K2 TRADING VENTURES, LLC v. U.S., Cite as 108 AFTR 2d 2011-XXXX, 11/30/2011

K2 TRADING VENTURES, LLC, NEW VISTA, LLC, TAX MATTERS PARTNER, Plaintiff, v. UNITED STATES, Defendant.

Case Information:

Code Sec(s):       

Court Name:       In the United States Court of Federal Claims,

Docket No.:        No. 04-1419T; No. 05-1067T,

Date Decided:    11/30/2011.

Disposition:        

HEADNOTE

.

Reference(s):

OPINION

In the United States Court of Federal Claims,

OPINION AND ORDER

Discussion

Jurisdiction

This Court has “jurisdiction to hear and to render judgment upon any petition under   section 6226 ... of the Internal Revenue Code.” 28 U.S.C. § 1508; see Marriott Int'l Resorts, L.P. v. United States,   586 F.3d 962, 968 [104 AFTR 2d 2009-7171] (Fed. Cir. 2009).   Section 6226(f) grants this Court:

jurisdiction to determine all partnership items of the partnership for the partnership taxable year to which the notice of final partnership administrative adjustment relates, the proper allocation of such items among the partners, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item. 4

Plaintiff brings this partnership tax refund action seeking judicial review of the FPAAs that adjusted K2's partnership items relating to the spread transaction. The Court's jurisdiction over partnership items is detailed in the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) 26 U.S.C. §§ 6221 et seq. TEFRA provides a method of uniformly adjusting items of partnership income, loss, deduction, or credit that affect each partner. While partnerships themselves do not pay federal income taxes, TEFRA requires a partnership to file an annual information return that reports its partners' distributive shares of income, gains, deductions, and credits. Partners are individually responsible for reporting their pro rata share of tax on their personal income tax returns.

Because the matters addressed in the K2 FPAAs are partnership items and must be determined at the partnership level, this Court has jurisdiction to determine the tax treatment of those items. Crnkovich v. United States,   202 F.3d 1325, 1329 [85 AFTR 2d 2000-772] (Fed. Cir. 2000) (per curiam). This Court makes a de novo determination regarding partnership items of K2 that were adjusted by the FPAA.

The Code

Here, as in Jade Trading, Plaintiff claims that the partners' bases in their partnership interests increased by the value of the purchased option but did not decrease by the value of the sold option assumed by the partnership.   Section 722 addresses partnership basis, stating:

The basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution ....

At issue here is whether Puramsetti was required to reduce its basis in its partnership interest by the sold option assumed by K2, or whether this type of “liability” was too uncertain to fit within the parameters of a “liability” within the meaning of   section 752. The statute itself does not define liability.   Section 752(b) states:

Any decrease in a partner's share of the liabilities of a partnership, or any decrease in a partner's individual liabilities by reason of the assumption by the partnership of such individual liabilities, shall be considered as a distribution of money to the partner by the partnership.

In claiming tax benefits, Plaintiff treats the sold options assumed by K2 as contingent obligations, not liabilities, for purposes of lowering the basis in Puramsetti's partnership interests under   section 752(b). As noted in Jade Trading, earlier interpretations of the Code suggested that the sold call option contributed to the partnership would not be considered a liability for purposes of   section 752, and that the inflated basis resulting from the contribution of the spread transaction to the partnership complied with   section 752. Nonetheless, under Coltec, such compliance with the Code is insufficient in and of itself for Puramsetti to reap the tax benefits claimed here. 454 F.3d at 1354. Rather, the transaction must also meet the objective economic substance test.

The Economic Substance Doctrine

In Coltec, the Federal Circuit affirmed the continued vitality of the economic substance doctrine, disregarding a transaction that literally complied with the Code but that lacked economic substance. As the Federal Circuit explained, “[f]rom its inception, the economic substance doctrine has been used to prevent taxpayers from subverting the legislative purpose of the tax code by engaging in transactions that are fictitious or lack economic reality simply to reap a tax benefit.” Coltec, 454 F.3d at 1353–54. “Under this doctrine, [the Court] disregard[s] the tax consequences of transactions that comply with the literal terms of the tax code, but nonetheless lack “economic reality.” Such transactions include those that have no business purpose beyond reducing or avoiding taxes, regardless of whether the taxpayer's subjective motivation was tax avoidance.” Stobie Creek, 608 F.3d at 1375 (citations omitted). The Court also disregards “transactions shaped solely by tax-avoidance features.” Id.

In Coltec, the Federal Circuit articulated five key principles incorporated in the economic substance doctrine:

((1)) the transaction to be analyzed is the one that gave rise to the alleged tax benefit;

((2)) the transaction cannot lack economic reality (i.e., a bona fide business purpose or function besides mere tax avoidance);

((3)) the taxpayer bears the burden of proving that the transaction has economic substance by a preponderance of the evidence;

((4)) the economic substance of a transaction must be viewed objectively rather than subjectively; and

((5)) arrangements with subsidiaries that do not affect the economic interests of independent third parties deserve particularly close scrutiny.

Coltec, 454 F.3d at 1355–57; see also Jade Trading II, 598 F.3d at 1376.

Here, the transactions to be analyzed are the K2 Participants' spread transactions and contribution to K2, as this combination of events led to the inflated basis disallowed by the FPAAs. See JX 178; Jade Trading II, 598 F.3d at 1377–78; Coltec, 454 F.3d at 1356.

With respect to Coltec's fourth principle -- that the economic substance of a transaction must be viewed objectively rather than subjectively -- the inquiry is not whether the Participants believed the spread contribution was a real investment, but whether the transaction was a real investment. Jade Trading II, 598 F.3d at 1377–78. Whether a transaction has objective economic substance must be evaluated based upon the information available to a prudent investor at the time of the transaction. Stobie Creek, 608 F.3d at 1375 (citing Coltec, 454 F.3d at 1356).

The Spread Transactions Were Devoid of Economic Substance

Plaintiff has not met its burden of proving that the spread transactions contributed to K2 had economic substance by a preponderance of the evidence. Even assuming that the transactions had a potential for profit, this potential does not outweigh the other evidence of record demonstrating that the tax effects of the transaction were entirely fictional, and the K2 partnership was formed not as a legitimate investment vehicle, but as a mechanism for generating inflated basis.

The Transaction Led to Purely Fictional Tax Losses

In Jade Trading II and Stobie Creek, the Federal Circuit held that spread transactions like those contributed to K2 lacked economic reality. In both cases, the Federal Circuit emphasized that the claimed tax effects in each case were fictional. In Jade Trading II, the members in the relevant partnership contributed both purchased and sold call options with premia of $15 million each, paid a small net premium for this spread, and subsequently claimed losses equal to the premium of the purchased call option. But as the Federal Circuit noted, “[e]ach [member] did not invest $15 million in the spread transaction contributed to Jade and did not lose almost $15 million upon exiting Jade .... [E]ach [member] had a real loss of ... the difference between its capital contribution ... to the Jade partnership and its redemption proceeds.” Jade Trading II, 598 F.3d at 1377. The Federal Circuit therefore characterized the claimed losses as “purely fictional” and held that the transactions lacked economic substance. Id.

Similarly, the Federal Circuit in Stobie Creek considered spread transactions involving Foreign Exchange Digital Options (“FXDOTs”) with premia of over $200 million, later redeemed for Therma-Tru stock. The Federal Circuit also characterized these transactions as leading to purely fictional tax effects and as lacking economic substance, stating:

[T]he $204,575,000 stepped-up basis in the Therma-Tru stock was purely fictional: although the taxpayers only paid (and lost) about $2 million for the FXDOTs, they claimed a basis of over $200 million in their partnership interests, based on the contribution of those FXDOTS to Stobie Creek. It is true that the taxpayers did purchase and contribute long options with a stated premium of $204,575,000 to Stobie Creek. However, they also sold and contributed short options with a stated premium of $202,529,250. Even though a literal application of the tax code at that time may have permitted the taxpayers to treat these transactions separately, what matters under the economic substance doctrine is whether the tax treatment accords with economic reality.... Accordingly, the taxpayers' claimed basis of $204,575,000 is properly disregarded as lacking economic reality; it does not reflect what the taxpayers paid Deutsche Bank for the FXDOTs ($2,045,757), or what they lost when the FXDOTs expired out of the money.

Stobie Creek, 608 F.3d at 1377–78.

As in Jade Trading II and Stobie Creek, the transaction before this court generated tax effects that were purely fictional. The Puramsetti Trust purchased from AIG a European-style U.S. Dollar/Euro call option at a strike price of $0.9550 for a premium of $2,500,012, and sold to AIG a European-style U.S. Dollar/Euro call option at a strike price of $0.9560 for a premium of $2,477,424 on June 5, 2000. On the same day, the Puramsetti Trust purchased from AIG a European-style U.S. Dollar/British Pound call option at a strike price of $1.5120 for a premium of $2,500,006 and sold to AIG a European-style U.S. Dollar/British Pound call option at a strike price of $1.5130 for a premium of $2,479,088. The Puramsetti Trust paid AIG net premia of roughly $44,000 in connection with the June 5 trades. Joint Stip. ¶ 94; JX 78. The Puramsetti Trust later contributed the options to K2, along with $4,030 in cash, in order to receive a 4.49 percent partnership interest in K2. Joint Stip. ¶¶ 158–59; JX 155. The Puramsetti Trust withdrew from K2 on December 12, 2000, receiving [Euro]11,174 and 7,003 shares of Rare Medium Group, Inc. stock in exchange for its partnership interest. JX 162. On December 22, 2000, the Puramsetti Trust sold 578 shares of the Rare Medium stock that it had received in exchange for its interest in K2 and “reported a loss of $246,705 for the 2000 taxable year, in which the sold call options were disregarded as liabilities in the calculation of basis for federal income tax purposes.” Joint Stip. ¶ 166; JX 239. However, Puramsetti did not invest $246,705, and did not suffer a loss in that amount. The losses Puramsetti claimed do not reflect economic reality.

The Contribution of the Spreads to K2 was Meaningless

“[M]eaningless inclusion in a partnership” is another factor indicating that the spread transaction objectively lacked economic substance. Jade Trading II, 598 F.3d at 1377; Stobie Creek, 608 F.3d at 1379. In concluding that the transaction at issue in Jade Trading lacked economic substance, the Federal Circuit explained that creation of the Jade partnership -- and the contribution of options to that partnership -- did not “enhance the investment potential of the spread transaction ... [but] was imperative ... to generate the artificially inflated bases.” Jade Trading II, 598 F.3d at 1377.

Here, Plaintiff contends that contribution of the spread options to K2 appreciably affected the Participants' economic position by offering the benefits of diversification and centralized management. Pl.'s Post-Trial Br. 29–32. According to Plaintiff, “contribution and assignment of the positions to K2 Trading allowed the investors to diversify their portfolio by obtaining an interest in call spread options positions with varying strike prices and thus appreciably affected the investors' beneficial interests.” Id. at 6.

The Government counters that formation of and contribution to K2 did nothing but create the Participants' claim “to a hugely inflated, artificial tax basis in their partnership interest, the transfer of that basis to assets received when they redeemed their partnership interest, and to enormous tax losses when the assets are sold to shelter other income.” Def.'s Post-Trial Br. 30. The Government also argues that K2's creation generated an unnecessary transaction cost, since the spread positions were not traded after contribution and were closed out at a near total loss. Id. at 31; see also Tr. 462; Tr. 560 (“[T]he options were closed out at a loss of about 99.75 percent of their initial value.”); Tr. 732–33. The Government points out that creating the K2 partnership cost at least $830 in legal fees and presumably additional miscellaneous costs, such as set-up, bookkeeping, and preparing financial statements, as well. Joint Stip. ¶ 142.

The weight of the evidence and the persuasiveness of Defendant's expert opinions contravene Plaintiff's assertion that contributing options to the K2 partnership appreciably benefited the Participants by providing diversification and centralized management. Dr. DeRosa testified that the Participants' decision to pool their assets in the K2 partnership did not achieve any appreciable benefit from diversification because the bulk of the trades were identical. Tr. 459–61. As he explained, diversification was “minimal because most of these guys had the same trade on anyway.” Tr. 459. Dr. Kolbe agreed, testifying that spreads having different strike prices constituted less than 12% of the British Pound spreads and less than 17% of the Euro spreads. Tr. 729–32. Dr. DeRosa also emphasized that it would have been possible for any one of the Participants to achieve the same minimal diversification in his or her portfolio by “mak[ing] a miniature version of K2 any time they wanted” at no additional cost. Tr. 461. As such, he opined that “there's no advantage [to pooling their assets in the partnership].... [The Participants] didn't need to go to K2.” Id.

Although Dr. Taleb testified that diversification offered a gain, he could not opine on its magnitude. Tr. 183–84. Rather, Dr. Taleb testified, “there is a gain from diversification ... [but] I don't know how much.” Id.

According to Dr. DeRosa, moreover, the Participants did not have to join K2 to enjoy the purported benefit of centralized management. Tr. 462. In fact, Dr. DeRosa saw no benefit of centralized management and questioned whether centralized management even existed because “K2 rode the options into the ground. They didn't do anything. There was no trading. There was nothing going on.” Tr. 462; see also Tr. 732–33 (testifying that after the options were contributed to K2, they “were never traded again, they weren't reversed, they weren't restruck, nothing happened.”). Dr. Kolbe agreed, remarking, “to the extent there's official centralized control that didn't exist before [contribution to the partnership], when you put them into K2, there's no evidence from what actually happened that it was of any benefit.” Tr. 732.

In contrast to the lack of benefit the partnership vehicle offered for investment purposes, the creation and structure of the partnership and the contribution of the spreads to that entity were “imperative” to generate the artificially inflated basis. Jade Trading II, 598 F.3d at 1377. Plaintiff's expert declined to testify about the tax implications of the spread transaction. As Dr. Taleb explained, he “wanted to be not involved in knowing anything, so I'm making a decision on the economic aspect of the transaction regardless of whatever tax windfall or not windfall is there. So I'm not involved in the tax aspect.” Tr. 222.

The Potential for Profit Does Not Imbue the Transactions with Economic Substance

Plaintiff seeks to distance itself from the outcome in Jade Trading II, which invalidated a substantially similar spread transaction, by focusing myopically on the spread transactions' potential for profit. The parties agree that, unlike the transactions in Jade Trading, the transactions at issue here might have turned a profit even net of the costs of premia and fees. In Plaintiff's view, because the spread transactions may have been profitable, the transactions had economic substance.

Refocusing the economic substance inquiry solely on profit potential, however, does not alter the spread transaction's essence as an asset with low value, high basis, and fictional tax losses. The objective economic substance test requires that a taxpayer prove a transaction had a realistic financial benefit beyond tax avoidance. Coltec, 454 F.3d at 1356 n.16. While lack of reasonable profit-making potential is one indicator that a transaction does not possess economic substance, Stobie Creek, 608 F.3d at 1378, potential for profit does not in and of itself establish economic substance -- especially where the profit potential is dwarfed by tax benefits. As the Federal Circuit noted in Jade Trading II, a “disproportionate tax advantage as compared to the amount invested and potential return[] compel[s] a conclusion that the spread transaction objectively lacked economic substance.” 598 F.3d at 1377.

The Spreads' Potential for Profit Under a Static Strategy

The potential returns here were grossly disproportionate to the tax benefits of the transactions, even assuming the highest potential profitability. The June 7 Pound spread held by A.B.I.B., for instance, might have generated at most $202,054 in profits net of fees and premium. The corresponding tax benefit for A.B.I.B., however, would have been an inflated basis of some $26 million -- the value of the purchased call option. Def.'s Ex. 1 at 42. In a similar vien, the Puramsetti Trust stood to gain at most $14,763 from its pound spread and $15,938 from its Euro spread but claimed a tax loss of $246,705 when selling a portion of the assets received upon exiting K2. Def.'s Ex. 1 at 41, 45. 5 The high ratio of tax benefits to maximum potential profit indicates that the transactions were designed only to produce disproportionate tax benefits. In Sala v. United States,   613 F.3d 1249 [106 AFTR 2d 2010-5406] (10th Cir. 2010), a functionally similar spread transaction stood to gain at most $550,000 over one year, but generated tax benefits of almost $24 million. The “expected tax benefit [dwarfed] any potential gain from [the transaction] such that “the economic [realities] of [the] transaction [were] insignificant in relation to the tax benefits of the transaction.”” Id. at 1254 (quoting Rogers v. United States,  281 F.3d 1108, 1116 [89 AFTR 2d 2002-1115] (10th Cir. 2002)). So too, the potential profit of the K2 spread transactions, dwarfed by their attendant tax benefits, cannot endow the transactions with economic substance.

The Spreads' Potential for Profit Under a Dynamic Strategy

Plaintiff contends that the K2 Participants could have reasonably anticipated earning even more by repeatedly restriking their spreads. A reasonable expectation of profit earned by “dynamic” trading, according to Plaintiff, is further evidence that the spread transactions possessed economic substance here.

Restriking allows a trader to create a new spread position with new strike prices while retaining portions of the initial trade's strategy (such as notional amount and maturity). Tr. 126–27, 131, 135, 141, 413, 415, 419. As Dr. DeRosa explained, the “essence of [restriking] is that each time you do a restrike ... you sell the original option that you're long and you buy an option that you were short so that you undo the trades by doing a new set of trades, and then you buy the new spread.” Tr. 413. Where the long option is in the money at the time of the restrike, the restriking investor receives a cash settlement.

In restriking, the option-holder normally incurs additional fees in the form of bid-ask spreads, or the difference between the fair market value of an option and what a dealer actually charges an investor-client. Tr. 150–54. Here, however, the experts agree that there were no bid-ask spreads embedded in the premia of the original or the restruck options. Tr. 153, 470, 777. Plaintiff therefore extrapolates that the Participants' Master Trading Agreements with AIG, in conjunction with the up-front fee to AIG, allowed the Participants several -- if not unlimited -- restriking opportunities without fees. In Plaintiff's view, with each restrike, a Participant could have received a cash payment, which, when added to an ostensibly profitable spread at maturity, could have multiplied each Participant's total profit. However, Plaintiff's assumption that the Participants could have restruck repeatedly and at low cost is not supported by the Master Trading Agreements or the record as a whole.

Defendant posits that restriking did not actually increase the spread transactions' profit potential. According to Defendant's experts, restruck options are inherently less valuable because the new options have higher strike prices. Tr. 541–42; Tr. 586–88. For the new options to expire in-the-money, the foreign currency must move progressively higher against the dollar, a movement that becomes more unlikely as strike prices rise. In practice, this meant AIG's cash settlements with the Participants following restrikes merely compensated, but did not enrich, the Participants in exchange for a new spread that was less likely to expire in the money. Restriking was essentially like moving money from “one pocket” (the valuable, in-the-money spread transaction) into another (a cash settlement and a less valuable spread transaction). Tr. 415–16.

Ultimately, Plaintiff has not shown that the potential for restriking would have appreciably altered the spreads' profit potential or, consequently, the spreads' economic substance. Plaintiff's theory about the transactions' enhanced potential profit from dynamic trading is overly speculative. Plaintiff's argument, relying heavily on the testimony of Dr. Taleb, is essentially that dynamic trading is dependent on market conditions and investor psychology, making payoffs uncertain. Uncertain payoffs, in turn, imply an indeterminate possibility of large payoffs (and, conversely, no payoffs). Because the spread transactions were part of a dynamic trading strategy, Plaintiff argues, they had at least some chance for incredibly large profits. See Pl.'s Post-Trial Brief at 11; Tr. 128 (quoting Dr. Taleb) (“So we don't know the upper bound. There is no fixed upper bound, you see. I don't know where the upper bound is. Different environment deliver upper bounds, you see.”).

Under the economic substance doctrine, Plaintiff must show that there was some reasonable potential for profit, and speculation about potential unbounded profits does not suffice. Plaintiff does not meet its burden simply by pointing out that there was a theoretical “non-zero” chance of indeterminably large profits. In cases where courts have found that profit potential indicated economic substance, there has been clear evidence that the challenged transactions were reasonable bets, even though the transactions were risky. See, e.g., Southgate Master Fund, L.L.C. ex rel. Montgomery Capital Advisors, LLC v. United States,   659 F.3d 466, 481 [108 AFTR 2d 2011-6488] (5th Cir. 2011) (finding that acquisition of a portfolio of non-performing Chinese loans, though ultimately unprofitable, nonetheless possessed economic substance because at the time of purchase “the available market intelligence and valuation data strongly indicated that the emerging market in Chinese [non-performing loans] held significant profit potential”). In this case, however, Plaintiff has offered only an undefined possibility for meaningful profits, without showing that any particular bet on currency rates had a realistic possibility of significant gain. In any event, as explained above, potential profitability cannot be viewed in isolation from the magnitude of tax benefits generated.

Conclusion

In sum, the possibility of substantial payoffs cannot cloak this type of transaction in legitimacy when all other characteristics of the transaction duplicate the elements of the tax shelter disallowed in Jade Trading. Importantly, profit potential is only one of several factors indicating economic substance. Here, the transactions exhibit the same critical attributes which defined this strategy as a tax avoidance mechanism in Jade Trading: a fictional loss, a meaningless contribution to a partnership, and a disproportionate tax advantage as compared to the amount invested and potential return. Jade Trading II, 598 F.3d at 1377. On the opposite side of the ledger, Plaintiff has shown only highly speculative profit from a dynamic trading strategy and profit arising from a static trading strategy, that was dwarfed by tax benefits. As the Tenth Circuit succinctly put it in Sala, “[t]he existence of some potential profit is “insufficient to impute substance into an otherwise sham transaction” where a “common-sense examination of the evidence as a whole” indicates the transaction lacked economic substance.” 613 F.3d at 1254 (quoting Keeler v. Comm'r,   243 F.3d 1212, 1219 [87 AFTR 2d 2001-1224] (10th Cir. 2001)). Here, a common sense look at the totality of the evidence reveals that the spread transaction, just as in Jade Trading, was designed not for real economic gain, but for tax avoidance.

Because the spread transaction lacked economic substance and must be disregarded on that ground alone, the Court does not reach the issue of whether   Treasury Regulation §1.752–6 can be applied retroactively.

Plaintiff's petition for readjustment of the partnership items of K2 is DENIED, with costs awarded to Defendant.

MARY ELLEN COSTER WILLIAMS

JUDGE

1

  These findings of fact are derived from the parties' Joint Stipulation of Facts and the accompanying Joint Exhibits. Moreover, the parties have stipulated that the Court may take judicial notice of certain facts in Jade Trading I. Joint Stip. ¶ 1. Those facts, while not essential to the Court's holding, provide context to the origin and use of the type of transaction at issue here. In addition, the Court has considered the relevant expert opinions presented at trial.

2

  Through his company, MCS Asset Management, Morris Safdie also possessed an ownership stake in K2. Joint Stip. ¶ 19. The Court's analysis does not involve Mr. Safdie beyond noting his membership in Sentinel LLC, and his $20,000 cash contribution to K2 in exchange for a 4.61% ownership interest in the K2 partnership.

3

  Paragraph 11.6 appeared in the original Master Trading Agreements for A.B.I.B., Bergmann Family Trust, and Puramsetti Trust. Paragraph 11.6 was added by amendment to the Master Trading Agreements for the Bergmann and Pfeiffer Trusts.

4

  Unless indicated otherwise, all subsequent short form citations to the United States Code refer to Title 26 as codified in the relevant time period.

5

  These numbers incorporate Dr. DeRosa's calculations of maximum potential returns net of fees and premia. The experts agreed that the upfront fees paid to AIG must be accounted for in any estimation of potential profit, and Dr. Taleb and Dr. DeRosa each accounted for the fees by apportioning them among each of the Participants' various trades, including restrikes. Tr. 237, 405, 571. Because Dr. Taleb testified that the number of potential restrikes was uncertain, however, he did not provide specific examples of potential returns net of fees. Tr. 237–39. Only Dr. DeRosa provided specific estimates of returns for each Participant.

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