A district court held that a partnership’s reported capital loss stemming from nonperforming loans lacked economic substance and denied the claimed tax benefits. D. Andrew Beal owned a bank that was in the business of acquiring nonproducing loans (NPLs) at extreme discounts. With an associate and China Cinda Asset Management Co., a Chinese “bad bank,” Beal formed Southgate Master Fund LLC (Southgate) to invest in Chinese NPLs. Beal claimed a $1.1 billion tax loss in the years 2002 through 2004 arising out of the LLC’s NPL investments, which the government denied following an audit.
Cinda contributed a portfolio of low-grade NPLs to Southgate and took a 99% interest in the LLC. The NPLs that Cinda contributed to Southgate had a basis of more than $1.3 billion but a fair market value of only $19.4 million. Beal then purchased 90% of Southgate from Cinda. Southgate then sold some of the NPLs, which generated a loss of $295 million, $293 million of which was built-in loss. Since Beal had purchased most of Cinda’s interest, the majority of the built-in loss was allocated to him under IRC § 704(c). At the time the loss was recognized, the majority of Beal’s loss was nondeductible under section 704(d) because of insufficient basis.
To generate basis to permit deduction of the loss, Beal contributed securities of the U.S. government-owned mortgage guarantor Ginnie Mae with a $300 million face value and $181 million fair market value to Martel, a single-member LLC he owned. Martel sold some of the Ginnie Mae securities to Swiss bank UBS for $162 million. The sale contract required Martel to repurchase the securities on UBS’ demand, essentially making the transaction a loan of $162 million to Martel with the Ginnie Mae securities as collateral. A subsequent agreement between Beal and UBS required Beal to agree to the repurchase and provided him with complete control and benefit from all Martel activities. Martel distributed the cash to Beal, and Beal personally guaranteed to pay the liability to UBS if it demanded repurchase. Beal then contributed his interest in Martel to Southgate. Because he had personally guaranteed to pay Martel’s liability if UBS demanded that Martel repurchase the securities, he was able to increase his outside and at-risk basis in Southgate by the amount of the liability, creating basis to deduct the losses from the NPLs. The government denied the loss, alternately arguing that the basis of the NPLs was inflated or that the transactions lacked economic substance. The case went before the District Court for the Northern District of Texas.
The court rejected the government’s arguments that the transactions’ basis was artificially inflated. It did, however, agree that the transactions lacked economic substance; that is, they claimed a tax benefit not intended by Congress and served no economic purpose except to generate a tax saving. The Fifth Circuit Court of Appeals, to which this case would go, applies a two-part test for economic substance: The transaction must have a realistic possibility of profit, and it must be motivated by a legitimate nontax business purpose.
In making its determination, the district court separated the formation and operations of Southgate from the Martel restructure (the Ginnie Mae sale/repurchase agreement and the contribution of Martel to Southgate). It concluded that Southgate was a genuine business venture and had a reasonable possibility of profit. Therefore, the economic substance doctrine did not apply to its formation or operations. It reached the opposite conclusion for the Martel restructure. The court noted that only Beal could benefit from profits earned by Martel. Therefore, the contribution by Martel to Southgate lacked a reasonable chance for profit by the owners of Southgate other than Beal. The court also held that the contribution transaction was motivated solely to raise Beal’s basis and not for any nontax reasons. Failing either test would have permitted the court to deny the benefit under the doctrine. Southgate failed both tests, the court said.
The government also argued for 20% penalties under several provisions. However, the court held that Southgate had substantial authority for its position and had acted in good faith and with reasonable cause and denied the penalties. It noted that Southgate had obtained opinions from a law firm and an accounting firm that had both stated that the transaction was more likely than not to be sustained on its merits. These firms were not part of the group creating the transactions and had been used previously by the taxpayer.
Southgate Master Fund LLC v. U.S. , docket no. 06-2335 (N.D. Texas, Aug. 18, 2009)
Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor
of Accounting and director, MTA Program, Culverhouse School of
Accounting, University of Alabama, Tuscaloosa.