Court: Court of Appeals for the Eleventh Circuit; December 5, 2018; Federal Appellate Court
In 2000, Curtis Investment Company (CIC) engaged in a Custom Adjustable Rate Debt Structure (CARDS) transaction, claiming a capital loss of $27,724,620 on its tax return. In 2007, the IRS disallowed this loss and associated deductions through a Final Partnership Administrative Adjustment (FPAA), imposing a gross valuation misstatement penalty under 26 U.S.C. §§ 6662 and 6664. CIC contested the FPAA and penalties in Tax Court, which upheld the IRS's determinations. CIC argues that the Tax Court misapplied the "economic substance" test and overlooked facts supporting its reasonable cause defense. The court's affirmation followed a review and oral argument.
CARDS transactions involve a tax-indifferent party borrowing foreign currency, while a U.S. taxpayer assumes joint liability for the entire loan by purchasing a small portion of its proceeds. This allows the taxpayer to claim a tax basis equivalent to the total loan amount rather than just the small portion paid, creating artificially inflated tax losses. The IRS issued warnings about such schemes in 2000 and 2002 and later offered settlement options to taxpayers involved in CARDS transactions to mitigate penalties.
CIC is an investment holding company established by Henry Curtis for his family's benefit, with Lonnie Baxter as managing partner since 1986. Since 1995, CIC has relied on internal and external advisors for investment decisions and tax guidance.
In 1998, Henry "Jay" Bird, son of Lonnie Baxter and president of Birdhouse Mortgages, became the managing partner of CIC. He formed an Investment Committee that, along with Zimmerman, developed an asset-allocation plan aimed at diversifying CIC's portfolio through low-interest borrowing for higher-return investments. Prior to February 2000, CIC's main asset was stock in American Business Products (ABP), which was sold in February 2000, resulting in a capital gain of $27-28 million and an estimated $7 million tax liability for CIC's partners.
In fall 2000, Barbara Coats from Windham introduced CARDS transactions to CIC through Roy Hahn of Chenery Associates. The proposal involved a €35.3 million loan from HVB to Brondesbury Financial Trading, LLC, with CIC purchasing a €5.295 million promissory note and assuming full liability for the loan. Brondesbury would maintain €30 million in HVB to cover interest, rendering CIC's note interest-free. CIC claimed its advisors conducted due diligence on the transaction, negotiating terms and requiring investment of the interest-free loan proceeds in other opportunities. While Chenery indicated that tax benefits from CARDS would be permanent, Windham suggested taxes would be spread over time.
In December 2000, CIC's Investment Committee approved a "Capital Leverage" plan involving the CARDS transaction. HVB deposited 85% of the loan proceeds into a one-year time deposit and disbursed the remaining funds as a €5.592 million promissory note, which CIC purchased, thereby assuming liability for the entire €35.3 million debt to HVB. CIC also provided a $6.7 million letter of credit from CIBC as collateral. Additionally, CIC entered a forward contract to convert U.S. dollars into euros at a specified rate in December 2001. Brondesbury's €30.005 million time deposit served as the primary collateral for HVB. CIC asserted that HVB confirmed the loan's 30-year duration, expiring in December 2030, with the understanding that interest payments would be made directly to HVB for the last four years. After acquiring the €5.592 million note, CIC redeemed it and directed HVB to convert it into $4,892,580, which was then deposited into a CIBC interest-bearing account.
CIC allocated proceeds to its asset managers at an Investment Committee meeting on February 15, 2001, paying $1,938,465 to Chenery for its CARDS plan and $241,000 in upfront fees to CIBC for a letter of credit. The payment to Chenery included indirect payments to Brondesbury and HVB, as well as $50,000 to B&W for an opinion letter on CARDS legality, amounting to approximately 45% of the total received by CIC. On November 13, 2001, CIC's advisors learned of HVB's intention to call its loans, leading CIC to negotiate an $8.5 million margin loan from CIBC, part of which was used to repay HVB. CIC paid a total of $5,378,764.49 to retire the €35.3 million HVB loan, utilizing forward contract proceeds to cover nearly all of the final payment obligation. For its 2000 tax return, CIC reported a long-term capital gain of $28,597,759 from an ABP stock sale and claimed a $27,724,620 capital loss from the CARDS transaction, treating the full HVB debt as the basis in the redeemed promissory note. Additionally, CIC claimed a fee deduction of $1,400 for loan origination fees, asserting reliance on Windham for tax return preparation. In 2007, the IRS issued a FPAA disallowing the capital loss and fee deductions, citing failure to establish basis and lack of economic substance in the CARDS transaction, along with imposing a gross valuation misstatement penalty. CIC subsequently petitioned for redetermination in 2008, leading to a Tax Court trial where CIC challenged the IRS's expert testimony. The Tax Court ultimately upheld the IRS's FPAA determinations, finding the CARDS transactions lacked economic substance and business purpose, and confirmed the imposition of accuracy-related penalties. CIC appealed the decision.
On February 27, 2018, CIC submitted a letter to the Court under Rule 28(j) of the Federal Rules of Appellate Procedure, challenging the Tax Court's imposition of an underpayment penalty related to 26 U.S.C. 6571(b)(1). CIC contends that the Tax Court erred by not fully considering certain aspects of the CARDS transaction, which led to an incorrect determination that the transaction lacked economic substance and business purpose, apart from generating tax benefits. The review of the Tax Court's legal conclusions is conducted de novo, while its factual findings are assessed for clear error, where permissible evidence interpretations support the Tax Court's choices. Section 165(a) of the Internal Revenue Code permits deductions for actual losses sustained during the taxable year, emphasizing that only bona fide losses are deductible. Federal tax law disregards transactions that lack economic purpose and are solely designed for tax savings. A transaction must have objective economic effects or a subjective business purpose to be respected for tax purposes. Courts should evaluate transactions based on their economic substance, focusing on specific transactions rather than the overall activities of the entity. A transaction demonstrates economic substance if it has potential for profit beyond tax deductions and involves genuine obligations enforceable by unrelated parties. The Tax Court correctly identified the CARDS transaction as the source of the tax benefit tied to CIC's 2000 tax returns, highlighting that the underpayment was due to a gross valuation misstatement linked to an artificially inflated basis, which also indicated the transaction's lack of economic substance.
CIC contends that its CARDS transaction was driven by a legitimate business purpose and had economic impacts beyond tax implications, specifically aiming to generate profit from investments funded by an interest-free loan. However, the Tax Court determined that these investments were ancillary to the CARDS transaction and did not enable a tax benefit claim, thus not qualifying as part of the "specific transaction." Accepting CIC's rationale would allow taxpayers to fabricate transactions for tax advantages under the guise of legitimate financing, which is impermissible.
The Tax Court found that the CARDS transactions diminished CIC's wealth by over €2 million, with further losses anticipated, indicating no reasonable chance of profit. Although CIC intended to borrow for long-term investment, it lacked a legitimate rationale for selecting this financing method, which provided significantly less capital than traditional financing options. The court noted that CIC did not explore alternative financing avenues or seek to minimize borrowing costs, resulting in financing expenses approximating 45% of the loan proceeds. Evidence suggested that CIC did not genuinely engage in the CARDS transaction for long-term investments or believe in a legitimate obligation to repay the HVB debt.
Consequently, the Tax Court concluded that CIC's CARDS transaction lacked both economic substance and a non-tax business purpose, disqualifying it from tax recognition. The court's findings were upheld as not constituting clear error. Additionally, the Tax Court relied on expert testimony from Dr. Kolbe, which CIC challenged on grounds of qualification, reliability, and methodology. The admissibility of expert testimony is reviewed for abuse of discretion, and the relevant standard encompasses both the assessment of reliability and the ultimate conclusion. Federal Rule of Evidence 702 governs the admission of such testimony in Tax Court proceedings.
The Supreme Court in Daubert v. Merrell Dow Pharmaceuticals established that Rule 702 requires district courts to evaluate the admissibility of expert scientific evidence. Key considerations for admissibility include the expert's qualifications, the reliability of their methodology, and the helpfulness of their testimony to the trier of fact. These requirements—qualification, reliability, and helpfulness—are distinct but may overlap. An expert can be qualified based on knowledge, training, skill, education, or experience. Reliability assessment involves evaluating whether the expert's reasoning or methodology is scientifically valid and applicable to the facts. Factors to consider include whether the theory has been tested, peer-reviewed, the potential error rate, and general acceptance in the relevant community. The analysis is flexible, allowing judges discretion in determining reliability. The Tax Court exercised its discretion in admitting expert testimony, particularly favoring Dr. Kolbe's qualifications and methods despite concerns of bias due to prior compensation from the IRS. The court found his testimony reliable and informative. Regarding the imposition of the underpayment penalty, CIC contends it should not be penalized due to reasonable cause and good faith concerning tax understatement. This determination is a factual question reviewed for clear error. Section 6662(a) imposes a 20% accuracy-related penalty on tax underpayment, including substantial valuation misstatements.
Section 6662(h) establishes a 40% penalty for gross valuation misstatements, defined as overstating the value or basis by 400% or more. A substantial misstatement is characterized by a 200% overstatement. Under Treasury Regulation 1.6662-5(g), any property with an adjusted basis of zero is automatically considered to have a gross valuation misstatement, triggering the 40% penalty. The IRS must demonstrate sufficient evidence to impose a 6662(a) penalty, after which the taxpayer must prove reasonable cause and good faith to avoid misstatement penalties. The evaluation of reasonable cause considers all relevant facts, and factors indicating reasonable cause may include honest misunderstandings or taking debatable positions on tax returns. Taxpayers can also establish reasonable cause by showing they relied in good faith on professional advice, provided that the advice was based on accurate facts and did not stem from conflicts of interest or unreasonable assumptions. The 40% penalty applies to CIC's tax loss from the CARDS transaction due to a lack of economic substance and a zero basis for the redeemed note, resulting in tax underpayments for its partners in 2000. CIC can contest this penalty only by demonstrating reasonable cause and good faith regarding its underpayment.
CIC contends that it should not incur a penalty for claiming a $27,724,620 capital loss on its 2000 tax return, asserting it had reasonable cause and acted in good faith. CIC's arguments are based on its managers’ reliance on professional advice, notably an opinion letter from B&W, and the unclear legal context of CARDS transactions at that time. However, the Tax Court found this reliance objectively unreasonable, determining that CIC was aware or should have been aware that B&W's opinion was not independent but part of a promotional effort for the CARDS plan. The court evaluated the credibility of witnesses and the evidence, concluding that CIC's managers were not as unsophisticated as claimed, given their educational backgrounds and business experience in financing transactions. Despite the complexity of the CARDS scheme, the court noted that the legal principle that transactions lacking economic substance are disregarded for tax purposes was already established. The IRS's Notice 2000-44, issued in August 2000, warned taxpayers against generating artificial losses from such schemes and emphasized that losses must reflect actual economic consequences to be allowable. The notice indicated that transactions lacking economic substance would not be recognized for tax purposes, reinforcing the court's conclusion that CIC did not have reasonable cause for its underpayment in 2000.
Notice 2000-44 references case law, specifically Scully v. United States and Shoenberg v. Commissioner, to establish that deductible losses must represent genuine economic losses with economic substance. In Shoenberg, the Eighth Circuit emphasized the need to assess the entire transaction related to the claimed loss. CIC's involvement in a CARDS transaction was scrutinized, leading the Tax Court to conclude that CIC, informed by B&W's opinion letter and Notice 2000-44, should have recognized its actions as an effort to artificially generate tax losses. The court found that CIC lacked reasonable cause and good faith, considering factors such as reliance on professional advisors and the sophistication of CIC's management.
CIC also contested the IRS's penalty imposition under 26 U.S.C. 6751(b)(1), arguing that the IRS did not properly obtain written approval for the penalty assessment. However, the court determined that CIC waived this challenge by raising it for the first time in supplemental appellate briefing, thus declining to consider it. Appellate courts maintain discretion over whether to address new legal issues introduced at this stage, and CIC had the opportunity to challenge the penalty during the Tax Court proceedings but failed to do so. The court referenced precedent to support its decision not to entertain this non-jurisdictional challenge at this late stage.
The Tax Court concluded that CIC's CARDS transaction lacked economic substance and business purpose, resulting in a 40% gross valuation misstatement penalty for CIC's 2000 tax return. The court also found that CIC did not exhibit reasonable cause or good faith regarding the understatement on its tax return. This decision has been affirmed. Additionally, Lonnie Baxter and Guy Baxter participated in a similar CARDS scheme, and their case is being appealed in the Fourth Circuit.
Chenery, an investment firm involved in CARDS plans, and HVB Structured Finance, Inc., the lender for the CARDS transaction, were noted as key players. Brondesbury, a company formed by two British residents, was associated with a letter of credit that was set to expire in December 2001. The Tax Court highlighted conflicts of interest involving Chenery and B&W, with connections between their executives.
Testimonies were provided by various experts, including James A. Walker on commercial lending practices, Dr. Conrad S. Ciccotello on profit potential from CARDS transactions, and Dr. Kolbe, who suggested that the loans would decrease taxpayers' wealth by €2.19 million.
CIC's tax return indicated a loss corresponding to HVB's loan to Brondesbury, which supported the view that the CARDS scheme was the primary loss-generating activity. The Tax Court determined that the fees paid by CIC for financing were significantly above market rates, negatively impacting investment profitability, and noted that several components of the transaction had one-year timeframes, contradicting the notion of a long-term 30-year loan.
The Tax Court dismissed CIC's assertion that HVB called the loan due to the September 11, 2001 events and rejected the belief that CIC had full liability for the HVB debt as the primary obligor to Brondesbury for 30 years. CIC's urgency in concluding its CARDS transaction before the end of the 2000 tax year, coupled with a nearly six-week delay in investing the proceeds, undermined its claim that the transaction was for investment purposes. Under Rule 702, expert witnesses can testify based on various qualifications, not solely experience or consultations. CIC contested Dr. Kolbe's qualifications, noting he lacked loan officer experience and did not consult banks, but the court clarified that expertise can arise from different sources. The amendments to Sections 6662 and 6664 after 2000 introduced lesser percentage requirements for valuation misstatements and included provisions for "reasonable cause" and "economic substance," with the 2000 versions relevant to CIC's tax return. Penalties related to partnership item adjustments were determined at the partnership level in 2000. Taxpayer advice should not rely on known or likely false representations regarding transaction purposes. The Tax Court highlighted that Chenery appointed B&W to assess the CARDS transaction, with a conflict of interest stemming from their relationship, as evidenced by a promised opinion letter and indirect payment from CIC. Despite this, CIC's advisors did not perform independent legal research. CIC's Committee comprised individuals with diverse educational and investment backgrounds, including experienced loan managers Lonnie Baxter and Henry Bird.
