Boca Invst Prtnshp, et al v. USA, No. 01-5429 (D.C. Cir. 2003)

United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued November 21, 2002 Decided January 10, 2003

No. 01-5429

Boca Investerings Partnership,

a Partnership and

American Home Products Corporation, Tax Matters Partner,

Appellees

v.

United States of America,

Appellant

Appeal from the United States District Court

for the District of Columbia

(No. 97cv00602)

Mark V. Holmes, Attorney, U.S. Department of Justice,

argued the cause for appellant. With him on the briefs were

Roscoe C. Howard, Jr., U.S. Attorney, Richard Farber and

Edward T. Perelmuter, Attorneys, U.S. Department of Jus-

tice.

 Christopher Kliefoth argued the cause for appellees. With

him on the brief were William L. Goldman and Diane L.

Cafritz. Melvin White entered an appearance.

Before: Sentelle, Henderson and Tatel, Circuit Judges.

Opinion for the Court filed by Circuit Judge Sentelle.

Sentelle, Circuit Judge: In 1990, American Home Prod-

ucts (AHP), sold a subsidiary, Boyle-Midway, for a capital

gain of more than $605 million. Just before the sale, Merrill

Lynch approached AHP with an investment plan which would

enable AHP to claim paper tax losses of a comparable

amount, while generating only about $8 million in actual

losses. AHP was one of several Fortune 500 companies that

Merrill approached with this idea, and this is the third case

before us involving this particular type of scheme. See Saba

P'ship v. Comm'r, 273 F.3d 1135 (D.C. Cir. 2001); ASA

Investerings P'ship v. Comm'r, 201 F.3d 505 (D.C. Cir. 2000).

Following Merrill Lynch's proposal, AHP formed Boca Inves-

terings Partnership with another AHP subsidiary and two

foreign corporations. After completing the transactions pro-

posed by Merrill Lynch, AHP filed tax returns which re-

flected the losses offsetting its capital gains for 1990-1993.

After the Internal Revenue Service challenged these returns,

AHP filed a complaint in the district court contesting the

Commissioner of Internal Revenue's proposed adjustments to

its partnership returns, and on October 5, 2001, the district

court issued an opinion rejecting the Commissioner's adjust-

ments, and entering judgment in favor of Boca. See Boca

Investerings P'ship v. United States, 167 F. Supp. 2d 298

(D.D.C. 2001). We reverse the district court's decision as

inconsistent with ASA Investerings, 201 F.3d 505.

Background

We explored this Merrill Lynch-created tax shelter and the

regulation on which it depends at significant length in our

opinion in ASA Investerings, 201 F.3d at 506-08, and there-

fore will not belabor the details here. The plan proposed by

Merrill Lynch to AlliedSignal, the domestic corporation in-

volved in the ASA partnership, was virtually identical to the

one Merrill proposed to AHP in the case before us now. The

plan requires the formation of a partnership between a

United States corporation and a foreign corporation not sub-

ject to United States tax, combined with a series of invest-

ment transactions that exploit the terms of Temp. Treas. Reg.

s 15A.453-1(c)(3)(I) (26 C.F.R.). That regulation provides a

tax accounting rule for contingent installment sales. An

installment sale is defined in the code as "a disposition of

property where at least 1 payment is to be received after the

close of the taxable year in which the disposition occurs."

I.R.C. s 453(b)(1) (2001). A contingent installment sale is

one where the total purchase price is unknown at the time of

the transaction. Because the total price is unknown, the total

gain on the sale is likewise unknown. The regulation supplies

a general rule of "ratable basis recovery" for situations where

a seller at least knows the maximum period over which the

purchase price will be paid. The partnership formed between

the domestic entities and the foreign entities takes advantage

of this regulation by first buying, then immediately selling a

debt instrument on an installment basis.

As we noted in our opinion in Saba Partnership, which also

considered this regulation and another virtually identical ser-

ies of transactions, "[a]lthough the transaction is basically a

wash, generating hardly any economic gain or loss, Merrill

Lynch's lawyers' interpretation of the relevant provisions

allows the partnership to claim a massive tax gain, which is

allocated to the foreign partner, and a massive tax loss, which

the U.S. corporation keeps for itself." 273 F.3d at 1136.

This sentence essentially describes the transactions in which

AHP; its subsidiary; and its foreign partners, Syringa and

Addiscombe, engaged after forming the Boca partnership.

The massive loss AHP was able to claim for tax purposes was

then used to offset the tax gain it realized from the sale of its

subsidiary, Boyle-Midway.

The facts in this case are substantially similar to those in

ASA Investerings and Saba Partnership. In 1990, Merrill

Lynch representatives approached AHP, as it had also ap-

proached AlliedSignal and Brunswick, other Fortune 500

companies, with the idea for this scheme to shelter large

capital gains. After meeting with the representatives, Thom-

as Nee, AHP's vice-president for taxes prepared a memoran-

dum for AHP's Chairman and Chief Executive Officer, John

Stafford, entitled, "Tax Planning Re: Sale of Boyle-Mid-

way." This memo outlined the proposal as follows, in perti-

nent part.

1) Formation of Partnership



The partnership would be formed in a favorable tax

jurisdiction such as the Netherlands, Antilles under the

New York general partnership law. The members of the

partnership would be AHPC, one of its domestic subsid-

iaries (henceforth referred to as AHPC) and an unrelated

foreign financial institution (XYZ). AHPC will contrib-

ute cash of $110 million (representing a 10% ownership)

and XYZ will contribute $990 million. Under the part-

nership agreement, all the income, gain, expense and loss

of the partnership will be allocated among the members

in proportion to their capital accounts. * * *



2) Purchase of Corporate Bonds



* * * [I]nvest $1.057 billion in [corporate bonds]* * *



3) Installment Sale



The Partnership will sell the Bonds to a financial institu-

tion in exchange for $898.5 million in cash and $158.5

million at fair market value, five year LIBOR installment

notes. * * *



4) Increase of AHPC's Partnership Interest



Following Step 3, AHPC will purchase a 45.5% interest

in the partnership from XYZ for $500 million in cash

bringing its total interest to 55.5% and XYZ's interest

down 44.5%.



5) Contribution of Assets to Partnership



AHPC will thereupon contribute assets with a fair mar-

ket value of $200 million to the partnership further

increasing its partnership interest to 62%. * * *



6) Partial Redemption of Partnership Interest



The partnership will distribute $159 million fair market

value installment note to AHPC and $96 million in cash

to XYZ. * * *



7) Sale of Installment Note



* * * $159 million in cash resulting in a $723.2 million

in capital loss



* * *

The memo also noted that, "[w]e believe that the above

transaction is technically sound. We expect it would be

vigorously attacked by the IRS. * * * Merrill Lynch is

requesting a fee of $8 million. Their contribution is signifi-

cant in that they identify XYZ, arrange for purchase of the

Corporate Assets (Bonds) and locate a buyer for the install-

ment notes."

AHP decided to accept Merrill Lynch's proposal and the

transaction took form by precisely following the steps laid out

in Nee's memo. Boca Investerings, 167 F. Supp. 2d at 319.

On April 19, 1990, the Boca partnership was formed between

partners AHP; another AHP subsidiary and two Netherlands

Antilles special purpose corporations, Addiscombe and Syrin-

ga, with initial partner contributions mirroring those antici-

pated in the memo. Id. Merrill Lynch received a $7 million

fee for structuring the transaction. On May 1 and 2, 1990,

Boca purchased $1.1 billion of private placement floating-rate

notes (PPNs) from two Japanese banks and PepsiCo. Boca

Investerings, 167 F. Supp. 2d at 329-30. A week after Boca

made the purchases, Merrill Lynch began arranging for the

sale of the PPNs. During one week in late May, 1990, Boca

sold over $1 billion of the PPNs for $880 million in cash, and

indefinite debt instruments known as LIBOR (London Inter-

bank Offering Rate) notes. Boca Investerings, 167 F. Supp. 2d

at 333-34. The district court found that this sale generated

transaction costs of $13 million, which was ultimately borne

by AHP, id. at 337, and that Boca received less than $7

million in interest on its $1.1 billion investment in the PPNs,

id. at 351.

On its 1990 partnership tax return, Boca treated the sale as

an installment sale under I.R.C. s 453(b). Id. at 362. Boca

reported a short-term capital gain of over $721 million from

the transaction, calculated by subtracting the ratably-

recovered basis from the $880 million in cash generated by

the sale of the PPNs. Id. Ten percent of the gain was

allocated to AHP and its domestic subsidiary, while the

remaining ninety percent was allocated to the foreign part-

ners, who were not subject to U.S. tax on the gain. Id.

ABN, a Netherlands bank which controlled the two foreign

partnerships, id. at 319, and was also involved in the Saba

Partnership and ASA Investerings transactions, see Saba

P'ship, 273 F.3d at 1138-40; ASA Investerings, 201 F.3d at

508-11, entered into interest-rate swaps with Addiscombe,

Syringa and Merrill Lynch to hedge the interest-rate risk on

the LIBOR notes. Boca Investerings, 167 F. Supp. 2d at 360,

361.

On July 20, 1990, the parties agreed that AHP would

purchase approximately 45% of Syringa's interest in Boca at a

$2.5 million above-book-value premium. Boca Investerings,

167 F. Supp. 2d at 338. This transaction left the foreign

partners with approximately a 45% ownership interest in

Boca. Id. at 339. In August 1990, Boca distributed $175

million in cash to the foreign partners and nearly $220 million

in LIBOR notes to the AHP partners. Id. at 341. In

September and October 1990, Boca redeemed more of the

foreign partners' interest, resulting in an 85% ownership

interest for the AHP partners. Id. at 343, 344. In Novem-

ber 1990, the AHP partners sold the LIBOR notes Boca had

distributed to them. Id. at 344-45. This disposition trig-

gered a paper loss of more than $770 million for AHP. Id. at

345. This loss offset the capital gains of AHP from the sale

of Boyle-Midway, and other gains from 1990 to 1993. Id. In

December 1990, AHP redeemed Syringa's remaining interest

in Boca for cash. Id. Finally, in September 1991, the foreign

partners were bought out of Boca entirely, with the cash

redemption of Addiscombe's remaining interest, which includ-

ed a premium of $2.2 million above book value. Id. at 346-47.

Following the government's audit of Boca's partnership tax

returns for 1990-1993, the Commissioner of Internal Revenue

proposed different adjustments based on different theories.

Under one theory, the Commissioner found that the foreign

entities had not entered into a valid partnership with AHP,

and therefore recognized the Merrill Lynch transaction for

tax purposes, but allocated all the gains and losses reported

by Boca to AHP. Under a second theory, that the transac-

tion was an economic sham, the Commissioner eliminated any

gains and losses reported by Boca as resulting from the

transaction. AHP deposited with the Treasury the amount it

determined would be due as a result of the proposed adjust-

ments and filed suit in district court contesting the Commis-

sioner's proposals. The district court determined after a

lengthy trial that the Commissioner erred in proposing the

adjustments. See Boca Investerings, 167 F. Supp. 2d at 388.

The government's appeal is now before us.

We review the findings of fact of the district court under

the "clear error" standard. ASA Investerings, 201 F.3d at

511. "A finding is 'clearly errroneous' when although there is

evidence to support it, the reviewing court on the entire

evidence is left with the definite and firm conviction that a

mistake has been committed." United States v. United

States Gypsum Co., 333 U.S. 364, 395 (1948). The district

court, after a seventeen day trial, issued a well-documented

and cross-referenced 180 page opinion which included 392

separate findings of fact, as well as conclusions of law.

Analysis

At the outset, we reject two of the government's assign-

ments of error without difficulty. Although the district court

reached a different conclusion than other courts had on

previous occasions in cases with very similar facts, these

findings of fact do not constitute clear error by the district

court. The mere similarity of facts in two cases with differ-

ent litigants and different evidence provides no basis for a

finding of clear error on the part of either trial judge whose

findings differ from the other. This is particularly evident in

a case such as this in which many of the district court's

findings were based on the demeanor and believability of

witnesses at trial. See Boca Investerings, 167 F. Supp. 2d at

303. Nor did the district court err when it refused to admit

into evidence materials which did not relate to the parties in

this case and which the government argued should be admit-

ted principally because they were admitted as evidence in

ASA Investerings. However, our rejection of these assign-

ments of error does not mean we reject all assignments. We

reverse the judgment below because the district court erred

as a matter of law when it did not properly apply the holding

of ASA Investerings, requiring that a legitimate non-tax

business necessity exist for the creation of the otherwise

sham entity inserted into the partnership for tax avoidance

reasons in order to meet the intent test of Commissioner v.

Culbertson, 337 U.S. 733 (1949), as applied to this type of

partnership transaction.

The government argues that the district court erred in

determining that this case was materially different from the

case in ASA Investerings, in which we affirmed the Tax

Court's ruling that a very similar partnership between Allied-

Signal and ABN Bank was a sham for purposes of the

"business purpose doctrine." We agree. While the similarity

of facts in the two cases does not, in itself, invalidate the

district court's finding that Boca Investerings Partnership

was not a sham partnership, the district court's misapplica-

tion of ASA Investerings's instructions for interpreting trans-

actions such as these does constitute reversible error. As we

noted in Saba Partnership, "ASA makes clear that 'the

absence of a nontax business purpose is fatal' to the argument

that the Commissioner should respect an entity for federal

tax purposes." 273 F.3d at 1141 (quoting ASA Investerings,

201 F.3d at 512).

Boca claimed at oral argument and in a post-argument

submission that the government failed to raise the require-

ment stated in ASA Investerings that a partnership have a

non-tax need in order for it to be recognized for tax purposes.

Accordingly, Boca argues that we should not consider this

point on appeal, citing Flynn v. Commissioner, 269 F.3d 1064, 1068-69 (D.C. Cir. 2001) ("generally an argument not

made in the lower tribunal is deemed forfeited and will not be

entertained absent exceptional circumstances.") However, as

the government rightly points out, its Memorandum of Points

and Authorities filed with the district court approximately

three months before trial expressly argues "given the sub-

stantial costs incurred, AHP's use of this elaborate 'partner-

ship' cannot be justified by a non-tax business purpose. The

factual similarity to the ASA Investerings partnership case is

obvious and undeniable."

The business purpose doctrine applied in ASA Investerings

establishes that while taxpayers are allowed to structure their

business transactions in such a way as to minimize their tax,

these transactions must have a legitimate non-tax avoidance

business purpose to be recognized as legitimate for tax pur-

poses. The reasoning behind this doctrine is readily applica-

ble to this case. As we noted in ASA Investerings:

A tax system of rather high rates gives a multitude of

clever individuals in the private sector powerful incen-

tives to game the system. Even the smartest drafters of

legislation and regulation cannot be expected to antici-

pate every device. The business purpose doctrine re-

duces the incentive to engage in such essentially wasteful

activity, and in addition helps achieve reasonable equity

among taxpayers who are similarly situated--in every

respect except for differing investments in tax avoidance.



201 F.3d at 513.

We then approved the Tax Court's approach to the Su-

preme Court's test set out in Culbertson which determined

that the existence of a partnership would depend on whether,

"considering all the facts ... the parties in good faith and

acting with a business purpose intended to join together in

the present conduct of the enterprise." ASA Investerings,

201 F.3d at 511 (quoting Culbertson, 337 U.S. at 742). We

stated that "the Tax Court was, we think, sound in its basic

inquiry, trying to decide whether, all facts considered, the

parties intended to join together as partners to conduct

business activity for a purpose other than tax avoidance." Id.

at 513. Finally, we affirmed the Tax Court's conclusion that

AlliedSignal and ABN did not have "the requisite intent to

join together for the purpose of carrying on a partnership."

Id. at 511 (quoting 76 T.C.M. at 335).

 As the government argued, ASA Investerings set out fac-

tors which pointed to AlliedSignal's lack of a legitimate non-

tax business purpose for its transactions with the partnership.

"[T]his evidence says nothing about AlliedSignal's use of the

elaborate partnership--with a pair of partners concocted for

the occasion. There is no reason to believe that AlliedSignal

could not have realized [AlliedSignal's assistant treasurer]'s

interest rate play without the partnership at far, far lower

transactions costs." Id. at 516. In the current case, the

district court never made a finding of fact in regard to the

necessity of AHP's acquisition of foreign partners in order to

engage in the transactions. No official testified that AHP

needed a partnership with a foreign corporation to invest in

LIBOR notes or PPNs. AHP's participation in the partner-

ship defies common sense from an economic standpoint, since

it could have purchased the PPNs and the LIBOR notes

directly, and avoided millions in transaction costs, including

the $7 million fee it paid to Merrill Lynch and the "premi-

ums" paid to the foreign partners for the purchase of their

ownership interests.

Without a finding on the business need for the partnership

from AHP's standpoint in this transaction, the judgment

under review cannot stand. In addition, the foreign partners

Syringa and Addiscombe were, like the foreign entities in

ASA, "concocted" for the occasion--neither having existed

prior to the transaction's commencement, nor serving any

other purpose, and both being funded through loans from

ABN, the bank which we found to lack the requisite intent to

enter a legitimate business partnership with Allied Signal in

ASA. In fact, the parties stipulated in the court below that

both entities came into being only on April 19, 1990, the same

day that Boca was created. Stip. of Facts at p 29. Nothing

in the record indicates that AHP ever considered or weighed

the benefits of using a different type of transaction in order

to make these investments, including the option of purchasing

them directly.

Boca argues that the district court made the finding that

the parties "intended to, and did, organize Boca as a partner-

ship to share the income, expenses, gains and losses from

Boca's investments." Boca Investerings, 167 F. Supp. 2d at

349-50. This finding, contrary to the appellee's assertion,

does not satisfy the legal test for recognition of this type of

partnership for tax purposes, as we held in ASA Investerings.

In order to satisfy the legal test for this type of partnership,

the district court must have found a non-tax business purpose

need for the partnership in order to accomplish the goals of

the partners. In this case, there is no evidence of any need

for AHP to enter into the Boca partnership with the newly-

minted Addiscombe and Syringa in order to invest in the

LIBOR notes and PPNs. Nor is there even evidence of any

non-tax purpose in the use of the partnerships. The only

logical explanation then, for the partnership's formation was

the exploitation of Temp. Treas. Reg. s 15A.453-1(c)(3)(I)

and the gain of a paper tax loss to absorb its enormous capital

gains. The district court stated as its first conclusion of law

that

the transactions financing the purchase and sale of the

PPNs had economic substance, were not prearranged

and predetermined, and had a legitimate purpose. They

therefore should be recognized for federal income tax

purposes.



Boca Investerings, 167 F. Supp. 2d at 580. As the record

would not support a finding that the partnership form served

any non-tax business purpose, this conclusion is unsupported,

inconsistent with ASA Investerings, and constitutes revers-

ible error.

Boca argues that the clear error standard places a heavy

burden on the appellant upon review, and we agree that there

was ample evidence in the record to support the numerous

and well-documented findings of fact made by the district

court. As we stated above these findings are not the prob-

lem. The principal error is in the lack of findings on the non-

tax purpose for the partnership, but that error is determina-

tive. We do not of course suggest that in every transaction

using a partnership a taxpayer must justify that to form, but

as we made clear in both ASA Investerings and Saba Part-

nership, where taxpayers use an "elaborate partnership" with

entities created solely for the purpose of the questioned

transaction, "the absence of a non-tax business purpose" is

fatal to the recognition of the entity for the tax purposes.

ASA Investerings, 201 F.3d at 512. See also Saba P'ship, 273 F.3d at 1141. Because the district court did not find that a

legitimate, non-tax necessity existed for the formation of the

Boca partnership, and because the evidence of record would

not have supported such a finding if made, we reverse.