Curtis Inv. Co. v. Comm'r, 17-14573

909 F.3d 1339

CURTIS INVESTMENT COMPANY, LLC, Plaintiff - Appellant,

v.COMMISSIONER OF INTERNAL REVENUE, Defendant - Appellee.

No. 17-14573

United States Court of Appeals, Eleventh Circuit.

December 6, 2018

David DeCoursey Aughtry, Jasen D. Hanson, Hale E. Sheppard, Chamberlain Hrdlicka White Williams & Aughtry, Atlanta, GA, for Petitioner-Appellant.

Jennifer Marie Rubin, Arthur Thomas Catterall, Teresa E. McLaughlin, Gilbert Steven Rothenberg, U.S. Department of Justice, Chief Appellate Section Tax Division, William M. Paul, Internal Revenue Service, Acting Chief Counsel, Washington, DC, Jason P. Oppenheim, John W. Sheffield, III, Office of Chief Counsel-IRS, Atlanta, GA, for Respondent-Appellee.

Petition for Review of a Decision of the U.S. Tax Court, Agency No. 010181-08

Before WILSON and JORDAN, Circuit Judges, and GRAHAM,^* District Judge.

WILSON, Circuit Judge:

In 2000, Curtis Investment Company (CIC) entered into a tax avoidance scheme known as a CARDS transaction, allowing it to claim a $27,724,620 capital loss on its annual tax return. In 2007, the Internal Revenue Service (IRS) Commissioner issued a Final Partnership Administrative Adjustment (FPAA) disallowing CIC’s claimed capital loss and fee deductions on its 2000 tax return. The IRS also applied a gross valuation misstatement penalty under 26 U.S.C. §§ 6662 and 6664. CIC challenged the FPAA and penalties in Tax Court; the court upheld both. CIC now contends that the Tax Court erred by incorrectly applying the "economic substance" analysis and ignoring facts that supported CIC’s reasonable cause defense. After review and with the benefit of oral argument, we affirm the Tax Court’s determinations.

I. Factual and Procedural Background

A. CARDS Basics

A Custom Adjustable Rate Debt Structure (CARDS) transaction is a tax-avoidance scheme involving a series of pre-arranged steps whereby (1) a tax-indifferent party not subject to U.S. taxation borrows foreign currency from a foreign bank, with interest due annually and principal due in a single "balloon" payment 30 years in the future, (2) a U.S. taxpayer purchases a small percentage of the loan proceeds—in the form of foreign currency or the bank’s promissory note—in exchange for taking on joint liability for the entire loan, and (3) the U.S. taxpayer then exchanges the purchased foreign currency for U.S. dollars or redeems the promissory note. Currency exchanges and promissory note redemptions are taxable occurrences. The U.S. taxpayer claims that its tax basis in the exchanged currency or redeemed note is the full amount of the loan proceeds, not just the small percentage it actually paid for.

Section 1012 of the Internal Revenue Code provides that a taxpayer’s basis in property is generally equal to its "cost" of acquiring the property, including any assumption of a seller’s liabilities. This rule is premised on the expectation that buyers will fully pay the assumed liabilities. See Comm’r v. Tufts , 461 U.S. 300, 308–09, 103 S.Ct. 1826, 1831–32, 75 L.Ed.2d 863 (1983). In a CARDS transaction, the U.S. taxpayer is nominally responsible for payment of the entire principal amount of the tax-indifferent party’s loan and thus can claim the entire amount as its basis. In these transactions, however, banks always "call" such loans after about one year, when a large percentage of the tax-indifferent party’s loan proceeds are available to pay the loan at that time. Thus, the U.S. taxpayer is responsible for only slightly more than its small share of the loan proceeds rather than the entire loan amount but can still claim a large, artificially inflated tax loss to shelter unrelated income.

In August 2000, the IRS issued Notice 2000-44, warning taxpayers about generating artificial losses from schemes that purported to inflate their basis in assets. I.R.S. Notice 2000-44, 2000-2 C.B. 255. In March 2002, the IRS issued another notice that more specifically targeted the technical argument underlying CARDS transactions and imposed disclosure obligations on CARDS shelters’ promoters and participants. See I.R.S. Notice 2002-21, 2002-1 C.B. 730. In 2005, the IRS offered a settlement initiative whereby taxpayers could avoid litigation and liability for a gross valuation misstatement penalty by conceding the claimed tax benefits from their CARDS shelters and paying a reduced penalty. See I.R.S. Announcement 2005-80, 2005-2 C.B. 967.

B. CIC’s Background

Curtis Investment Company (CIC) is an investment holding company formed by Henry Curtis for the benefit of his family. Lonnie Baxter was named CIC’s managing partner in 1986.¹ Prior to 1995, Baxter made CIC’s investment decisions with assistance from private money managers. In 1995, CIC hired Eric Zimmerman as an internal investment advisor. CIC alleges that, since 1997, it has also relied upon business experts including Matt Levin, Barbara Coats, and others at Windham Brannon (Windham), as well as Thomas Rogers and his firm, Rogers & Watkins, for tax and business advice.

In 1998, Henry "Jay" Bird—son of Lonnie Baxter and president of a mortgage company called Birdhouse Mortgages—became managing partner of CIC. Bird formed an Investment Committee that, along with Zimmerman, created an asset-allocation plan for CIC. CIC planned to diversify its portfolio, borrowing funds at a low interest rate to make investments that would yield returns greater than the interest cost.

CIC’s principal asset prior to February 2000 consisted of stock in American Business Products (ABP). ABP was sold via stock sale in February 2000, generating a $27–28 million capital gain for CIC. CIC’s accountants estimated that CIC’s partners would owe approximately $7 million in taxes on the gain realized on the ABP stock sale.

C. CIC’s CARDS Transaction

In the fall of 2000, Barbara Coats of Windham learned about CARDS transactions from Roy Hahn, founder of Chenery Associates, Inc. (Chenery).² After advisors from Windham met with Hahn, he presented a CARDS transaction proposal to Henry Bird and CIC. The transaction would involve a 30-year €35.3 million loan from HVB, a foreign bank,³ to Brondesbury Financial Trading, LLC (Brondesbury), a foreign tax-indifferent entity.⁴ The loan included a €5.295 million promissory note; CIC would purchase this note and assume joint and several liability on the full €35.3 million loan. Brondesbury would hold the residual €30 million in a HVB deposit account to pay interest, making CIC’s €5.295 million note interest-free.

CIC contends that its advisors investigated the proposed transaction and parties involved. CIC negotiated loan terms and refused to proceed with the transaction unless it could invest its interest-free loan proceeds in other investment opportunities. CIC allegedly relied on Rogers & Watkins and Windham to independently analyze the tax consequences of CARDS transactions. These advisors studied a draft opinion letter from Brown & Wood (B&W), a New York law firm, which suggested that it was "more likely than not" that CARDS transactions had economic substance. While Chenery said that CIC’s tax benefits resulting from the CARDS transaction would be permanent, CIC alleges that its advisors at Windham said its taxes would be spread, not eliminated. In December 2000, CIC’s Investment Committee approved a "Capital Leverage" plan including the CARDS transaction.

HVB deposited 85% of the €35.3 million loan proceeds into a one-year time deposit at HVB, and disbursed the remainder in the form of a one-year €5.592 million promissory note payable to Brondesbury. CIC purchased the €5.592 million note from Brondesbury and, in exchange, took on joint and several liability for 100% of Brondesbury’s €35.3 million debt to HVB. CIC agreed to comply with the HVB/Brondesbury credit agreement and to provide a $6.7 million letter of credit from Canadian Imperial Bank of Commerce (CIBC) in favor of HVB as substitute collateral in place of the HVB note.⁵ In December 2000, CIC entered into a one-year forward contract with HVB which would allow CIC to convert U.S. dollars into euros on December 14, 2001 at a specified rate: 0.9402 dollar-to-euro.⁶

Brondesbury’s collateral—the €30.005 million time deposit— was the first source of payment for all obligations to HVB under the credit agreement. CIC alleges that HVB confirmed that the €35.3 million loan would last for 30 years, until December 14, 2030.⁷ If the credit agreement remained in place, Brondesbury’s collateral would decrease over time due to net outflows of interest, and CIC would have to increase the CIBC line of credit. If the loan lasted for 30 years, CIC would pay interest directly to HVB for the last four years of the term.

After purchasing the €5.592 million note from Brondesbury, CIC redeemed the note and directed HVB to exchange it for $4,892,580, which CIC deposited into a CIBC interest-bearing account. CIC allocated the proceeds among its chosen asset managers six weeks later, at the next Investment Committee meeting on February 15, 2001.

CIC paid Chenery $1,938,465 for its CARDS plan and paid CIBC $241,000 in upfront fees for its letter of credit. CIC’s payment to Chenery included indirect payments to Brondesbury and HVB, as well as an indirect payment of $50,000 to B&W for an opinion letter regarding the legality of CARDS plans.⁸ In total, these CARDS transaction fees constituted around 45% of the amount received by CIC.

On November 13, 2001, CIC’s advisors learned that HVB planned to call its loans to CIC and the Baxters.⁹ CIC then received a mandatory prepayment election, negotiated a traditional margin loan from CIBC for $8.5 million, and used part of that margin loan to satisfy its obligations to HVB. Because Brondesbury’s collateral account at HVB still contained most of the original loan amount, CIC only paid the equivalent of $5,378,764.49 to retire the entire €35.3 million HVB loan. CIC used $5,369,208.60 of the margin loan proceeds to purchase €5,710,709 from HVB pursuant to their December 2000 forward contract, which it...