taxpayers such as Dow
from invoking the substantial-authority defense for items attributable to a tax
shelter. 26 U.S.C. § 6662(d)(2)(C)(ii) (2000) (amended 2004). The Treasury
Regulations, however, grandfathered in transactions occurring before Decem-
ber 9, 1994. 26 C.F.R. § 1.6662-4(g)(1)(ii)(B). For such transactions, a
15 See Palmer v. Waxahachie Indep. Sch. Dist., 579 F.3d 502, 506 (5th Cir. 2009) ([I]t
is an elementary proposition, and the supporting cases too numerous to cite, that this court
may affirm . . . on any grounds supported by the record.”) (citation omitted); United States
ex. rel. Doe v. Dow Chem. Co., 343 F.3d 325, 330 (5th Cir. 2003) (“[T]his Court may affirm on
any grounds supported by the record below[.]”).
16We explicitly decline to rule (as unnecessary) on whether the district court’s actual
reasons for finding that the negligence and substantial-understatement penalties applied
were correct.
9
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corporate taxpayer may invoke the substantial-authority defense if it can show
that it “reasonably believed that the tax treatment of such item by the taxpayer
was more likely than not the proper treatment.” 26 U.S.C. § 6662(d)(2)(C)(i)(II)
(1997) (amended 2004).
We agree with the government that Dow is subject to the reasonable-
belief requirement because it began Chemtech I in 1993 and because Chem-
tech I was a tax shelter. During the years at issue, a tax shelter was defined
as a partnership, entity, plan, or arrangement “if the principal purpose of the
entity, plan or arrangement, based on objective evidence, is to avoid or evade
Federal income tax.” 26 C.F.R. § 1.6662-4(g)(2)(i) (1997). The principal pur-
pose is tax avoidance or evasion “if that purpose exceeds any other purpose.”
Id. The district court found that Dow’s only business purpose in forming
Chemtech I was to obtain tax benefits. Chemtech, 2013 WL 704037, at *18.
Because that finding is not clearly erroneous, we affirm the district court’s
determination that Chemtech I was a tax shelter. Id. at *30. Dow is therefore
subject to the reasonable-belief requirement.
Nonetheless, we disagree with the government’s notion that Dow was
required to make its reasonable-belief showing in the district court. In a recent
decision, we expressed uncertainty over whether the reasonable-belief require-
ment can be determined in a partnership-level proceeding such as this. 17 The
government draws attention to the decisions of several out-of-circuit district
courts that considered reasonable belief in partnership-level rather than
partner-level proceedings. 18 But the government cites no authority that
17NPR Invs., 740 F.3d at 1012 (“Whether the Taxpayers reasonably believed that the
tax treatment of their respective investments was more likely than not the proper treatment
would appear to be a partner-level matter that should not be resolved in a partnership-level
proceeding.”).
18 See Fidelity Int’l Currency Advisor A Fund, LLC v. United States, 747 F. Supp. 2d
10
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requires litigation of reasonable belief in a partnership-level proceeding, and
we decline to impose such a requirement, particularly where, as here, the
government failed to raise any objection to the availability of the substantial-
authority defense in the district court. We may therefore consider the
substantial-authority defense in this partnership-level proceeding. 19
2.
In addition to rejecting the government’s claim that the substantial-
authority defense is unavailable to Dow, we likewise decline its insistence that
Dow waived its substantial-authority argument by failing to brief the issue in
the first appeal. In its original decision, the district court failed to justify the
negligence and substantial-understatement penalties on the basis of its sham-
partnership holding. Under those circumstances, Dow sufficiently preserved
its substantial-authority argument in the first appeal through its general
assertion that it possessed a reasonable basis and substantial authority for all
of its challenged tax positions. Dow was under no obligation to brief in extenso
issues not addressed by the district court.
3.
On the merits of Dow’s appeal, in order for there to be substantial author-
ity, the weight of the authorities supporting treatment of an item must be
substantial in relation to the weight of those supporting contrary treatment.
26 C.F.R. § 1.6662-4(d)(3)(i). This standard is more stringent than the
reasonable-basis standard but less stringent than the more-likely-than-not
49, 245 (D. Mass. 2010), aff’d, 661 F.3d 667 (1st Cir. 2011); Long Term Capital Holdings v.
United States, 330 F. Supp. 2d 122, 205 (D. Conn. 2004), aff’d, 150 F. App’x 40 (2d Cir. 2005);
Santa Monica Pictures LLC v. Comm’r, 89 T.C.M. (CCH) 1157, 1229 (2005).
19We limit this conclusion to the instant proceeding, given the absence of a govern-
ment objection, and express no view on whether the same result would obtain otherwise.
11
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standard. Id. § 1.6662-4(d)(2). For purposes of the substantial-authority
inquiry, an authority’s weight “depends on its relevance and persuasiveness,
and the type of document providing the authority.” Id. § 1.6662-4(d)(3)(ii). An
authority is not particularly relevant if it is materially distinguishable on its
facts. Id. Moreover, it is relevant for purposes of the substantial-authority
inquiry only if it existed at the time the return containing the item was filed
or the last day of the taxable year to which the return relates. See id.
§ 1.6662-4(d)(3)(iv)(C).
Under these criteria, Dow lacked substantial authority for its position
that Chemtech I was a valid partnership. Dow points to only two authorities
in existence at the time of the filing of Chemtech I’s tax returns as allegedly
supporting treatment of Chemtech I as a valid partnership. In Morris v. Com-
missioner, 13 T.C. 1020 (1949), the Tax Court held that the petitioner’s wife
was a true limited partner in her husband’s brokerage partnership even
though she received only a fixed 6% return on her investment plus 2% of any
profits earned in excess of expenses and charges. And in Hunt v. Commis-
sioner, T.C. Memo. 1990-248, 59 T.C.M. (CCH) 635 (1990), the Tax Court held
that a partnership was not a sham in which one of the partners was entitled
to a cumulative return of 18%, followed by a return of its capital contribution,
before any of the other partners began receiving returns of their capital contri-
butions. According to Dow, both decisions treated an interest with minimal
sharing in profits and losses as a partnership interest and the holder of such
an interest as a valid partner.
We deny Dow’s interpretation of Morris and Hunt, which would elimin-
ate any intent element from the sham-partnership doctrine. Under the
totality-of-the-circumstances test in Commissioner v. Culbertson, 337 U.S. 733,
741–42 (1949), a partnership is a sham if the putative partners do not possess
12
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the intent to share profits and losses. Morris and Hunt explicitly recognize and
purport to apply Culbertson’s holding and thus cannot be read in the way that
Dow proposes, as authority that the owner of an equity instrument automati-
cally satisfies Culberton. To the contrary, Morris and Hunt show that an
interest with minimal sharing in profits and losses can qualify as a partnership
interest only if the owner of that interest intends to share profits and losses.
The government urges that Morris and Hunt are entirely inapposite
because, as found by the district court and affirmed by us, Dow lacked the
intent to share profits and losses with the foreign banks, Chemtech, 766 F.3d
at 464–65, and no authority supports the recognition of a partnership in which
the putative partners lacked the intent to share profits and losses. We might
find the government’s position persuasive if there were direct evidence that
Dow lacked the intent to share profits and losses. Given the lack of direct
evidence of intent, however, Dow can satisfy the substantial-authority stan-
dard if it produces authority for the view that the circumstantial evidence in
this case would permit a not-clearly-erroneous finding that Dow possessed the
intent to share profits and losses. That test is essentially the same as the one
adopted by the Sixth Circuit, though our reasoning differs. 20 That test also
accords with how at least one district court in this circuit has handled the
substantial-authority inquiry. 21
Because Morris and Hunt can be interpreted as providing some support
20See Estate of Kluener v. Comm’r, 154 F.3d 630, 637–39 (6th Cir. 1998) (holding that
facts can be substantial authority for a tax position, so a taxpayer may have substantial
authority that a partnership was not a sham even where the court finds that the partners
lacked a business purpose).
21See Southgate Master Fund, LLC v. United States, 651 F. Supp. 2d 596, 666 (N.D.
Tex. 2009), aff’d on other grounds, 659 F.3d 466 (5th Cir. 2011) (holding that the plaintiff had
substantial authority for its position even though the court also held the partnership to be a
sham).
13
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for the view that Dow possessed the intent to share profits and losses with the
foreign banks, we disagree with the government’s contention that those deci-
sions are entirely inapposite. Nevertheless, they are not “substantial author-
ity,” because they are materially distinguishable on their facts. In contrast to
the entities here, the partnerships in Morris and Hunt did not make use of any
contribution-leaseback transactions. Nor did they possess a mechanism that
would have allowed the managing partner or real party in interest to make the
sharing of profits illusory, as the district court found was the case with
Chemtech I. 22
Even if Morris and Hunt were not materially distinguishable on their
facts, they would fail to constitute substantial authority in light of Merryman
v. Commissioner, 873 F.2d 879 (5th Cir. 1989). There, we affirmed, as not
clearly erroneous, the finding that a partnership was a sham and should be
disregarded for tax purposes. The partnership in Merryman contained many
of the same features as does Chemtech I: a partner that retained complete
control over the property contributed to the partnership; a circular flow of
funds; minority partners’ total lack of risk with respect to partnership prop-
erty; and the partnership’s lack of employees and failure to hold itself out as
being engaged in a business.
Because Merryman is more apposite than are Morris and Hunt, and
because Merryman is published circuit authority, whereas Morris and Hunt
are Tax Court cases (one old and the other unpublished), Dow lacked substan-
tial authority for its position that Chemtech I was a valid partnership. For
substantially the same reasons, Dow fails to meet the lesser reasonable-basis
22 Morris, moreover, involved the shifting of income between spouses at a time of
steeply graduated tax rates and before creation of the married-filing-jointly status on income
tax returns. The extent to which Morris remains good law is thus doubtful.
14
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standard.
The judgment is AFFIRMED.
15