United States: Federal Court of Appeals affirms denial of loss deduction for lack of economic substance

April 26, 2013

The US Federal Court of Appeals for the Sixth Circuit has disallowed a deduction for a loss from a transaction that was lacking in economic substance (Mark L. Kerman and Lucy M. Kerman vs. Commissioner of Internal Revenue, No. 11-1822, 8 April 2013).

The case involved a US taxpayer who entered into a complex series of transactions, referred to as the Custom Adjustable Rate Debt Structure (CARDS) transaction.

The CARDS transaction centered on a “high basis, low value” foreign currency loan designed to generate a tax benefit by creating an artificial tax loss to offset real taxable income.

The CARDS transaction generally included the following steps:

  • Two British citizens created a limited liability company (LLC).
  • The LLC borrowed US$5m worth of euros from a bank in Germany.
  • The proceeds of the loan were left, as collateral, in the German bank, which paid less interest than due on the loan.
  • The taxpayer purchased US$784,750 worth of the euros from the LLC, and agreed to be jointly and severally liable for the entire loan of US$5m.
  • The taxpayer exchanged his share of the loan for US dollars.
  • One year after the transaction was entered into, the collateral held by the German bank was used to pay off the loan.

The taxpayer took the position that US$784,750 in foreign currency that he purchased had a basis of US$5m.

The taxpayer claimed that an ordinary loss deduction of US$4,251,389 resulted from the exchange of his share of the loan for the US dollars.

The loss was claimed on his 2000 tax return, with a resulting tax saving of US$1,248,876. US tax law treats a loss realized on the disposition of foreign currency as an ordinary loss.

The IRS issued a notice of deficiency to the taxpayer, disallowing the loss deduction and imposing an accuracy-related penalty. After the US Tax Court affirmed the IRS’s decision, the taxpayer appealed.

Denial of loss deduction

The US Court of Appeals stated that, for an asserted deduction to be valid under IRC section 165, the deduction must satisfy both components of a two-part test; that is, whether the transaction had economic substance and whether the taxpayer was motivated by profit to participate in the transaction.

The US Court of Appeals held that the CARDS transaction had both hallmarks of a sham transaction (i.e., a transaction that lacks economic substance) on grounds that:

  • The transaction had negative pre-deduction cash flows, absent the tax benefits, because the transaction cost more than US$600,000, including the interest and the borrowing fees, and returned approximately US$60,000.
  •  The transaction had no practical economic effects other than the creation of artificial income tax losses.
  • Accordingly, the US Court of Appeals affirmed the US Tax Court’s decision that disallowed the taxpayer’s deduction based on the transaction’s lack of economic substance.

The transaction predated the codification of the economic substance doctrine in 2010 as IRC section 7701(o). As a result, IRC section 7701(o) was not applied in the present case.

Accuracy-related penalty

IRC section 6662(a) and (b) imposes a 20% accuracy-related penalty for the underpayment of tax, including for any “substantial valuation misstatement.”

Under IRC section 6662(e), a “substantial valuation misstatement” occurs when a taxpayer overstates the basis in property by 200% or more.

IRC section 6662(h)(a)(i) doubles the penalty to 40% for “gross valuation misstatements” when a taxpayer overstates the basis in property by 400% or more.

IRC section 6664(c)(1) offers an exception to the imposition of accuracy-related penalties if there was a reasonable cause and the taxpayer acted in good faith with respect to the underpayment.

The Court of Appeals stated that, although the US federal courts of appeals are divided, the Sixth Circuit follows an approach of the majority of the circuits.

Under the majority approach, the deficiency that occurs when a transaction is disallowed for lack of economic substance is deemed to be attributable to an overstatement of value, and is subject to the penalty pursuant to IRC section 6662.

The US Court of Appeals held that, because the taxpayer’s actual basis in the currency is what he purchased (i.e., US$784,750), he overstated the basis (i.e., US$5m) by 530%, which exceeds the 400% threshold of IRC section 6662(h).

The US Court of Appeals further held that the taxpayer did not act with reasonable cause because:

  • The promotional materials for the CARDS transaction warned that the IRS might challenge the transaction.
  • The taxpayer did not reasonably investigate the CARDS strategy’s legitimacy before, during, or after the CARDS transaction.
  • The US Court of Appeals held that the valuation misstatement penalty of IRC section 6662(e), which may be enhanced by subsection (h), is specifically targeted at tax shelters, and affirmed the US Tax Court’s imposition of the gross valuation misstatement penalty pursuant to IRC section 6662(h).

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