Court Negates Tax Planning Transaction
Schnee, Edward J., Journal of Accountancy
A district court held that a partnership's reported capital loss stemming from non-performing 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 [section] 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. …