UNITED STATES TAX COURT
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T.C. Memo. 1999-359
UNITED STATES TAX COURT
SABA PARTNERSHIP, BRUNSWICK CORPORATION,
TAX MATTERS PARTNER, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
OTRABANDA INVESTERINGS PARTNERSHIP, BRUNSWICK CORPORATION,
TAX MATTERS PARTNER, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 1470-97, 1471-97.
Filed October 27, 1999.
During 1990 and 1991, B, a domestic corporation,
realized substantial capital gains from the sale of a
number of its business units.
In 1990, B joined with a foreign bank (ABN) to
form two general partnerships, S and O. Immediately
upon their formation, S purchased private placement
notes (PPNs) and O purchased certificates of deposit
(CDs). Within 1 month, and immediately prior to the
close of the partnerships' first taxable year, S and O
sold their PPNs and CDs for cash (80 percent) and LIBOR
notes (20 percent). These transactions were intended
to satisfy the requirements of a contingent installment
sale under I.R.C. sec. 453. Relying on the ratable
basis recovery rules under sec. 15A.453-1(c), Temporary
- 2 Income Tax Regs., 46 Fed. Reg. 10711 (Feb. 4, 1981),
the partnerships applied one-sixth of their bases in
the PPNs and CDs in computing their "gains" on the
sales of the PPNs and CDs. Due to a large disparity in
the partners' initial capital contributions to the
partnerships, ABN was allocated 90 percent of the
"gains" on the sales of the PPNs and CDs. As a foreign
entity, ABN's distributive share of the partnerships'
"gains" was not subject to U.S. income tax.
Following the close of the partnerships' first
taxable year, ABN's interests in the partnerships were
reduced through direct purchases by B and redemptions
by the partnerships. S and O subsequently distributed
cash to ABN and the LIBOR notes to B. B sold the LIBOR
notes for cash. Relying on the ratable basis recovery
rules under sec. 15A.453-1(c), Temporary Income Tax
Regs., supra, B allocated the remaining bases in the
PPNs and CDs in computing its "losses" on the sales of
the LIBOR notes. For the taxable years ending 1990 and
1991, B reported capital losses of $142,953,624 and
$32,631,287, respectively.
Held: The disputed transactions were not
motivated by legitimate non-tax business purposes and
were not imbued with objective economic substance.
Held, further, the disputed transactions are shams that
will not be respected for Federal income tax purposes.
Held, further, the partnerships' income for the years
in issue does not include interest earned on the PPNs
and CDs. Held, further, the partnerships are entitled
to deductions for certain organizational expenses
subject to the limitations contained in sec. 709(b),
I.R.C.
Joel V. Williamson, Thomas C. Durham, Daniel A. Dumezich,
Clisson S. Rexford, Gary S. Colton, Jr., Stuart E. Thiel, Neil B.
Posner, and Judith P. Zelisko, for petitioner.
Jill A. Frisch, Karen P. Wright, Lewis R. Mandel, and
Theresa G. McQueeney, for respondent.
- 3 CONTENTS
FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . . . 7
I.
Brunswick Corporation . . . . . . . . . . . . . . . . . . 7
A. Business Groups . . . . . . . . . . . . . . . . . . . 7
B. Takeover Concerns/Defenses . . . . . . . . . . . . . . 8
C. Divestitures . . . . . . . . . . . . . . . . . . . . 11
D. Merrill Lynch Partnership Proposal . . . . . . . . . 14
E. The Zelisko Memorandum . . . . . . . . . . . . . . . 14
F. O'Brien's Interest Rate Forecast . . . . . . . . . . 20
II.
Algemene Bank Nederlands N.V.
. . . . . . . . . . . . .
20
III. Saba Partnership . . . . . . . . . . . . . . . . . . . .
A. Sodbury Corporation . . . . . . . . . . . . . . . .
B. Skokie Investment Corporation . . . . . . . . . . .
C. Saba Organizational Meeting . . . . . . . . . . . .
D. Miscellaneous Fees . . . . . . . . . . . . . . . . .
23
23
25
25
27
IV.
30
30
31
37
V.
Saba Transactions . . . . . . . . . . . . . . . . . . .
A. Purchase of Private Placement Floating Rate Notes .
B. Saba's Sale of Private Placement Notes . . . . . . .
C. McManaman's Tax Projections . . . . . . . . . . . .
D. Brunswick's Purchase of 50 Percent of Sodbury's
Partnership Interest . . . . . . . . . . . . . . .
E. Brunswick-ABN Consulting Agreement . . . . . . . . .
F. Payments on 4 LIBOR Notes . . . . . . . . . . . . .
G. Distribution of 3 LIBOR Notes to Brunswick . . . . .
H. Brunswick's Sale of 3 LIBOR Notes . . . . . . . . .
I. Partial Redemption of Sodbury's Partnership Interest
. . . . . . . . . . . . . . . . . . . . . . . . .
J. Payments on Norinchukin LIBOR Note . . . . . . . . .
K. Transfer and Termination of 3 LIBOR Notes . . . . .
L. Formation of SBC International Holdings, Inc. (SBC)
M. Downgrade of Brunswick’s Credit Rating . . . . . . .
N. Dissolution of Saba . . . . . . . . . . . . . . . .
O. Dissolution of Sodbury . . . . . . . . . . . . . . .
P. SBC's Sale of Remaining Norinchukin LIBOR Note . . .
Q. Termination of Chase Private Placement Notes . . . .
Saba-Related Swaps . . . . . . . . . . . . . . . . . . .
A. Fuji and Norinchukin Swaps . . . . . . . . . . . . .
B. Sodbury-ABN-Merrill Lynch Swaps . . . . . . . . . .
C. Bank of Tokyo Swaps . . . . . . . . . . . . . . . .
38
39
39
39
40
43
43
44
44
45
45
47
48
49
49
49
51
51
- 4 D.
E.
Banque Francaise du Commerce Exterieur Swaps . . . .
Brunswick Swaps . . . . . . . . . . . . . . . . . .
51
52
VI.
Otrabanda Investerings Partnership . . . . . . . . . . .
A. Structure . . . . . . . . . . . . . . . . . . . . .
B. Bartolo Corporation . . . . . . . . . . . . . . . .
C. Otrabanda Organizational Meeting . . . . . . . . . .
D. Miscellaneous Fees . . . . . . . . . . . . . . . . .
53
53
55
56
60
VII.
Otrabanda Transactions . . . . . . . . . . . . . . . .
A. Otrabanda's Purchase of Certificates of Deposit . .
B. Otrabanda's Sale of Certificates of Deposit . . . .
C. Brunswick's Purchase of 50 Percent of Bartolo's
Partnership Interest . . . . . . . . . . . . . . .
D. Payments on LIBOR Notes . . . . . . . . . . . . . .
E. Distribution of LIBOR Notes to Brunswick . . . . . .
F. Brunswick's Sale of LIBOR Notes . . . . . . . . . .
G. Partial Redemption of Bartolo's Partnership Interest
. . . . . . . . . . . . . . . . . . . . . . . . .
H. Formation of OBC International Holdings, Inc. . . .
I. Dissolution of Otrabanda . . . . . . . . . . . . . .
J. Dissolution of Bartolo . . . . . . . . . . . . . . .
K. Termination of the 4 LIBOR Notes . . . . . . . . . .
L. Termination of the IBJ CDs . . . . . . . . . . . . .
61
61
62
67
68
68
69
70
72
72
74
75
75
VIII. Otrabanda-Related Swaps . . . . . . . . . . . . . . .
A. Otrabanda Swap . . . . . . . . . . . . . . . . . . .
B. Sumitomo Swaps . . . . . . . . . . . . . . . . . . .
C. Bartolo-ABN-Merrill Lynch Swaps . . . . . . . . . .
D. Banque Francaise du Commerce Exterieur Swaps . . . .
E. Brunswick Swaps . . . . . . . . . . . . . . . . . .
75
75
75
76
76
76
IX.
Saba's and Otrabanda's Tax Returns . . . . . . . . . . .
77
X.
Brunswick's Partnership Expenses . . . . . . . . . . . .
A. Transaction Costs . . . . . . . . . . . . . . . . .
B. Legal and Accounting Fees . . . . . . . . . . . . .
C. Total Expenses . . . . . . . . . . . . . . . . . . .
77
77
78
79
XI.
Interest Rate Forecasts
. . . . . . . . . . . . . . . .
81
XII.
Brunswick's Tax Returns and Related Documents . . . . .
83
XIII. Respondent's Determinations . . . . . . . . . . . . .
A. Saba FPAA . . . . . . . . . . . . . . . . . . . . .
B. Otrabanda FPAA . . . . . . . . . . . . . . . . . . .
85
85
86
- 5 OPINION . . . . . . . . . . . . . . . . . . . . . . . . . . .
87
I.
Evidentiary Matters . . . . . . . . . . . . . . . . . . .
A. Attorney-Client Privilege . . . . . . . . . . . . .
B. Work-Product Doctrine . . . . . . . . . . . . . . .
88
89
91
II.
93
Contingent Installment Sale Provisions
. . . . . .
III.
Petitioner's Argument That An Economic Substance Analysis
Is Not Warranted . . . . . . . . . . . . . . . . . . . . 96
A. Gregory v. Helvering and Horn v. Commissioner . . . 96
B. Section 1001 and Cottage Savings . . . . . . . . . . 103
IV.
Petitioner's Contention That CINS Transactions Are Imbued
With Economic Substance . . . . . . . . . . . . . . . . 110
A. Business Purpose . . . . . . . . . . . . . . . . . . 112
B. Economic Substance . . . . . . . . . . . . . . . . . 117
C. Conclusion . . . . . . . . . . . . . . . . . . . . . 129
V.
Secondary Issues
. . . . . . . . . . . . . . . . . . . . 130
MEMORANDUM FINDINGS OF FACT AND OPINION
NIMS, Judge:
Respondent issued a notice of final
partnership administrative adjustment (FPAA) to Saba Partnership
(Saba) setting forth adjustments to Saba's partnership returns
for the taxable years ended March 31, 1990, March 31, 1991, and
June 21, 1991.
Respondent also issued an FPAA to Otrabanda
Investerings Partnership (Otrabanda) setting forth adjustments to
Otrabanda's partnership returns for the taxable years ended July
31, 1990, and June 21, 1991.
Brunswick Corporation, the tax
matters partner for both Saba and Otrabanda, invoked the Court's
jurisdiction by filing timely petitions for readjustment
challenging the FPAAs.
(For simplicity, we refer to Brunswick
- 6 Corporation as Brunswick or petitioner.)
These cases were
consolidated for purposes of trial, briefing, and opinion.
On the date that Brunswick filed the petitions herein, Saba
and Otrabanda had been liquidated and no longer maintained a
principal place of business.
Respondent's adjustments in these cases are based on
alternative determinations.
The central issue for decision is
whether the partnerships' purported contingent installment sale
transactions (hereinafter CINS transactions) should be
disregarded for tax purposes because they lack economic
substance.
Unless otherwise clear from the context, the following
words, their derivatives, and related terms are used for
narrative convenience only to describe the form of the disputed
transactions:
"invest", "purchase", "gain", "loss", "borrow",
"loan", "pay", "sale", "distribute", "note", "agreement",
"commission", and "interest".
By our use of such terms, we do
not mean to suggest any conclusions concerning the actual
substance or characterization of the transactions for tax
purposes.
Unless otherwise indicated, section references are to
sections of the Internal Revenue Code in effect for the years in
issue, and Rule references are to the Tax Court Rules of Practice
and Procedure.
- 7 FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulated facts and exhibits are incorporated herein by this
reference.
I.
Brunswick Corporation
A.
Business Groups
Brunswick, headquartered in Skokie, Illinois, has been in
business for over 150 years.
Brunswick's stock is traded on the
New York, Midwest, Pacific, London, and Tokyo stock exchanges.
During the late 1980s, Brunswick's operations were
organized among 3 lines of business:
Technical.
Marine, Recreation, and
The Marine group manufactured and sold pleasure and
fishing boats and marine engines on a worldwide basis.
The
Recreation group operated 125 recreation centers worldwide and
manufactured and sold fishing rods, reels, and accessories, and
golf, bowling, and billiards products.
The Technical group,
which consisted of the Defense, Technetics, and Industrial
Products divisions, manufactured and sold a wide variety of
products for military, aerospace, and industrial use.
Jack F. Reichert (Reichert) served as Brunswick's chairman,
president, and chief executive officer; William R. McManaman
(McManaman) served as Brunswick's vice president-Finance; Thomas
K. Erwin (Erwin) served as Brunswick's controller; Richard S.
- 8 1.
O'Brien (O'Brien) served as Brunswick's treasurer; and
Judith P. Zelisko (Zelisko), an attorney, served as Brunswick's
assistant vice president, Director of Taxes.
In June 1988, Reichert informed Brunswick's Board of
Directors that the company's sales of marine products, then
approximately 75 percent of Brunswick's overall net sales,
appeared to be slowing.
In fact, between 1988 and 1989,
Brunswick's net marine sales dropped from $2,449,000,000 to
$2,000,000,000, or by approximately 18 percent.
In response to
these developments, Brunswick immediately reduced capital
expenditures in marine-related manufacturing facilities and
equipment, permanently closed two boat manufacturing plants,
idled 5 other plants, and laid off 5,000 employees.
On October 24, 1989, Standard and Poor's Corporation
(Standard & Poor's) downgraded Brunswick's long-term debt rating
from A- to BBB+.
Standard and Poor's did not change Brunswick's
commercial paper rating.
During this period, Reichert and
McManaman determined that it would be in Brunswick's best
interests to maximize the company's cash-flow and reduce debt.
B.
Takeover Concerns/Defenses
In 1981, Brunswick's stock was selling at a discount to book
value.
In January 1982, Whittaker Corporation (Whittaker) made
an unsolicited tender offer in an effort to acquire 49 percent of
the total voting power of Brunswick's outstanding securities.
It
- 9 appears that Whittaker coveted Sherwood Medical Industries, Inc.
(Sherwood), a Brunswick subsidiary, and that Whittaker intended
to sell Brunswick's remaining businesses if its takeover attempt
were successful.
Brunswick determined that the Whittaker tender
offer was unfair to Brunswick's shareholders and successfully
defeated the takeover attempt by selling Sherwood to American
Home Products, Inc.
During the period 1982 to 1983, Gulf & Western Industries,
Inc. (Gulf & Western), accumulated up to 21 percent of
Brunswick's stock and threatened a takeover.
The Gulf & Western
takeover threat abated when Gulf & Western's chief executive
officer died unexpectedly in February 1983.
During the 1980s, Brunswick took the following steps to
deter a hostile takeover:
(1) Revised several of its
compensation-related programs in order to protect the interests
of its employees; (2) amended its charter to (a) provide for
staggered elections of directors, (b) restrict actions by
stockholders outside of stockholder meetings, and (c) increase
the number of authorized shares of Brunswick common stock from 40
million to 100 million shares; (3) amended the company's salaried
pension plans to protect against the use of Brunswick's excess
pension funds to finance a hostile takeover of the company; (4)
adopted a Preferred Share Purchase Rights Plan or poison pill;
and (5) amended its deferred compensation arrangements to provide
- 10 that all amounts held under such arrangements could be paid to
the participants in the event of a change in control of the
company.
During March 1989, rumors surfaced that Irwin Jacobs or Ron
Perlman might attempt to take over Brunswick.
On March 30, 1989,
Dow Jones News Service reported that McManaman had dismissed the
rumors.
Nevertheless, on March 31, 1989, Brunswick's Board of
Directors called a special meeting and decided to amend the
company's "poison pill" to provide, among other things, that if a
person or group were to acquire 15 percent or more of Brunswick's
common stock, other stockholders would be permitted to purchase
Brunswick common stock at a discount of 50 percent of market
price.
On April 1, 1989, the New York Times reported that Mr.
Jacobs had denied that he was planning a takeover bid for
Brunswick.
In April 1989, Brunswick amended its Employee Stock
Option Plan (ESOP) to permit the plan to borrow funds in order to
purchase Brunswick stock.
Shortly after the amendment was
adopted, the ESOP obtained a bridge loan of $100 million,
guaranteed by Brunswick, and purchased 5,095,542 shares of
Brunswick common stock.
No formal hostile takeover attempt was initiated against
Brunswick during 1989 or 1990.
- 11 C.
Divestitures
In 1988, Brunswick decided to sell a number of businesses in
its Technical group.
In June 1989, Brunswick announced its
intention to sell its Industrial Products Division (IPD),
including Vapor Corporation and a group of businesses known as
TXT.
In October 1989, Brunswick announced its intention to sell
its Technetics Division, including Energy Conservation Systems,
Circle Seal, and MIMS.
On June 24, 1989, Brunswick executed a letter agreement with
Merrill Lynch Capital Markets, a subsidiary of Merrill Lynch &
Co., Inc. (hereinafter collectively referred to as Merrill
Lynch), under which Merrill Lynch agreed to act as Brunswick's
exclusive financial adviser in connection with the sale of IPD
(the IPD fee agreement).
Brunswick agreed to pay Merrill Lynch a
fee for its services as follows:
(i) in the case of a single sale transaction, 1.25% of
the aggregate purchase price paid in such sale
transaction, (but in no event less than $1,000,000) or
(ii) in the case of multiple sale transactions, the sum
of (1) 1.25% of the aggregate purchase price paid for
Vapor and (2) 2.50% of the aggregate purchase price
paid for any or all of the businesses which comprise
TXT, each such transaction fee payable in cash upon the
closing of each such sale transaction.
As of January 1989, Brunswick owned 3.1 million shares, or
approximately 36 percent, of Nireco Corporation (Nireco), a
Japanese corporation.
In October 1989, Brunswick sold 400,000 of
its Nireco shares in connection with a public offering and
- 12 listing of Nireco shares on the Japanese Over-the-Counter stock
exchange.
In November 1989, Brunswick decided to sell all of its
remaining Nireco shares.
On January 29, 1990, Brunswick and Merrill Lynch executed a
letter agreement under which Merrill Lynch agreed to act as
Brunswick's exclusive financial adviser in connection with the
sale of Brunswick's Nireco stock in exchange for a fee of 1.125
percent of the proceeds of the sale (the Nireco fee agreement).
On March 5, 1990, Reichert and McManaman appeared before the
New York Society of Security Analysts.
McManaman informed the
analysts that Brunswick anticipated realizing approximately $125
million from the sale of businesses in its Technical group and
that net proceeds from the sales would be used to reduce
Brunswick's debt.
Between October 1989 and October 1990,
Brunswick's debt to capitalization ratio was reduced from 42.2
percent to 28.3 percent.
On March 28, 1990, Brunswick and Merrill Lynch executed a
letter agreement amending the IPD and Nireco fee agreements to
provide that Brunswick would pay additional fees of $750,000,
$500,000, and $250,000 upon the sales of Vapor Corporation, TXT,
and Brunswick's Nireco stock, respectively.
On September 4, 1990, Brunswick and Merrill Lynch executed a
letter agreement further amending the IPD and Nireco fee
agreements to provide that Brunswick would pay additional fees of
- 13 $500,000 and $675,000 upon the sales of Vapor Corporation and
Brunswick's Nireco stock, respectively.
Brunswick sold the following businesses from its Technical
group on the dates and at the prices indicated:
Transaction
Nireco - 400,000 shares
Energy Conservation Systems
Vapor AC
Nireco - 2,386,000 shares
TXT (Valve & Control)
Circle Seal
MIMS
Nireco - 450,000 shares
Vapor
Date
October, 1989
May 11, 1990
June 27, 1990
July 1990
August 24, 1990
September 6, 1990
September 6, 1990
September, 1990
December 21, 1990
Sales Price
$16,606,964
37,220,000
4,515,000
91,061,851
22,532,000
24,500,000
845,000
13,433,275
39,502,000
The $22,532,000 sales price for TXT included a $7,500,000
promissory note.
On December 28, 1990, Brunswick received
$5,500,000 in exchange for cancellation of the note.
On October 22, 1990, Brunswick paid Merrill Lynch
$1,210,493--an amount equal to 1.125 percent of the proceeds from
the sale of 2,836,000 Nireco shares, plus an additional $925,000
pursuant to the March 28 and September 4, 1990, amendments to the
Nireco fee agreement.
On January 18, 1991, Brunswick paid Merrill Lynch
$1,161,116--an amount equal to 1.25 percent of the proceeds from
the sale of Vapor Corporation and Vapor AC, and 2.5 percent of
the sales price of TXT, plus an additional $1,750,000 pursuant to
the March 28 and September 4, 1990, amendments to the IPD fee
agreement.
- 14 Brunswick filed a Form 1120 (U.S. Corporation Income Tax
Return) for 1990 reporting capital gains of $29,809,938 and
$100,782,182 attributable to the sales of its Technetics division
businesses and Nireco stock, respectively.
D.
Merrill Lynch Partnership Proposal
In December 1989, after Brunswick had announced its
intention to sell its Technical businesses and Nireco stock,
Brunswick officials, including McManaman, Erwin, and Zelisko, met
with representatives of Merrill Lynch's investment banking group,
including E.S.P. Das (Das), managing director and vice chairman
of Investment Banking, Arshad R. Zakaria (Zakaria), Thomas R.
Williams, Jr. (Williams), and Jeff Neal (Neal).
During this
meeting, Das described a structured transaction, including the
formation of a partnership between Brunswick and a foreign
financial institution, that would generate capital losses that
Brunswick could use to offset the capital gains that it would
realize from the sale of its Technical businesses.
Merrill Lynch used flowcharts in making its presentation to
Brunswick.
The only scenario depicted in the flowcharts was a
tax loss for Brunswick.
E.
The Zelisko Memorandum
In January 1990, O'Brien and Zelisko attended a second
meeting with Das and other Merrill Lynch representatives for
further discussions regarding the partnership proposal.
On
- 15 January 26, 1990, Zelisko prepared a memorandum, addressed to
Erwin and McManaman, summarizing the Merrill Lynch partnership
proposal in pertinent part as follows:
Set forth below is a bullet point summary of a
transaction proposed by Merrill Lynch to Brunswick
Corporation (BC) on December 8, 1989 to generate
sufficient capital losses to offset the capital gain
which will be generated on the sale of the Nireco
shares. The specific dollar amounts can be adjusted to
increase or decrease the capital loss required.
Step 1:
BC and an unrelated foreign partner (FP) would form a
Partnership no later than March 1, 1990 with BC
contributing $20 million in cash and the FP
contributing $180 million in cash. The Partnership
would have a fiscal year-end of March 31st since that
would be the year-end of the FP, the majority Partner.
Step 2:
Partnership buys a private placement note for $200
million with the cash in the Partnership and holds the
note for one month.
Step 3:
Before March 31, 1990, the Partnership would sell the
$200 million private placement note for $160 million in
cash and five-year contingent note with an assumed fair
market value (fmv) of $40 million. Under this
contingent note, payments would be made to the
Partnership over a five-year period equal to LIBOR[1]
times a fixed notional principal. The details
concerning the terms of this note require further
discussion by the Treasury Department with Merrill
Lynch.
1
LIBOR is an acronym for London Interbank Offering Rate
which is the primary fixed income index reference rate used in
European financial markets.
- 16 The Partnership would recognize gain on the sale of the
private placement note calculated as follows:
Cash
Basis
(1/6 of 200)
Gain
160.0
33.3
_____
126.7
BC's Gain
FP's Gain
Total Gain
12.67
114.03
126.70
BC's share of the gain equals its 10% ownership in the
Partnership for a taxable gain to BC of $12.67 million
in 1990.
Step 4:
In April 1990 or later, (i.e. until there has been some
movement in the value of the contingent note) BC buys
50% of FP's interest in the Partnership for $90
million, assuming that the fmv of the contingent note
is still $40 million. With this purchase, BC's basis
in its Partnership interest is $122.67 million
calculated as follows:
BC's initial investment
Gain
Purchase of 50% of FP's
interest
$20.0 million
12.67
90.00
122.67
Step 5:
The Partnership distributes the contingent note to BC
assuming a fmv of $40 million. In addition, the
Partnership would distribute approximately $32.72
million in cash to FP which is the equivalent cash
distribution to FP given its percentage ownership.
Step 6:
BC sells the contingent note for cash. This sale of
the contingent note by BC generates the capital loss.
- 17 BC's basis in the note
FMV of the note
Capital loss
Net Gain on sale of FP note
Net Capital loss
122.67
40.00
82.67
12.67
70.00
After the sale of the note, BC's tax basis in the
Partnership is zero and the Partnership still has
127.28 in cash (160-32.72).
Step 7:
In April 1991, the Partnership will be terminated.
There cannot have been any agreements, negotiations, or
understandings of any kind among the Partners or their
representatives regarding the possible liquidation of
the Partnership or the assets to be distributed to each
respective Partner upon termination and liquidation of
the Partnership or the transactions described in Steps
4 and 5. Prior to termination, 55% of the cash in the
Partnership will be contributed to Newco, a whollyowned subsidiary of the Partnership. Upon termination
of the Partnership, the Newco stock will be distributed
to BC and the remaining cash to FP.
Risks Involved
[Redacted material deleted.] Merrill Lynch did assure
us that their fee would not be due if the tax law
changed prior to implementation.
Cost Involved:
1. Merrill Lynch's fee is 5-10% of the tax savings.
Assuming a capital loss of $82 million, the tax savings
would be around $28 million and a 10% fee on such savings
results in a fee of $2.8 million. This 10% fee is
negotiable. Also, need to clarify whether the fee is on the
gross or net capital loss generated.
2. Legal fees for BC and operating expenses of the
Partnership which would be paid by BC, would run about
$400,000 - $500,000.
3. Compensation fees to the FP. Merrill Lynch talked
in terms of 40-75 basis points on the FP's equity
investment.
- 18 4. Bid/offer spread on the private placement note and
on the contingent note.
The foregoing should be viewed as a summary of the
Merrill Lynch proposal. [Redacted material deleted.]
Merrill Lynch's partnership proposal, and specifically the
partnership's purchase of private placement notes (PPNs) and
their subsequent sale for approximately 80 percent cash and 20
percent LIBOR notes, was intended to comply with the contingent
installment sale provisions and ratable basis recovery rules
under section 453 and section 15A.453-1(c), Temporary Income Tax
Regs., 46 Fed. Reg. 10709 (Feb. 4, 1981).
Merrill Lynch's role was to manage all aspects of the
transactions, including enlisting the foreign partner, serving as
a financial adviser to the partnership, arranging for the
purchase and sale of the PPNs, and arranging for the purchase and
sale of the LIBOR notes.
On February 7, 1990, O'Brien wrote a memorandum to McManaman
regarding investment of the proceeds that Brunswick would derive
from the sale of its Technical businesses.
O'Brien suggested
that Brunswick's need for investment advice should be used as a
"vehicle to acquaint ourselves with the investment expertise of a
sophisticated financial institution with worldwide marketplace
experience."
- 19 On February 13, 1990, McManaman, O'Brien, and Zelisko
appeared before Brunswick's Board of Directors.
The minutes of
the meeting state in pertinent part:
Mr. McManaman described a proposal for a
partnership with a foreign entity. The arrangement
would require the Company to make an equity investment
in the partnership of at least $20 million and not more
than $120 million in cash which would be invested in a
diversified portfolio of investments, including high
quality debt instruments, by the partnership. Mr.
McManaman then discussed the business purpose, tax
benefits and risks in the arrangement.
The minutes do not describe the business purpose underlying
Brunswick's participation in the partnership.
McManaman
recommended approval of the proposal with the caveat that
Brunswick would not proceed with the transaction if management
were dissatisfied with the proposed foreign partner.
McManaman
believed that tax benefits were a primary reason for Brunswick to
invest in the partnership.
The Board of Directors immediately authorized both McManaman
and O'Brien, or either of them, to enter into a partnership on
behalf of Brunswick for an equity investment of at least $20
million and not more than $120 million.
On April 3, 1990,
Brunswick's Board of Directors conducted a meeting by way of a
telephone conference call and, upon the recommendation of
McManaman, authorized McManaman or O'Brien, or either of them, to
enter into a second partnership on behalf of Brunswick for an
equity investment of at least $20 million and not more than $120
- 20 million.
The second partnership investment was recommended
because Brunswick was generating additional cash and capital
gains from the sale of its Technical businesses and Nireco stock.
The Board of Directors also authorized McManaman and/or O'Brien
to enter into agreements on behalf of Brunswick for the purchase
and sale of treasury securities for forward delivery and to
increase the amount authorized for interest rate swap
transactions up to $225 million.
F.
O'Brien's Interest Rate Forecast
One of O'Brien's duties as Brunswick's treasurer was to
track the movement of interest rates.
In early 1990, O'Brien
believed that interest rates would rise.
However, during the
period June through September 1990, O'Brien's view of the
direction of interest rates was "in transition", and he was
uncertain whether interest rates would rise or fall.
By early
September 1990, O'Brien was convinced that interest rates would
fall.
II.
Algemene Bank Nederlands N.V.
During the period in question, Algemene Bank Nederlands N.V.
(ABN), was the largest bank in the Netherlands.
During all
relevant periods, ABN offered comprehensive corporate,
institutional, and individual financial services including
domestic and international lending, trade finance and
international payments, international corporate finance and
- 21 advisory services, global investment management and advisory
services, foreign exchange, treasury, and risk management
services, and trust services.
ABN Trust Company (ABN Trust), was
an ABN affiliate.
In 1989, Merrill Lynch representatives contacted Johannes
den Baas (den Baas), vice president, Corporate Finance (ABN-New
York), and proposed that ABN enter into general partnerships with
certain U.S. corporations.
In an August 7, 1989 memorandum to
Arthur Arnold, executive vice president, Corporate Finance (ABNNew York), den Baas described the structure of the partnerships
and timing of partnership investments in terms substantially
similar to those set forth in the Zelisko memorandum.
Unlike the
Zelisko memorandum, den Baas stated that the partnership was
designed to reduce a U.S. corporation's liability for alternative
minimum tax.
The den Baas memorandum includes a discussion of
the financial risks to ABN in pertinent part as follows:
Credit risk: The structure demands that virtually no
credit risk will be taken in the partnership since any
defaults on the principal of the investments will
jeopardize the objective as described hereafter. The
nature of paper invested in will be of the highest
credit quality and will have short term maturities.
* * *
*
*
*
*
*
*
*
Market interest rate risk: ABN New York will take care
of perfect hedges in order to protect the bank from the
changes in the value of the underlying securities * * *
due to interest rate fluctuations. * * *
- 22 Legal and tax risk for ABN will be covered by opinions
of legal and tax counsel. Furthermore the proposed
structure for ABN that follows will in itself provide a
protection against U.S. tax liabilities.
den Baas summarized ABN's remuneration for participating in the
partnerships as follows:
The remuneration for ABN * * * will be 70-80 bps.
spread over the outstanding participation plus $100,000
upfront fee and all out of pocket expenses covered
(legal fees etc.). Since the structure itself will not
carry the possibilities for this level of remuneration
the income will be received by ABN New York in upfront
payments made by the corporation.
ABN eventually formed partnerships with several U.S.
corporations.
In early 1990, Merrill Lynch representatives contacted den
Baas and inquired whether ABN would enter into a partnership with
Brunswick.
On February 15, 1990, den Baas drafted a memorandum
proposing a $180 million facility or loan to a Netherland
Antilles special purpose corporation (SPC) that would be managed
by ABN Trust and would enter into a partnership with Brunswick.
The memorandum stated in pertinent part:
ABN will receive again an upfront fee representing 75
bps over LIBOR over the outstanding plus the 15 bps
funding difference between LIBOR and CP [commercial
paper] upfront. The amount will be around $600,000 but
we have negotiated a minimum fee of $750,000 upfront
excluding ABN Trust Curacao's fees.
On the same date, den Baas drafted a credit proposal which
included a description of the partnership's anticipated
investment activities, including the purchase in the last week of
- 23 February of highly rated PPNs, the sale of the PPNs in late March
for cash and installment notes, investment of the cash proceeds
in highly rated commercial paper, and Brunswick's gradual buydown of ABN's partnership interest.
den Baas' credit proposal
stated that ABN would have the option to withdraw fully from the
partnership after January 1, 1991.
On February 20, 1990, ABN's North Atlantic Credit Committee
recommended approval of den Baas' credit proposal stating:
WE RECOMMEND APPROVAL. AS BRUNSWICK DOES NOT POSSESS
THE SAME HIGH CREDIT STANDING AS PREVIOUS DEALS, PLEASE
MAKE SURE WE CAN LIQUIDATE THE PORTFOLIO IF BRUNSWICK
IS UNABLE TO COME UP WITH THE CASH TO PAY US OUT BY
JANUARY 1991.
On February 23, 1990, ABN's Risk Management Department
granted approval for ABN to participate in the proposed
partnership on the condition that ABN would maintain the right to
liquidate the portfolio.
III. Saba Partnership
A.
Sodbury Corporation
In The Netherlands, a foundation or stichting is a legal
entity that is managed and administered by a board.
On January
18, 1990, ABN established two stichtings, Ronde Klip Foundation
(Ronde Klip) and Pietermaai Foundation (Pietermaai).
On January 18, 1990, Sodbury Corporation (Sodbury) was
incorporated in Curacao, Netherlands Antilles.
On February 23,
1990, Sodbury and ABN Trust executed an agreement under which ABN
- 24 Trust agreed to provide managerial services to Sodbury in
exchange for an annual fee of $25,000.
At the time that Sodbury
was incorporated, Ronde Klip and Pietermaai each received onehalf or 3,000 shares of the 6,000 shares of Sodbury common stock
authorized to be issued.
Each Sodbury share had a par value of
$1 for a total capitalization of $6,000.
On February 26, 1990, ABN's Willemstad branch (ABNWillemstad) and Sodbury entered into a revolving credit agreement
(RCA) under which ABN-Willemstad agreed to loan Sodbury up to
$125 million.
By agreements dated February 26, 1990, Ronde Klip
and Pietermaai pledged their Sodbury stock as security for the
RCA.
On February 26, 1990, ABN-Willemstad and Sodbury entered
into a second agreement under which ABN-Willemstad agreed to lend
Sodbury up to $60 million, subordinated to the RCA described
above.
Sodbury would not be required to pay interest on any such
loan unless the outstanding principal was not paid on the
expiration date.
By agreements dated February 26, 1990, Ronde Klip and
Pietermaai granted ABN irrevocable options to purchase their
Sodbury shares at par value.
- 25 Sodbury was organized to participate as a general partner in
Saba because ABN was not interested in assuming the unlimited
liability of a general partner and ABN's loans to Sodbury could
be syndicated.
B.
Skokie Investment Corporation
On February 21, 1990, Brunswick organized a wholly owned
subsidiary, Skokie Investment Corporation (Skokie), under the
laws of the State of Delaware.
On February 28, 1990, Brunswick
agreed to lend Skokie $1 million in exchange for a demand
promissory note in that amount with interest at the prime rate.
C.
Saba Organizational Meeting
On February 22, 1990, Brunswick representatives McManaman,
O'Brien, and Zelisko met in Bermuda with ABN representatives den
Baas and Peter H. de Beer (de Beer), Assistant Managing Director,
and Merrill Lynch representatives Macauley R. Taylor (Taylor),
Managing Director for Merrill Lynch Capital Markets, Das, and
Zakaria.
Lawyers from the law firms of Cravath, Swaine & Moore,
and Mayer, Brown, & Platt, also attended the Bermuda meeting.
This was the first meeting between Brunswick and ABN.
During
this meeting, McManaman and ABN representatives discussed the
possibility of ABN’s providing consulting services to Brunswick
for a fee.
On February 22, 1990, Brunswick and Merrill Lynch executed a
letter agreement under which Merrill Lynch agreed to serve as
- 26 Brunswick's financial adviser regarding Saba in exchange for a
fee of $500,000.
Brunswick paid Merrill Lynch's fee on April 4,
1990.
By partnership agreement dated February 23, 1990, Brunswick,
Skokie, and Sodbury formed Saba as a general partnership under
the laws of the State of New York.
The partners agreed that Saba
would maintain its principal place of business in Curacao,
Netherlands Antilles.
The partnership agreement stated that the
partnership was being formed "for the object and purpose of
making investments in notes, bonds, debentures, and other
interest bearing instruments, owning, managing and supervising
such investments, sharing the profits and losses therefrom, and
engaging in such activities necessarily incidental or ancillary
thereto."
The partnership agreement further stated that
generally each item of partnership income, gain, expense, and
loss for each fiscal year would be allocated among the partners
in proportion to each partner's capital account.
However, if a
partner's proportionate interest in partnership capital were to
change during any fiscal year, the partnership's books would be
closed as of the date of such a change and partnership income,
gain, expense, and loss would be allocated to the partners in
proportion to their respective capital accounts as determined
immediately prior to such change.
The partnership agreement
stated that a partner would be permitted to request in writing
- 27 that the partnership redeem all or any portion of its partnership
interest provided that no such request may be made by a partner
before April 1, 1991, if such redemption would reduce the
partner's partnership interest to less than $10 million.
However, the partnership agreement stated that no such redemption
would be permitted if Merrill Lynch determined that the
redemption would cause a disorderly liquidation of the
partnership's assets.
On February 28, 1990, the Saba partners made capital
contributions as follows:
Capital Contribution
$1,000,000
19,000,000
180,000,000
$200,000,000
Skokie
Brunswick
Sodbury
Percentage
Interest
.5
9.5
90.0
100.0
Skokie made its capital contribution from the proceeds of its
loan from Brunswick.
Sodbury made its capital contribution from
the proceeds of its loans from ABN-Willemstad.
The partners'
capital contributions were deposited into Saba's bank account at
ABN-New York.
D.
Miscellaneous Fees
On February 23, 1990, Saba executed a letter agreement with
N.V. Fides (Fides), an ABN affiliate, under which Fides agreed to
provide a variety of administrative services for Saba in exchange
for an annual fee of $25,000.
On the same date, Saba and Fides
- 28 executed a second letter agreement in which Saba agreed to
indemnify Fides.
During 1990 and 1991, Saba made the following
payments to N.V. Fides:
Date
May 21, 1990
August 22, 1990
September 20, 1990
January 3, 1991
March 15, 1991
April 17, 1991
June 21, 1991
Amount
$53,921.81
1,156.50
972.16
1,035.10
1,093.31
1,191.57
1,074.35
On February 23, 1990, Saba (through Fides) and Merrill Lynch
executed a letter agreement under which Merrill Lynch agreed to
act as Saba's exclusive financial adviser.
The letter agreement
does not state the amount of Merrill Lynch's fee for such
services.
Merrill Lynch expected to be compensated for its
services (at least in part) by acting as the dealer in
transactions with Saba.
Saba maintained certain audited and unaudited financial
statements.
The audited financial statements were prepared by
Arthur Andersen, Willemstad, Curacao (Arthur Andersen).
The
unaudited financial statements were prepared by Fides pursuant to
its agreement with Saba.
Saba made the following payments to Cravath, Swaine & Moore
and Arthur Andersen for professional fees:
- 29 Date
July 31, 1990
November 16, 1990
June 21, 1991
June 21, 1991
Amount
Payee
$130,266
10,000
10,000
8,851
$159,117
Cravath
Arthur Andersen
Arthur Andersen
Cravath
The $130,266 fee paid to Cravath on July 31, 1990, was composed
of $125,000 for professional services and advice, $2,962.35 for
miscellaneous costs, i.e., postage, copying, and messenger
charges, and $2,303.65 for travel and transportation charges.
In a December 2, 1994 memorandum from Cravath to Brunswick,
Cravath itemized the $125,000 charge for professional services as
follows:
The $125,000.00 fee was for negotiation and
drafting of the documentation, and for other related
services, in connection with: (a) the formation of Saba
($19,452.45), (b) the purchase by Saba of certain notes
($25,576.37), (c) the sale by Saba of such notes
($46,649.86), (d) the assignment of Saba’s right to
receive payments from such sale ($11,887.60) and (e)
other related matters ($21,433.72). * * *
Saba paid commercial paper fees as follows:
Date
August 10, 1990
September 12, 1990
October 3, 1990
November 6, 1990
December 18, 1990
January 9, 1991
February 14, 1991
March 15, 1991
April 17, 1991
May 31, 1991
June 12, 1991
Amount
$3,342.50
620.00
510.00
840.00
620.00
195.00
450.00
415.00
345.00
305.00
115.00
$7,757.50
- 30 -
IV.
Saba Transactions
A.
Purchase of Private Placement Floating Rate Notes
Merrill Lynch prearranged for Chase Manhattan Bank (Chase)
to sell private placement floating rate notes (Chase PPNs) to
Saba.
On February 26, 1990, Merrill Lynch transmitted to Chase a
Summary of Terms for the PPNs.
On February 28, 1990, the same
day that the Saba partners made their capital contributions to
the partnership, Saba paid Chase $200 million for one newlyissued 5-year PPN in the principal amount of $200 million.
On
March 19, 1990, Chase reissued the $200 million PPN as four $50
million 5-year PPNs.
Other than the principal amounts, the 4
PPNs had the exact same terms as the original $200,000,000 PPN.
In particular, the Chase PPNs were due on February 15, 1995, and
paid interest at the 1-month commercial paper rate plus nine
basis points (360-day year) converted to a money market yield for
the actual number of days in the coupon period.
The rate on the
PPNs was favorable to Chase because it was slightly less than
Chase's alternative sources of funding.
Interest on the Chase
PPNs was due and payable monthly on the third Wednesday of each
month commencing on March 21, 1990.
The Chase PPNs included a
European-style put option exercisable by the holder on April 17,
1991, at par plus accrued interest.
- 31 At the time the Chase PPNs were issued, Chase was rated Aby Standard & Poor's and Baa2 by Moody's Investors Service
(Moody's).
The Chase PPNs were not registered under the
Securities Act of 1933 and were not traded on an established
securities market.
On March 21, 1990, Chase made a timely interest payment of
$975,298.51 to Saba on the Chase PPNs.
Saba included this
payment in its interest income on its Form 1065 (U.S. Partnership
Return of Income) for the taxable year ended March 31, 1990.
B.
Saba's Sale of Private Placement Notes
While arranging Saba's purchase of the Chase PPNs, Merrill
Lynch began making arrangements for Saba to sell the Chase PPNs.
On March 6, 1990, and March 8, 1990, Merrill Lynch transmitted a
Summary of Terms for the Chase PPNs to Fuji Capital Markets
(Fuji) and Norinchukin Bank (Norinchukin), respectively.
Fuji
and Norinchukin each prepared memoranda, seeking approval to
purchase the Chase PPNs, which stated that the transactions were
designed to provide tax savings for Merrill Lynch's customers.
Merrill Lynch had approached Fuji and Norinchukin regarding
the sale of the Chase PPNs because they were able to issue debt
instruments; i.e., LIBOR notes.
Although Saba would have
incurred lower transaction costs by selling the Chase PPNs to a
money market fund, such funds were eliminated from consideration
inasmuch as they could not issue LIBOR notes.
- 32 On March 13, 1990, Saba conducted a partnership meeting at
Merrill Lynch's office in Toronto.
O'Brien represented Brunswick
and Skokie at the meeting, while de Beer represented ABN by way
of a telephone conference call.
Taylor and Joel Van Dusen, an
Investment Banking analyst, participated in the meeting on behalf
of Merrill Lynch.
During the meeting, the partners discussed their belief that
interest rates were likely to rise due to a stronger economy,
rising rates in Japan and Europe, and the reunification of
Germany.
According to minutes of this meeting, Saba adopted a
resolution (at the suggestion of Merrill Lynch) authorizing and
directing the sale of the Chase PPNs for consideration consisting
of 80 percent cash and 20 percent contingent payments based on
LIBOR.
The LIBOR notes would provide for periodic payments at a
designated LIBOR rate on a notional principal amount (NPA) for a
set term.
The LIBOR note NPA was not intended to represent the
principal amount due but was used solely as a multiplier to
determine the amount of LIBOR-based contingent payments.
On March 23, 1990, immediately prior to close of Saba's
first taxable year, Saba sold 2 Chase PPNs to Fuji and 2 Chase
PPNs to Norinchukin.
In exchange for the 2 Chase PPNs sold to
Fuji, Saba received $80 million in cash and 2 installment
purchase agreements dated March 23, 1990 (Fuji LIBOR notes), each
with a stated NPA of $25,720,000 for a total NPA of $51,440,000.
- 33 In exchange for the 2 Chase PPNs sold to Norinchukin, Saba
received $80 million in cash and 2 installment purchase
agreements dated March 23, 1990 (Norinchukin LIBOR notes), each
with a stated NPA of $25,765,000 for a total NPA of $51,530,000.
At the time of these transactions, Fuji was rated Aa1 by
Moody's and AA by Standard & Poor's, while Norinchukin was rated
Aaa by Moody's and AAA by Standard & Poor's.
The sale of the Chase PPNs to Fuji and Norinchukin included
$94,384 of interest that had accrued on the PPNs for the period
from March 21, 1990 through March 23, 1990.
Saba reported this
amount as interest income on its Form 1065 for the taxable year
ended March 31, 1990.
The Fuji and Norinchukin LIBOR notes were effective as of
April 2, 1990, and provided for a stream of 20 quarterly
payments, beginning on July 2, 1990, and ending on April 2, 1995,
in an amount that would float based on 3-month LIBOR determined
at the beginning of the payment period multiplied by (1) the NPA
of the note, and (2) a fraction consisting of the number of days
between payment dates divided by 360.
Saba sold the Chase PPNs at 99.25 percent of par, or at a
private placement discount of $1,500,000 (75 basis points times
$200,000,000).
Paul A. Pepe (Pepe), vice president for Merrill
Lynch Capital Markets, determined the origination value for the
Fuji and Norinchukin LIBOR notes based upon the sum of the par
- 34 value of the Chase PPNs and the accrued interest on the PPNs,
less the private placement discount and the cash received upon
the sale of the Chase PPNs, as follows:
Fuji LIBOR Notes
Par value of 2 Chase PPNs
Plus accrued interest (through March 23)
Less private placement discount
Less cash received
Merrill Lynch origination value
$100,000,000
47,192
100,047,192
(750,000)
99,297,192
(80,000,000)
$ 19,297,192
Norinchukin LIBOR Notes
Par value of 2 Chase PPNs
Plus accrued interest (through March 23)
Less private placement discount
Less cash received
Merrill Lynch origination value
$100,000,000
47,192
100,047,192
(750,000)
$ 99,297,192
(80,000,000)
$ 19,297,192
According to Pepe's computations, Saba received
consideration totaling $198,594,384 consisting of the
$160,000,000 in cash and the Fuji and Norinchukin LIBOR notes
with a combined present value of $38,594,384.
The difference
between the par value of the Chase PPNs plus accrued interest
($200,094,384) and the total consideration that Saba received
($198,594,384) reflects the $1,500,000 private placement discount
on the sale of the Chase PPNs.
Contrary to the origination value that Pepe assigned to the
LIBOR notes, Saba listed the value of the LIBOR notes in its
- 35 general ledger for the period ended March 31, 1990, at
$40,094,384.
Saba carried the LIBOR notes on its audited and
unaudited financial statements at cost; i.e., the present value
of the LIBOR notes of $38,594,384, plus the $1,500,000 private
placement discount on the sale of the Chase PPNs.
this approach based upon advice from Merrill Lynch.
Saba adopted
As discussed
in detail below, the private placement discount on the sale of
the Chase PPNs eventually was borne solely by Brunswick following
the distribution and sale of the LIBOR notes.
A portion of the $1,500,000 private placement discount on
the sale of the Chase PPNs was attributable to the PPNs' lack of
liquidity.
If Saba had invested directly in LIBOR notes, as
opposed to first purchasing and then selling the Chase PPNs, Saba
could have avoided the portion of the $1,500,000 discount
attributable to the PPNs' lack of liquidity.
O'Brien understood that Saba had invested in the Chase PPNs,
prior to its investment in the LIBOR notes, to ensure that the
transactions would be treated for tax purposes as CINS
transactions.
The Chase PPNs were not readily tradeable on an
established market.
In addition, because the LIBOR notes
provided for 20 variable quarterly payments, Saba could not
determine the aggregate selling price of the Chase PPNs by the
end of its March 31, 1990, taxable year.
Consequently, Saba
reported the sale of the Chase PPNs as an "installment sale"
- 36 under section 453(b).
Saba computed its gain on the sale through
a ratable allocation (or recovery) of its basis in the Chase PPNs
under section 15A.453-1(c), Temporary Income Tax Regs., 46 Fed.
Reg. 10711 (Feb. 4, 1981).
Although the Fuji and Norinchukin LIBOR notes provided for
20 quarterly payments to be paid over a 5-year period beginning
July 2, 1990, Saba had received the $160 million cash portion of
the sale proceeds immediately prior to the end of its March 31,
1990 taxable year.
Taking the position that the maximum period
over which payments could be received on the sale of the Chase
PPNs was 6 years, Saba applied 1/6th of its basis in the Chase
PPNs in computing its gain on the sales under section 15A.4531(c), Temporary Income Tax Regs., supra.
Saba reported the sale
of the Chase PPNs on its Form 1065 for the year ended March 31,
1990, as follows:
Cash Proceeds:
Cost:
Basis = 1/6 cost:
Gain:
$160,000,000
200,000,000
33,333,333
$126,666,667
Saba allocated the gain reported on its Form 1065 for the
tax year ended March 31, 1990, among its partners (per its
Schedule K-1s) as follows:
- 37 -
Partner
Percentage
Interest
Skokie
Brunswick
Sodbury
Total
.5
9.5
90.0
100.0
Gain
$633,333
12,033,334
114,000,000
$126,666,667
The $126,666,667 gain that Saba reported on its March 31, 1990
tax return was not included on Saba's audited or unaudited
financial statements for the year ended March 31, 1990.
Saba invested the $160 million that it received on the sale
of the Chase PPNs in time deposits and commercial paper.
Saba
acquired approximately $50 million of Brunswick commercial paper
between September 20 and 26, 1990.
Saba held Brunswick's
commercial paper through April 3, 1991, when it contributed the
commercial paper to SBC International Holdings, Inc.
See
discussion infra p. 44.
C.
McManaman's Tax Projections
On April 20, 1990, McManaman prepared a schedule entitled
"FOREIGN PARTNERSHIP TAX UPDATE" in which he projected that
Brunswick would realize capital losses of $80 million
attributable to "FOREIGN PARTNERSHIP I" (Saba) and capital losses
of $57 million attributable to "FOREIGN PARTNERSHIP II" (the yet
to be formed Otrabanda partnership).
In addition, McManaman
projected that Brunswick would realize capital gains of $91
million attributable to the sales of its Technical businesses and
Nireco stock, that such capital gains would be offset by
- 38 Brunswick's capital losses from its partnership investments, and
that Brunswick would have $51 million in capital losses to carry
back to taxable years 1987 through 1989.
On April 25, 1990,
McManaman presented his projections to Brunswick's Board of
Directors.
D. Brunswick's Purchase of 50 Percent of Sodbury's
Partnership Interest
During a July 13, 1990, Saba partnership meeting, Sodbury
requested that the remaining partners purchase 50 percent of its
interest in the partnership.
Brunswick agreed to pay $92,452,227
in cash for 50 percent of Sodbury's partnership interest based in
part upon Pepe's valuation of the Fuji and Norinchukin LIBOR
notes.
In notes dated July 13, 1990, Pepe valued the Fuji and
Norinchukin LIBOR notes held by Saba at $36,213,588, and then
added to that amount $2,035,000--the sum of the $1,500,000
private placement discount and an unidentified additional amount
of $535,000.
Pepe rounded the resulting figure of $38,248,588 up
to $38,250,000.
By valuing the Fuji and Norinchukin LIBOR notes
in this fashion, Sodbury was relieved of the cost or private
placement discount associated with the sale of the Chase PPNs.
After Brunswick's purchase of 50 percent of Sodbury's
interest in Saba, Brunswick held a 54.5-percent partnership
interest in Saba, Skokie held a .5-percent partnership interest,
and Sodbury held a 45-percent partnership interest.
- 39 On July 13, 1990, Sodbury transferred the $92,452,227
received from Brunswick to ABN to be applied as a credit against
its loan account.
E.
Brunswick-ABN Consulting Agreement
On July 3, 1990, Brunswick and ABN entered into an agreement
under which ABN agreed to provide consulting services to
Brunswick in exchange for a fee.
Brunswick charged the fees that
it paid to ABN pursuant to the consulting agreement against the
portion of Brunswick's Accrued Disposition Costs reserve account
allocated to partnership activity.
Brunswick paid ABN a total of
$750,000 pursuant to the consulting agreement:
$250,000 on or
about July 10, 1990; $250,000 on or about February 26, 1991; and
$250,000 on or about February 27, 1992.
F.
Payments on 4 LIBOR Notes
On July 2, 1990, Fuji and Norinchukin made timely LIBOR note
payments to Saba of $1,115,320.33 and $1,113,372.36,
respectively.
Saba included $49,882 of these payments in its
interest income on its Form 1065 for the taxable year ended
March 31, 1991.
G.
Distribution of 3 LIBOR Notes to Brunswick
On August 17, 1990, Saba distributed $24,016,789 in cash to
Sodbury, $266,853 in cash to Skokie, and 2 Fuji LIBOR notes and 1
Norinchukin LIBOR note to Brunswick.
In notes dated August 17,
1990, Pepe valued the 3 LIBOR notes distributed to Brunswick by
- 40 first assigning a base value of $36,758,918 to all 4 of the Fuji
and Norinchukin LIBOR notes and adding to that amount the
$1,500,000 private placement discount and the $535,000 amount
that first appeared in Pepe's notes dated July 13, 1990.
Pepe's
notes dated August 17, 1990, identify the $535,000 amount as a
"fee".
Pepe rounded the resulting figure of $38,793,918 up to
$38,794,000 and multiplied that figure by the ratio of the total
NPA of the retained Norinchukin LIBOR note ($25,765,000) to the
NPA of all the LIBOR notes ($102,970,000).
Pursuant to these
computations, Pepe valued the Norinchukin LIBOR note that Saba
retained at $9,707,000 and the 3 LIBOR notes that Saba
distributed to Brunswick at $29,087,000.
Sodbury transferred the $24,016,789 that it received from
Saba to ABN to be applied as a credit against its loan account.
H.
Brunswick's Sale of 3 LIBOR Notes
In August 1990, concurrent with Saba's distribution of the 3
LIBOR notes to Brunswick, Merrill Lynch was making arrangements
for Brunswick to sell the LIBOR notes.
On August 14, 1990, a
representative of the Bank of Tokyo, Ltd. (BOT) prepared a
memorandum seeking approval from BOT's head office to purchase
the 3 LIBOR notes from Brunswick in connection with a structured
transaction to be arranged by Merrill Lynch.
On August 24, 1990,
- 41 Brunswick and Merrill Lynch executed a letter agreement
appointing Merrill Lynch as Brunswick's exclusive agent to
arrange for the sale of the 3 LIBOR notes.
On September 6, 1990, Brunswick sold the 3 LIBOR notes to
BOT for $26,601,451.
Brunswick determined that it incurred a
capital loss on the sale of the LIBOR notes.
First, Brunswick
computed its inside basis in the 3 LIBOR notes by multiplying
$166,666,667 ($200,000,000 (Saba's original cost basis in the
Chase PPNs) less $33,333,333 (the portion of Saba's cost basis in
the Chase PPNs used in computing Saba's gain on the sale of the
PPNs)) by 75 percent to account for the fact that Brunswick had
received 3 of the 4 LIBOR notes originally held by Saba.
Under
this formula, Brunswick determined that it had an inside basis in
the LIBOR notes of $125,000,000.
In the alternative, Brunswick
computed its outside basis in Saba as of September 6, 1990, as
follows:
Contributions
Distributive share for 3/31/90
Capital gain
Income
Purchase of partnership interest
Total basis
$19,000,000
12,033,334
127,470
92,452,227
$123,613,031
Brunswick determined that its basis in the 3 LIBOR notes was
$123,613,031--the lesser of its outside basis in Saba or its
inside basis in the 3 LIBOR notes.
- 42 On its consolidated Federal income tax return for 1990,
Brunswick reported a net short-term capital loss of $84,978,246
attributable to Saba.
The $84,978,246 net short-term capital
loss consists of the difference between Brunswick's purported
basis in the 3 LIBOR notes and the sales price of the notes, less
Brunswick's distributive share of the gain reported by Saba on
the sale of the Chase PPNs: ($123,613,031 - $26,601,451) $12,033,334 = $84,978,246.
Brunswick reported a loss on its audited and unaudited
financial statements on the sale of the 3 LIBOR notes in the
amount of $2,485,549, which is the difference between the cash
proceeds of $26,601,451 and the $29,087,000 value that Pepe
assigned to the 3 LIBOR notes at the time that they were
distributed.
The $2,485,549 loss was recorded in the portion of
Brunswick's Accrued Disposition Costs reserve account allocated
to partnership activity.
Brunswick's IPD and Tech Divestitures
Analysis of Deferred Disposition Costs account number 2107265
reflects the above $2,485,549 loss.
On its consolidated Federal income tax return for 1990,
Brunswick reported Skokie’s distributive share of the gain
reported by Saba on the sale of the Chase PPNs ($633,333) as
other income, rather than capital gain.
If Brunswick had
reported Skokie’s distributive share of the gain as capital gain
- 43 on its consolidated Federal income tax return, Brunswick would
have reported a short-term capital loss attributable to Saba of
$84,344,913.
I.
Partial Redemption of Sodbury's Partnership Interest
On September 14, 1990, Saba distributed $60,204,145 in cash
to Sodbury in redemption of a 35-percent partnership interest.
For purposes of determining the amount to be distributed in the
redemption, Pepe valued the remaining Norinchukin LIBOR note held
by Saba at $9,680,000.
The $9,680,000 amount included a $375,000
private placement discount (25 percent of the original $1,500,000
private placement discount) and $133,750 (25 percent of the
unidentified $535,000 "fee").
After the September 14, 1990 distribution, Brunswick held a
89.181882-percent partnership interest in Saba, Skokie held an
.8181818-percent partnership interest, and Sodbury held a 10percent partnership interest.
On September 14, 1990, Sodbury transferred the $60,204,145
that it received from Saba to ABN to be applied as a credit
against its loan account.
J.
Payments on Norinchukin LIBOR Note
Norinchukin made timely payments to Saba on the remaining
LIBOR note between October 1990 and April 1991.
Saba amortized
the LIBOR note payments for tax purposes and reported imputed
interest as follows:
- 44 -
Payment Date
LIBOR Note
Payment
Principal
Imputed
Interest
October 2, 1990
January 2, 1991
April 2, 1991
$551,443
548,356
488,126
$528,099
514,425
448,778
$23,344
33,931
39,348
K.
Transfer and Termination of 3 LIBOR Notes
On December 27, 1990, BOT assigned its rights under the
Norinchukin LIBOR note that it had purchased from Brunswick to
Banque Francaise du Commerce Exterieur (BFCE) for $7,510,040.
On
January 2, 1991, Fuji paid $16,063,182 to BOT in cancellation of
the two Fuji LIBOR notes that BOT had purchased from Brunswick.
On June 28, 1991, Norinchukin paid $7,040,954 to BFCE in
cancellation of the Norinchukin LIBOR note.
L.
Formation of SBC International Holdings, Inc. (SBC)
On April 3, 1991, Saba organized SBC International Holdings,
Inc. (SBC).
Saba transferred $744,109 in cash, $49,835,451 of
Brunswick commercial paper, $27,902,067 of other commercial
paper, and the remaining Norinchukin LIBOR note valued at
$7,752,000 to SBC in exchange for all 100 shares of SBC's
outstanding stock.
On April 3, 1991, Saba amended its partnership agreement to
provide, among other things, that Sodbury would not pay any
portion of SBC's Federal income taxes.
- 45 M.
Downgrade of Brunswick’s Credit Rating
On June 6, 1991, Moody’s announced that it was placing
Brunswick's debt ratings under review.
On June 19, 1991, Moody’s
announced that it was downgrading Brunswick’s long-term debt
rating from Baa1 to Baa2.
N.
Dissolution of Saba
During a June 21, 1991, Saba partnership meeting, Brunswick
informed the partnership that, due to a recent downgrading of
Brunswick’s credit rating, Brunswick would have to liquidate its
investment in Saba in order to reduce the amount of its
outstanding commercial paper and other borrowings.
On June 21,
1991, Saba transferred $1,161,928 to SBC as additional paid-in
capital.
The following schedule lists SBC's assets as reflected
on its June 21, 1991 unaudited financial statement:
Amount
Item
Cash
$1,161,928
Time deposits
2,922,499
Norinchukin LIBOR Note (as valued by Merrill Lynch)
7,760,000
Brunswick commercial paper
49,787,895
Non-Brunswick commercial paper
26,696,262
Accrued interest on Brunswick commercial paper
73,757
Accrued interest on non-Brunswick commercial paper
54,744
Accrued interest from time deposits
931
Total
$88,458,016
On June 21, 1991, Saba was dissolved.
For purposes of
Saba’s audited and unaudited financial statements, Brunswick was
allocated $1,101,381, Skokie was allocated $10,104, and Sodbury
was allocated $123,499 of Saba's income from April 1, 1991
- 46 through June 21, 1991.
For tax purposes, Brunswick was allocated
$190,177, Skokie was allocated $1,744, and Sodbury was allocated
$21,325 of Saba's income from April 1, 1991 through June 21,
1991.
These differences were reported on Saba’s Form 1065
(Schedule M) for the period ended June 21, 1991.
Saba's partners received the following property in
liquidation of their Saba partnership interests: (1) Brunswick
received Saba's 100 shares of SBC stock; (2) Skokie received
$811,541 in cash; and (3) Sodbury received $9,918,840 in cash.
On June 21, 1991, Sodbury's loan account with ABN was
credited in the amounts of $4,946,172.46 and $2,000,000.
Brunswick filed SBC's Federal income tax return for the
period April 3, 1991 through June 21, 1991, reporting taxable
income of $1,054,460 and tax due of $358,516.
tax due.
Brunswick paid the
Brunswick included SBC on its consolidated Federal
income tax return for 1991.
Brunswick did not report its receipt
of, or any gain or loss from, the 100 shares of SBC stock that it
received upon Saba's dissolution.
- 47 O.
Dissolution of Sodbury
On or about March 20, 1991, Sodbury paid dividends of $328
to both Pietermaai and Ronde Klip.
The dividends were
transferred to ABN and were credited to Pietermaai's and Ronde
Klip's loan accounts.
On June 21, 1991, ABN-Willemstad released all of its right,
title, and interest in and to the collateral assigned to it under
the February 26, 1990, pledge agreements between ABN, Pietermaai,
and Sodbury and between ABN, Ronde Klip, and Sodbury.
Effective
July 26, 1991, ABN exercised its options under the February 26,
1990, option agreements to buy Pietermaai's and Ronde Klip's
holdings in Sodbury.
On July 26, 1991, Sodbury paid ABN $3,065,347, an amount
representing Sodbury's total liabilities and stockholder's equity
of $3,071,347 less $6,000 of capital.
On that same date,
Sodbury's loan account with ABN was credited in the amount of
$3,065,347.
This amount is reflected as an interim dividend on
Sodbury's financial statement.
On July 29, 1991, Pietermaai and Ronde Klip each repurchased
3,000 shares of Sodbury stock from ABN for $1.
On the same date,
an extraordinary meeting of Sodbury's shareholders was held, and
it was resolved to dissolve Sodbury.
Curab, N.V., an entity
controlled by ABN Trust, was appointed liquidator.
- 48 P.
SBC's Sale of Remaining Norinchukin LIBOR Note
On July 2, 1991, SBC, then Brunswick's subsidiary, sold the
remaining Norinchukin LIBOR note via a Satisfaction and
Termination Agreement with Norinchukin dated June 28, 1991.
Norinchukin paid SBC $7,040,954 for the remaining note.
Lynch arranged the transaction.
Merrill
Norinchukin's July 2, 1991,
payment included a LIBOR note payment of $419,262.75 due on that
same date.
SBC, through Brunswick, amortized the Norinchukin
LIBOR note payment for tax purposes and reported imputed interest
as follows:
Payment Date
LIBOR Note
Payment
Principal
Imputed
Interest
July 2, 1991
$419,263
$377,684
$41,579
Brunswick determined that SBC incurred a capital loss on the
sale of the Norinchukin LIBOR note.
Brunswick computed SBC's
basis in the Norinchukin LIBOR note by multiplying $166,666,667
($200 million (original cost basis of the Chase PPNs) less
$33,333,333 (the portion of cost basis of the Chase PPNs used in
computing Saba's gain on the sale of the PPNs)) by 25 percent to
account for the fact that SBC had received 1 of the 4 LIBOR notes
originally held by Saba.
Under this formula, Brunswick
determined that SBC's basis in the Norinchukin LIBOR note was
$41,666,667.
Brunswick reported a long-term capital loss of
$32,631,287 on its consolidated Federal income tax return for
- 49 1991 attributable to SBC's sale of the remaining Norinchukin
LIBOR note.
Brunswick reported a loss of $719,046 on its audited
and unaudited financial statements attributable to the sale of
the remaining Norinchukin LIBOR note.
Brunswick charged the
$719,046 loss to the portion of Brunswick's Accrued Disposition
Costs reserve account allocated to partnership activity as part
of a $758,213 entry.
Q.
Termination of Chase Private Placement Notes
Between June 1990 and August 1990, Merrill Lynch exercised
its option under a side agreement with Fuji and purchased $40
million of the $100 million principal amount of Chase PPNs that
Fuji was holding.
On February 25, 1991, Fuji elected to exercise
the put option with respect to the remaining $60 million
principal amount of the Chase PPNs.
On April 17, 1991,
Norinchukin elected to exercise the put option with respect to
the $100 million principal amount of the Chase PPNs that it held.
V.
Saba-Related Swaps
A.
Fuji and Norinchukin Swaps
Merrill Lynch offered Fuji and Norinchukin structured
transactions to be implemented in conjunction with their
agreement to purchase the Chase PPNs from Saba for cash and LIBOR
notes.
In financial terminology, a "structured transaction" is
one that combines two or more financial instruments or
derivatives.
Most structured transactions, like those in this
- 50 case, involve derivatives.
The structured transaction that
Merrill Lynch offered to Fuji and Norinchukin consisted of two
swaps:
(1) A basis swap related to the asset that the banks
would be purchasing (the Chase PPNs), and (2) a hedge swap
related to the liability that the banks would be undertaking in
connection with the issuance of the LIBOR notes.
In general
terms, a swap is an agreement between two parties to exchange one
set of payments for another.
For example, one party might
exchange payments based on a floating interest rate for a payment
based on a fixed interest rate.
Economically, the Fuji and Norinchukin swaps provided the
banks with both an asset and a liability that were attractively
priced compared to other alternatives in the market.
Merrill
Lynch was the counterpart in the swaps.
The Fuji and Norinchukin basis swaps had the effect of
passing to Merrill Lynch the interest payments that accrued on
the Chase PPNs from March 21, 1990 through the date that the
Chase PPNs were terminated.
Further, Merrill Lynch made payments
to Fuji and Norinchukin which, when considered in conjunction
with the purchase of the Chase PPNs, enhanced Fuji's and
Norinchukin's returns from the Chase PPNs.
The net cash flows
resulting from the combination of the Chase PPNs with the basis
swaps were tied to LIBOR--the interest rate index under which
Fuji and Norinchukin normally conducted business.
- 51 The Fuji and Norinchukin hedge swaps were designed to allow
the banks to transform their liabilities under the LIBOR notes to
an amortizing liability at an interest rate below LIBOR.
Consequently, the Fuji and Norinchukin hedge swaps effectively
converted the transactions, from the banks' perspective, to
synthetic funding below the banks' funding rates.
Further, the
banks' payments under the hedge swaps were much less volatile
than the payments required to be made under the LIBOR notes.
B.
Sodbury-ABN-Merrill Lynch Swaps
Sodbury entered into interest rate swaps with ABN and ABN
entered into mirror swaps with Merrill Lynch to reduce Sodbury's
and ABN's interest rate risk associated with the 4 LIBOR notes
held by Saba.
C.
Bank of Tokyo Swaps
Effective September 6, 1990, Merrill Lynch and BOT executed
a swap in connection with BOT's purchase of the 3 LIBOR notes
from Brunswick.
The swap, which was designed to replicate the
economic effect of investing in an amortizing loan that paid a
margin over LIBOR, effectively converted the purchase of the
LIBOR notes, from BOT's perspective, to a synthetic amortizing
asset at a rate above BOT's normal financing rate.
D.
Banque Francaise du Commerce Exterieur Swaps
Effective January 2, 1991, Merrill Lynch and BFCE executed a
swap in connection with BOT's assignment of the Norinchukin LIBOR
- 52 note to BFCE.
The swap, which was designed to replicate the
economic effect of investing in an amortizing loan that paid a
margin over LIBOR, effectively converted the purchase of the
LIBOR Note, from BFCE's perspective, to a synthetic amortizing
asset at a rate above LIBOR.
E.
Brunswick Swaps
On April 5, 1990, Brunswick and Merrill Lynch entered into
an Interest Rate and Currency Exchange Agreement to govern
anticipated swap transactions between them.
On July 16, 1990,
concurrent with Brunswick's purchase of 50 percent of Sodbury's
interest in Saba, Brunswick and Merrill Lynch entered into a swap
agreement.
Brunswick used the swap to hedge a substantial
percentage of its interest in the LIBOR notes held by Saba.
On August 20, 1990, concurrent with the Saba's distribution
of 3 LIBOR notes to Brunswick, Brunswick and Merrill Lynch
entered into a second swap agreement.
Brunswick used the swap to
hedge a substantial percentage of its interest in the LIBOR
notes.
On September 6, 1990, Brunswick and Merrill Lynch partially
terminated the July 16, 1990, swap in connection with Brunswick's
sale of the 3 LIBOR notes to BOT.
The July 16, 1990, swap was
completely terminated on July 2, 1991, following SBC's sale of
the remaining Norinchukin LIBOR note.
On September 6, 1990,
Brunswick and Merrill Lynch partially terminated the August 20,
- 53 1990, swap due to Brunswick's sale of the 3 LIBOR notes.
This
swap was completely terminated on July 2, 1991, following SBC's
sale of the remaining Norinchukin LIBOR note.
On September 14, 1990, concurrent with the partial
redemption of Sodbury's partnership interest, Brunswick and
Merrill Lynch entered into a third swap.
Brunswick used the swap
to hedge a substantial percentage of its interest in the
remaining Norinchukin LIBOR note held by Saba.
This swap was
completely terminated on July 2, 1991, following SBC's sale of
the remaining Norinchukin LIBOR note.
VI.
Otrabanda Investerings Partnership
A.
Structure
On June 13, 1990, Brunswick, through Mayer, Brown & Platt,
requested that Merrill Lynch arrange a second partnership with a
structure slightly different from Saba.
Brunswick requested that
the foundations (stichtings) own the stock of subsidiary #1 which
in turn would own the stock of subsidiary #2.
Brunswick
requested that subsidiary #1 obtain a loan from ABN and use the
proceeds to capitalize subsidiary #2 with equity and that
subsidiary #2 act as the third partner in the new partnership.
On June 20, 1990, Brunswick and Merrill Lynch entered into a
letter agreement under which Merrill Lynch agreed to serve as
- 54 Brunswick's adviser regarding Otrabanda in exchange for a fee.
On or about September 5, 1990, Brunswick paid a $250,00 fee to
Merrill Lynch.
By memorandum dated June 19, 1990, den Baas informed ABN's
Risk Management Department that Brunswick was interested in
forming a second partnership.
den Baas' memorandum stated in
pertinent part:
although the loan spread will be 30 bps. the
transaction will yield 85 bps. over LIBOR (the
difference to be paid separately). Total remuneration
$600,000 excluding the Trust fee.
The previous deal has been unwound ahead of schedule
and outstandings per June 30, 1990 are $25mm.
Brunswick is in the process of divesting more of its
subsidiaries than originally planned and expects to
generate more capital gains than covered by the first
transaction. Therefore they requested ABN Trust
Curacao to create a new SPC for a second transactions
with the same parameters as before.
We will be brought down from $135mm. within three
months to appr. $20mm. and then to $10mm. before yearend. The total term of the transaction is anticipated
for one year with a maximum term of 1.5 years.
We are in the process of further syndicating present
outstandings in Willemstad to such a level that this
transaction will not bring us over the agreed upon
level of $2 bln. per June 30, 1990. This transaction
will NOT be put on the books if this attempt is
unsuccessful and by no means will the maximum
outstandings be more than the $2 bln.
*
*
*
*
*
*
*
The calendar for this transaction will look as follows:
Last week of June purchase of the private placements
for a total amount of $150mm.
- 55 Last week of July sale of these private placements for
cash ($120mm.) and installment note issued by AA or
better rated bank, with NPV of $30mm. Cash will be
invested in C.P. rated A-1/P-1 with a maximum of $20mm.
per name and a maximum maturity of 60 days. This to be
invested by ABN Trust and held by ABN New York.
In August the SPC's interest will be reduced to $50mm.
with a further reduction in early September to $20mm.
In December the SPC will reduce its involvement further
to $10mm. which will be reduced fully to zero in July
of 1991.
On June 19, 1990, ABN's North Atlantic Credit Committee
recommended approval of the second partnership "IN ACCORDANCE
WITH PREVIOUS ADVICES".
On June 22, 1990, ABN's Risk Management
Department approved the transaction so long as ABN would have the
right to liquidate the portfolio if its interest in the
partnership were not reduced according to the proposed schedule.
B.
Bartolo Corporation
On June 20, 1990, ABN established two stichtings, Rocky
Foundation (Rocky) and Jasper Foundation (Jasper).
On June 20, 1990, Bartolo Corporation, N.V. (Bartolo) was
incorporated in Curacao, Netherlands Antilles.
sole managing director of Bartolo.
ABN Trust was the
At the time that Bartolo was
incorporated, Rocky and Jasper each received one-half or 3,000
shares of the 6,000 shares of Bartolo common stock authorized to
be issued.
Each Bartolo share had a par value of $1 for a total
- 56 capitalization of $6,000.
Bartolo paid ABN Trust $28,338.94,
invoiced as a $25,000 fee for management, $3,335 for
incorporation costs, and $3 in expenses.
On June 25, 1990, Clavicor Corporation, N.V. (Clavicor) was
incorporated in Curacao, Netherlands Antilles.
sole managing director of Clavicor.
ABN Trust was the
At the time that Clavicor
was incorporated, Rocky and Jasper each received one-half or
3,000 shares of the 6,000 shares of Clavicor common stock
authorized to be issued.
Each Clavicor share had a par value of
$1 for a total capitalization of $6,000.
Clavicor paid ABN Trust
$6,013, invoiced as a $3,500 fee for management, $2,500 in
incorporation costs, and $13 in expenses.
On June 25, 1990, Rocky and Jasper transferred all 6,000
shares of Bartolo to Clavicor.
Bartolo was organized to serve as
a general partner in Otrabanda because ABN was not interested in
assuming the unlimited liability of a general partner and the
funding that ABN would provide to Bartolo could be syndicated.
C.
Otrabanda Organizational Meeting
By partnership agreement dated June 20, 1990, Brunswick,
Skokie, and Bartolo formed Otrabanda as a general partnership
under the laws of the State of New York.
The partners agreed
that Otrabanda would maintain its principal place of business in
Curacao, Netherlands Antilles.
- 57 The partnership agreement stated that the partnership was
being organized "for the object and purpose of making investments
in notes, bonds, debentures, and other interest bearing
instruments, owning, managing, and supervising such investments,
sharing the profits and losses therefrom, and engaging in such
activities necessarily incidental or ancillary thereto."
The
partnership agreement further stated that the partnership was
being organized to enable Brunswick and Skokie "to reduce their
credit risk exposure on investments while obtaining a yield in
excess of what they could obtain from U.S. treasury securities"
and to permit Bartolo "to earn a rate of return which reflects
the additional credit risk it may incur on Partnership
investments."
The partnership agreement provided for the payment of
"preferred amounts" from partnership income.
In particular,
partnership income would be allocated on a quarterly basis, first
to Brunswick and Skokie in an amount equal to a noncompounded per
annum return on the daily amounts of their unrecovered capital at
a rate equal to the Treasury bill rate plus 10 basis points, and
then to Bartolo in an amount equal to a noncompounded per annum
return on the daily amounts of its unrecovered capital at a rate
equal to LIBOR plus 5 basis points.
Any remaining partnership
income would be allocated to the partners in proportion to their
partnership percentages.
- 58 The partnership agreement stated that an act of the
partnership committee would require the vote or consent of
partners whose aggregate partnership percentages were not less
than 95 percent.
By letter dated June 20, 1990, Otrabanda engaged Fides to
perform certain administrative and investment management
services.
By letter dated June 20, 1990, Otrabanda entered into
an indemnity agreement with Fides.
During 1990 through 1991,
Otrabanda made the following payments to Fides:
Date
September 6, 1990
November 14, 1990
February 14, 1991
March 15, 1991
June 21, 1991
Amount
$50,822.79
1,471.75
1,742.61
2,390.15
1,028.01
On June 21, 1990, Brunswick representatives O'Brien and
Zelisko attended Otrabanda's organizational meeting in Bermuda.
ABN's representative, de Beer, participated in the meeting by way
of telephone conference call.
By letter agreement dated June 21, 1990, Otrabanda engaged
Merrill Lynch as its financial adviser.
The June 21, 1990,
letter does not state the amount of Merrill Lynch's fee for such
services.
Merrill Lynch expected to be compensated for its
services (at least in part) by acting as the dealer in
transactions with Otrabanda.
- 59 On June 25, 1990, Skokie executed a promissory note
evidencing a loan of $1,500,000 from Brunswick.
On November 1,
1990, Skokie made a loan repayment to Brunswick in the amount of
$354,522.67.
On June 21, 1991, Skokie made a loan repayment to
Brunswick in the amount of $741,777.70.
After this second
payment, the outstanding balance of the loan was $403,699.63.
On June 25, 1990, ABN-Willemstad and Clavicor entered into a
Revolving Credit Agreement (RCA) under which ABN-Willemstad
agreed to make available to Clavicor one or more loans in the
aggregate principal amount of $150 million.
expire no later than June 24, 1991.
The RCA was to
By agreements dated June 25,
1990, Rocky and Jasper pledged their 6,000 shares of Clavicor to
ABN-Willemstad as security for the RCA.
On June 25, 1990, ABN-
Willemstad and Clavicor entered into a Subordinated Loan
Agreement (SLA) under which ABN-Willemstad agreed to loan
Clavicor $15 million, subordinated to the RCA.
According to the
SLA, the loan was not to bear interest, unless the outstanding
principal was not paid on the expiration date.
By Option Agreement dated June 25, 1990, Rocky and Jasper
each granted ABN the irrevocable option to purchase up to 100
percent of their Clavicor shares at par.
On June 25, 1990, the Otrabanda partners made the following
capital contributions to the partnership:
- 60 Capital Contribution
Brunswick
Skokie
Bartolo
$13,500,000
1,500,000
135,000,000
$150,000,000
Percentage Interest
9.0
1.0
90.0
100.0
The partners' June 25, 1990, capital contributions were deposited
into Otrabanda's bank account at ABN-New York.
Bartolo's initial capital contribution to Otrabanda came
from a loan from Clavicor.
Clavicor was able to provide $135
million to Bartolo through funds obtained under its RCA with ABNWillemstad.
D.
Miscellaneous Fees
Otrabanda maintained certain audited and unaudited financial
statements.
Otrabanda's audited financial statements were
prepared by Arthur Andersen.
Otrabanda made the following
payments to Arthur Andersen and Cravath, Swaine & Moore for
professional fees:
Date
November 14, 1990
January 7, 1991
June 21, 1991
Amount
$71,524.25
10,000.00
13,165.19
Payee
Cravath
Arthur Andersen
Cravath
The $71,524.25 fee paid to Cravath on November 14, 1990, included
a fee for professional services of $68,000.
In a December 2,
1994 memorandum from Cravath to Brunswick, Cravath itemized the
$68,000 charge for professional services as follows:
The $68,000.00 fee was for negotiation and
drafting of the documentation, and for other related
- 61 services, in connection with: (a) the formation of
Otrabanda ($12,215.57), (b) the purchase by Otrabanda
of certain certificates of deposit ($12,537.03), (c)
the sale by Otrabanda of such certificates
($23,193.51), (d) the assignment of Otrabanda’s right
to receive payments from such sale ($6,209.58) and (e)
other related matters ($13,844.31). * * *
Otrabanda paid commercial paper fees as follows:
Date of Payment
August 10, 1990
September 7, 1990
October 5, 1990
November 6, 1990
December 7, 1990
January 19, 1991
February 14, 1991
March 15, 1991
April 17, 1991
May 31, 1991
June 18, 1991
VII.
Amount
$385
605
315
645
575
215
315
330
290
195
100
Otrabanda Transactions
A.
Otrabanda's Purchase of Certificates of Deposit
On June 29, 1990, Otrabanda purchased from Industrial Bank
of Japan (IBJ) 4 newly issued $25 million floating-rate
certificates of deposit (IBJ CDs) for a total principal amount of
$100 million.
The IBJ CDs included a European-style put option
exercisable at par plus accrued interest by the holder on January
15, 1992, and were due to mature on June 21, 1995.
The IBJ CDs
bore interest at 8.25 percent for the first month and at 1-month
LIBOR minus 12.5 basis points thereafter.
- 62 At the time the IBJ CDs were issued, IBJ was rated Aaa by
Moody's.
The IBJ CDs were not registered under the Securities
Act of 1933 and were not traded on an established securities
market.
On July 18, 1990, IBJ made a timely interest payment of
$435,416.67 to Otrabanda with respect to the IBJ CDs.
(IBJ’s
July 18, 1990, interest payment was for $458,333.33, which
exceeded the interest amount due by $22,916.66.
1990, the excess interest was reversed.)
On July 31,
Otrabanda included this
interest payment in its interest income on its Form 1065 for the
taxable year ended July 31, 1990.
B.
Otrabanda's Sale of Certificates of Deposit
Brunswick and Merrill Lynch discussed an investment in an
instrument analogous to an inverse floater, that would increase
in value as interest rates declined and decrease in value as
interest rates increased.
Otrabanda did not purchase such an
instrument.
On July 24, 1990, Otrabanda held a partnership meeting at
Merrill Lynch's office in Toronto.
Zelisko attended the meeting
on behalf of Brunswick and Skokie, while de Beer from ABN and
Taylor from Merrill Lynch participated in the meeting by way of
telephone conference call.
The partnership committee adopted a
resolution, upon the advice of Merrill Lynch, authorizing and
directing the sale of the IBJ CDs for consideration consisting of
- 63 cash and contingent payments based upon LIBOR.
The resolution
does not explain the basis for Merrill Lynch's recommendation to
sell the IBJ CDs.
On July 27, 1990, Otrabanda sold its IBJ CDs to Sumitomo
Bank Capital Markets (Sumitomo) for $80 million in cash and 4
installment purchase agreements dated July 27, 1990 (Sumitomo
LIBOR notes) each with a stated NPA of $13,349,000 for a total
NPA of $53,396,000.
The sale of the IBJ CDs to Sumitomo included $201,562 of
interest that had accrued on the IBJ CDs for the period from July
18, 1990 through July 27, 1990.
Otrabanda included this amount
in interest income on its Form 1065 for the taxable year ended
July 31, 1990.
Each of the Sumitomo LIBOR notes that Otrabanda received
provided for 20 quarterly payments of an amount equal to 3-month
LIBOR, generally set 3 months preceding the payment date,
multiplied by (1) the NPA of each note and (2) a fraction
consisting of the number of days between payment dates divided by
360.
Payments on the Sumitomo LIBOR notes were to commence on
November 1, 1990, and to conclude on August 1, 1995.
The
effective date of the Sumitomo LIBOR notes was August 1, 1990.
Otrabanda sold the IBJ CDs at 99.25 percent of par, or at a
private placement discount of $750,000 (75 basis points x
$100,000,000).
Pepe of Merrill Lynch determined the origination
- 64 value of the Sumitomo LIBOR notes based on the sum of the par
value of the IBJ CDs plus accrued interest, less the private
placement discount and the cash received upon the sale of the IBJ
CDs, as follows:
Par value of IBJ CDs
Plus accrued interest (through 7/29)
Less private placement discount
Net amount
Less cash received
Merrill Lynch origination value
$100,000,000
201,562
100,201,562
(750,000)
99,451,562
(80,000,000)
$19,451,562
Sumitomo valued the LIBOR notes that it had issued to Otrabanda
at $18,905,565.
According to Pepe's computations, Otrabanda received
consideration totaling $99,451,562 consisting of the $80 million
in cash and the Sumitomo LIBOR notes with a present value of
$19,451,562.
The difference between the par value of the IBJ CDs
plus accrued interest ($100,201,562) and the total consideration
that Otrabanda received ($99,451,562) reflects the $750,000
private placement discount on the sale of the IBJ CDs.
Contrary to the origination value that Pepe assigned to the
Sumitomo LIBOR notes, Otrabanda carried the LIBOR notes on its
audited and unaudited financial statements at their cost of
$20,201,562--the present value of the LIBOR notes of $19,451,562,
plus the $750,000 private placement discount on the sale of the
IBJ CDs.
Otrabanda adopted this approach based upon advice from
Merrill Lynch.
As discussed in detail below, the private
- 65 placement discount on the sale of the IBJ CDs eventually was
borne solely by Brunswick following the distribution and sale of
the LIBOR notes.
A portion of the $750,000 private placement discount on the
sale of the IBJ CDs was attributable to the CDs' lack of
liquidity.
If Otrabanda had invested directly in LIBOR notes, as
opposed to first purchasing the IBJ CDs, Otrabanda could have
avoided the portion of the $750,000 discount attributable to the
CDs' lack of liquidity.
O'Brien understood that Otrabanda had invested in the IBJ
CDs, prior to its investment in the LIBOR notes, to ensure that
the transactions would be treated for tax purposes as CINS
transactions.
The IBJ CDs were not readily tradeable on an
established market.
In addition, because the Sumitomo LIBOR
notes provided for 20 variable, quarterly payments, Otrabanda
could not determine the aggregate selling price of the IBJ CDs by
the end of its July 31, 1990 taxable year.
Consequently,
Otrabanda reported the sale of the IBJ CDs as an "installment
sale" under section 453(b).
Otrabanda computed its gain on the
sale of the IBJ CDs through a ratable allocation (or recovery) of
its basis in the IBJ CDs under section 15A.453-1(c), Temporary
Income Tax Regs., 46 Fed. Reg. 10711 (Feb. 4, 1981).
Although the Sumitomo LIBOR notes provided for 20 quarterly
payments to be paid over a 5-year period beginning November 1,
- 66 1990, Otrabanda had received the $80 million cash portion of the
sale proceeds immediately prior to the end of its July 31, 1990
taxable year.
Taking the position that the maximum period over
which payments could be received on the sale of the IBJ CDs was 6
years, Otrabanda applied 1/6th of its basis in the IBJ CDs in
computing its gain on the sale under section 15A.453-1(c),
Temporary Income Tax Regs.
Otrabanda reported the sale of the
IBJ CDs on its Form 1065 for the tax year ended July 31, 1990, as
follows:
Cash Proceeds:
Cost:
Basis = 1/6 cost:
Gain
$80,000,000
100,000,000
(16,666,666)
$63,333,334
Otrabanda allocated the gain reported on its Form 1065 for
the tax year ended July 31, 1990, among its partners (per
Schedule K-1s) as follows:
Partner
Percentage
Interest
Skokie
Brunswick
Bartolo
Total
1.0
9.0
90.0
100.0
Gain
$633,333
5,700,000
57,000,001
$63,333,334
The $63,333,334 that Otrabanda reported on its July 31, 1990 tax
return was not included in Otrabanda's audited and unaudited
financial statements for the year ended July 31, 1990.
Otrabanda invested the $80 million that it received on the
sale of the IBJ CDs in time deposits and commercial paper.
- 67 Otrabanda acquired approximately $40 million of Brunswick
commercial paper between December 5 and 7, 1990.
Otrabanda held
Brunswick commercial paper until April 3, 1991, when it
contributed its commercial paper holdings to OBC International
Holdings, Inc.
See discussion infra p.72.
C. Brunswick's Purchase of 50 Percent of Bartolo's
Partnership Interest
On October 11, 1990, Brunswick purchased 50 percent of
Bartolo's interest in Otrabanda for $69,239,696 in cash.
For
purposes of computing the price to be paid for Bartolo's
interest, the partners relied upon Pepe to assign a value to the
Sumitomo LIBOR notes.
Pepe valued the Sumitomo LIBOR notes at
$20,016,983, and then added to that amount the $750,000 private
placement discount and rounded up to derive a value of
$20,767,000.
After Brunswick's purchase of 50 percent of
Bartolo's partnership interest, Brunswick held a 54.0009108percent partnership interest in Otrabanda, Skokie held a
.9990892-percent partnership interest, and Bartolo held a 45percent partnership interest.
On October 11, 1990, Bartolo transferred the $69,239,696
received from Brunswick to Clavicor.
On October 11, 1990,
Clavicor transferred the $69,239,696 to ABN to be credited
against its loan account.
- 68 D.
Payments on LIBOR Notes
On November 1, 1990, Sumitomo made a timely payment of
$1,085,255.84 to Otrabanda on the LIBOR notes.
Otrabanda
amortized this payment for tax purposes and reported $23,907 of
the payment as imputed interest on its Form 1065 for the taxable
year ended June 21, 1991.
E.
Distribution of LIBOR Notes to Brunswick
On November 1, 1990, Otrabanda distributed $354,523 in cash
to Skokie, $15,968,064 in cash to Bartolo, and the 4 Sumitomo
LIBOR notes to Brunswick.
The partners relied on Pepe to
determine the value of the Sumitomo LIBOR notes.
Pepe assigned a
value of $19,162,000 to the Sumitomo LIBOR notes, inclusive of
the $750,000 private placement discount on the sale of the IBJ
CDs.
By valuing the Sumitomo LIBOR notes in this fashion,
Bartolo was relieved of the cost or private placement discount
associated with the sale of the IBJ CDs.
On November 1, 1990, Bartolo transferred $16,100,000 to
Clavicor, including the $15,968,064 received in the Otrabanda
distribution.
On November 1, 1990, Clavicor transferred
$16,083,986 of the $16,100,000 to ABN to be credited against its
loan account.
- 69 F.
Brunswick's Sale of LIBOR Notes
On November 5, 1990, Brunswick and Merrill Lynch executed a
letter agreement under which Merrill Lynch agreed to serve as
Brunswick's exclusive agent to arrange for the sale of the 4
Sumitomo LIBOR notes.
On November 28, 1990, Brunswick sold the 4 Sumitomo LIBOR
notes to BFCE for $17,458,827.
transaction.
Merrill Lynch arranged the
Brunswick determined that it incurred a capital
loss on the sale of the Sumitomo LIBOR notes.
Brunswick
determined that its basis in the 4 LIBOR notes was equal to the
unused portion of Otrabanda's basis in the IBJ CDs or
$83,333,333: ($100,000,000 (Otrabanda's cost basis in the IBJ
CDs) less $16,666,667 (the portion of Otrabanda's cost basis used
in computing Otrabanda's gain on the sale of the IBJ CDs)).
On its consolidated Federal income tax return for 1990,
Brunswick reported a net short-term capital loss of $60,174,506
attributable to Otrabanda.
The $60,174,506 net short-term
capital loss consists of the difference between Brunswick's
purported basis in the 4 Sumitomo LIBOR notes and the sales price
of the notes, less Brunswick's distributive share of the gain
reported by Otrabanda on the sale of the IBJ CDs: ($83,333,333 $17,458,827) - $5,700,000 = $60,174,506.
On its consolidated Federal income tax return for 1990,
Brunswick reported Skokie’s distributive share of the gain
- 70 reported by Otrabanda on the sale of the IBJ CDs ($633,333) as
other income, rather than capital gain.
If Brunswick had
reported Skokie’s distributive share of the gain as capital gain
on its consolidated Federal income tax return, Brunswick would
have reported a short-term capital loss attributable to Otrabanda
of $59,541,173.
For financial reporting purposes, Brunswick reported a loss
of $1,703,173 on the sale of the 4 Sumitomo LIBOR notes.
The
$1,703,173 loss represents the difference between the cash
proceeds of $17,458,827 from the sale and the $19,162,000 present
value that Merrill Lynch assigned to the Sumitomo LIBOR notes on
the date that they were distributed to Brunswick.
The $1,703,173
loss was recorded in the portion of Brunswick's Accrued
Disposition Costs reserve account allocated to partnership
activity.
G.
Partial Redemption of Bartolo's Partnership Interest
On December 4, 1990, Otrabanda held a partnership meeting
and the partners agreed that the partnership would partially
redeem Bartolo’s interest in the partnership.
On the same date,
Otrabanda distributed $46,370,431 in cash to Bartolo in
redemption of a 35-percent partnership interest.
On December 4,
1990, Bartolo transferred the $46,370,431 plus $34,569 to
Clavicor, and Clavicor transferred the full amount to ABN to be
applied as a credit against its loan account.
- 71 After the December 4, 1990 distribution, Brunswick held a
88.3651268-percent partnership interest in Otrabanda, Skokie held
a 1.6348732-percent partnership interest, and Bartolo held a 10percent partnership interest.
On December 4, 1990, Brunswick, Skokie, and Bartolo also
agreed to amend the Otrabanda partnership agreement to provide
that an act of the partnership committee would only require the
vote or consent of partners whose aggregate partnership
percentages were not less than 90 percent.
This amendment had
the practical effect of vesting Brunswick with control of
Otrabanda inasmuch as Brunswick's and Skokie's aggregate
partnership percentage interest was exactly 90 percent.
On December 10, 1990, Brunswick paid Bartolo $645,000 in
cash.
It appears that this payment represents the price that
Brunswick paid to obtain control of Otrabanda.
The $645,000
amount was recorded in the portion of Brunswick's Accrued
Disposition Costs reserve account allocated to partnership
activity.
Brunswick Corporation Posting Cycle Journal Entry No.
12-79 states that the $645,000 represents "fees due to ABN for
Otrabanda Partnership."
On December 11, 1990, Bartolo
transferred the $645,000 to Clavicor and Clavicor transferred the
$645,000 to ABN to be applied as a credit to its loan account.
- 72 H.
Formation of OBC International Holdings, Inc.
On April 3, 1991, Otrabanda organized OBC International
Holdings, Inc. (OBC).
Otrabanda transferred $98,734 in cash,
$39,892,597 of Brunswick's commercial paper, and $26,435,369 of
other commercial paper to OBC in return for all of OBC's
outstanding stock.
On April 3, 1991, Otrabanda amended its
partnership agreement to provide, among other things, that
Bartolo would not pay any portion of OBC's Federal income taxes.
Brunswick filed OBC's Federal income tax return for the period
April 3 through June 21, 1991.
This return reflects taxable
income of $891,134 and a tax due of $302,986.
Brunswick paid the
tax due.
I.
Dissolution of Otrabanda
During a June 21, 1991, Otrabanda partnership meeting,
Brunswick informed the partnership that, due to a recent
downgrading of Brunswick’s credit rating, Brunswick would have to
liquidate its investment in Otrabanda in order to reduce the
amount of its outstanding commercial paper and other borrowings.
As previously mentioned, on June 19, 1991, Moody’s had downgraded
Brunswick’s long-term debt rating from Baa1 to Baa2.
p. 45.
See supra
O'Brien proposed that Otrabanda be dissolved.
For purposes of Otrabanda’s audited and unaudited financial
statements, Brunswick was allocated $3,166,221, Skokie was
allocated $82,024, and Bartolo was allocated $3,289,820 of
- 73 Otrabanda's income from August 1, 1990, through June 21, 1991.
For tax purposes, Brunswick was allocated $2,587,763, Skokie was
allocated $67,040, and Bartolo was allocated $2,688,779 of
Otrabanda's income from August 1, 1990, through June 21, 1991.
These differences were reported on Otrabanda’s Form 1065,
Schedule M, for the period ended June 21, 1991.
On June 21, 1991, Otrabanda was dissolved.
Otrabanda's
partners received the following property in liquidation of their
interests in Otrabanda: (1) Brunswick received 99.265361541
shares of OBC stock; (2) Skokie received .734638459 shares of OBC
stock plus cash of $741,778; and (3) Bartolo received cash of
$7,562,179.
On June 21, 1991, OBC held the following assets:
Item
Time deposits
Brunswick commercial paper
Non-Brunswick commercial paper
Accrued Interest--Brunswick commercial paper
Accrued Interest--non-Brunswick commercial paper
Accrued Interest from time deposits
Total
Amount
$633,979
39,856,500
26,787,631
15,375
24,152
197
$67,317,834
Brunswick treated OBC as part of its consolidated group on its
Federal income tax return for the fiscal year ended June 21,
1991.
Brunswick did not report its receipt of, or any gain or
loss from, the 100 shares of OBC stock received from Otrabanda on
its Form 1120 for the 1991 tax year.
- 74 J.
Dissolution of Bartolo
On March 20, 1991, Clavicor paid a dividend of $494 to
Jasper and Rocky.
On June 21, 1991, ABN-Willemstad released all of its right,
title, and interest in and to the collateral assigned to it under
the June 25, 1990, pledge agreements between ABN, Jasper, and
Clavicor and between ABN, Rocky, and Clavicor.
Effective July 26, 1991, ABN exercised its options under the
June 25, 1990, option agreements with Rocky and Jasper to buy
their holdings in Clavicor.
On July 26, 1991, Clavicor paid ABN
$859,917 representing Clavicor's total stockholder's equity.
On July 29, 1991, Jasper and Rocky repurchased the 6,000
shares of Clavicor from ABN for $1.
the same date.
Clavicor was dissolved on
Curab, N.V., an entity controlled by ABN Trust,
was appointed liquidator.
On July 29, 1991, Bartolo declared a dividend of $4,795,973,
even though its net assets only consisted of $287,404.
Bartolo
had previously paid $4,514,569 to Clavicor in multiple payments;
Clavicor had then paid the $4,514,569 to ABN in multiple
payments.
Bartolo was dissolved on July 29, 1991.
was appointed liquidator.
Curab, N.V.
- 75 K.
Termination of the 4 LIBOR Notes
On August 1, 1991, the 4 Sumitomo LIBOR notes held by BFCE
were terminated in exchange for Sumitomo's payment of $15,223,523
to BFCE.
L.
Termination of the IBJ CDs
On August 14, 1990, Sumitomo transferred the IBJ CDs to
Sumitomo Bank Limited, Cayman Branch (Sumitomo Cayman).
Sumitomo
Cayman elected to exercise its put option with respect to the IBJ
CDs effective January 15, 1992.
VIII.
Otrabanda-Related Swaps
A.
Otrabanda Swap
On June 29, 1990, concurrent with Otrabanda's purchase of
the IBJ CDs, Otrabanda entered into an interest rate swap with
Merrill Lynch.
The swap, which was used to transform Otrabanda's
return on the IBJ CDs from a floating LIBOR-based rate to one
based on Treasury bills, was terminated on July 27, 1990,
concurrent with Otrabanda' sale of the IBJ CDs.
B.
Sumitomo Swaps
Merrill Lynch offered Sumitomo a structured transaction in
connection with its purchase of the IBJ CDs for cash and LIBOR
notes.
In particular, Merrill Lynch and Sumitomo executed a swap
that provided Sumitomo with both an asset and liability that were
attractively priced versus other alternatives in the market.
Sumitomo swap was designed to replicate the economic effect of
The
- 76 partly financing the purchase of the IBJ CDs with a conventional
amortizing loan and effectively converted the transaction, from
Sumitomo's perspective, to synthetic funding below Sumitomo's
funding rates.
Further, Sumitomo's payments under the hedge swap
were much less volatile than the payments required to be made
under the LIBOR notes.
C.
Bartolo-ABN-Merrill Lynch Swaps
Bartolo entered into interest rate swaps with ABN and ABN
entered into mirror swaps with Merrill Lynch to reduce Bartolo's
and ABN's interest rate risk associated with the 4 Sumitomo LIBOR
notes held by Otrabanda.
D.
Banque Francaise du Commerce Exterieur Swaps
Merrill Lynch offered BFCE a swap in connection with BFCE's
purchase of the 4 LIBOR notes from Brunswick.
The Merrill Lynch-
BFCE swap, which was designed to replicate the economic effect of
investing in an amortizing loan that paid a margin over LIBOR,
effectively converted the purchase of the LIBOR notes, from
BFCE's perspective, to a synthetic amortizing asset at a rate
above BFCE's financing rate.
E.
Brunswick Swaps
On October 11, 1990, concurrent with Brunswick's purchase of
50 percent of Bartolo's partnership interest in Otrabanda,
Brunswick and Merrill Lynch entered into a swap agreement.
November 1, 1990, concurrent with the partial redemption of
On
- 77 Bartolo's partnership interest in Otrabanda, Brunswick and
Merrill Lynch entered into a second swap agreement.
Brunswick
used these swaps to hedge a substantial percentage of its
interest in the Sumitomo LIBOR notes.
On November 28, 1990, the swaps that Brunswick and Merrill
Lynch entered into on October 11, 1990, and November 1, 1990,
were completely terminated upon Brunswick's sale of the 4
Sumitomo LIBOR notes to BFCE.
IX.
Saba's and Otrabanda's Tax Returns
Saba filed Forms 1065 (U.S. Partnership Return of Income)
for the years ending March 31, 1990, March 31, 1991, and June 21,
1991.
Brunswick prepared the returns as Saba’s tax matters
partner.
Otrabanda filed Forms 1065 (U.S. Partnership Return of
Income) for the years ending July 31, 1990, and June 21, 1991.
Brunswick prepared the returns as Otrabanda’s tax matters
partner.
X.
Brunswick's Partnership Expenses
A.
Transaction Costs
Petitioner retained Clifford W. Smith, Jr. (Smith),
Professor of Finance at the William E. Simon Graduate School of
Business Administration at the University of Rochester, to serve
as an expert witness in these cases.
Smith computed the present
values of the LIBOR notes that were issued to Saba and Otrabanda
- 78 in connection with the sales of the Chase PPNs and IBJ CDs.
In
particular, Smith determined that, as of March 23, 1990, the
present values of the Fuji and Norinchukin LIBOR notes issued to
Saba were $18,728,061 and $18,760,828, respectively.
Smith
further determined that, as of July 27, 1990, the present values
of the Sumitomo LIBOR notes issued to Otrabanda were $18,909,546.
Smith's valuations of the LIBOR notes were lower than those
determined by Pepe.
See supra pp. 33-34, 63-64.
Relying on his lower valuations of the LIBOR notes, Smith
concluded that Saba incurred transaction costs of $2,605,495 on
the sale of the Chase PPNs, and that Otrabanda incurred
transaction costs of $1,292,017 on the sale of the IBJ CDs.
Smith opined that these transaction costs included fees to
Merrill Lynch for locating the issuers of the PPNs and CDs and
the LIBOR notes, a spread between the bid-ask price on the sale
of the PPNs and CDs, and a spread on the bid-ask price on the
purchase of the LIBOR notes.
Considering the volatile nature of
LIBOR notes, Smith concluded that the bid-ask spread included the
cost that the issuers of the LIBOR notes would incur in obtaining
interest rate swaps.
B.
Legal and Accounting Fees
Brunswick paid the Mayer, Brown & Platt law firm for
services related to Saba and Otrabanda as follows:
- 79 Year
1990
1991
1992
1993
Amount
$288,736.75
72,533.90
15,092.64
6,027.50
Brunswick paid total fees of $26,000 to Arthur Andersen for
services related to Saba and Otrabanda.
C.
Total Expenses
As of October 3, 1990, Brunswick had established a reserve
for expenses attributable to Saba and Otrabanda of $10,600,000 as
part of Brunswick's Accrued Disposition Costs account.
Brunswick
established the Accrued Disposition Costs account to accrue
expenses that would be netted against the gains that Brunswick
expected to realize on the sale of its Technical businesses and
Nireco stock.
Arthur Andersen served as Brunswick's independent accountant
from 1980 through 1993.
In an interoffice memorandum dated
October 16, 1990, authored by Michael P. Abrahamson (Abrahamson)
and circulated to Arthur Andersen representatives in New York and
Chicago, Abrahamson discussed Brunswick's accounting for its
investment in Saba.
The memorandum states that the accounting
treatment for the transaction had been discussed with Arthur
Andersen prior to Brunswick’s recording the transaction.
The
memorandum further states in pertinent part:
Any transaction costs (i.e., formation of the
partnership) to be borne by Brunswick were charged
against a gain on sale (i.e., below the line) recorded
by Brunswick in connection with the disposition of
- 80 certain technical segment businesses. These costs were
charged against the gain because the only reason
Brunswick formed the partnership was to maximize the
after tax earnings and cash flow from these
dispositions.
Although the second sentence quoted above is crossed out in the
copy of the Abrahamson memorandum provided to the Court, the word
"STET" appears in the margin next to the sentence in question.
Arthur Andersen also prepared a schedule, set forth below,
itemizing Brunswick's accrual of $10,370,000 in foreign
partnership expenses for the quarter ended December 31, 1990:
Fees (in thousands)
Saba
Otrabanda
Total
Merrill Lynch
ABN (advisory fee)(actual $645)
1,750
750
1,425
3,175
750
900
900
250
50
250
50
500
100
300
3,100
2,625
300
5,725
Bartolo-2nd FP
Cravath, Swaine & Moore
N.V. Fides (Trust Co.)
Other
Total Fees
Financing Costs
Underwriting Costs
Chase Note and 3 CNs
Swap and Other
2,840
355
1,450
4,290
355
Total
6,295
4,075
10,370
Say 10.6
Merrill Lynch
Paid in
1990
Accrued
at 12-31
TOTAL
1,436
1,750
3,186
TOTAL
EST.EXP.
DIF
3,175
11
Relying on a schedule prepared by Brunswick's accounting
department on February 4, 1991, Arthur Andersen estimated that,
- 81 for the period ending December 31, 1990, Brunswick had incurred
expenses of $3,667,000 relating to the sales of Brunswick's
Technical businesses and Nireco stock.
The $3,667,000 in
expenses were allocated as follows:
Company
Vapor
Vapor A/C
TXT
ECS
Circle Seal
Biotech
NIRECO
Amount
$562,000
64,000
585,000
367,000
516,000
59,000
1,514,000
Total
3,667,000
On October 31, 1991, Brunswick's accountants reallocated
$2,425,000 from a total reserve of $10,600,000 for partnership
expenses and accounted for the $2,425,000 as commissions paid to
Merrill Lynch in connection with the sales of Vapor, TXT, and
Nireco stock.
Brunswick reallocated $1,250,000 to Vapor AC,
$500,000 to TXT, and $675,000 to Nireco.
Brunswick never
informed Arthur Andersen about the reallocation of expenses.
Based upon Arthur Andersen's work papers, Brunswick incurred
net partnership expenses of $8,950,000.
Accounting for the
reallocation of $2,425,000 of expenses described above, Brunswick
concluded that it incurred net partnership expenses of
$6,006,944.
XI.
Interest Rate Forecasts
Smith, petitioner's expert, prepared a report in which he
employed various methods for forecasting interest rates in an
- 82 effort to determine the potential profitability of an investment
in the LIBOR notes at issue.
Relying on a market-based forecast
for 3-month LIBOR as of February 23, 1990 and June 20, 1990,
Smith opined that the LIBOR notes had the potential to provide
returns up to $10,826,000 over their 5-year terms.
Relying on
the "symmetric" theory of interest rate behavior--the theory that
a 525 basis point increase in interest rates was as equally
probable as the actual 525 basis point decrease in interest rates
that occurred during the period in question--Smith opined that
the LIBOR notes had the potential to provide returns of up to
$40,487,000.
Relying on the "equal probability" theory of
interest rate behavior--the theory that the likelihood of
interest rates falling by one-half is equal to that of interest
rates doubling over the same period--Smith opined that the LIBOR
notes had the potential to provide returns of up to $80,683,000
over their 5-year terms.
Respondent retained Richard W. Leftwich (Leftwich),
Professor of Accounting and Finance at the University of Chicago
Graduate School of Business, to serve as an expert witness in
these cases. Leftwich believed that Smith's market-based forecast
for 3-month LIBOR was too high based on prevailing market rates
and forecasts.
Leftwich further opined that, in assessing the
market's forecast of future interest rates, Smith improperly
ignored the impact of the so-called liquidity and risk premium
- 83 hypotheses on the shape of the yield curve.
Respondent presented
evidence that market prognosticators were anticipating declining
interest rates as of February 23, 1990.
Specifically, the March
10, 1990, edition of Blue Chip Economic Indicators, a monthly
publication containing a survey of the Wall Street community and
economists, reported that the "consensus" view was that Treasury
bill rates would decline from 7.7 percent in the first quarter of
1990 to 7.4 percent in the fourth quarter of 1990 and to 7.3
percent in the fourth quarter of 1991.
Treasury bills are short-
term debt instruments that correlate with 3-month LIBOR.
The
Blue Chip Economic Indicators survey remained fairly constant
throughout the summer of 1990.
However, the August 10, 1990,
edition reported that the "consensus" view was that Treasury bill
rates would fall to 7.2 percent in the fourth quarter of 1990 and
remained virtually unchanged through the fourth quarter of 1991.
Contrary to Smith's forecast, interest rates fell
dramatically between February 1990 and September 1992.
Specifically, 3-month LIBOR rates declined from 8.375 percent in
February 1990 to 3.125 percent in September 1992.
If the
partnerships had held the LIBOR notes for their full 5-year
terms, the partnerships would have lost $19,716,000.
XII.
Brunswick's Tax Returns and Related Documents
Brunswick filed a Form 1120 (U.S. Corporation Income Tax
Return) for 1990 reporting (on a consolidated basis) a net short-
- 84 term capital loss of $142,953,624.
The $142,953,624 net loss,
reported on Schedule D, included gains and losses not specified
on Schedule D or on any related schedules.
The $142,953,624
figure included $162,886,086 in capital losses attributable to
the sale of the LIBOR notes distributed to Brunswick by Saba and
Otrabanda.
The $162,886,086 figure represents the sum of
$97,011,580 (the loss that Brunswick purportedly incurred on the
sale of the 2 Fuji LIBOR notes and the Norinchukin LIBOR note)
and $65,874,506 (the loss that Brunswick purportedly incurred on
the sale of the 4 Sumitomo LIBOR notes).
The $142,953,624 net
loss also included capital gains of $12,033,334 (attributable to
Brunswick's distributive share of the gain purportedly realized
on the sale of the Chase PPNs) and $5,700,000 (attributable to
Brunswick's distributive share of the gain purportedly realized
on the sale of the IBJ CDs).
Brunswick applied $115,202,991 of the $142,953,624 net
short-term capital loss to offset net long-term capital gains
reported on its 1990 tax return.2
Brunswick carried back
$27,588,222 and $162,411 of the claimed 1990 capital losses to
1988 and 1987, respectively.
2
The parties stipulated that Brunswick applied
$116,135,453 of the $142,953,624 net short-term capital loss to
offset capital gains reported on its 1990 tax return. We have
relied on Brunswick's Form 1139 (Corporation Application for
Tentative Refund), filed August 30, 1991, in finding that
Brunswick actually applied $115,202,991 of the $142,953,624 to
offset capital gains reported in 1990.
- 85 Brunswick filed a Form 1120 for 1991 reporting (on a
consolidated basis) a long-term capital loss of $32,631,287
attributable to SBC's sale of the remaining Norinchukin LIBOR
note.
Brunswick used $846,745 of its claimed 1991 capital losses
in 1991 and carried back $16,580,600 and $6,362,009 of the loss
to 1989 and 1988, respectively.
Brunswick carried forward
$8,841,933 of its claimed 1991 capital losses.
Brunswick provided reserves for 100 percent of the tax
attributable to its reported net capital losses from the Saba and
Otrabanda transactions in its deferred tax account.
XIII.
Respondent's Determinations
A.
Saba FPAA
On December 30, 1996, respondent issued an FPAA to Saba.
Respondent determined:
(1) The transactions financing the
purchase and sale of the Chase PPNs would not be recognized for
Federal income tax purposes for lack of economic substance; (2)
Saba would not be recognized as a partnership; (3) partnership
items would be reallocated to Brunswick (95 percent) and Skokie
(5 percent); and (4) the basis of the 3 LIBOR notes distributed
to Brunswick was $26,601,451 and the basis of the remaining LIBOR
note transferred to SBC was $7,032,954.
disallowed certain deductions.
In addition, respondent
First, respondent disallowed
$25,000 of a $56,050 deduction that Saba had reported for amounts
paid to N.V. Fides during the taxable year ended March 31, 1991.
- 86 The $25,000 item was labeled "incorporation fee".
In addition,
respondent disallowed a deduction of $120,266 that Saba had
reported for amounts paid to Cravath, Swaine & Moore during the
taxable year ended March 31, 1991, as well as the amortization of
$1,500 and $8,500 attributable to amounts paid to Cravath, Swaine
& Moore for the taxable years ended March 31, 1991 and June 21,
1992, respectively.
Respondent determined that the disallowed
amounts had not been substantiated and that petitioner had failed
to demonstrate that the amounts represented ordinary and
necessary business expenses.
Respondent made several alternative determinations in the
event the Court were to recognize Saba as a partnership for
Federal income tax purposes.
part:
Respondent determined in pertinent
(1) No gain or loss would be recognized on the purchase
and sale of the Chase PPNs because the transactions lacked
economic substance; and (2) Saba’s bases in the LIBOR notes
distributed to Brunswick and SBC were $26,601,451 and $7,032,954,
respectively.
B.
Otrabanda FPAA
On December 30, 1996, respondent issued an FPAA to
Otrabanda.
Respondent determined:
(1) The transactions
financing the purchase and sale of the IBJ CDs would not be
recognized for Federal income tax purposes for lack of economic
substance; (2) Otrabanda would not be recognized as a
- 87 partnership; (3) partnership items would be reallocated to
Brunswick (90 percent) and Skokie (10 percent); and (4)
Brunswick's basis in the 4 LIBOR notes was $17,458,827.
addition, respondent disallowed certain deductions.
In
First,
respondent disallowed $25,000 of a $50,823 deduction that
Otrabanda had reported for amounts paid to N.V. Fides during the
taxable year ended June 21, 1991.
"incorporation fee".
The $25,000 item was labeled
In addition, respondent disallowed a
deduction of $72,996 that Otrabanda had reported for amounts paid
to Cravath, Swaine & Moore during the taxable year ended June 21,
1991.
Respondent determined that the disallowed amounts had not
been substantiated and that petitioner had failed to demonstrate
that the amounts represented ordinary and necessary business
expenses.
Respondent made several alternative determinations in the
event the Court were to recognize Otrabanda as a partnership for
Federal income tax purposes.
part:
Respondent determined in pertinent
(1) No gain or loss would be recognized on the purchase
and sale of the IBJ CDs because the transactions lacked economic
substance; and (2) Otrabanda’s basis in the LIBOR notes
distributed to Brunswick was $17,458,827.
OPINION
The central issue in these cases is whether the
partnerships' CINS transactions should be disregarded for Federal
- 88 income tax purposes for lack of economic substance.
bears the burden of proof.
Petitioner
See Rule 142(a); Brown v.
Commissioner, 85 T.C. 968, 998 (1985), affd. sub nom. Sochin v.
Commissioner, 843 F.2d 351 (9th Cir. 1988).
As discussed in detail below, we shall sustain respondent's
adjustments on the ground that the disputed CINS transactions
lack economic substance.
See ACM Partnership v. Commissioner,
157 F.3d 231 (3d Cir. 1998), affg. in part and revg. in part T.C.
Memo. 1997-115, where the Court of Appeals for the Third Circuit
affirmed this Court’s holding that virtually identical CINS
transactions arranged by Merrill Lynch lacked economic substance.
Based upon our holding in these cases, we need not decide whether
Saba and Otrabanda were valid partnerships.
Cf. ASA Investerings
Partnership v. Commissioner, T.C. Memo. 1998-305, on appeal to
the Court of Appeals for the District of Columbia Circuit.
I.
Evidentiary Matters
Prior to trial, petitioner asserted that certain documents
in its possession, including the Zelisko memorandum, were
privileged and not subject to discovery.
After respondent moved
to compel production of the documents, the Court ordered
petitioner to submit the documents to the Court for in camera
review.
On August 14, 1998, the Court issued an order holding,
among other things, that only limited portions of the Zelisko
- 89 memorandum were privileged and directing petitioner to produce
the document with appropriate redactions.
Petitioner complied
with the Court's order.
In its reply brief, petitioner states that "Exhibit 408-J
[the Zelisko memorandum] is protected by attorney-client
privilege and the work-product doctrine.
Petitioners renew their
claim of attorney-client privilege and application of the workproduct doctrine with respect to Exhibit 408-J."
A.
Attorney-Client Privilege
Our rules provide for discovery of information that is not
privileged but relevant to the subject matter involved in the
pending case.
See Rule 70(b).
The party opposing discovery
bears the burden of establishing that the information sought is
privileged.
See Zaentz v. Commissioner, 73 T.C. 469, 475 (1979);
Branerton Corp. v. Commissioner, 64 T.C. 191, 193 (1975).
Section 7453 provides that the Court is bound by the rules
of evidence applicable in trials without a jury in the U.S.
District Court for the District of Columbia.
See Rule 143(a).
The Court of Appeals for the District of Columbia "adheres to the
axiom that the attorney-client privilege must be 'strictly
confined within the narrowest possible limits consistent with the
logic of its principle.'"
Linde Thomson Langworthy Kohn & Van
Dyke v. Resolution Trust Corp., 5 F.3d 1508, 1514 (D.C. Cir.
- 90 1993)(quoting In re Sealed Case, 676 F.2d 793, 807 n.44 (D.C.
Cir. 1982)); see Mead Data Cent. Inc. v. U.S. Dept. of Air Force,
566 F.2d 242 (D.C. Cir. 1977).
The attorney-client privilege is "the oldest of the
privileges for confidential communications known to the common
law."
Upjohn Co. v. United States, 449 U.S. 383, 389 (1981);
Hartz Mountain Indus. v. Commissioner, 93 T.C. 521, 524-525
(1989).
The attorney-client privilege "applies to communications
made in confidence by a client to an attorney for the purpose of
obtaining legal advice, and also to confidential communications
made by the attorney to the client if such communications contain
legal advice or reveal confidential information on which the
client seeks advice."
Hartz Mountain Indus. v. Commissioner,
supra at 525, (citing Upjohn Co. v. United States, supra).
However, "the privilege only protects disclosure of
communications; it does not protect disclosure of the underlying
facts by those who communicated with the attorney."
Upjohn Co.
v. United States, supra at 395.
Except for the matters that were redacted, the Zelisko
memorandum, set forth in its redacted form supra pp. 15-18, does
not contain privileged communications.
The memorandum is self-
described as "a bullet point summary of a transaction proposed by
Merrill Lynch to Brunswick Corporation (BC) on December 8, 1989
to generate sufficient capital losses to offset the capital gain
- 91 which will be generated on the sale of the Nireco shares."
The
portion of the Zelisko memorandum that we ordered to be disclosed
does not contain communications from Brunswick to its attorney,
or legal advice or analysis, but is merely a factual account of a
meeting between a third party, Merrill Lynch, and Brunswick’s tax
counsel.
See United States v. Ackert, 169 F.3d 136, 139-140 (2d
Cir. 1999); see also
Mead Data Cent. Inc. v. U.S. Dept. of Air
Force, supra at 254-255.
B.
Work-Product Doctrine
It is well settled that our Rules generally protect attorney
work-product from discovery.
See Note to Rule 70, 60 T.C. 1097,
1098; see also Hartz Mountain Indus. v. Commissioner, supra at
528; Zaentz v. Commissioner, supra at 478; Branerton Corp. v.
Commissioner, supra at 198; P.T. & L. Constr. Co. v.
Commissioner, 63 T.C. 404, 408 (1974).
The policies and concerns
underlying the attorney work product-doctrine are explained in
Hickman v. Taylor, 329 U.S. 495, 510-511 (1947), as follows:
In performing his various duties * * * it is essential that
a lawyer work with a certain degree of privacy, free from
unnecessary intrusion by opposing parties and their counsel.
Proper preparation of a client's case demands that he
assemble information, sift what he considers to be the
relevant from the irrelevant facts, prepare his legal
theories and plan his strategy without undue and needless
interference. * * * This work is reflected, of course, in
interviews, statements, memoranda, correspondence, briefs,
mental impressions, personal beliefs, and countless other
tangible and intangible ways--aptly though roughly termed
* * * the "work product of the lawyer." Were such materials
open to opposing counsel on mere demand, much of what is now
put down in writing would remain unwritten. An attorney's
- 92 thoughts, heretofore inviolate, would not be his own.
Inefficiency, unfairness and sharp practices would
inevitably develop in the giving of legal advice and in the
preparation of cases for trial. The effect on the legal
profession would be demoralizing. And the interests of the
clients and the cause of justice would be poorly served.
The attorney work-product doctrine generally protects materials
prepared in anticipation of litigation.
See In re Sealed Case,
146 F.3d 881, 885-887 (D.C. Cir. 1998); Branerton Corp. v.
Commissioner, supra at 198; P.T. & L. Constr. Co. v.
Commissioner, supra at 408.
Where an attorney has prepared a document in anticipation of
litigation, the document will be protected from discovery only to
the extent that it contains opinions, judgments, and thought
processes of counsel as opposed to purely factual materials.
In re Sealed Case, supra at 888.
See
We recognize that the Zelisko
memorandum may have been prepared in part in anticipation of
litigation.
In this regard, we permitted Brunswick to redact
portions of the document deemed to be privileged.
However, the
portion of the Zelisko memorandum that we ordered to be disclosed
does not qualify for protection from disclosure under the
attorney work-product doctrine inasmuch as it consists of a
factual account of a meeting between Zelisko and representatives
of Merrill Lynch and is bereft of material that could be
characterized as Zelisko’s legal opinion or judgment.
- 93 II.
Contingent Installment Sale Provisions
Section 453(a) provides the general rule that income from an
installment sale shall be taken into account for purposes of
title 26 under the installment method of accounting.
Section
453(b)(1) defines the term "installment sale" as a disposition of
property where at least 1 payment is to be received after the
close of the taxable year in which the disposition occurs.
Section 453(k)(2) provides that subsection (a) shall not apply to
an installment obligation arising out of a sale of stock or
securities which are traded on an established securities market
or, to the extent provided in regulations, property (other than
stock or securities) of a kind regularly traded on an established
market.
Section 453(j)(2) provides that the Secretary shall
prescribe regulations providing for ratable basis recovery in
transactions where the gross profit or the total contract price
or both cannot be readily ascertained.
Pursuant to this
authority, the Secretary promulgated the ratable basis recovery
rules under section 15A.453-1(c)(3)(i), Temporary Income Tax
Regs., 46 Fed. Reg. 10711 (Feb. 4, 1981), which provides in
pertinent part:
When a stated maximum selling price cannot be
determined as of the close of the taxable year in which
the sale or other disposition occurs, but the maximum
period over which payments may be received under the
contingent sale price agreement is fixed, the
taxpayer's basis (inclusive of selling expenses) shall
- 94 be allocated to the taxable years in which payment may
be received under the agreement in equal annual
increments. * * * If in any taxable year no payment
is received or the amount of payment received
(exclusive of interest) is less than the basis
allocated to that taxable year, no loss shall be
allowed unless the taxable year is the final payment
year under the agreement * * *.
In short, section 15A.453-1(c)(3)(i), Temporary Income Tax Regs.,
supra, provides that, in the case of an installment sale in which
the maximum selling price cannot be determined, but the period
over which payments are to be received is fixed, the taxpayer's
basis shall be allocated equally over the taxable years in which
payments may be received under the installment sale agreement.
Depending upon the particular terms of an otherwise valid
installment sale, the ratable basis recovery rules may have the
effect of accelerating the recognition of income on a CINS
transaction while deferring the recognition of losses.
See sec.
15A.453-1(c)(7), Temporary Income Tax Regs., 46 Fed. Reg. 10709
(Feb. 4, 1981).
However, the ratable basis recovery rules are
not inflexible, as explained in the preamble to the regulation,
T.D. 7768, which states in pertinent part:
Because the rules set forth in these regulations
may not provide a schedule of basis recovery which is
reasonable for every contingent transaction, these
regulations provide that a taxpayer may use an
alternative method of basis recovery where the rules in
the regulations would substantially and inappropriately
defer basis recovery. These regulations also provide
that when the general rules would substantially and
inappropriately accelerate bases recovery, the Service
may require a different method of basis recovery.
- 95 Read as a whole, the regulations impart an intention to establish
a method of accounting that reasonably will match the gains and
losses reported on a CINS transaction.
The partnerships sold the PPNs and CDs for cash and LIBOR
notes and reported their gains on the sales by ratably allocating
their bases pursuant to section 15A.453-1(c)(3)(i), Temporary
Income Tax Regs., supra.
Based on their partners' respective
capital accounts at the time of the sales, Saba and Otrabanda
allocated 90 percent of the gains realized on the transactions to
Sodbury and Bartolo, respectively.
However, because Sodbury and
Bartolo were not subject to U.S. income tax, their distributive
shares of the gains realized on the transactions escaped U.S.
taxation.
On the other hand, Brunswick's more modest 10 percent
distributive share of the gains on the sales of the PPNs and CDs
were dwarfed by the substantial capital losses that Brunswick
later realized following the distribution and sale of the LIBOR
notes.
Petitioner contends that the disputed transactions satisfy
the requirements of the contingent installment sale provisions
and the ratable basis recovery rules.
In particular, the
partnerships sold PPNs and CDs--assets that are not traded on an
established securities market.
See sec. 453(k)(2)(A).
In
exchange, the partnerships received cash and LIBOR notes.
Petitioner contends that the LIBOR notes represent a series of
- 96 contingent payments made over a period of years as required under
sections 453(b)(1) and 15A.453-1(c)(3)(i), Temporary Income Tax
Regs., supra.
Respondent contends that the LIBOR notes do not
constitute qualifying contingent payments under section 453 on
the ground that Merrill Lynch's swap arrangements created an
"artificially supported market" for the LIBOR notes and
effectively converted the LIBOR notes to "purchaser evidences of
indebtedness payable on demand or readily tradable" within the
meaning of sections 453(f)(4) and 15A.453-1(e), Temporary Income
Tax Regs., supra.
In light of our holding in these cases, we
need not consider this point.
III. Petitioner's Argument That An Economic Substance Analysis
Is Not Warranted
A.
Gregory v. Helvering and Horn v. Commissioner
Relying primarily on Gregory v. Helvering, 293 U.S. 465, 469
(1935), and Horn v. Commissioner, 968 F.2d 1229, 1238 n.12 (D.C.
Cir. 1992), revg. Fox v. Commissioner, T.C. Memo. 1988-570,
petitioner contends that, rather than having to prove that the
disputed CINS transactions were imbued with economic substance,
petitioner is required to show only that the disputed
transactions resulted in a contingent "sale" of the PPNs and CDs
within the meaning of sections 1001(a) and 453(a).
It is well settled that taxpayers generally are free to
structure their business transactions as they please, even if
motivated by tax avoidance considerations.
See Gregory v.
- 97 Helvering, supra at 469; Rice's Toyota World, Inc. v.
Commissioner, 81 T.C. 184, 196 (1983), affd. in part, revd. in
part and remanded 752 F.2d 89 (4th Cir. 1985).
Nonetheless, to
be accorded recognition for tax purposes, a transaction generally
is expected to have "economic substance which is compelled or
encouraged by business or regulatory realities, is imbued with
tax-independent considerations, and is not shaped solely by taxavoidance features that have meaningless labels attached."
Lyon Co. v. United States, 435 U.S. 561, 583-584 (1978).
Frank
This
last principle, which finds its origin in Gregory v. Helvering,
supra, is better known as the economic substance doctrine.
In Gregory v. Helvering, supra, the taxpayer was the sole
shareholder of United Mortgage Corporation (United) which held
1,000 shares of Monitor Securities Corporation (Monitor).
The
taxpayer intended to obtain the Monitor shares and sell them for
a profit.
However, the taxpayer hoped to structure the transfer
of the shares from United to herself so as to reduce or avoid the
income tax that would arise if the transfer were treated as a
dividend distribution.
In this regard, the taxpayer ostensibly
arranged a "reorganization" pursuant to section 112(g) of the
Revenue Act of 1928, ch. 852, 45 Stat. 791, 818.
Specifically,
the taxpayer organized a third corporation, Averill Corporation
(Averill), had United transfer its Monitor shares to Averill, and
- 98 then dissolved Averill.
The taxpayer ultimately received the
Monitor shares from Averill in a liquidating distribution.
Upon review of the matter, the Supreme Court sustained the
Commissioner's determination that the purported reorganization
was a sham.
The Supreme Court concluded that the transaction was
carried out in contravention of the plain intent of the
controlling statute, reasoning in pertinent part as follows:
Putting aside, then, the question of motive in respect
of taxation altogether, and fixing the character of the
proceeding by what actually occurred, what do we find?
Simply an operation having no business or corporate
purpose--a mere device which put on the form of a
corporate reorganization as a disguise for concealing
its real character, and the sole object and
accomplishment of which was the consummation of a
preconceived plan, not to reorganize a business or any
part of a business, but to transfer a parcel of
corporate shares to the petitioner. No doubt, a new
and valid corporation was created. But that
corporation was nothing more than a contrivance to the
end last described. It was brought into existence for
no other purpose; it performed, as it was intended from
the beginning it should perform, no other function.
[Gregory v. Helvering, supra at 469.]
In sum, Gregory v. Helvering, supra, stands for the
principle that, although a business transaction may be structured
in strict compliance with all pertinent statutory requirements, a
court charged with reviewing the transaction is not obliged to
- 99 respect its form for tax purposes where the record shows that the
transaction was in fact a contrivance designed to obtain a tax
benefit not intended by Congress under the taxing statute.
The Court of Appeals for the District of Columbia Circuit
has considered the scope and application of the economic
substance doctrine.
In Horn v. Commissioner, supra, the
Commissioner disallowed losses claimed by commodities dealers
with respect to so-called option-straddle transactions on the
ground that the transactions were economic shams.
This Court
granted the Commissioner's motion for summary judgment,
sustaining the Commissioner's determination that the transactions
were devoid of economic substance.
See Fox v. Commissioner,
supra.
On appeal, the Court of Appeals for the District of Columbia
Circuit reversed after concluding that Congress had intended to
allow the disputed losses pursuant to section 108 of the Tax
Reform Act of 1984 (Division A of the Deficit Reduction Act of
1984, Pub. L. 98-369, 98 Stat. 494, 630), as amended under the
Tax Reform Act of 1986 (TRA 1986), Pub. L. 99-514, sec. 1808(d),
100 Stat. 2817.
For the text of section 108, and the 1986
amendment, see Glass v. Commissioner, 87 T.C. 1087, 1164-1166
(1986).
After reviewing Supreme Court precedent and scholarly
articles on the subject, the Court of Appeals described the sham
transaction doctrine as follows:
- 100 first, the sham transaction doctrine is simply an aid
to identifying tax-motivated transactions that Congress
did not intend to include within the scope of a given
benefit-granting statute; and second, a transaction
will not be considered a sham if it is undertaken for
profit or for other legitimate nontax business
purposes. * * * As the Seventh Circuit pointed out in
Yosha,[861 F.2d at 498,] “the taxpayer [in Gregory] was
trying to take advantage of a loophole inadvertently
created by the framers of the tax code; in closing such
loopholes the courts could not rightly be accused of
having disregarded congressional intent or
overreached.” * * * [Horn v. Commissioner, 968 F.2d at
1238.]
Relying on section 108(a) and (b) as amended under TRA 1986,
the Court of Appeals stated that "Congress undoubtedly has the
power to grant beneficial tax treatment to economically
meaningless behavior, if indeed that is what happened here."
Horn v. Commissioner, 968 F.2d at 1234.
Pointing to the plain
language of section 108, the Court of Appeals held that Congress
had authorized deductions for losses associated with optionstraddle transactions so long as the taxpayer qualified as a
commodities dealer.
See Horn v. Commissioner, supra at 1239.
The Court of Appeals stated that "section 108(b) does all that it
need do for the taxpayers to prevail here--it creates an
irrebuttable presumption that a commodities dealer has made his
straddle trades in a trade or business, i.e., he has not engaged
in an economic sham."
Id. at 1239.
The Court of Appeals further
noted that section 108(a) closely tracked the sham transaction
doctrine insofar as a loss was allowed only if the transaction
was entered into for profit or in a trade or business.
See id.
- 101 Concluding that it was inappropriate to apply the sham
transaction doctrine to section 108, the Court of Appeals
reasoned as follows:
The sham transaction doctrine is an important judicial
device for preventing the misuse of the tax code; but
the doctrine cannot be used to preempt congressional
intent. As Government counsel properly conceded at
oral argument, Congress has the power to authorize
these transactions, whether or not they are economic
shams. And the language of section 108(a)--providing
that the deduction shall be allowed if the transaction
was in a trade or business or engaged in for profit-coupled with the irrebuttable presumption of section
108(b) [that every straddle loss incurred by a
commodities dealer shall be treated as a loss incurred
in a trade or business], makes it clear that that is
exactly what Congress intended to do. [Horn v.
Commissioner, 968 F.2d at 1236.]
Citing Gregory v. Helvering, 293 U.S. 465 (1935), and Horn
v. Commissioner, supra, petitioner contends that "Application of
the 'economic substance' doctrine must therefore begin with the
Code, and the lack of a business purpose and the absence of a
prospect of profit are irrelevant unless the underlying Code
provisions require the presence of those elements". (Emphasis
added.)
Petitioner misconstrues both cases.
As previously discussed, Gregory v. Helvering, supra, stands
for the principle that a court is not obliged to respect the form
of a transaction for tax purposes where the record shows that the
transaction was in fact a contrivance designed to obtain an
unintended tax benefit.
Although the Supreme Court made it clear
that a transaction cannot be disregarded solely because it was
- 102 driven by a tax motive, the Supreme Court held that the
reorganization in question was a sham in large part because the
transaction had no business or corporate purpose.
Helvering, supra at 469.
See Gregory v.
The Supreme Court's reliance on the
lack of a business or corporate purpose for the transaction is
notable in that the corporate reorganization provision in
question did not explicitly require a business purpose--the
Supreme Court concluded that a business or corporate purpose was
implied in the provision.
See id. at 469; see also Yosha v.
Commissioner, 861 F.2d 494, 499 (7th Cir. 1988) (quoting
Commissioner v. Transport Trading & Terminal Corp., 176 F.2d 570,
572 (2d Cir. 1949)).
Nor does Horn v. Commissioner, supra, support petitioner's
position that the economic substance doctrine is only relevant
where the controlling statutory provision by its terms requires a
business purpose and a reasonable prospect of a profit.
Although
the Court of Appeals in Horn v. Commissioner, supra, concluded
that it would be premature to proceed with an economic substance
analysis without first examining the controlling statutory
provision and its legislative history, the relevant inquiry is
not whether business purpose or the prospect of a profit are
required elements under the controlling provision, but rather
whether Congress enacted the provision with the intention of
sanctioning a particular transaction regardless of its economic
- 103 substance.
See Knetsch v. United States, 364 U.S. 361, 369
(1960), where the Supreme Court sustained the Commissioner's
disallowance of interest deductions on the ground that "nothing
in the Senate Finance and House Ways and Means Committee Reports
on section 264 * * * [suggests] that Congress in exempting pre1954 annuities intended to protect sham transactions."
Consistent with the foregoing, an analysis of the economic
substance of the CINS transactions is appropriate in the absence
of an indication in the controlling statutory provisions that
Congress intended to favor such transactions regardless of their
economic substance.
B.
Section 1001 and Cottage Savings
Petitioner further contends that an analysis of the economic
substance of the disputed CINS transactions is unwarranted under
section 1001(a) and the Supreme Court's interpretation of that
provision in Cottage Sav. Association v. Commissioner, 499 U.S.
554 (1991).
Specifically, petitioner maintains that section
1001(a) and Cottage Savings demonstrate that the gain or loss
realized on a sale or exchange of property shall be recognized
for tax purposes regardless of the business purpose or potential
for profit underlying the transaction.
Section 1001(a) provides that gain or loss from a sale or
other disposition of property is determined by the difference
between the amount realized from the sale and its adjusted basis.
- 104 Section 1001(b) defines the "amount realized" as "the sum of any
money received plus the fair market value of the property (other
than money) received."
Section 1001(c) provides: "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."
According to petitioner, section 1001(c) and section 1.10021(b), Income Tax Regs., which provides that exceptions to the
general rule of section 1001(c) must be "strictly construed and
do not extend either beyond the words or the underlying
assumptions and purposes of the exception", compel the Court to
respect the tax consequences of a sale or exchange of property
regardless of the economic substance of the transaction.
Petitioner further asserts that the legislative history of
section 1001 reflects Congress' clear intent to tax the gain or
loss on all exchanges of property.
Petitioner cites the
legislative history of section 203 of the Revenue Act of 1924,
ch. 234, 43 Stat. 253, which states:
It appears best to provide generally that gain or loss is
recognized from all exchanges and then except specifically
and in definite terms those cases of exchange in which it is
not desired to tax the gain or allow the loss. This results
in definiteness and accuracy and enables a taxpayer to
determine prior to the consummation of a given transaction
- 105 the tax liability that will result therefrom. [H. Rept. 179,
68th Cong., 1st Sess. (1924), 1939-1 C.B. (Part 2) 251; S.
Rept. 398, 68th Cong., 1st Sess. (1924), 1939-1 C.B. (Part
2) 275.]
Unlike the statutory provision at issue in Horn v.
Commissioner, 968 F.2d 1229 (D.C. Cir. 1992), neither the plain
language of section 1001 nor its legislative history lends any
support to the proposition that Congress intended to respect the
tax consequences of sales or exchanges of property that lack
economic substance.
While it is true that Congress crafted
section 1001 as a provision that would be broadly applicable to
sales or exchanges of property, subject to specific statutory
exceptions, Congress did not proscribe an analysis of the
economic substance of a sale or exchange of property.
Cf. Compaq
Computer Corp. v. Commissioner, 113 T.C. 17 (1999) (Rejecting the
taxpayer’s argument that the foreign tax credit regime completely
sets forth Congress’ intent as to allowable foreign tax credits
and that an additional economic substance requirement was not
intended by Congress).
In this regard, it is important to
recognize that the economic substance doctrine is not a
judicially created exception to the general rule of section
1001(c), as petitioner implies, but rather is a "canon of
statutory interpretation that statutes should not be read to
create 'absurd results.'"
Horn v. Commissioner, supra at 1239.
Moreover, petitioner's position conflicts with long-standing
Supreme Court precedent holding that the tax consequences of
- 106 sales or exchanges of property need not be respected where "the
challenged tax event is * * * a sham”, and that the Government
may look at the realities of a transaction and "disregard the
effect of the fiction as best serves the purposes of the tax
statute."
Higgins v. Smith, 308 U.S. 473, 477 (1940).
In
Higgins v. Smith, supra, the Supreme Court held that a taxpayer
did not sustain a loss within the meaning of section 23(e) of the
Internal Revenue Code of 1939 when he sold securities below cost
to his wholly owned corporation.
Because the taxpayer retained
dominion and control over the stock transferred through his
ownership of the corporate transferee, the Court found that "no
loss in the statutory sense could occur upon a sale by a taxpayer
to * * * [a wholly owned corporation]", notwithstanding the fact
that an actual transfer of the stock had occurred.
Id. at 476;
see also Frank Lyon Co. v. United States, 435 U.S. 561 at 573
("In applying this doctrine of substance over form, the Court has
looked to the objective economic realities of a transaction
rather than to the particular form the parties employed.");
Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945) ("To
permit the true nature of a transaction to be disguised by mere
formalisms, which exist solely to alter tax liabilities, would
seriously impair the effective administration of the tax policies
of Congress.")
- 107 Petitioner's reliance on Cottage Sav. Association v.
Commissioner, 499 U.S. 554 (1991), likewise is misplaced.
Petitioner contends that the disputed CINS transactions must be
respected for tax purposes inasmuch as they were structured and
carried out in strict compliance with the requirements of
sections 1001 and 453.
In Cottage Sav. Association v. Commissioner, supra, the
taxpayer, a savings and loan association, owned participation
interests in mortgages that had declined in value due to a surge
in interest rates during the late 1970s.
After holding the
participation interests for a number of years, the taxpayer sold
them to several savings and loan associations and purchased from
them participation interests in mortgages of approximately equal
fair market value.
The taxpayer claimed a $2.4 million loss
deduction equal to the excess of its bases in the participation
interests that it sold over the fair market value of the
participation interests that it purchased.
The Commissioner disallowed the claimed loss on alternative
grounds:
(1) The taxpayer had not realized the losses within the
meaning of regulations promulgated under section 1001; and (2)
the transactions lacked economic substance.
However, the Supreme
Court sustained the taxpayer's loss deduction, holding that the
taxpayer had realized a loss pursuant to section 1001 because the
participation interests exchanged were "materially different"
- 108 embodying "legally distinct entitlements".
Id. at 566.
In
rejecting the Commissioner's determination that the losses should
be disallowed because they lacked economic substance, the Supreme
Court noted that the Commissioner's argument on the point had
consisted of one sentence in a footnote in his brief with a
citation to Higgins v. Smith, supra.
See Cottage Sav.
Association v. Commissioner, supra at 567-568.
Emphasizing that
the transfers in question were made at arm's length, the Supreme
Court concluded that the Commissioner's citation to Higgins v.
Smith, supra, without further elaboration, was insufficient to
deny the losses under section 165(a).
Cottage Sav. Association
v. Commissioner, supra at 568.
We reject petitioner's contention that we are obliged to
respect the tax consequences of the CINS transactions at issue in
these cases under Cottage Sav..
In rejecting the Commissioner's
economic substance argument in Cottage Sav., the Supreme Court
held that the Commissioner had failed to rebut evidence that the
transaction was conducted at arm's length.
See Lerman v.
Commissioner, 939 F.2d 44, 55-56 n.14 (3d Cir. 1991), affg. Fox
v. Commissioner, T.C. Memo. 1988-570.
The Supreme Court did not
apply the economic substance test as fully articulated in cases
such as Frank Lyon Co. v. United States, 435 U.S. at 583-584, and
Horn v. Commissioner, 968 F.2d at 1237.
Accordingly, Cottage
Sav. Association v. Commissioner, supra, "cannot be read for the
- 109 proposition that, as long as a transaction is bona fide, i.e.,
actually occurred, it cannot be denied economic substance."
Lerman v. Commissioner, supra at 55-56 n.14.
In any case, the transaction disputed in Cottage Sav.
Association v. Commissioner, supra, is fundamentally different
from the transactions disputed in the cases before the Court.
The taxpayer in Cottage Sav. Association v. Commissioner, supra,
sought to minimize its taxes by closing out a real economic loss,
whereas the disputed CINS transactions were designed to generate
fictional losses to offset Brunswick's capital gains.
See Compaq
Computer Corp. v. Commissioner, 113 T.C. 17 (1999).
In ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir.
1998), affg. in part and revg. in part T.C. Memo. 1997-115, the
Court of Appeals for the Third Circuit affirmed this Court’s
holding that a CINS transaction that Merrill Lynch had arranged
for Colgate-Palmolive Company lacked economic substance.
We
agree with the Court of Appeals’ reasoning in that case,
distinguishing Cottage Sav. Association v. Commissioner, supra,
in pertinent part as follows:
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
- 110 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. [ACM Partnership v. Commissioner, supra
at 251; fn. ref. omitted.]
In accord with the preceding discussion, we conclude that
Cottage Sav. Association v. Commissioner, supra, neither mandates
that we respect the tax consequences of the CINS transactions
disputed in these cases, nor precludes a review of the economic
substance of those transactions.
Moreover, based upon our review
of sections 1001 and 453, and their underlying regulations and
legislative histories, we are satisfied that Congress did not
intend to create the loophole that the partnerships have
attempted to exploit.
1238.
See Horn v. Commissioner, 968 F.2d at
Consequently, we will proceed with an analysis of the
economic substance of the CINS transactions.
IV. Petitioner's Contention That CINS Transactions Are Imbued
With Economic Substance
Petitioner contends that respondent's partnership
adjustments must be rejected even assuming that the economic
substance doctrine, as articulated in ACM Partnership v.
Commissioner, supra, is applicable.
An evaluation of the economic substance of the CINS
transactions requires:
(1) A subjective inquiry whether the
- 111 partnerships carried out the transactions for a valid business
purpose other than to obtain tax benefits; and (2) an objective
inquiry whether the CINS transactions had practical economic
effects other than the creation of tax benefits.
See ACM
Partnership v. Commissioner, supra at 247-248; Horn v.
Commissioner, 968 F.2d at 1237; Casebeer v. Commissioner, 909
F.2d 1360, 1363 (9th Cir. 1990), affg. in part, revg. and
remanding in part Larsen v. Commissioner, 89 T.C. 1229 (1987),
and affg. Memorandum Opinions of this Court; Rose v.
Commissioner, 868 F.2d 851, 853-854 (6th Cir. 1989), affg. 88
T.C. 386 (1987).
A transaction imbued with economic substance normally will
be recognized for tax purposes even in the absence of a nontax
business purpose.
See Northern Ind. Pub. Serv. Co. v.
Commissioner, 115 F.3d 506, 512 (7th Cir. 1997), affg. 105 T.C.
341 (1995); Larsen v. Commissioner, supra at 1253.
The Court of
Appeals for the District of Columbia Circuit has held that "a
transaction undertaken for a nontax business purpose will not be
considered an economic sham even if there was no objectively
reasonable possibility that the transaction would produce
profits."
Horn v. Commissioner, 968 F.2d at 1237.
But cf.
Kirchman v. Commissioner, 862 F.2d 1486, 1492 (11th Cir. 1989),
(existence of a nontax business purpose does not mandate the
- 112 recognitition of a transaction that otherwise lacks economic
substance) affg. Glass v. Commissioner, 87 T.C. 1087 (1986).
A.
Business Purpose
Petitioner argues that the partnerships engaged in the CINS
transaction to achieve a number of business objectives other than
to obtain tax benefits.
Petitioner first contends that the
partnerships provided an appropriate investment vehicle for the
proceeds from the sale of Brunswick's Technical businesses and
Nireco stock, at a time when Brunswick was vulnerable to a
takeover attempt.
The partnerships purportedly were viewed in
part as a means to "tie up" Brunswick's excess cash so that it
could not be used against Brunswick in a leveraged buy out.
Petitioner further contends that the acquisition of LIBOR notes,
with floating interest rates, provided a hedge against a decline
in Brunswick's marine sales (and lower profits) associated with
periods of rising interest rates.
Finally, petitioner maintains
that the partnerships provided Brunswick with an opportunity to
establish a relationship with a large, international financial
institution consistent with Brunswick's long-term strategic
planning.
- 113 Despite petitioner's assertions to the contrary, there is
overwhelming evidence in the record that Saba and Otrabanda were
organized solely to generate tax benefits for Brunswick.
Although petitioner has attempted to downplay the significance of
the document, the Zelisko memorandum is direct and compelling
evidence that Brunswick intended to use the partnerships as a
device to generate capital losses to offset the capital gains
that Brunswick anticipated on the sales of its Technical
businesses and Nireco stock.
The Zelisko memorandum, prepared
shortly after Ms. Zelisko's meeting with Merrill Lynch
representatives and well in advance of the formation of the
partnerships, describes in precise detail the steps that would be
required for the CINS transactions to generate substantial
capital losses for Brunswick's benefit.
Each of the partnerships
subsequently fulfilled all of the steps outlined in the Zelisko
memorandum.
Equally compelling is the "FOREIGN PARTNERSHIP TAX UPDATE"
that McManaman prepared on April 20, 1990, in which he projected
that Brunswick would realize capital losses of $80 million and
$57 million from its participation in Saba and Otrabanda,
respectively.
Significantly, McManaman's projections generally
- 114 were consistent with those set forth in the Zelisko memorandum
and were made 2 months before the Otrabanda partnership was
formed.
McManaman's projections were also made well before
O'Brien purportedly formed the view that interest rates would
fall.
On April 25, 1990, McManaman's projections were presented
to Brunswick's Board of Directors.
The record also shows that ABN and the other financial
institutions involved in the CINS transactions fully understood
Brunswick's intentions.
The assumptions underlying the Zelisko
memorandum and McManaman's projections are echoed in a number of
ABN documents describing the partnerships.
In addition, internal
memoranda maintained by Fuji and Norinchukin stated that the
transactions were designed to provide tax savings for Merrill
Lynch's customers.
Finally, an internal Arthur Andersen
memorandum stated that "the only reason Brunswick formed the
partnership was to maximize the after tax earnings and cash flow"
from the sale of its Technical businesses.
Against this backdrop, we conclude that each of the
ostensible business purposes that petitioner cites as a taxindependent justification for Brunswick's participation in the
partnerships is nothing more than a derivative or by-product of
the CINS transactions.
Specifically, the partnerships' purchase
of the PPNs and CDs was not driven by the desire to "tie-up"
Brunswick's funds at a time when Brunswick was vulnerable to a
- 115 hostile takeover, but rather was driven by section 453(k)(2)
which provides that the installment sale provisions do not apply
to sales of stock, securities, or certain other property which is
traded on an established market.
In other words, as O'Brien
admitted at trial, the partnerships attempted to comply with
section 453(k)(2) by initially investing in the PPNs and CDs.
We
are not convinced on the record presented that Brunswick
participated in these partnerships because it was particularly
vulnerable to a hostile takeover atte
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