Broader Interpretation of Economic Substance Blunts Deductions


The Fifth Circuit Court of Appeals affirmed a district court ruling that Klamath Strategic Investment Fund’s loan transactions lacked economic substance and that no penalties applied. Furthermore, the appeals court held that the lower court erred in allowing Klamath deductions for operational expenses in connection with a sham transaction and lacked jurisdiction to order a refund in connection with the expenses.


The 2007 ruling by the District Court for the Eastern District of Texas (5:04-CV-278; see “Tax Matters,” JofA, June 07, page 90, and March 07, page 72) disallowed tax losses claimed by the taxpayers in a tax shelter transaction referred to as Bond Linked Issue Premium Structure (BLIPS). The taxpayers believed that the BLIPS program was a bona fide investment strategy to earn a profit through foreign currency trading. Unknown to the taxpayers, the investment firm that marketed the program and the third-party bank that provided loans for it did not intend to fully carry out the program, and intended it solely as a method to generate large tax losses. Although a district court disallowed the losses, it waived accuracy-related penalties, holding that the taxpayers’ understatements were not attributable to any valuation misstatement because they reasonably believed the tax treatment was proper. The court came to this conclusion because the taxpayers had relied in good faith on professionals—CPAs and well-known tax attorneys. It also held that the partners could deduct the interest expenses related to the transactions.


The Fifth Circuit affirmed the district court’s holding with respect to the losses from the transactions, but overruled the lower court’s decision to allow Klamath to deduct the interest expenses. With respect to the interest expenses, the appeals court quoted the Tax Court in Winn-Dixie Stores Inc. v. Commissioner, 113 TC 254 (1999, aff’d, 11th Cir., 2001) “observing that ‘a transaction that lacks economic substance is not recognized for [f]ederal tax purposes’ and that ‘denial of recognition means that such a transaction cannot be the basis for a deductible expense.’ … The overall transaction must have economic substance to show genuine indebtedness, otherwise ‘every tax shelter … could qualify for an interest expense deduction as long as there was a real creditor in the transactions that demanded repayment.’ ”


The Fifth Circuit also ruled in favor of the IRS in its contention that the district court had misinterpreted its authority to order a refund following a readjustment of partnership items under IRC §§ 6226(f) and 6230(d)(5). Though section 6226(f) specifies the district court’s jurisdiction to determine partnership items, and to allocate those items to individual partners and apply penalties, taxes or additional amounts, it does not grant jurisdiction to order a refund. Partnerships may seek refunds through administrative proceedings, as governed by section 7422(a), which provides that no suit or proceeding may be maintained for the recovery of a refund “until a claim for refund or credit has been duly filed with the Secretary. …”


  Klamath Strategic Investment Fund LLC v. U.S. , 07-40861 (5th Cir. 2009)


By Laura Jean Kreissl, Ph.D., assistant professor of accounting, and Darlene Pulliam, CPA, Ph.D., McCray Professor of Business and professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.



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