Friday, September 2, 2011
IRS denies losses claimed in distressed asset/debt transaction
Superior Trading, LLC, Jetstream Business Ltd., Tax Matters Partner, et al. (2011) 137 TC No. 6
In consolidated partnership-level proceedings, the Tax Court has denied partnership losses claimed for distressed consumer receivables acquired from a company (a retailer in bankruptcy reorganization), finding that the receivables had a zero basis rather than the full face amount of carryover basis that was claimed. Further, the Court treated the purported contribution of the receivables by the company to a nominal partnership and the later redemption of the company's partnership interest as a single transaction and recharacterized it as a sale of the receivables.
Typically, in a distressed asset/debt (DAD) transaction, a foreign party that owns a distressed asset with a substantial built-in loss contributes the high-basis, low-value asset to a newly formed domestic partnership. The partnership doesn't make a basis adjustment election under Code Sec. 754 , and so keeps the asset's high basis. Shortly thereafter, the foreign party sells its interest in the partnership to a U.S. taxpayer. The sale (always more than a 50% interest in the partnership) causes a technical termination of the partnership year but, because the adjustment to partnership property basis under Code Sec. 743(b) doesn't apply, the asset's basis in the partnership's hands doesn't change.
For transfers after Oct. 22, 2004, Sec. 833(c) of the American Jobs Creation Act of 2004 (AJCA, P.L. 108-357 ) amends Code Sec. 734(d) and Code Sec. 743(d) to require a mandatory basis adjustment on distributions by partnerships with substantial (greater than $250,000 ) built-in loss, regardless of whether the partnership makes a election. However, since the transactions at issue in the consolidated cases took place before Oct. 22, 2004, the AJCA changes weren't applicable to them.
The partnership then contributes the distressed asset to a second partnership in return for a partnership interest in which it takes a basis equal to the asset's basis. The second partnership takes a basis in the asset equal to the first partnership's basis in the asset. Finally, the second partnership sells (or exchanges) the distressed asset to a promoter entity for its fair market value (FMV), realizing a loss on the transaction (the “built-in” loss) equal to the difference between the second partnership's adjusted basis in the asset and the value of the asset (i.e., the amount received). Alternatively, the first partnership sells its interest in the second partnership to a promoter for its FMV, realizing a loss on the transaction equal to the difference between its adjusted basis in the second partnership and the value of the asset (i.e., the amount received). Generally, this loss is solely allocable to the U.S. taxpayer.
The U.S. taxpayer may contribute other property or money to the first partnership in order to create basis in its partnership interest. The U.S. taxpayer then claims the significant tax loss that has passed through the partnership to offset other income or gain. The net effect is that the U.S. taxpayer benefits from the built-in economic losses in the foreign party's distressed asset without having incurred the economic costs of that asset. The U.S. taxpayer may also benefit from claimed deductions for fees paid to the promoter for structuring the transaction.
In May of 2003, Lojas Arapua, S.A. (Arapua), a Brazilian retailer in bankruptcy reorganization, entered into a Contribution Agreement (contribution agreement) with Warwick Trading, LLC (Warwick), an Illinois limited liability company. Under the contribution agreement, Arapua purported to contribute to Warwick certain past due consumer receivables in exchange for 99% of the membership interests in Warwick. At different times during the latter half of 2003, Warwick claimed to have contributed varying portions of the Brazilian consumer receivables acquired from Arapua in exchange for a 99% membership interest in each of 14 different limited liability companies (trading companies).
Individual U.S. investors acquired membership interests in the trading companies through yet another set of limited liability companies (holding companies). To this end, Warwick contributed virtually all of its membership interests in each trading company to the corresponding holding company.
During 2003 and 2004, each of the trading companies wrote off almost the entire basis in its share of the Brazilian consumer receivables resulting in business bad debt deductions and, in one instance, a capital loss. Individual U.S. investors holding membership interests in a given trading company, through the corresponding holding company, claimed the benefits of these deductions on their respective Federal income tax returns. Warwick also claimed losses on the sale of membership interests in the holding companies to the individual U.S. investors.
IRS denied the losses claimed by the various partnerships and tax matters or other participating partners on behalf of the purported partnerships for the distressed consumer receivables. IRS adjusted the partnership items, attributing a zero basis to the receivables in lieu of the claimed carryover basis in the full face amount of the receivables. In addition, IRS determined Code Sec. 6662(h) accuracy related penalties for gross valuation misstatements of inside bases.
The Tax Court held that the partnerships failed to establish that the distressed consumer receivables had any tax basis upon transfer from the Brazilian company, Arapua. The purported contribution of the receivables from Arapua to a nominal partnership and the later redemption of Arapua's partnership interest were properly treated as a single transaction and recharacterized as a sale of the receivables. The partnerships did not substantiate the amount paid for the receivables, and so the receivables had a zero basis for Federal tax purposes following their transfer.
The Tax Court reasoned that other than to achieve the tax outcome sought, there was no logical reason for the many intermediate steps in the transaction. Arapua's purported membership in Warwick was engineered solely to obtain a carryover basis for the receivables and retain their built-in loss. Arapua's subsequent redemption was apparently contrived to complete a disguised purchase of the receivables and remove Arapua from the picture when the built-in loss was recognized. The recognized loss could then be allocated away from Arapua and entirely to the holding companies. In other words, the Court said, Arapua's entry and exit were timed to maneuver in between the constraints of partnership tax accounting rules to preserve and bring to fruition an alleged tax loss.
Further, the Tax Court concluded that the partnerships were unable to demonstrate good faith and reasonable cause, and so the accuracy-related were penalties were sustained.