United States Tax Court

United States Tax Court

167 T.C. No. 8

SIH PARTNERS LLLP, EXPLORER PARTNER CORP., TAX

MATTERS PARTNER,

Petitioner

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

—————

Docket No. 10099-20.

Filed August 6, 2026.

—————

The TMP of partnership S timely petitioned this

Court challenging R’s adjustments in a Notice of Final

Partnership Administrative Adjustment regarding

qualified dividend income (QDI), reclassified as ordinary

dividend income, and corresponding foreign tax credits

(FTC). R principally contends that investment positions

held by S are substantially similar or related property as

defined by I.R.C. § 246(c)(4) and accompanying Treasury

regulations.

Held: The Substantial Overlap Test in Treas. Reg.

§ 1.246-5(c)(1)(iii) has not been met; however, the AntiAbuse Rule of Treas. Reg. § 1.246-5(c)(1)(vi) is applicable,

and therefore S is not entitled to QDI treatment under

I.R.C. §§ 1(h)(11)(B)(iii)(I) and 246(c).

Held, further, S has not satisfied all statutory

requirements to qualify for the FTC.

—————

Served 08/06/26

2

Nathan P. Wacker, Rajiv Madan, Nathaniel J. Dorfman, Christopher P.

Bowers, Erin E. Girbach, and Nadiya F. Beckwith-Stanley, for

petitioner.

Brandon S. Cline, Christopher A. Pavilonis, Thomas J. Kerrigan,

Naseem Jehan Khan, and Michael E. Washburn, for respondent.

WEILER, Judge: On December 5, 2019, the Internal Revenue

Service (IRS) issued a Notice of Final Partnership Administrative

Adjustment (FPAA) for the tax year ending December 31, 2012 (tax year

at issue), to Explorer Partner Corp., the tax matters partner for SIH

Partners, LLLP (SIHP). In the FPAA respondent (i) reduced SIHP’s

qualified dividend income (QDI) by $170,764,863; (ii) reclassified the

reported QDI of $170,764,863 as ordinary dividend income; and

(iii) reduced SIHP’s foreign tax credit by $25,614,729 on the basis of

section 246(c)(4) 1 and accompanying Treasury regulations.

The two issues for decision are whether (1) SIHP’s $170,764,863

of QDI should be reclassified as ordinary dividend income and (2) SIHP’s

foreign tax credit should be reduced by $25,614,729.

FINDINGS OF FACT

Some of the facts are stipulated and are so found. The Stipulation

of Facts and the attached Exhibits are incorporated herein by this

reference.

I.

SIHP

SIHP, the partnership at issue in the case, is a limited liability

partnership organized under the laws of the State of Delaware on April

2, 2007, and classified as a partnership under the Tax Equity and Fiscal

Responsibility Act of 1982 (TEFRA), 2 Pub. L. No. 97-248, §§ 401–407, 96

1 Unless otherwise indicated, statutory references are to the Internal Revenue

Code, Title 26 U.S.C. (I.R.C. or Code), in effect at all relevant times, regulation

references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all

relevant times, and Rule references are to the Tax Court Rules of Practice and

Procedure. All monetary amounts are rounded to the nearest dollar.

2 Before its repeal TEFRA governed the tax treatment and audit proceedings

for many partnerships, including SIHP.

3

Stat. 324, 648–71. SIHP had its principal place of business in Delaware

when the Petition was timely filed.

SIHP wholly owns Susquehanna International Holdings, LLC

(SIH), a limited liability company organized under the laws of the State

of Delaware. SIH in turn owns CVI Holdings LLC (CVIH), also a limited

liability company organized under the laws of the State of Delaware.

CVIH wholly owns Capital Ventures International (CVI), an unlimited

liability company with share capital organized under the laws of the

Cayman Islands. For U.S. federal income tax purposes, SIH, CVIH, and

CVI were disregarded entities of SIHP with all items of income, gain,

loss, deduction, and credit reported by SIHP.

During the tax year at issue SIHP had six partners: petitioner,

Colombus International Holdings, Inc., Cortes International Holdings,

Inc., Coronado International Holdings, Inc., Lasalle International

Holdings, Inc., and Balboa International Holdings, Inc. Petitioner’s

shareholders during the tax year at issue were Jeffrey Yass, Arthur

Dantchik, Eric Brooks, and Joel Greenberg.

II.

SIG

SIHP, SIH, CVIH, and CVI are affiliated with Susquehanna

International Group, LLP (SIG). SIG is a privately held global trading

firm, founded in 1987, and it is an active participant in the options and

futures market in over 50 stock and options exchanges. SIG’s core

business is to act as a liquidity provider in financial markets, such as

the NYSE and NASDAQ, as a “market maker” where it provides twosided markets—a bid price and an offer price—on a continuous basis to

ensure a fair, efficient, and liquid market.

SIG engages in millions of trades around the world each business

day. SIG trades and makes proprietary investments in equities, fixed

income, energy, commodity, index, derivative products, private equity,

and venture capital, research, customer trading, and institutional sales.

SIG has a work force of approximately 3,300 employees who are

employed through entities under its management that are registered as

broker-dealers with the U.S. Securities and Exchange Commission. Like

other market makers, when SIG buys or sells a particular option it

typically also acquires an offsetting position to hedge 3 any risk. This

3 Typically, a “hedge” is two investments that offset the specific risks of each

other. For example, long and short positions of similar value in S&P 500 index (SPX)

and SPY, respectively, would be a typical hedge.

4

hedging allows SIG to be financially indifferent as to whether the values

of the options being traded increase or decrease in price. Because market

makers like SIG are hedged in this way, they do not earn a profit

through hedge trading. Rather, SIG makes a return from its bid-ask

spread, which is the fractional difference (often pennies or less) between

their offered bid price and their offered ask price. 4 This small margin,

however, correlates to the minimal risk involved, a key factor for SIG’s

interest as market makers avoid taking on potential risks with respect

to the positions they choose to trade in.

SIG maintains longstanding, unhedged short positions 5 in one or

more indexes or securities to mitigate risk in the event of an economic

downturn (Firm Hedge). The Firm Hedge has existed in some form and

amount continuously since 1987 and has lost approximately $1.25 to

$2.5 billion. In 2012 the Firm Hedge 6 consisted of three indexes: an

index fund and two exchange-traded funds (ETFs) 7 which included the

SPX, the IWM, and the FXI. 8

SIG often transferred ownership of the Firm Hedge among its

affiliates. Ultimately, the location of the Firm Hedge, i.e., which entity

holds the rights at what time, is irrelevant as the overall financial

impact remains the same because of the structure of the firm. Moreover,

4 A “bid price” is the highest price that a buyer is willing to pay for an option,

while an “ask price” is the lowest price that a seller is willing to accept.

5 Maintaining a short position in stocks is essentially the practice of selling

borrowed shares of stocks, called equities, anticipating that the stocks’ prices will

decline, and the same numbers of borrowed shares can be repurchased at lower prices.

6 The Firm Hedge is not hedging against any specific investment. Instead, it

mitigates firm risk in the event of an economic downturn by betting against the

market.

7 The S&P 500 is a stock market index which tracks the performances of 500

of the largest publicly traded U.S. companies. It serves as a key indicator of the U.S.

stock market and economy, similar to the Russell 2000 ETF (IWM) and the China

Large Cap ETF (FXI). Investors cannot own or trade an index as all it does is take a

measure of the market. Instead, companies can buy or create index funds or ETFs.

ETFs are a type of investment fund that holds a collection of assets, such as stocks,

bonds, or other securities like indexes. ETFs trade like stocks throughout the day on

an exchange. This allows investors to buy and sell ETFs at any time during the

market’s trading hours. FXI, for example, is an ETF that provides exposure to the

FTSE China 50 index and serves as an indicator of China’s equity market. An index

fund, by contrast, can be bought and sold only at the end of each trading day.

8 SPX is the ticker shorthand for the S&P 500. It is not in and of itself a

tradable fund; however, there are various SPX ETFs and index funds on the market.

5

petitioner and respondent agree it was common for SIG to change the

form in which its Firm Hedge positions were held. Firm Hedge positions

have been held in portfolio swaps, individual swaps, and in different

prime brokerage accounts 9 from different providers over time both

before and after the tax year at issue.

III.

The Transaction at Issue

Until 2010 the Firm Hedge was held within a prime brokerage

account with Merrill Lynch. Merrill Lynch required a 15% margin—i.e.,

cash or collateral—for the short position indexes held in the Firm Hedge.

In 2010 Morgan Stanley Co. approached SIG with a twofold proposition:

first, to move the Firm Hedge from Merrill Lynch to one or more of

Morgan Stanley Co.’s foreign-owned entities in exchange for a lower

margin rate; second, to enter into a series of agreements that would

structure a complex portfolio swap centered upon four specific Swiss

equities (Transaction). 10 Jeff Cohen, SIG’s equity finance group

manager, served as the lead for the Transaction. As part of the decisionmaking process on whether to enter into the Transaction, SIHP directed

Mr. Cohen to create a preliminary pretax profit and loss analysis.

On April 5, 2010, Mr. Cohen conducted an initial expected pretax

profit and loss analysis (Cohen’s 2010 Analysis) of the proposed

Transaction. The proposal involved the acquisition of long positions in

four specific equities based in Switzerland: (1) Novartis (Ticker Symbol:

NOVN VX); (2) Roche (ROG VX); (3) Nestle (NESN VX); and

(4) Swisscom (SCMN VX) (collectively, Swiss Equities). The core

portfolio within the Transaction would additionally include the Firm

Hedge. The analysis of the prospective deal and the inclusion of the Firm

Hedge was not unusual. Mr. Cohen was often responsible for finding the

most cost-effective placements for Firm Hedge positions and frequently

placed the Firm Hedge into portfolio swaps when it would lower overall

financing costs.

A “prime brokerage” account is a bundled set of brokerage services that

operate similarly to the services received by an individual at brokerage firms such as

Robinhood or Schwab.

9

10 A portfolio swap is a type of equity swap. An equity swap is an over-thecounter instrument created by a broker-dealer firm that gives its counterparty client

exposure to a long or short position in a security. A single equity swap deals with one

cashflow, or “underlier,” from a single stock. In a portfolio swap the exchanged

cashflow is a formula based on multiple stock indices. Portfolio swaps offer exposure

to multiple securities such as indices, individual equities, or fixed income products.

6

Cohen’s 2010 Analysis anticipated that the trade would be an

over-the-counter transaction that would not be listed on any financial

exchange. He estimated the cost of dividends payable on the short

positions of the Swiss Equities to be up to 78% of the anticipated gross

dividends. Cohen’s 2010 Analysis did not account for the necessary trade

costs associated with required foreign currency transactions but did

account for Swiss withholdings of 15%.

Mr. Cohen concluded his analysis by estimating a net profit of

$974,347 on the Transaction as follows:

Gross Dividend

(100%)

$39,189,275

Less withholdings

(35%)

(13,716,246)

Net Dividend Due

(65%)

25,473,029

Potential Reclaim

Amount (20%)

7,837,855

Dividend Payable

on Swap

(30,567,635)

Trade Costs

(1,768,902)

Net Trade PNL

A.

$974,347

Brokerage Agreements for the Transaction

On April 13, 2010, in order to facilitate the Transaction, SIHP

entered into an International Swaps and Derivatives Association (ISDA)

master agreement with Morgan Stanley & Co. International plc

(Morgan Stanley International) and Morgan Stanley Co. (collectively,

Morgan Stanley). 11

11 Morgan Stanley International is a London-based legal entity, regulated by

the Financial Conduct Authority in the United Kingdom. Morgan Stanley Co. is the

U.S. affiliate of Morgan Stanley International. SIG and Morgan Stanley Co. entered

into a bridge agreement under which Morgan Stanley International was able to treat

SIG’s assets held in its U.S. prime brokerage account as collateral. SIG, Morgan

Stanley International, and Morgan Stanley Co. all signed the ISDA, which determined

the specific margin requirements for the Swiss Equities as the Transaction progressed.

7

Before the Transaction the Firm Hedge with Merrill Lynch

required margin rate collateral equal to 15% market value of the Firm

Hedge. The ISDA with Morgan Stanley offered a significantly lower rate

of 6.5% collateral for both the Firm Hedge and the indexes. Each smaller

transaction entered into under the ISDA master agreement was

documented by a trade confirmation which set the terms and conditions

of the specific transactions. The agreements facilitated (1) the purchase

of equities; (2) the formation and maintenance of the portfolio; and

(3) operational efficiencies across the two components. Taken in sum,

these agreements make up the Transaction, which held the Swiss

Equities in prime brokerage accounts, and facilitated the Transaction,

which exposed SIHP to a portfolio of positions through the Firm Hedge.

SIHP purchased the Swiss Equities through Credit Suisse to be

delivered to SIHP’s prime brokerage account with Morgan Stanley.

SIHP then held the Swiss Equities over their respective ex-dividend

dates. At the same time that SIHP 12 acquired the Swiss Equities, SIHP

entered into a portfolio swap arrangement with Morgan Stanley. This

portfolio swap provided SIHP with identical short positions in each of

the four Swiss Equities and other market indices.

The ISDA Agreement with Morgan Stanley facilitated the

Transaction, which occurred from April 2010 until October 2013. The

Transaction was styled as an equity portfolio swap holding short

positions 13 in the Swiss Equities and the Firm Hedge, while SIHP and

Morgan Stanley held identical long positions in the Swiss Equities

within a prime brokerage account.

12 As noted CVIH is a wholly owned subsidiary of SIHP and is a disregarded

entity for U.S. federal income tax purposes. Thus, SIHP is treated as directly engaging

in the Transaction at issue.

13 Holding a short position in stocks is essentially the practice of selling

borrowed shares of stocks, called equities, anticipating that the stocks’ price will

decline, and the same number of shares can be repurchased at a lower price. Thus a

“short” position in stock is only profitable when the value of that stock falls while a

“long” position is profitable when the value rises. As respondent’s expert Dr. DeRosa

said at trial: “[L]ong means you own it. Short means that you sold it and you don’t own

it, you just borrowed the shares.” An entity that holds a short position in an equity

does not receive a dividend when the equity pays a dividend. Instead, when the

dividend is paid, an entity holding a short position on the dividend-paying equity is

required to make a payment to the counterparty known as a “substitute dividend.”

8

B.

Dividends Received from the Swiss Equities

SIHP expected to receive dividends from the Swiss Equities in the

long position. SIHP also expected to pay a portion of those dividends

(approximately 78%) to Morgan Stanley through the Transaction. The

expected revenue equals the difference between the dividends received

by SIHP for the Swiss Equities and the amount of the substitute

dividends that SIHP expected to pay to Morgan Stanley as part of the

Transaction.

In January of 2012 Mr. Cohen conducted another expected pretax

profit and loss analysis (Cohen’s 2012 Analysis) of the proposed

Transaction. Cohen’s 2012 Analysis, like Cohen’s 2010 Analysis, could

be considered incomplete, as Mr. Cohen did not account for the costs

associated with the foreign currency transactions necessary to facilitate

the trade. Cohen’s 2012 Analysis projected profits and losses for only

two of the four Swiss Equities, the quantity and pricing of which do not

reflect the actual agreements later entered into with Morgan Stanley.

Moreover, Cohen’s 2012 Analysis included Swiss taxes in the profit

calculation. Despite these issues Cohen’s 2010 Analysis and Cohen’s

2012 Analysis (collectively, Cohen’s Analyses) were relied upon by SIHP

and later served as the basis for each expert report.

For the tax year at issue SIHP reported $170,764,863 in QDI from

the Swiss Equities, which breaks down as follows:

Description

Dividend Record

Date

Dividend Payment

Date

Nestle SA

(NESN VX)

4/25/2012

4/26/2012

$64,871,330

Novartis AG

(NOVN VX)

2/29/2012

3/1/2012

45,005,029

Roche Holding

AG

(ROG VX)

3/12/2012

3/13/2012

55,968,147

Swisscom

(SCMN VX)

4/12/2012

4/13/2012

4,920,358

Total:

Dividend

Amount

$170,764,863

9

SIHP transferred $130,175,828 in substitute dividends to Morgan

Stanley for 2012. 14 This amount was calculated by multiplying the

dividends that SIHP received on each of the Swiss Equities by the

weighted average dividend ratio for each of the four Swiss Equities as

negotiated with Morgan Stanley. In sum, SIHP was entitled to

$40,589,035 in net dividends from its long position in the Swiss Equities.

C.

Taxes Withheld by Swiss Federal Tax Authority

During the tax year at issue foreign taxes of $59,767,702 were

withheld by the Swiss Federal Tax Authority (SFTA) 15 on dividends

received from the Swiss Equities. The $59,767,702 of tax withheld

breaks down as follows:

Description

Dividend Record

Date

Dividend

Payment Date

Nestle SA

(NESN VX)

4/25/2012

4/26/2012

$22,704,965

Novartis AG

(NOVN VX)

2/29/2012

3/1/2012

15,751,760

Roche Holding

AG

(ROG VX)

3/12/2012

3/13/2012

19,588,851

Swisscom

(SCMN VX)

4/12/2012

4/13/2012

1,722,125

Total:

Foreign Tax

Withheld

$59,767,702

Under the U.S.-Swiss Income Tax Treaty (Swiss Treaty)

nonresidents of Switzerland can file a “reclaim” or refund request to the

SFTA to obtain a return of prior Swiss tax withholdings, effectively

reducing the withholding from 35% to 15% of the gross dividends

received (or a reduction of 20%), if the dividend is from a Switzerland

domiciled entity. See Convention for the Avoidance of Double Taxation

14 Under the ISDA and Transaction SIHP was entitled to retain only 22% of

the gross dividend, and Morgan Stanley was due 78%; hence the substitute dividend

payment back to Morgan Stanley by SIHP of $130 million in 2012.

15 Switzerland imposes a 35% withholding tax on gross dividends paid by the

Swiss Equities.

10

with Respect to Taxes on Income, Switz-U.S., art. 10, Oct. 2, 1996,

T.I.A.S. No. 97-1219; I.R.S. Notice 2011-64, 2011-37 I.R.B. 231.

On or around March 2, 2012, and again on December 10, 2012,

SIHP submitted Forms 82 E, Claim for Refund, to the SFTA, claiming a

refund of 20% of the gross dividends SIHP (through CVIH) received from

the Swiss Equities during tax years 2010 and 2011. To date, the SFTA

has not accepted CVIH’s claim for refund for tax years 2010, 2011, and

2012.

SIHP reported $25,614,729 in foreign tax credit on its tax return

for the tax year at issue related to the withheld Swiss taxes. This

amount reported by SIHP equals 15% of $170,764,863—the gross

dividend amount SIHP reported as received from the Swiss Equities

during the tax year at issue. Notably, this amount was reported before

SIHP received confirmation of the 2012 reclaim, a type of refund request

with SFTA, pursuant to the Swiss Treaty.

IV.

SIHP’s FPAA

SIHP timely filed its Form 1065, U.S. Return of Partnership

Income, for the tax year at issue with the IRS’s Ogden, Utah, service

center. Several years later, on December 5, 2019, respondent issued his

FPAA to the tax matters partner of SIHP for the tax year at issue.

Petitioner disputes all adjustments made in the FPAA, and on July 10,

2020, Explorer Partner Corp. in its capacity as a notice partner of SIHP

filed its Petition with this Court, pursuant to section 6226(d)(1).

V.

Testimony Presented at Trial

A.

Petitioner’s Expert Luc Faucheux

Luc Faucheux is a lecturer at the University of Miami Herbert

School of Business and has served as an employee and manager of

various international trading firms since 2000. Dr. Faucheux has

provided expert witness testimony in five previous cases and is

recognized by this Court as an expert in equity swaps and equity

portfolio swaps.

Petitioner called Dr. Faucheux to rebut the expert reports of

respondent’s experts, David F. DeRosa and Israel Nelken. In his

rebuttal Dr. Faucheux asserts that respondent’s experts incorrectly

state that a swap that provides exposure to multiple securities or

indexes is essentially a collection of individual swaps on those same

11

components. His report detailed key characteristics of the Transaction

as well as the significant financial consequences SIHP would have faced

had it chosen to structure the transaction as a collection of single-equity

swaps instead.

B.

Petitioner’s Expert Michael Cragg

Michael Cragg is a senior partner at Keystone Strategy and a

former economics professor at Columbia University and the University

of California, Los Angeles. He has served on the faculty of the World

Bank Training Programs, held an NIH Fellowship at RAND, and was a

senior research economist at the Milken Institute in Santa Monica,

California. Dr. Cragg previously testified on behalf of the Government

and taxpayers on intercompany financings, joint ventures, and

partnerships and acted as the lead expert in high profile matters.

This Court recognized Dr. Cragg as an expert in financial

economics for this proceeding. Dr. Cragg’s report focused on expected

pretax economic profit. Dr. Cragg’s analysis of expected pretax profits

for 2012 was based on the actual results from CVIH’s bank statements

and broker statements, and it included an expected total gross dividend

of $170,215,970 from the Swiss Equities in 2012. Dr. Cragg asserts that

he used this data, rather than Cohen’s 2010 Analysis data, because it

was derived from the actual amounts and terms in each executed trade

as agreed upon in advance by SIHP and Morgan Stanley. Dr. Cragg also

calculated that the total substitute dividend payments SIHP expected

to owe in 2012 was $130,175,828. Thus, Dr. Cragg in his report stated

that SIHP expected to earn approximately $32 million on a pretax basis

in net dividends from the Swiss Equities.

In rebuttal Dr. Cragg argues that respondent’s experts, Dr.

Nelken and Dr. DeRosa, based their conclusions on two specific errors,

leading to absurd results. The first error Dr. Cragg alleges is that both

experts included tax in their “pre-tax” calculations. This error, Dr. Cragg

argues, was compounded by including the costs of each transaction

without including the corresponding benefit in the pretax profit and

including costs that were not contingent upon the transactions. The

second error Dr. Cragg alleges is regarding Dr. Nelken’s and Dr.

DeRosa’s use of Cohen’s 2010 Analysis rather than the data produced by

the arrangements themselves. Dr. Cragg argues that such use was

inappropriate as it did not reflect the ultimate Transaction and thus

would not meet the requirements of Treasury Regulation § 1.2465(c)(1)(vi) (Anti-Abuse Rule).

12

C.

Petitioner’s Expert James Kermisch

James Kermisch is the founder and chief executive officer of JAK

Advisory with more than 34 years of experience in alternative asset

management and investment banking in the United Kingdom and the

United States, specifically with Morgan Stanley. In his report Mr.

Kermisch explained how various investment options that achieve

equivalent financial exposure are not, in substance, interchangeable.

The report placed significance on the investor’s choice of instrument,

which includes factors such as liquidity requirements, trading

flexibility, risk tolerance, relative cost, tax efficiency, investment

horizon, and regulatory considerations. Mr. Kermisch’s report

emphasized the specific benefits of a portfolio equity swap transaction.

D.

Petitioner’s Expert Thomas J. Brennan

Thomas J. Brennan is a professor of law at Harvard Law School

and a former strategist in the Capital Markets Strategies Group at

Goldman, Sachs & Co. This Court recognized him as an expert in

mathematics, financial analysis and economics. Dr. Brennan’s report

focused on the first test of the relevant Anti-Abuse Rule, namely

Treasury Regulation § 1.246-5(c)(1)(vi)(A) (Virtual Tracking Test).

Dr. Brennan was asked by petitioner to independently evaluate

whether the value of the equity portfolio swap was reasonably expected

to “virtually track” changes in the value of SIHP’s stock holdings or any

portions of SIHP’s stock holdings. In Dr. Brennan’s opinion there are

three key attributes that inform the application of the Virtual Tracking

Test. First, the Virtual Tracking Test is distinct from actual tracking.

Second, the Virtual Tracking Test involves a comparison of changes in

the value of a taxpayer’s stock holdings with changes in the value of the

entirety of the stocks reflected in a position. Third, the Virtual Tracking

Test requires the change in the value of the position to be reasonably

expected to be nearly the same as the change in the value of the

taxpayer’s stock holdings. In Dr. Brennan’s opinion, this expected

difference in change in values should be no greater than 5% to be

considered “virtual tracking.”

On the basis of this analysis he concludes that the value of the

entirety of the stock reflected in SIHP’s Transaction was not reasonably

expected to “virtually track” changes in value of the Swiss Equities.

Therefore, Dr. Brennan opines that the Anti-Abuse Rule cannot be

applied to reduce SIHP’s holding period in the Swiss Equities.

13

E.

Respondent’s Expert David DeRosa

David DeRosa holds an undergraduate degree in economics and a

Ph.D. in economics and finance from the University of Chicago. Dr.

DeRosa is currently on the boards of directors of hedge fund groups that

trade equity swaps. His duties include oversight of the businesses, by,

for instance, hiring auditors, hiring service providers, signing financial

statements, signing agreements such as ISDA agreements and support

documents, generally being aware of what trading is occurring,

understanding strategies, and signing confirmations. Dr. DeRosa has

been recognized by other federal courts as an expert in derivatives,

which include equity swaps, derivatives risk management, options and

foreign exchange trading, economics and finance, statistics, economics

and finance with real world applications, economic analysis, and the

hedge fund industry.

This Court recognized Dr. DeRosa as an expert in economics,

finance, derivatives, and equity swaps for this proceeding. Dr. DeRosa’s

analysis for respondent relied upon Cohen’s Analyses and focused on the

control exercised by CVIH to open and close transactions on individual

securities at will. Dr. DeRosa argued that SIHP’s control over the

Transaction demonstrated that it held multiple positions, referencing a

single stock or index, rather than a single position. He based this opinion

on the fact that SIHP selected which Swiss equities to include in the

Transaction and made decisions regarding the addition and subtraction

of stock components and when and how to execute the trades.

F.

Respondent’s Expert Israel Nelken

Israel Nelken has a bachelor of science in mathematics and

computer science from Tel Aviv University, and a master’s and a Ph.D.

in computer science from Rutgers University. From 1996 to the present

Dr. Nelken has owned a firm called Super CC or Super Computer

Consulting that manufactures software to value financial instruments

including exotic options, derivatives, and convertible bonds. Dr. Nelken

was on the new product development committee at the Chicago Board

Options Exchange and is currently a director on the Chicago Futures

Exchange and an advisory board member for KnectIQ, a Minneapolisbased cybersecurity firm. This Court recognized Dr. Nelken as an expert

in the application of mathematical principles to the analysis of financial

instruments for this proceeding.

14

Dr. Nelken reviewed Cohen’s Analyses and concluded that they

were flawed for a variety of reasons. Specifically, he opines that Cohen’s

2010 Analysis understated slippage costs, short hedge costs, and

dividend rates for dividends owed on borrowed shares, and it failed to

consider the risk in not receiving the 20% Swiss reclaim or the costs

associated with a delay in repayment. Despite these flaws, Dr. Nelken

also relied upon Cohen’s Analyses and used them as the basis for his

report.

Dr. Nelken argued that SIHP neglected to use data from real

trades conducted in 2010 and 2011 when it conducted its final pretax

analysis in 2012. His rebuttal report concluded that SIHP anticipated

tax savings, including QDI and foreign tax credits (FTC), of at least $25

million. Ultimately, Dr. Nelken concluded that the actual profit on the

Swiss Equities for years 2010 and 2012 reflected losses of more than $42

million and nearly $120 million, respectively. In his rebuttal Dr. Nelken

contends that the referenced $10.7 million in tax saving was specific to

tax year 2010, and that he would expect 2012 to have proportionally

larger tax savings of at least $25 million. Dr. Nelken does not, however,

provide an estimated amount or computation to reflect this figure.

OPINION

The ultimate issues before the Court are whether SIHP is entitled

to QDI treatment for the gross dividends received from the Swiss

Equities, along with FTC for taxes paid to Switzerland on those same

dividends, for the tax year at issue.

I.

Burden of Proof

Generally, the Commissioner’s determinations in an FPAA are

presumed correct, and the party challenging the FPAA bears the burden

of proving those determinations are erroneous. See Rule 142(a)(1);

Crescent Holdings, LLC v. Commissioner, 141 T.C. 477, 485 (2013);

Republic Plaza Props. P’ship v. Commissioner, 107 T.C. 94, 104 (1996).

However, the record before us permits the resolution of all issues

in dispute on a preponderance of the evidence. See Facebook, Inc. &

Subs. v. Commissioner, 164 T.C. 194, 244 (2025); Kimberlin v.

Commissioner, 128 T.C. 163, 171 n.4 (2007).

15

II.

Summary of the Parties’ Arguments

Respondent argues that the dividends received from the

Transaction are ineligible for QDI treatment, contending that all risk of

loss was systematically diminished by holding a position with respect to

substantially similar or related property (SSRP), as defined by the rules

provided in section 246(c)(4) and accompanying Treasury regulations.

Moreover, on the basis of the corresponding reduction in the holding

period that would ensue from the application of section 246(c)(4),

respondent argues that SIHP is likewise not entitled to FTC.

SIHP’s systematic removal of risk (i.e., hedging), respondent

argues, flies in the face of congressional intent. Congress enacted section

246(c) to prevent avoidance schemes in which shareholders held both

long and short positions in the same stock over the recorded dividend

date, an action which when legal is generally referred to as “dividend

arbitrage.” 16 When enacting section 246(c), Congress sought to prevent

taxpayers from obtaining favorable tax treatment in these types of

transactions by ensuring that taxpayers held the long stock position for

a minimum holding period at the risk of the market—thus preventing

risk-free tax arbitrage—and denying tax-favored treatment for

dividends—i.e., QDI—where taxpayers held both long and short

positions in a dividend-paying stock. See S. Rep. No. 85-1983, at 28–29,

139–40 (1958), reprinted in 1958 U.S.C.C.A.N. 4791, 4817–18, 4929–30.

Respondent first raises the substance-over-form doctrine, namely

that the substance of the Transaction fails to match its form and should

be recharacterized accordingly. Under respondent’s argument, the

Transaction should be recharacterized from a single, unitary position

reflecting a portfolio of stocks to a collection of separate individual short

positions, each referencing a single stock or index. The result of such

disaggregation is that Treasury Regulation § 1.246-5(c)(1)(v) would

apply to the Transaction rather than Treasury Regulation § 1.2465(c)(1)(ii) through (iv). If tested as a collection of separate positions,

rather than as a single position, the Transaction decidedly concerns

SSRP and the holding period of each stock, consequently, would be

reduced. Respondent also contends the Transaction violates the

“Substantial Overlap Test” set forth in Treasury Regulation § 1.246-5.

16 Dividend arbitrage is an investment strategy that centers around

simultaneously buying long and short positions in common stock shortly before and

after payment of a dividend. This allows the investor to collect the dividend payment

while hedging against potential losses in the stock’s value.

16

Next, if the Transaction does not involve SSRP under the “Substantial

Overlap Test,” respondent then contends it would violate the general

“Anti-Abuse Rule” likewise found in Treasury Regulation § 1.246-5.

Petitioner argues that the dividends from the Swiss Equities

qualify for QDI treatment because the Transaction, as a whole, complies

with the tests found in Treasury Regulation § 1.246-5(c)(1)(iii) and (iv).

Petitioner contends that respondent should not be permitted to raise the

“substance over form doctrine” and change the Transaction by looking

only to the Swiss Equities. Petitioner contends that when the entire

portfolio of investments with Morgan Stanley is considered, including

the Swiss Equities, the Firm Hedge, and other indexes, it maintained

the necessary market risk as mandated by section 246(c) and thus

satisfied the 60-day holding requirements necessary to claim QDI tax

treatment. See I.R.C. § 1(h)(11)(B)(iii). Finally, petitioner contends that

SIHP is entitled to a foreign tax credit of $25,614,729 under section

901(k).

III.

Legal Background

QDI preferential tax treatment generally includes any dividend

from a domestic corporation or a qualified foreign corporation. See I.R.C.

§ 1(h)(1), (11). A qualified foreign corporation is any foreign corporation

(i) incorporated in a possession of the United States, (ii) eligible for

benefits under a comprehensive income tax treaty with the United

States which is satisfactory to the IRS and includes an exchange of

information program, or (iii) the stock of which is readily tradable on an

established securities market in the United States. I.R.C.

§ 1(h)(11)(C)(i) and (ii). The parties agree that each of the Swiss Equities

was issued by a company residing in Switzerland, and each of those

Swiss companies was a “qualified foreign corporation” within the

meaning of section 1(h)(11)(C)(i)(II) and Notice 2006-101, 2006-2 C.B.

930. The dispute, rather, lies over calculation of the holding period

regarding SIHP’s positions in the Swiss Equities.

In order to obtain QDI treatment a taxpayer must hold the equity

for a requisite holding period. See I.R.C. § 1(h)(11)(B)(iii). The holding

period for QDI treatment adopts by reference the exclusionary holding

period provisions provided in section 246(c). See I.R.C.

§ 1(h)(11)(B)(iii)(I).

Sections 1(h)(11)(B)(iii)(I) and 246(c) specify the number of days

needed to hold stock to satisfy holding requirements but also contain

17

important restrictions and exceptions. As relevant here, section

246(c)(4)(C) provides that the calculated holding period for QDI

treatment is tolled for any period in which, under regulations prescribed

by the Secretary, a taxpayer has diminished his risk of loss by holding

one or more other positions with respect to SSRP. Treasury Regulation

§ 1.246-5 provides rules for applying section 246(c)(4)(C).

Respondent relies on subparagraph (C) of section 246(c)(4) and

the relevant regulations thereunder. Petitioner contends the Secretary

issued Treasury Regulation § 1.246-5 to provide “bright-line rules” for

determining when such diminished risk exists and that, throughout the

Swiss Equities trades, SIHP has consistently complied with these rules

as prescribed. Respondent, on the other hand, contends SIHP has

violated Treasury Regulation § 1.246-5(b) as, if both the Swiss Equities

and the Transaction are considered, SIHP has diminished its risk of loss

and its position consists of SSRP.

IV.

Analysis

A.

Background on Treasury Regulation § 1.246-5

Treasury Regulation § 1.246-5(a) provides that the holding period

of stock for purposes of the dividends received deduction is reduced for

any period in which a taxpayer has diminished its risk of loss by holding

one or more other positions with respect to SSRP. A taxpayer has

diminished its risk of loss on its stock by holding positions with respect

to SSRP if changes in the fair market values of the stock and the

positions are reasonably expected to vary inversely. See id. para. (b)(2).

A position with respect to property is an interest (including a futures or

forward contract or an option) in property or any contractual right to a

payment, whether or not severable from stock or other property. See id.

para. (b)(3). Treasury Regulation § 1.246-5(b)(1) provides that SSRP is

determined according to facts and circumstances of each case.

Treasury Regulation § 1.246-5(c)(1) provides special rules for the

treatment of positions that reflect the value of more than one stock. In

general, positions that reflect the value of a portfolio of stocks are

treated under the rules of paragraph (c)(1)(ii) through (iv) of this section

(Portfolio Rules). A portfolio of stocks for this purpose is any group of

stocks of 20 or more unrelated issuers. See Treas. Reg. § 1.246-5(c)(1).

Positions that reflect the value of more than one stock but less than a

portfolio are treated under the rules of paragraph (c)(1)(v) of this section

(Nonportfolio Rules).

18

Portfolio Rules determine that a position involves SSRP to the

stocks held by the taxpayer only if the position and the taxpayer’s

holdings substantially overlap as of the most recent testing date. See

Treas. Reg. § 1.246-5(c)(1)(ii). A position may be substantially similar or

related to a taxpayer’s entire stock holdings or a portion of a taxpayer’s

stock holdings. See id. To determine whether a position and the

taxpayer’s stock holdings “substantially overlap” under the Portfolio

Rules, the Secretary set forth a mechanical, bright-line test, sometimes

referred to as the “Substantial Overlap Test.” Treasury Regulation

§ 1.246-5(c)(1)(iii) provides as follows:

(A) Step One. Construct a subportfolio (the

Subportfolio) that consists of stock in an amount equal to

the lesser of the fair market value of each stock represented

in the position and the fair market value of the stock in the

taxpayer’s stock holdings. (The Subportfolio may contain

fewer than 20 stocks.)

(B) Step Two. If the fair market value of the

Subportfolio is equal to or greater than 70 percent of the

fair market value of the stocks represented in the position,

the position and the Subportfolio substantially overlap.

(C) Step Three. If the position does not substantially

overlap with the Subportfolio, repeat Steps One and Two

(paragraphs (c)(1)(iii)(A) and (B) of this section) reducing

the size of the position. The largest percentage of the

position that results in a substantial overlap is

substantially similar or related to the Subportfolio

determined with respect to that percentage of the position.

The above regulation provides rules for determining whether a

position and a taxpayer’s stock holdings or a portion of a taxpayer’s stock

holdings substantially overlap. The test comprises three steps. First, the

taxpayer is to construct a “Subportfolio” consisting of stock in an amount

equal to the lesser of the fair market value of (i) each stock represented

in the portfolio (Portfolio Position) and (ii) the stock in the taxpayer’s

stock holdings.

Second, if the fair market value of the Subportfolio is equal to or

greater than 70% of the fair market value of the stocks represented in

the Portfolio Position, the Portfolio Position and the Subportfolio

substantially overlap. Id. The regulations provide that the Substantial

Overlap Test must be applied on any testing date, which is defined to

mean

19

any day on which the taxpayer purchases or sells any stock

if the fair market value of the stock or the fair market value

of substantially similar or related property is reflected in

the position, any day on which the taxpayer changes the

position, or any day on which the composition of the

position changes.

Id. subdiv. (iv).

Finally, if the Portfolio Position does not substantially overlap

with the Subportfolio, the taxpayer is to then repeat the steps after

reducing the size of the position, while maintaining the relative

proportions of each stock, to see whether a portion of the Subportfolio

substantially overlaps with the reduced Portfolio Position. See id.

subdiv. (iii)(C).

The Nonportfolio Rules apply when a position reflects the fair

market value of more than one stock but not of a portfolio of stocks

(Nonportfolio Position); therefore, when testing for SSRP it is treated as

a separate position with respect to each of the stocks the value of which

the position reflects. 17

B.

Substance Over Form

The substance-over-form doctrine originated in Gregory v.

Helvering, 293 U.S. 465 (1935). The Supreme Court again recognized the

substance-over-form doctrine in Frank Lyon Co., where it noted that

“[t]he Court has never regarded ‘the simple expedient of drawing up

papers’ . . . as controlling for tax purposes when the objective economic

realities [of the transaction] are to the contrary.” Frank Lyon Co. v.

United States, 435 U.S. 561, 573 (1978) (quoting Commissioner v. Tower,

327 U.S. 280, 291 (1946)). Under the substance-over-form doctrine, the

Commissioner and the courts may recharacterize a transaction in

accordance with its substance if the substance of the transaction is

demonstrably contrary to the form. Neonatology Assocs., P.A. v.

Commissioner, 299 F.3d 221, 230 n.12 (3d Cir. 2002), aff’g 115 T.C. 43

(2000).

17 The parties do not dispute that if the Transaction is considered as a whole,

it passes the Substantial Overlap Test and the holdings are thus not considered SSRP.

As discussed above, however, respondent contends that application of the test to the

Transaction is inappropriate and that the substance-over-form doctrine should be

applied to disaggregate SIHP’s position when applying this test.

20

The substance-over-form doctrine is a common law doctrine. See

Associated Wholesale Grocers, Inc. v. United States, 927 F.2d 1517, 1521

(10th Cir. 1991) (“The step-transaction doctrine developed as part of the

broader tax concept that substance should prevail over form.” (quoting

Am. Potash & Chem. Corp. v. United States, 399 F.2d 194, 207 (Ct. Cl.

1968))); Bail Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d

1543, 1549 (9th Cir. 1987) (“The economic substance factor involves a

broader examination of whether the substance of a transaction reflects

its form, and whether from an objective standpoint the transaction was

likely to produce economic benefits aside from a tax deduction.”), aff’g

T.C. Memo. 1986-23. We have said that this doctrine, and others like it,

require “a searching analysis of the facts to see whether the substance

of the transaction is different from its form or whether the form reflects

what actually happened.” See Andantech L.L.C. v. Commissioner, T.C.

Memo. 2002-97, 83 T.C.M. (CCH) 1476, 1501 (citing Harris v.

Commissioner, 61 T.C. 770, 783 (1974)), aff’d in part and remanded, 331

F.3d 972 (D.C. Cir. 2003).

The Commissioner specifically may challenge the purported tax

benefits of a transaction where the substance of a particular transaction

produces tax results inconsistent with the form embodied in the

underlying documentation and has done so regularly across multiple

courts of appeals. See, e.g., Feldman v. Commissioner, 779 F.3d 448, 457

(7th Cir. 2015) (disregarding sham loan designed to avoid income tax),

aff’g T.C. Memo. 2011-297; Southgate Master Fund, L.L.C. ex rel.

Montgomery Cap. Advisers, LLC v. United States, 659 F.3d 466, 491–92

(5th Cir. 2011) (disregarding sham partnership); Rogers v. United

States, 281 F.3d 1108, 1116–18 (10th Cir. 2002) (recharacterizing a

secured loan that had no likelihood of ever being repaid as a sale).

However, there has yet to be a case that outright holds tax-avoidance

alone may nullify an otherwise Code-compliant and substantive set of

transactions. See Summa Holdings, Inc. v. Commissioner, 848 F.3d 779,

787 (6th Cir. 2017), rev’g T.C. Memo. 2015-119. After all, taxpayers may

lawfully arrange their affairs to keep taxes as low as possible. Gregory

v. Helvering, 293 U.S. at 469–70. 18

To qualify for the tax benefits at issue petitioner must establish

that SIHP held the Swiss Equities for the requisite holding periods, here

60 days, set forth in section 1(h)(11)(B)(iii) or 901(k)(1)(A). Each section

18 Judge Learned Hand mentioned in Helvering v. Gregory, 69 F.2d 809, 810

(1934), the case that gave rise to the substance over form doctrine, there is “not even a

patriotic duty to increase one’s taxes.”

21

determines the applicable holding periods according to section 246,

which provides restrictions and exceptions. In general, these holding

period requirements are “bright-line” rules. Congress has set forth a

minimum number of days that a taxpayer must own stock in a given

period for QDI treatment. The required holding period reflects a choice

by Congress to set the boundaries of a particular tax treatment. Here,

there is no dispute SIHP held the Swiss Equities for more than 60 days;

rather the dispute lies in whether this period should be reduced because

the property is deemed SSRP under section 246(c)(4)(C).

Congress was primarily concerned with taxpayers effectively

holding stock in form but without bearing any economic risk of loss by

engaging in hedging and similar transactions. See Robert Willens, New

Decision Expands Availability of Dividends Received Deduction, 74 J.

Tax’n 276 (1991).

Because the federal tax system “is, and always has been, based

on statute,” Santander Holdings USA, Inc. v. United States, 844 F.3d

15, 21 (1st Cir. 2016), we look first to the text of the Code, see Gregory v.

Helvering, 293 U.S. at 469–70. In doing so the Court considers the

“objective economic realities of [the] transaction rather than . . . the

particular form the parties employed.” Frank Lyon Co., 435 U.S. at 573.

Respondent alleges that under section 246(c)(4)(C), risk of loss

has been diminished under the Transaction. Section 246(c)(4)(C)

provides that the holding period of stock is appropriately reduced for any

period in which “a taxpayer has diminished his risk of loss by holding

[one] or more other positions with respect to [SSRP].” That section

provides that any period for which a taxpayer has diminished its risk of

loss on stock by holding one or more positions with respect to SSRP will

not be counted as part of the holding period. Id. 19

Congress does not define SSRP or provide an answer as to when

a taxpayer has diminished its risk of loss. Instead, it authorizes the

Secretary to promulgate regulations. See I.R.C. § 246(c)(4)(C). In 1995

the Secretary promulgated a final regulation, see Treas. Reg. § 1.246-5,

providing the rules for determining when a taxpayer has diminished its

risk of loss by holding positions with respect to SSRP. A “[d]iminished

19 Congress expressly enacted section 246(c) to prevent tax avoidance and deny

tax benefits where taxpayers were long and short with respect to substantially

identical stock or securities (or otherwise under obligation to make corresponding

payments with respect to these securities) over the dividend payment date. See S. Rep.

No. 85-1983, at 28–29, 139–40, 1958 U.S.C.C.A.N. at 4817–18, 4929–30.

22

risk of loss” occurs when a taxpayer holds positions with respect to SSRP

if changes in the fair market value of the stock and the positions are

reasonably expected to vary inversely. Id. para. (b)(2).

Respondent first argues that petitioner incorrectly uses a

portfolio when the substance of the Transaction actually reflects a

nonportfolio position. The regulation defines “position” to mean an

interest (including a futures or forward contract or an option) in

property or any contractual right to a payment, whether or not severable

from stock or other property. Id. para. (b)(3). A position does not include

traditional equity rights to demand payment from the issuer, such as

the rights traditionally provided by mandatorily redeemable preferred

stock, and it can reflect a single stock or the value of a portfolio of stocks.

Id. paras. (b)(3), (c)(1)(i). Consequently, a position may be substantially

similar or related to a taxpayer’s entire stock holdings or a portion of a

taxpayer’s stock holdings. Id. para. (c)(1)(ii).

Critically for the facts before us here, a portfolio is defined to be

any group of stocks of 20 or more unrelated issuers. Treas. Reg. § 1.2465(c)(1)(i). Treasury Regulation § 1.246-5 prescribes both a Nonportfolio

Rule (a position referencing a single stock) and a Portfolio Rule (any

group of stocks of 20 or more unrelated issuers) to test whether a

position is SSRP to stocks held by a taxpayer. Id. para. (c)(1)(i), (v).

It is undisputed that the Transaction consisted of stocks of 20 or

more unrelated issuers. 20 Respondent contends that the four Swiss

Equities should be disaggregated from the position, i.e., remove the

Firm Hedge and be treated as separate positions for purposes of

Treasury Regulation § 1.246-5. The basis of respondent’s argument lies

in the more static nature of the indexes contained in the Firm Hedge as

compared to the more regulated Swiss Equities. Respondent argues that

the comparative control SIHP demonstrated over the dividend divesting

Swiss Equities makes their placement in, or with, the Firm Hedge

inappropriate. For this reason, respondent contends this Court may use

substance over form and its related judicial doctrines to change SIHP’s

chosen form and later apply the Nonportfolio rules to the Transaction

rather than apply the Substantial Overlap test found in the Portfolio

Rules.

20 An investor who purchases an SPX index fund or an ETF invests in 500 large

U.S. companies in a single transaction. As the Firm Hedge includes the S&P 500,

among other ETFs, the position in question thus consists of 20 or more unrelated

issuers.

23

Petitioner argues 21 that the substance-over-form doctrine is

applicable only where a transaction’s substance is actually inconsistent

with its form. See, e.g., Turner Broad. Sys., Inc. v. Commissioner, 111

T.C. 315, 326 (1998) (stating that to apply the substance-over form

doctrine, we are to first determine that the substance of the transaction

differs from its form); Historic Boardwalk Hall, LLC v. Commissioner,

694 F.3d 425, 448 n.50 (3d Cir. 2012), rev’g and remanding 136 T.C. 1

(2011); see also Neonatology Assocs., P.A. v. Commissioner, 299 F.3d at

230 n.12. Petitioner relies on its expert Dr. Faucheux to support its

position.

We agree with petitioner and find that the inclusion of the Firm

Hedge as part of the Transaction is appropriate. This Court has

previously held that the form of a transaction governs its federal tax

consequences when the form of the transaction and the steps taken

clearly reflect its substance. See, e.g., Goudas v. Commissioner, T.C.

Memo. 1996-555, aff’d, 137 F.3d 368 (6th Cir. 1998). The Firm Hedge

has changed form and location multiple times throughout its existence.

Petitioner and respondent agree it was common for SIG to change the

form in which its Firm Hedge positions were held. Firm Hedge positions

have been placed in portfolio swaps, individual swaps, and in different

prime brokerage accounts. Respondent specifically argues that a

substance-over-form argument should be applied to the Substantial

Overlap Test when testing for the SSRP. Respondent’s argument hinges

upon excluding the Firm Hedge as part of SIHP’s overall Portfolio

Position. However, to do so would require us to change the substance of

the Transaction.

As Dr. Faucheux testified, it is common industry practice for

different types of equities, such as the Firm Hedge, to be included in a

swap arrangement, such as the Transaction, as offered by Morgan

Stanley. As confirmed by Dr. Faucheux, it is likewise common practice

within a portfolio swap arrangement to have the ability to actively

manage the equities within the swap as SIHP so managed the Swiss

Equities. We determine Dr. Faucheux’s testimony to be convincing; and

ultimately, we find that the Transaction at issue here consists of a

conventional portfolio swap arrangement, with standard terms and

21 Petitioner also asserts that any application of substance over form would be

improper. We disagree. For the substance-over-form doctrine may be applied when and

where appropriate. In this instance, however, and for the reasons detailed herein, we

decline to apply the substance-over-form doctrine and find that SIHP’s chosen form

matches the substance of the Transaction.

24

provisions. In other words, we decline respondent’s invitation to

disaggregate portions of the swap arrangement—namely the Firm

Hedge—for purposes of testing the Portfolio Position for SSRP under the

Substantial Overlap Test.

Further, disaggregating SIHP’s portfolio to that of only the Swiss

Equities, while ignoring its other indexes, is contrary to Treasury’s

Decision, made in response to comments received, which states, in

relevant part, as follows:

The final regulations adopt this suggestion subject to an

anti-abuse rule. Under the final regulations, a position that

reflects the value of a portfolio is not treated as

substantially similar or related to the taxpayer’s stock

holdings unless the stock holdings and the portfolio

substantially overlap.

T.D. 8590, 1995-1 C.B. 15, 16 (emphasis added).

Respondent’s application of substance over form would

undermine the very purpose of the Substantial Overlap Test. Using the

substance-over-form doctrine to disaggregate SIHP’s position would

accomplish precisely what the Substantial Overlap Test seeks to avoid.

Disaggregating the portfolio, as respondent seeks to do, would otherwise

ignore the fact that SIHP held substantial, unhedged market risk in

excess of 30% of the value of any Subportfolio within its Portfolio

Position. Respondent should not be permitted to use the substance-overform doctrine to undermine the express intent behind this regulation

and the method for testing. See, e.g., Benenson v. Commissioner, 887

F.3d 511, 517 (1st Cir. 2018) (“[T]he substance-over-form doctrine does

not ‘tak[e] a transaction entirely outside its statutory framework,’ but

instead, ‘helps courts read tax statutes in a way that makes their

technical language conform more precisely with Congressional intent.’”

(quoting Dewees v. Commissioner, 871 F.2d 21, 35 (1st Cir. 1989)), rev’g

Summa Holdings, Inc., T.C. Memo. 2015-119.

We conclude that respondent’s attempt to invoke the substanceover-form doctrine seeks to apply subjective views regarding the

propriety of the Transaction at issue. Respondent remains obligated to

apply the SSRP regulations as written and cannot use substance-overform principles to avoid the clear application of a highly specific rule.

See, e.g., Falconwood Corp. v. United States, 422 F.3d 1339, 1351 (Fed.

25

Cir. 2005) (foreclosing an application of the substance-over-form

doctrine where “the regulations at issue leave no room” for it).

We think it is far more appropriate to require both parties to turn

square corners and to live with the end result of SIHP’s regulatory

compliance. See id. at 1352; Granite Tr. Co. v. United States, 238 F.2d

670, 675 (1st Cir. 1956) (noting that applicable regulations “emphasize

the rigid requirements of the section and make no allowance for the type

of ‘step transaction’ theory advanced in this case”); CSI Hydrostatic

Testers, Inc. v. Commissioner, 103 T.C. 398, 411 (1994) (“[W]e will apply

the consolidated return regulations and the Code as written.”), aff’d per

curiam, 62 F.3d 136 (5th Cir. 1995).

The question, however, remains whether the Transaction,

without altering its substance and disaggregating SIHP’s Portfolio

Position, is permissible under the Code and applicable regulations. Both

parties point us to Treasury Regulation § 1.246-5(d) (ex. 3) for an

answer. Specifically, the parties discuss whether paragraph (c)(1)(ii) and

(iii) Portfolio Rules or paragraph (c)(1)(v) Nonportfolio Rules applies.

C.

Applying Treasury Regulation § 1.246-5

1.

Portfolio vs. Nonportfolio Rules

Treasury Regulation § 1.246-5(d) (ex. 3) sets forth a scenario

wherein Corporation Z holds a portfolio of stocks (valued at $4,200) and

acquires a short position on a publicly traded index through a regulated

futures contract (RFC) 22 that reflects the value of a portfolio of stocks

($6,750). The example compares the overall value of the short Portfolio

Position ($6,750) with the amount of the taxpayer’s Subportfolio

($4,100); because there is less than a 70% overlap, there is no SSRP. The

value of the Subportfolio is 60.74% of the value of the stocks represented

in the position ($4,100/$6,750), so the position and the Subportfolio in

the example do not substantially overlap.

The Substantial Overlap Test functions as a regulatory safe

harbor to permit partial risk reduction in a taxpayer’s Portfolio Position.

While a taxpayer cannot eliminate all risk, the taxpayer’s holding period

will not be reduced so long as at least 30% of the short position is

unhedged. This test reflects a policy choice to allow a significant amount

of overlap between a Portfolio Position and a taxpayer’s stock holdings—

22 An RFC, also referred to as a section 1256 contract, is specifically governed

by the Commodity Futures Trading Commission rules and marked to market.

26

up to 70%—before the overlap is considered “substantial” and the

taxpayer’s holding period is reduced. See id.

There is no dispute between the parties that Treasury Regulation

§ 1.246-5 is applicable. The dispute lies entirely in whether the Portfolio

Rules or the Nonportfolio Rules apply. Respondent argues that SIHP’s

Transaction is a series of separate swaps “wrapped in legal paper” to

exploit the regulations. Petitioner rebuts this argument and contends

that there is no difference between the substance of SIHP’s Transaction

and its form. We turn to expert opinion testimony on the application of

this test.

Respondent’s expert Dr. DeRosa argues that the Transaction

itself must be recharacterized to avoid abuse of the Code and the

regulations. Respondent asserts that the substance of the transaction is

more accurately that of multiple positions (each referencing a single

stock or index) than a single portfolio and that, specifically, the Swiss

Equities should be treated as separate positions, exclusive of the Firm

Hedge position held within the Transaction. We disagree and find that

respondent ignores the definitions provided by Treasury on this issue,

namely portfolio vs. nonportfolio classification, see Treas. Reg. § 1.2465(c)(1), and likewise misconstrues the purpose of Example 3.

We interpret regulations using canons of statutory construction,

beginning with the text of the regulation, and giving effect to its plain

meaning. See Austin v. Commissioner, 141 T.C. 551, 563 (2013). To

determine plain meaning, we look to the text at issue as well as the text

and design of the regulation as a whole. AptarGroup Inc. v.

Commissioner, 158 T.C. 110, 116 (2022) (citing K Mart Corp. v. Cartier,

Inc., 486 U.S. 281, 291 (1988)). “A regulation should be interpreted so as

to avoid conflict with the statute.” Id.

The Code and the regulations not only authorize the creation of

positions in more than one stock, i.e., portfolios, but also define the term

and instruct a taxpayer in how to do so. See Treas. Reg. § 1.2465(c)(1)(ii). The regulations state the following:

In general, positions that reflect the value of a portfolio of

stocks are treated under the rules of paragraphs (c)(1)(ii)

through (iv) of this section, and positions that reflect the

value of more than one stock but less than a portfolio are

treated under the rules of paragraph (c)(1)(v) of this

section. A portfolio for this purpose is any group of stocks of

27

20 or more unrelated issuers. Paragraph (c)(1)(vi) of this

section provides an anti-abuse rule.

Id. subdiv. (i) (emphasis added).

The regulations refer to positions comprising more than one but

fewer than 20 unrelated issuers as “[n]onportfolio positions,” to which

the Substantial Overlap Test does not apply. See id. subdivs. (i), (v).

After considering the straightforward text of the applicable regulations,

we determine that SIHP has created a portfolio of stocks in both

substance, a collection of 20 or more stocks, and form. This portfolio of

stocks—including the Swiss Equities—is SIHP’s Portfolio Position.

Our conclusion is equally supported by the statute, which

provides that “a taxpayer has diminished his risk of loss by holding 1 or

more other positions with respect to substantially similar or related

property.” I.R.C. § 246(c)(4)(C) (emphasis added). Congress’s use of

plural terms confirms its intent that Treasury’s (to be created) tests

would apply against a taxpayer’s unitary position of indexes or portfolio,

and not any single indexes as respondent contends. Respondent further

contends that the type of portfolio chosen by SIHP is not intended to be

permitted by the legislative history or the Portfolio Rules in the final

regulations. We disagree.

Respondent, supported by expert Dr. DeRosa, argues that

petitioner’s reliance on Example 3 is erroneous because the example

intentionally uses an RFC. Unlike petitioner’s position, an RFC cannot

control the underlying holdings. By contrast, respondent argues that

SIHP has demonstrated regular control, directly in opposition to the

chosen form of the position, over the contents of the Transaction.

Because the only example provided by Treasury for a portfolio of stocks

uses an RFC, respondent contends that only RFCs, which lack the

aforementioned control, may be permitted under section 246 and

Treasury Regulation § 1.246-5.

We determine that respondent’s claim regarding SIHP’s control

over the position is accurate. SIHP altered the securities within the

Transaction some 214 times over the course of the tax year at issue; of

these, 200 corresponded to the Swiss Equities’ dividend dates and each

trade synchronized the long and short positions, thereby generating a

“100 percent hedge.” However, neither party disputes at any point in the

case before us that the Swiss Equities were hedged.

28

Respondent’s briefs focus on SIHP’s allegedly impermissible

ability to control aspects of the position. 23 It seems unlikely that

Treasury intended all portfolios to remain static as, in determining

whether diminished risk of loss within a position has occurred, the

regulation looks to a taxpayer’s entire stock holding or portion of a

taxpayer’s stock holdings at a recent “testing date.” Treas. Reg. § 1.2465(c)(1)(iii).

Treasury Regulation § 1.246-5(c)(1)(iv) defines the term “testing

date” to mean:

(iv) Testing date. A testing date is any day on which

the taxpayer purchases or sells any stock if the fair market

value of the stock or the fair market value of substantially

similar or related property is reflected in the position, any

day on which the taxpayer changes the position, or any day

on which the composition of the position changes.

(Emphasis added.)

The foregoing definition confirms that testing for diminished risk

of loss under the Substantial Overlap Test is to occur on any day in

which a taxpayer makes a change to the portfolio. This concept, found

in the regulations, is overlooked by respondent. Simply put, the

Substantial Overlap Test is triggered only when one of the above events

occurs, namely, when a taxpayer buys or sells stock within its portfolio.

While testing for SSRP is required at the beginning of a transaction, a

taxpayer must retest the position for SSRP at every subsequent change

made to the position including but not limited to changing the weights,

23 Respondent begins by invoking the investor control doctrine as an analogous

argument regarding the incidents of control, likening SIHP’s management of the

position to the actions of the taxpayer in Webber v. Commissioner, 144 T.C. 324, 368

(2015). There, the owner of life insurance funded by separate accounts was held to have

exercised “sufficiently capacious and comprehensive” control over the separate

accounts of his life insurance policies because he directed the investment manager to

“buy, sell, and exchange securities and other property,” particularly in companies in

which the taxpayer sat on the board and in which he invested his personal accounts,

individual retirement accounts, and private-equity funds. Id. at 350, 364. In

determining whether the taxpayer owned the assets supporting the policies, the Court

explained that “[t]he core ‘incident of ownership’ is the power to select investment

assets by directing the purchase, sale, and exchange of particular securities.” Id. at

361. Nothing before us invites us to reconsider our holding in Webber, and neither do

we find the case to be analogous. As conceded by respondent, nothing in Webber

addresses whether or when swaps referencing an index of stocks may be disaggregated.

29

adding or subtracting holdings, selling a long position, or adding a stock

to the portfolio. Id. In summary, we determine that SIHP holds a

portfolio of stocks, and accordingly, we will apply the Substantial

Overlap Test.

2.

Application of the Substantial Overlap Test

Although Example 3 refers to an RFC, we determine this is not

intended as evidence of Treasury’s prohibition against application of the

Substantial Overlap Test to a portfolio containing an equity swap

arrangement, such as in this Transaction. Respondent acknowledges

that if the Transaction is viewed as a unitary position (i.e., as a Portfolio

Position), it complies with the Substantial Overlap Test. Petitioner

argues that SIHP’s Portfolio Position is substantially similar to

Example 3 and provides substantial evidence, including a regulatory

testing date from the Transaction. We agree with petitioner here.

On April 24, 2012, SIHP’s Portfolio Position consisted of a

permissible 64% overlap. Of the total $3,441.8 million value in the

Transaction, $2,215.9 million or 64% overlapped with the stock holdings

on the testing date. The at-risk portion, the remaining 36%, however,

was not from any difference between the long and short holdings in the

Swiss Equities, but rather from the inclusion of the Firm Hedge. By

including the Firm Hedge, as depicted below, SIHP ensured that it was

always exposed to market risk for more than the required percentage,

regardless of the Swiss Equities’ being fully hedged. Below is an

illustration of SIHP’s compliance with the Substantial Overlap Test:

30

In sum, and relying upon the plain text of the regulation, we hold

that the Transaction, consisting of a swap arrangement containing the

Firm Hedge and the Swiss Equities, does not qualify as SSRP under the

Substantial Overlap Test. See Treas. Reg. § 1.246-5(c)(1)(iii).

D.

The Anti-Abuse Rule

Respondent argues, notwithstanding SIHP’s compliance with the

Substantial Overlap Test, that the Transaction violates the Anti-Abuse

Rule of Treasury Regulation § 1.246-5(c)(1)(vi), which reads as follows:

Notwithstanding paragraphs (c)(1)(i) through (v) of this

section, a position that reflects the value of more than one

stock is a position in substantially similar or related

property to the appropriate portion of the taxpayer’s stock

holdings if—

(A) Changes in the value of the position or the

stocks reflected in the position are reasonably

expected to virtually track (directly or inversely)

changes in the value of the taxpayer’s stock

holdings, or any portion of the taxpayer’s stock

holdings and other positions of the taxpayer; and

(B) The position is acquired or held as part of

a plan a principal purpose of which is to obtain tax

savings (including by deferring tax) the value of

which is significantly in excess of the expected pretax economic profits from the plan.

There is no express activation or trigger for the Anti-Abuse Rule.

The rule applies to any position that reflects the value of more than one

stock and is intended to affect both Portfolio and Nonportfolio Positions.

Id.

The Anti-Abuse Rule comprises three elements: (i) the taxpayer

has eliminated his economic risk of his stock holdings by holding a

position that “virtually track[s]” its stock holdings, (ii) that position is

held “as part of a plan a principal purpose of which is to obtain tax

savings,” and (iii) the tax savings obtained by the taxpayer are

“significantly in excess of the expected pre-tax economic profits” of

holding the position. 24 See id. For purposes of the Anti-Abuse Rule,

24 The rule is elemental, meaning all three tests must be satisfied in order for

the holding period to be reduced. While there are only two prongs to the rule, the

31

“reasonable expectations” are defined as “expectations of a reasonable

person, based on all the facts and circumstances at the later of the time

the stock is acquired or the positions are entered into.” Id. para. (b)(4).

1.

Treasury Regulation § 1.246-5(c)(1)(vi)(A): The

Virtual Tracking Test

Under the first requirement of the Anti-Abuse Rule a taxpayer’s

changes in the value of the position must be reasonably expected to

“virtually track” changes in its stock holdings. Treas. Reg. § 1.2465(c)(1)(vi)(A). The Virtual Tracking Test is designed to identify

circumstances where the taxpayer has formally complied with the

Substantial Overlap Test and yet substantially eliminated all risk by

looking to whether changes in the value of the position or the stocks

reflected are reasonably expected to track (directly or inversely) changes

in the value. 25 Id.

The text of the Virtual Tracking Test is broad and states:

Changes in the value of the position or the stocks reflected

in the position are reasonably expected to virtually track

(directly or inversely) changes in the value of the taxpayer’s

stock holdings, or any portion of the taxpayer’s stock

holdings and other positions of the taxpayer . . . .

Id.

Petitioner’s argument centers upon a unique reading of the

foregoing text. Petitioner asserts that the Virtual Tracking Test applies

differently to Portfolio and Nonportfolio Positions. Petitioner argues

that the Virtual Tracking Test was crafted to “allow[] for the distinct

treatment that Treasury mandated for Portfolio and Nonportfolio

Positions” and interprets the “or” as an indication of separate guidance

for the two classifications. Specifically, petitioner argues that the phrase

second prong includes a quantifying aspect, that the tax savings be “significantly in

excess,” which makes for a tertiary qualifying element to the Anti-Abuse Rule. Mere

tax savings are not enough to trigger the rule.

25 “Although there is no guidance on what it means for a derivative to virtually

track a stock position, the term ‘virtually track’ is thought to require a fairly high

standard of correlation (likely 0.9 to 0.95).” Matthew A. Stevens & David Martin, The

Care and Feeding of Basket Swaps, 174 Tax Notes Fed. 1507 (2022) (citing I.R.S. Tech.

Adv. Mem. 9128050 (July 12, 1991)). “Otherwise, the antiabuse rule would seem to

subsume all the technical rules.” Id.

32

“or the stocks reflected in the position” is meant to refer only to

Nonportfolio Positions while the phrase “changes in the value of the

position” may be used to test only Portfolio Positions. Petitioner also

contends that Dr. Brennan has demonstrated, without rebuttal, through

quantitative mathematics that the Transaction and Swiss Equities did

not meet the Virtual Tracking Test for the tax year at issue.

Respondent in turn points us to the value of the short Swiss

Equities reflected in the Transaction, which would reasonably be

expected to virtually track inverse changes in the value of long Swiss

equities held in the prime brokerage account. Respondent also contends

Dr. Brennan’s interpretation of the Virtual Tracking Test does not

apply, claiming it is contrary to the Code and the regulations and is

unreliable and unreasonable. We agree with respondent’s arguments.

At trial Dr. Brennan opined that virtual tracking—in terms of a

formula—is best thought of as a fraction wherein the change in overall

value of a taxpayer’s entire holdings acts as the numerator, while the

change in value of taxpayer’s stock holdings acts as the denominator.

According to Dr. Brennan, if the percentage of this formula equals 100%

or −100%, then the changes between a taxpayer’s position and holdings

virtually track; if the percentage deviation exceeds more than 5% (105%

or 95%) then there is no virtual tracking. Applying this formula for

virtual tracking, Dr. Brennan concluded SIHP’s ownership in the Swiss

Equities did not virtually track with that of the other positions taken in

the Transaction. 26

While the Court appreciates Dr. Brennan’s expertise and

knowledge on the subject, we find his proposed test to be contrary to our

reading of the regulation. We agree with Dr. Brennan that the Virtual

Tracking Test acts as a check to determine whether there is any hidden

(or virtual) overlap between the entirety of a position, or the entirety of

stocks reflected in the position, and a taxpayer’s stock holdings, or a

portion of the taxpayer’s stock holdings and other positions of the

taxpayer. However, we disagree with Dr. Brennan’s application of a

deviation percentage. Example 1 of Treasury Regulation § 1.246-5(d)

provides as follows:

26 Using three dates, March 1, April 2, and May 1, 2012, Dr. Brennan

performed his virtual tracking test and arrived at a range of percentages of no greater

than 91%.

33

Corporation A and Corporation B are both automobile

manufacturers. The fair market values of Corporation A

and Corporation B common stock primarily reflect the

value of the same industry. Because Corporation A and

Corporation B common stock are affected not only by the

general level of growth in the industry but also by

individual corporate management decisions and corporate

capital structures, changes in the fair market value of

Corporation A common stock are not reasonably expected

to approximate changes in the fair market value of the

Corporation B common stock. Under paragraph (b)(1) of

this section, Corporation A common stock is not

substantially similar or related to Corporation B common

stock.

Contrary to Dr. Brennan’s claims, the regulation does not contain

a standard of deviation. Instead, like many examples found in the

Treasury regulations, it was written to be purposefully generic as a

guideline.

Dr. Brennan arrived upon a 5% deviation range by selecting a

specific set of stocks (Toyota Motor Corp and Honda Motor Co. Ltd.) from

the tax year at issue. While Dr. Brennan’s formula follows good logic and

appears apt, we find his sweeping application of a standard 5% deviation

to be beyond the plain and ordinary meaning of the phrase “virtual

tracking.” 27

We likewise find petitioner’s reading of the Virtual Tracking Test

unreasonably narrow and contrary to both the text of the regulation and

its meaning. The regulation uses with the phrase “[n]otwithstanding

paragraphs (c)(1)(i) through (v) of this section,” specifically instructing

the taxpayer to disregard the special rules regarding Portfolio and

Nonportfolio Positions. Treas. Reg. § 1.246-5(c)(1)(vi) (emphasis added).

We similarly find it difficult to locate the additional instructions

petitioner insists exist in the text of the regulation. Petitioner argues

that a Portfolio Position may be tested only on the full position and not

on the stocks reflected therein, yet the test itself does not make this

distinction and the Treasury regulations fail to use the word “portfolio.”

27 A wider, or alternatively narrower, precent of deviation (3% or 6%) could

easily be justified if we were to utilize different companies or different time periods.

For example, Dr. Cragg calculated a 10% deviation range during his testimony at trial

between the change in values of Citigroup and Morgan Stanley.

34

Similarly, paragraph (c)(1)(vi) of the regulation, unlike paragraph

(c)(1)(i) through (v), does not distinguish nor create separate rules for

taxpayers to apply the Virtual Tracking Test based upon the relevant

position (i.e., Portfolio vs. Nonportfolio Position).

On the basis of the above we read the regulation to be broad in

application and determine Treasury intended for it to serve as a catchall for potential abuse. If petitioner’s arguments were correct, the AntiAbuse Rule would seem to never apply in circumstances where a

taxpayer has passed the Substantial Overlap Test. The preamble to the

final regulations makes it clear that this is not the case. If the AntiAbuse Rule applies, a position that reflects the value of two or more

stocks (including a portfolio) is treated as SSRP even if those stocks and

the taxpayer’s stock holdings do not substantially overlap. See T.D.

8590, 1995-1 C.B. at 16. Considering SIHP also held short positions in

the Swiss Equities under the Transaction, we determine these two

positions are reasonably expected to virtually track under the AntiAbuse Rule. See Treas. Reg. § 1.246-5(c)(1)(vi)(A).

2.

Treasury Regulation § 1.246-5(c)(1)(vi)(B): Principal

Purpose and Significantly in Excess

Virtual Tracking alone, however, is insufficient to apply the AntiAbuse Rule. The second element of the test contains multiple variables

and provides:

[A] position that reflects the value of more than one stock

is a position in substantially similar or related property to

the appropriate portion of the taxpayer’s stock holdings if—

....

(B) The position is acquired or held as part of

a plan a principal purpose of which is to obtain tax

savings (including by deferring tax) the value of

which is significantly in excess of the expected pretax economic profits from the plan.

Treas. Reg. § 1.246-5(c)(1)(vi)(B). Breaking down the text of this

Treasury regulation, we are to determine first whether the “position is

acquired or held as part of a plan a principal purpose of which is to

obtain tax savings.”

Petitioner’s expert witness Dr. Cragg asserts that there were no

“tax savings” generated by the Transaction, arguing that neither QDI

nor FTC should be classified as such. Respondent’s experts each

35

produced their reports on the basis of Cohen’s Analyses and contend the

“tax savings” are attributed to QDI treatment and the anticipated FTC,

which greatly exceeded the pretax profit. Respondent points to a range

of estimated tax savings from $10.7 million to $14.7 million based on

Cohen’s 2010 Analysis and $22.2 million to $54.7 million based on

Cohen’s 2012 Analysis. Despite continuing to argue that no tax savings

were considered or generated by the transaction, petitioner

acknowledges that Dr. Nelken determined $10.7 million as the

approximate “tax savings” from the Transaction. On rebuttal Dr. Nelken

contends Dr. Brennan’s reference to $10.7 million in tax savings was

specific to tax year 2010 only and he would expect 2012 to have tax

savings of more than $25 million because of the larger volume of trades.

We agree. 28 Accordingly, and after considering all arguments presented,

we adopt Dr. Nelken’s conclusions and determine the approximate “tax

savings” from the Transaction to be more than $25 million. 29

Next, under the regulation we are to determine whether the “tax

savings” obtained by the taxpayer are “significantly in excess” of the

“expected pre-tax economic profits.” Id.

When applying the Anti-Abuse Rule, paragraph (c)(1)(vi), the

regulation defines the term “reasonable expectations” to mean:

For purposes of paragraphs (b)(1)(i), (b)(2), or (c)(1)(vi) of

this section, reasonable expectations are the expectations

of a reasonable person, based on all the facts and

circumstances at the later of the time the stock is acquired

or the positions are entered into. Reasonable expectations

include all explicit or implicit representations made with

respect to the marketing or sale of the position.

Id. para. (b)(4) (emphasis added). This definition supplies two options

applicable to the facts before us; the expected pretax economic profit of

the plan could be calculated on the basis of either (1) the time the

28 Respondent proposes the tax savings are far greater, and total to some $54

million. However, we decline to consider a tax credit for foreign taxes paid as a

reduction in tax or tax savings. Equally, we do not accept the QDI savings figure

offered, since some 78% to 80% of the gross dividend amounts paid on the Swiss

Equities to SIHP was due back to Morgan Stanley under the ISDA and Transaction.

See supra note 11.

29 Our determination of the “tax savings” is akin to Dr. Nelken’s conclusion and

is a culmination of QDI treatment as well as foreign tax credits received under the

relevant tax period.

36

position was entered into, shortly after Cohen’s Analyses, or (2) the time

the stock was acquired, here represented by the reports written by Dr.

Cragg and respondent’s experts. Respondent argues the former while

petitioner argues the latter.

This case turns on the comparison of the expected pretax

economic profit to the tax savings. If the latter is “significantly in excess”

of the former, then the Anti-Abuse Rule applies, and the relevant

holding periods must be reduced. Adjusting either value significantly

affects the outcome of the regulation and this case. Both values are

contested by the parties as neither “significantly in excess” nor “pre-tax”

is defined by the regulation. We begin our analysis by assessing each

party’s calculations of expected pretax economic profit.

In determining the expected “pre-tax profit” under the

Transaction, the parties’ experts disagree over three material issues: the

impact of Swiss taxes, the impact of the Firm Hedge, and the impact of

other costs and expenses (including slippage and commissions) under

the Transaction.

Petitioner argues that “pre-tax” as used in the Anti-Abuse Rule

follows its common use elsewhere and that the pre-tax profit calculation

should be just that; namely, the “expected pre-tax profit” should be

calculated before application of all taxes.

Respondent’s experts argue otherwise, asserting that it is

improper to exclude the mandatory foreign Swiss tax withholdings as

doing so would result in an inflation of any expected pretax profit. Drs.

Nelken and DeRosa also note that SIHP’s own profit analyses, Cohen’s

Analyses, account for Swiss taxes. The economic reality of the

Transaction lends merit to respondent’s argument. Because of

applicable Swiss withholding taxes, SIHP received only 65% of each

dividend from the Swiss Equities. There was no way for SIHP to receive

100% of the dividends on the Swiss Equities because 35% of each foreign

dividend was subject to withholding by SFTA, and under any reclaim

filed with SRTA the Swiss withholdings would only be reduced to 15%.

We agree in part with respondent’s position that Swiss withholdings

must be accounted for in determining the expected “pre-tax profit” under

the Transaction.

Endeavoring to apply the regulation as written, we will not

determine the actual economic profits because the regulation directs us

to determine the “expected pre-tax economic profits.” Treas. Reg. § 1.246-

37

5(c)(1)(vi)(B) (emphasis added). Although the regulation does not define

the term “pre-tax,” it clearly stresses the existence of a quantitative

value before the application of tax in order to compare the two and

determine the amount of savings (including deferred tax) produced. Id.

On the basis of Cohen’s Analyses and testimony for trial, SIHP

reasonably expected to receive preferential tax treatment under the

Swiss Treaty, culminating in a 15% foreign tax rate. Consequently, we

will consider the “pre-tax” calculation to include the reasonably

anticipated rate of 15% for Swiss taxes. This determined, we will next

address the impact of the Firm Hedge and the other costs and expenses

(including slippage and commissions) under the Transaction.

On brief respondent first contends, before corrections, that Mr.

Cohen’s pretax profit analysis reflects SIHP’s expected tax savings from

the Swiss Equities to be significantly in excess of the expected pretax

profit as follows:

April 5, 2010

April 15, 2010

January 11, 2012

Expected Pretax Profit

$151,529

$974,348

$2,422,913

Tax Savings from QDI

and Foreign Tax Credits

14,724,960

12,423,000

22,215,027

We find respondent’s argument here using Cohen’s Analyses

compelling. Mr. Cohen reflected an “expected pre-tax profit” of $2.4

million for the tax year at issue and tax savings significantly in excess

of this amount. Furthermore, the amounts above are conservative as

Cohen’s 2012 Analysis fails to accurately consider all costs of the

Transaction, including slippage costs, dividends owed, or the value of

market appreciation for any short positions held in the Firm Hedge.

Finally, Cohen’s 2012 Analysis continued to unreasonably assume an

immediate reclaim from SFTA, despite not receiving one in either year

2010 or 2011. 30

Petitioner’s expert Dr. Cragg ultimately concluded there was an

expected 2012 pre-tax economic profit of approximately $32 million. He

arrived at this amount on the basis of net dividends of $40 million, Firm

Hedge savings of $663,229, and expected costs of $8.7 million.

30 The SFTA has no record of SIHP’s filing a reclaim request for 2012 and

similarly has not accepted the claim for either 2010 or 2011.

38

In rebuttal Drs. DeRosa and Nelken offer several opinions as to

the expected pretax profit of the Transaction. Dr. Cragg contends both

Drs. Nelken and DeRosa in turn erroneously determine the pretax

economic profits under the Anti-Abuse Rule because their calculations

include taxes and consider only the burdens of the Firm Hedge and none

of the benefits. Dr. Cragg’s final calculation reflects a pretax profit of

$31 million, but only after adding an estimate of the economic benefits

of the Firm Hedge, which Dr. Cragg qualifies as being some $121

million, and other adjustments. We find Dr. Cragg’s benefit valuation of

the Firm Hedge, estimated at $121 million, to be unreasonably

subjective overall, and therefore we are unwilling to account for this

benefit as he proposes. Further, Dr. Cragg’s approach regarding the

calculation of gross and substitute dividends appears inconsistent.

Respondent’s expert Dr. DeRosa concluded that there was an

expected pretax loss of more than $17.5 million. 31 However, upon

examining Dr. DeRosa’s report we noticed several inconsistencies. Dr.

DeRosa begins his analysis by estimating fewer total shares for the

Swiss Equities than those reported by SIHP and used by the other two

opining experts. Having calculated a substantially different gross

dividends amount, Dr. DeRosa proceeds to use a dividend ratio32

different from that of Dr. Cragg or Dr. Nelken, applying a flat rate of

80.5%. Regrettably, these factors give us pause in relying upon Dr.

DeRosa’s report on this matter, and we instead turn to consider Dr.

Nelken’s report for respondent.

Respondent’s expert Dr. Nelken calculated the actual profit on

the Swiss Equities for years 2010 and 2012, finding losses of more than

31 Dr. DeRosa noted at trial that, according to the data provided, the Firm

Hedge should have prevented SIHP from ever making a profit and questioned whether

SIHP had made a significant error in tracking the Firm Hedge. He opined that the

premise of the “industry leading firm in the trading world” entering into a deal that

resulted in such massive losses left the expert scratching his head.

32 Each expert applied the same basic formula to calculate initial profit before

cost. Gross Dividends (or Number of Stocks * Dividend Amount * USD Conversion

Rate) – Dividend Ratio (which equals the amount owed to Morgan Stanley per dividend

received). As noted, the dividend ratio affects the profit calculation directly and

independently of any applicable withholding taxes. Thus it is one of the most important

variables when determining whether tax savings were significantly in excess of

expected pretax profits. No two experts used the same ratio %.

39

$42 million and nearly $120 million, respectively. 33 He observed that

any margin of profit would be “razor thin,” meaning that even a small

difference between SIHP’s expectation and reality would result in an

overall loss.

Drs. Nelken and DeRosa agree that, on the basis of mandatory

withholding taxes and the anticipated dividend ratios owed to Morgan

Stanley, the Transaction could not be profitable. Still, it is difficult to

accept respondent’s contention that SIHP—a sophisticated financial

investment firm—would have entered into the Transaction expecting a

pretax loss anywhere near the conclusions reached by respondent’s

experts. The evidence, however, speaks for itself. All three experts agree

that if Swiss taxes and the Firm Hedge are included in the pretax profit

calculation, the transaction results in a substantial loss for the year at

issue.

While we generally agree with Dr. Cragg’s assessment that it

defies logic to conclude that SIHP entered the Transaction expecting to

lose between $70.8 million and $119.9 million, when the potential tax

savings were (as respondent contends) at most $54 million, we also

acknowledge that petitioner is unable to produce any expected profit and

loss analyses other than Cohen’s Analyses. If, as petitioner argues on

brief, Cohen’s spreadsheets were not intended to act as a comprehensive

analysis, then petitioner’s argument suggests that no comprehensive

analysis was performed before SIHP entered into the Transaction.

Subsequently, this implies that SIHP did not know to what extent the

venture might be profitable beyond potential tax savings, which were

available only because of the inclusion of the Firm Hedge, which held

short and long positions in the Swiss Equities. The lack of a prior

comprehensive analysis lends weight to respondent’s arguments

regarding the lack of anticipated profit when the Transaction was

entered into, and we accordingly accept Cohen’s expected pretax profit

estimate of $0 to $2.4 million.

Because of the inconsistencies in Dr. Cragg’s and Dr. DeRosa’s

reports, as well as the lack of any pretransactional analysis other than

the data presented by Cohen’s Analyses, we rely upon Dr. Nelken and

Cohen’s 2012 Analysis. Having reviewed all opinions offered, and on the

33 Dr. Nelken details a number of issues he has with Cohen’s calculations such

as the probability of the Swiss tax reclaim, typos, dividend payment obligations on the

short positions, obligations due under the Transaction, slippage, margin interest, and

dividend ratios used, to name a few.

40

basis of the preponderance of evidence received, we conclude the most

accurate and applicable determination of the expected pretax profit is a

pretax loss of $31 million on the low end as concluded by Dr. Nelken, to

a profit of $2.4 million on the high end, as reflected in Cohen’s 2012

Analysis.

Having determined that the expected pretax profit ranges

between $0 and $2.4 million, while the corresponding estimated tax

savings are some $25 million, we determine that the value of the tax

savings is significantly in excess of the expected pre-tax economic

profits. See Treas. Reg. § 1.246-5(c)(1)(vi)(B). We therefore determine

the Anti-Abuse Rule of Treasury Regulation § 1.246-5(c)(1) is applicable

to the Transaction and that, on the basis of the evidence presented, the

Transaction fails to comply with the Anti-Abuse Rule. We hold that

SIHP’s position in the Swiss Equities is SSRP.

V.

Foreign Tax Credits

Under the Swiss Treaty nonresidents of Switzerland can file a

reclaim to obtain a return of 20% of the gross dividends received on

Swiss equities. See Convention for the Avoidance of Double Taxation,

supra, art. 10; Notice 2011-64, 2011-37 I.R.B. at 231. At the time

dividends were paid on the Swiss Equities at issue, Swiss tax was

withheld at 35%. SIHP anticipated, however, that it would be entitled

to a refund of taxes, via submitting a reclaim request to SFTA, which

would reduce the rate to 15% and thus give rise to the foreign tax credits

at issue of $25,614,729.

To be eligible to claim FTC for withholding taxes imposed on

dividends, a taxpayer must hold the dividend-paying equity for at least

15 days during the 31-day period beginning on the date which is 15 days

before the ex-dividend date. I.R.C. § 901(k)(1). In no event shall a credit

be permitted if the recipient of the dividend is under an obligation

(whether pursuant to a short sale or otherwise) to make related

payments on SSRP positions. I.R.C. § 901(a), (k)(1).

Respondent does not dispute that SIHP held the Swiss Equities

for 62 days. Instead, respondent relies on petitioner’s argument that

SIHP diminished its risk of loss by holding one or more positions in

SSRP under section 246(c)(4)(C) and Treasury Regulation § 1.246-5.

Because we find that the Swiss Equities are SSRP for purposes of

section 246 and the related regulations, SIHP is barred from claiming

41

FTC under section 901(a) and (k)(1). We hold that SIHP has not satisfied

the statutory requirements to claim the FTC.

VI.

Conclusion

Since we have determined that the Swiss Equities are SSRP for

purposes of section 246 and the related regulations, the holding period

for these equities is accordingly reduced, and SIHP is ineligible to

receive QDI on dividends received or claim FTC. Accordingly, we will

sustain respondent’s proposed adjustments.

In reaching our decision we have considered all arguments made

by the parties, and to the extent not mentioned or addressed, they are

irrelevant, moot or without merit.

To reflect the foregoing,

Decision will be entered for respondent.