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CARDS transaction lacked economic substance; 40% penalty applies

August 8, 2017

The Tax Court has held that a Custom Adjustable Rate Debt Structure (CARDS) transaction entered into by an LLC and two individuals associated with the LLC lacked economic substance and that losses stemming from the transaction weren’t deductible. The Court found that the transaction—which was designed and entered into for the purpose of generating a tax loss—presented no real opportunity for profit and that the taxpayers had no valid non-tax reasons for participating in it. And, the Court upheld IRS’s imposition of 40% gross valuation misstatement penalties, rejecting the taxpayers’ claim that they acted reasonably and in good faith.

Background—economic substance. To determine whether a transaction has economic substance, courts usually make a two-pronged factual inquiry:

1. Was the taxpayer motivated by no business purpose (other than getting tax benefits) in entering into the transaction? (subjective test)
2. Did the transaction have objective economic substance, i.e., was there a reasonable possibility of a profit? (objective test) (Frank Lyon Co v. U.S., (S Ct 1978) 41 AFTR 2d 78-1142)

The economic substance doctrine allows the government to look beyond technical compliance with the Code to ascertain the real nature of the transaction at issue.

The Circuits have differed in their application of the two-prong test. A number of Circuits, including the Eleventh Circuit (United Parcel Service of America Inc, (CA 11 2001) 87 AFTR 2d 2001-2565), require that a transaction have both a subjective business purpose and objective economic substance in order to be respected (the conjunctive test). On the other hand, the Fourth Circuit requires only that a transaction have either a subjective business purpose or objective economic substance in order to be respected (the disjunctive test). (Rice’s Toyota World Inc v. Comm., (CA 4 1985) 55 AFTR 2d 85-580)

RIA observation: For transactions entered into after Mar. 30, 2010—i.e., after the time period involved in this case—the Health Care and Education Reconciliation Act (P.L. 111-152, 3/30/2010) added Code Sec. 7701(o). Under a conjunctive two-prong test, it provides that a transaction is treated as having economic substance only if, apart from Federal income tax effects, both: (1) the transaction changes the taxpayer’s economic position in a meaningful way; and (2) the taxpayer has a substantial purpose for entering into the transaction. That is, the taxpayer’s non-Federal-income-tax purpose for entering into a transaction must be “substantial.”

Background—CARDS transactions. A CARDS transaction is, in effect, a complex transaction designed to create an artificial capital loss to offset an unrelated capital gain. As previously described by the Third Circuit in Cirpin v. Comm., (CA 3 2013) 111 AFTR 2d 2013-829, which involved a transaction similar to the one in this case:

A CARDS transaction is a tax-avoidance scheme that…purports to generate, through a series of pre-arranged steps, large “paper” losses deductible from ordinary income. First, a tax-indifferent party…borrows foreign currency from a foreign bank (a “CARDS Loan”). Then, a United States taxpayer purchases a small amount…of the borrowed foreign currency by assuming liability for a an equal amount of the CARDS Loan. The taxpayer also agrees to be jointly liable with the foreign borrower for the remainder of the CARDS Loan and so the taxpayer purports to establish a basis equal to the entire borrowed amount. Finally, the taxpayer exchanges the foreign currency he purchased for United States dollars. That exchange is a taxable event, and the taxpayer claims a loss equal to the full amount of his supposed basis in the CARDS Loan, less the proceeds of the relatively small amount of currency actually exchanged. The taxpayer uses that loss to shelter unrelated income.

The CARDS strategy was targeted by IRS in August of 2000 in Notice 2000-44, 2000-2 CB 255. That Notice warned taxpayers that noneconomic losses produced by certain basis-inflating transactions aren’t allowable as tax deductions.

Background—accuracy-related penalty. Taxpayers are subject to a 20% accuracy-related penalty for an underpayment of tax required to be shown on a return that is attributable to a substantial valuation misstatement. (Code Sec. 6662(a), Code Sec. 6662(b)(3)) The penalty is 40% of the portion of an underpayment of tax attributable to one or more substantial valuation misstatements that meet the requirements for a “gross valuation misstatement”—i.e., one where the value or adjusted basis of any property claimed on a tax return is 200% or more of the amount determined to be the correct amount of such value or adjusted basis. (Code Sec. 6662(h)) The accuracy-related penalty does not apply, however, with respect to any portion of the underpayment for which the taxpayer shows that there was reasonable cause and that he or she acted in good faith. (Code Sec. 6664(c))

The Supreme Court in U.S. v. Woods, (S Ct 2013) 112 AFTR 2d 2013-6974 (see Weekly Alert ¶  20  12/05/2013), resolving a split in the circuits, held that the valuation misstatement penalty could be imposed where the underlying transaction lacked economic substance.

Facts. Curtis Investment Company LLC (Curtis Investment), a holding company formed by the Curtis family, owned approximately 30% of the stock of American Business Products, Inc. (ABP), as well as other assets. Mrs. Baxter, a member of the Curtis family, became managing member of Curtis Investment in ’86, and her son, Mr. Bird, assumed that role in ’98. In late ’99 or early 2000, ABP received a tender offer for the purchase of the company, which its board accepted. In February 2000, Curtis Investment sold ABP stock, generating approximately $28.6 million in long-term capital gain. Mrs. Baxter also sold ABP stock generating approximately $2.4 million in long-term capital gain and $19,000 in short-term capital gain.

In the fall of 2000, knowing that the sales of ABP stock would generate substantial tax liabilities, an accountant recommended a CARDS transaction to Curtis Investment and Mrs. Baxter. Mr. Bird had various legal and financial advisors, some of whom were also promoters of the transaction, review the transaction. He received a model opinion letter drafted by a law firm concluding that the transaction would “more likely than not” have economic substance. While none of the advisers actually provided their own opinion letters, they generally concurred with the model opinion letter as to the tax consequences of the transaction. Mr. Bird himself also researched the investment potential of the CARDS transaction and concluded that it would be profitable. They decided to participate.

The CARDS transaction resulted in a purported $28 million loss for Curtis Investment and a $2.3 million loss for Mr. and Mrs. Baxter. Both Curtis Investment and the Baxters reported these losses, as well as the long- and short-term gains from the ABP stock sale, on their 2000 returns. IRS, however, determined that they were not entitled to a capital loss deduction as a result of the CARDS transaction because it lacked economic substance. IRS also found that they were liable for gross valuation misstatement penalties.

Transaction lacks economic substance under both tests. In this case, Curtis Investment (an LLC organized in Georgia) would appeal the Tax Court’s decision to the Fourth Circuit, whereas the Baxters (residents of South Carolina) would appeal to the Eleventh Circuit. Therefore, in determining whether the transaction had economic substance, the Court had to apply the disjunctive test with respect to Curtis Investment and the conjunctive test with respect to the Baxters.

The Tax Court explained that, to satisfy the objective test, a transaction must be objectively likely to produce economic benefits other than the generation of a tax deduction. (Glass, (1986) 87 TC 1087) Curtis Investment and the Baxters argued that the Court should consider the profit potential from returns on investments that were purchased with proceeds of the CARDS transaction, but the Court rejected this argument, focusing instead on the transaction itself that gave rise to the tax loss. The Court then concluded that the CARDS transaction in this case, like prior ones it had considered, did not provide an objectively reasonable possibility of profit. Rather, the transaction was purposefully entered to create tax losses, and the Court found that “any testimony to the contrary is simply not credible.”

The Court noted that its conclusion that the CARDS transaction failed the objective test was enough for it to conclude that, with respect to Curtis Investment, the CARDS transaction lacked economic substance. However, it continued to apply the subjective test, satisfaction of which was also required to reach a similar conclusion with respect to the Baxters. The subjective test looks to whether there was a business purpose for a transaction—or, put otherwise, whether the transaction would have occurred absent tax avoidance reasons. The Baxters claim that their business purpose was to obtain proceeds for investment, but the Court found that this claim was belied by the facts of the transaction, including the high financing costs incurred, the overall timing, and the fact that the Baxters didn’t explore less expensive financing arrangements or attempt to obtain any other loan or maximize the amount they could borrow.

Finally, the Tax Court upheld IRS’s imposition of a 40% gross valuation misstatement penalty, citing Woods. The Court noted that the Tax Court had previously found that a taxpayer acted with reasonable cause and good faith when (a) a deficiency was the result of an issue of first impression and the taxpayer’s position was reasonably debatable; or (b) a taxpayer took a position on an initial interpretation of a statute and the statutory text was unclear. However, the Court rejected the argument that the CARDS transaction presented novel issues , finding that IRS had already taken an unfavorable position with regard to CARDS transactions in Notice 2000-44 (and that this Notice was discussed in the model opinion letter concerning the transaction); and even if it had presented novel issues, the facts of the case otherwise weighed against a finding of reasonable cause and good faith. Notably, any claimed reliance on tax advisers was belied by the fact that they had an inherent conflict of interest, and the Baxters, as well as Mr. Bird, were all financially sophisticated.

References: For the economic substance doctrine, see FTC 2d/FIN ¶  M-5900; United States Tax Reporter ¶  77,014.35.

Curtis Investment Company, LLC, TC Memo 2017-150