Leveraged forward contract was a swaption with a circular loan
Apply this to your situation
This page covers one taxpayer's ruling from 2015, which can't be cited as precedent. Ezel answers your situation under the current Code and IRS guidance, with citations.
Plain-English summary
Chief Counsel analyzed a promoted leveraged forward contract that paired a purported loan with matching payments under prepaid derivative contracts. The loan and guaranteed contract payments offset each other in timing and amount, no cash changed hands after the initial fees, and the investor's only real economic exposure was the right to payments resembling those from a swaption. The advice concluded under the substance-over-form doctrine that the loan was not genuine indebtedness, the offsetting part of the contracts should be disregarded, and the remaining transaction should be treated as a swaption. If that characterization did not prevail, IRC § 465 would limit losses because the investors had no meaningful amount at risk, subject to further factual development about their activities. IRC § 1258 would also recharacterize gain up to the applicable imputed income amount as ordinary income because the arrangement was marketed as converting an interest-like return into capital gain.
Ruling snapshot
- Question: Could the IRS disregard the circular loan and offsetting forward-contract payments, or alternatively limit losses under IRC § 465 and recharacterize gain under IRC § 1258?
- Outcome: Advice given, the transaction should be recast as a swaption; alternative loss-limitation and ordinary-income rules also applied
- Key authorities: IRC §§ 163, 465, and 1258; Treas. Reg. § 1.446-3; substance-over-form doctrine
Full text (IRS public release)
Office of Chief Counsel
Internal Revenue Service
memorandum
Number: 201501012
Release Date: 1/2/2015
CC:FIP:Br1:RAMartin
POSTS-117317-14
UILC: 9999.97-00, 9300.00-00, 465.02-00, 1258.00-00
date: July 25, 2014
to: Associate Area Counsel (Philadelphia)
(Large Business & International)
Attn: Eric Peter Ingala
from: Robert A. Martin
Senior Technician Reviewer, Branch 1
(Financial Institutions & Products)
subject: Leveraged "Forward Contract"
This Chief Counsel Advice responds to your request for assistance dated April 25,
2014. This advice may not be used or cited as precedent.
LEGEND
Taxpayers = ---------------------------------
Promoter = -----------------------------------------
HoldingCo = -------------------------------------------------
Advisor = ---------------------
Broker = -----------------------------------
HoldingSPE = -----------------------------
BrokerSPE = ------------------------------
Foreign Bank = ---------------------------------------------------
HoldingSPE2 = -------------------------------------------
PromoterLLC1 = -----------------------------------
PromoterLLC2 = -------------------------------------
PromoterLLC3 = --------------------------------------
Agent = --------------------------
TaxpayerLLC = --------------------
LawFirm = -----------------------
SoloP = ---------------------
SoloPP = -------------------
State A = ---------
State B = ------------
Date 1 = -------------
Date 2 = -------
Date 3 = ----------
Date 4 = --------
Date 5 = -------------
Date 6 = ----------
Date 7 = ------------------
Date 8 = ------------------
Date 9 = ------------------
Month 1 = ---------
Month 2 = -------------
Month 3 = -------------
Year 1 = ------
Year 2 = ------
Year 4 = ------
Year 5 = ------
Year 6 = ------
Year 7 = ------
Year 8 = ------
Year 9 = ------
Year 13 = ------
Year 17 = ------
Year 21 = ------
A = ----------------
B = --------------
C = --------------
D = --------------
E = --------------
F = ----------
G = --------
H = ----------------
I = ----------------
J = ----------------
K = ----------------
L = ----------------
M = --------------
2
N = --------------
O = -------
P = -------
Q = -------
R = -------
S = -------
T = -----
U = -----
V = ------------
W = ---
X = ----------------
Y = ----------------
Z = ----------------
AA = ---
BB = ----------------
CC = ---
DD = ----------------
EE = ----------
FF = ----------
GG = ---
HH = ----------
II = ---
JJ = ----------
KK = -----
LL = ----------
MM = -----
NN = ----------
Oo = 6
PP = ----------
QQ = --------
RR = --------
SS = ----
TT = 1
UU = ----------
VV = --------
WW = ----------
3
XX = ----------
YY = --------
ZZ = ----------
AAA = ----------
BBB = ----------
CCC = --------
ISSUES
-
Whether the Service may use the substance-over-form doctrine to recast the
form of a transaction in order to disregard a loan and the portion of a purported
forward contract that offsets the loan? -
Alternatively, whether the “at-risk” rules set forth in I.R.C. § 465 apply to limit
Taxpayers’ losses claimed in connection with the transaction? -
Alternatively, whether any component of the transaction that Taxpayers invested
in is a “conversion transaction” pursuant to I.R.C. § 1258?
CONCLUSIONS
-
The Service may disregard the form of the transaction, which in substance was
the purchase of a swaption contract. The loan was designed to be offset by the
provisions of a purported forward contract, with nothing ever really borrowed or
repaid. The Service may disregard the loan as lacking genuineness under recent
case law that addresses similarly circular flows of purportedly borrowed money.
Likewise, the Service may disregard the form of the forward contract, which
comprised a component designed only to repay the loan, and a component that
functioned like a swaption rather than a forward contract. The facts in Rev. Rul.
2003-97, 2003-2 C.B. 380, are distinguishable. -
If the Service is not permitted to recast the transaction, Taxpayers’ claimed
losses may be limited under section 465 as Taxpayers appear to have no
amounts at risk. The breadth of the loss limitation will depend upon further
development of facts concerning Taxpayers “activities,” as that term is used in
section 465(b) and (c). Given Taxpayers’ activities, as reflected on their return
for the year in issue, Taxpayers’ investment in the transaction appears unrelated
to any trade or business conducted by Taxpayers. -
If the Service is not permitted to recast the transaction, section 1258 will treat
gains that Taxpayers report with regard to the purported forward contract as
ordinary income up to the “applicable imputed income amount” (as defined in
section 1258(b)). Section 1258 applies generally to transactions that are
4
marketed as converting the return on the time value of money into capital gain.
Taxpayers invested in a transaction that converted the time value of money into
capital gain through the form of a purported forward contract that was designed
to mirror payments owed on a loan. Moreover, materials used to market the
transaction demonstrate that the transaction was sold as producing capital gains
from what was a guaranteed interest-like return on the time value of money.
FACTS
This memorandum addresses a transaction marketed and sold under the label,
“Leveraged Forward Contract,” or, alternatively, the “[Promoter] Shield” (hereafter the
“Transaction”). The Transaction consists of two legs: a loan obligation (hereafter the
“Loan”) and prepaid derivative contracts (hereafter the “Contracts”); as explained, infra,
the Loan and the Contracts are designed to create offsetting rights and obligations.
Though the Loan and Contracts were entered into in Year 1, Promoter purchased both
the Loan and Contract elements of the Transaction in Year 5 and Year 6, and then
marketed the Transaction to individuals for the Transaction’s “tax efficiency.” Taxpayers
in this case are among the investors who purchased an interest in the Transaction. This
memorandum considers the purported tax benefits arising from the Transaction as
claimed by Taxpayers, a married couple filing jointly, on their return for taxable Year 6.
Origins of the Transaction in Year 1
HoldingCo was a developer of real property in State A, specializing in the construction
of luxury beachfront condominiums. HoldingCo’s business plan was to construct one
condominium complex every four years. At its peak activity, HoldingCo had twenty full-
time employees.1
In Year 1, HoldingCo’s owners engaged Advisor, a financial advisor, to assess the
company’s interest rate risk. Advisor holds a doctorate in Economics and was, for a
time, on the Finance faculty of a large university. Advisor was, and remains, the sole
principal of a financial advisory firm.
Advisor maintains that his primary objective was the identification of financial
instruments that could effectively mitigate, at an acceptable price, HoldingCo’s exposure
to rising interest rates.2 He determined that interest rate caps and swaps met
HoldingCo’s effectiveness and affordability criteria for an interest rate hedge.3 Advisor
initially proposed that HoldingCo acquire four successive tranches of interest rate caps
1
HoldingCo ceased operations and liquidated in Year 4.
2
The Service has interviewed Advisor while developing the facts in this case. We recognize that Advisor’s
recollection of the Transaction’s origins may be self-serving.
3
An interest rate cap is an option that provides a payoff when a specified floating interest rate is above a
certain level, whereas an interest rate swap is an exchange of a fixed interest rate on a notional amount
of principal for a floating rate on that same principal. John C. Hull, Options, Futures, and Other
th
Derivatives 783 (7 ed., 2009).
5
and swaps, with quarterly deliveries to match HoldingCo’s business cycle. He
determined that a $N notional amount, coupled with protected rates ranging from O% to
R% across the tranches, offered the desired protection. According to Advisor, however,
HoldingCo’s management preferred to use a forward contract to manage its interest rate
risks, and so instructed Advisor to devise a suitable transaction.4
The planned forward contracts required the participation of a broker-dealer to execute
the transaction. HoldingCo and Advisor selected Broker to provide these services. The
parties agreed to incorporate a loan to accompany the forward contract in order to
increase, though leverage, the amount of assets referenced by the contract. HoldingCo
agreed to have Advisor structure the Transaction to its current form – Broker would sell
a prepaid forward contract to HoldingCo and lend to HoldingCo amounts needed to pay
the contract’s purchase price. The resulting forward contracts,5 and the loan used to
make the required upfront payment, are the Contracts and Loan that serve as the two
legs of the Transaction.
To execute the transaction, Broker and HoldingCo each created special purpose entities
(“SPE”) to act as transaction parties. On Date 1, Year 1, Broker formed BrokerSPE, and
HoldingCo formed HoldingSPE. BrokerSPE acted as the counterparty and “seller” of
four successive tranches of Contracts to HoldingSPE, and acted as lender of the Loan
to HoldingSPE. HoldingSPE acted as the counterparty and the “buyer” of the Contracts
and the obligor on the Loan that it used to pre-pay its future obligation under the
Contracts.
Specific Terms of the Loan and the Contracts
Advisor planned the Transaction so that the Contracts would require the quarterly
delivery of a specified “bond,” or its cash equivalent, in exchange for a predetermined
price. The bonds, specified as LIBOR-based variable-rate certificates of deposit,6 would
be subject to a “protected” minimum floor rate, thereby providing HoldingCo with
protection against increases in interest rates beyond a threshold rate. Advisor created
each Contract to be deep-in-the-money (i.e., HoldingSPE pre-paid its future obligation
with proceeds from the Loan), and each Contract’s quarterly cash-settled amounts are,
at a minimum, sufficient to offset the Contract’s predetermined price on each payment
date. The amounts of the prepayments are reflected on Table II.
4
A forward contract is a contract that obligates the holder to buy or sell an asset for a predetermined
delivery price at a predetermined time. Hull, supra note 3, at 781. As discussed, infra, the form of the
Transaction is needlessly complex. Since HoldingCo is not under examination, we do not address
whether HoldingCo’s motivation for entering into the Transaction was primarily tax related.
5
As explained, infra, the contracts do not operate like forward contracts, and we do not concede that
these contracts qualify as forward contracts for tax purposes.
6
The term “LIBOR” refers to the London Interbank Offered Rate. The Contracts define the referenced
“bonds” as 3-month LIBOR bank deposits issued by a bank that is a member of the British Bankers
Association, and whose deposit rates are used in the association’s LIBOR spot fixing.
6
The Loan had an initial principal amount of $A, and called for sixty-four quarterly
installments of interest and principal, payable as follows:
Table I
Period Quarterly Loan Payment
Date 2, Year 5 to Date 3, Year 9 $B
Date 2, Year 9 to Date 3, Year 13 $C
Date 2, Year 13 to Date 3, Year 17 $D
Date 2, Year 17 to Date 3, Year 21 $E
As originally executed in Month 1, Year 1, the Loan’s interest was set at F% per annum
with interest computed on a 360-day year basis. An amendment agreed to three years
after the Loan’s execution retroactively reset the interest rate to G% as of the loan
inception date. The amendment explained that a clerical error misstated the intended
interest rate in the original loan and security agreements. Although the Loan was
executed in Month 1 of Year 1, the first payment on the Loan was not due for nearly four
years, on Date 2, Year 5.7
The Contracts required HoldingSPE to make upfront prepayments as follows:
Table II
Contract effective dates
Required Prepayment Due in
(16 quarterly deliveries per
Year 1
contract)
Date 2, Year 5 to Date 3, Year 9 $H
Date 2, Year 9 to Date 3, Year 13 $I
Date 2, Year 13 to Date 3, Year 17 $J
Date 2, Year 17 to Date 3, Year 21 $K
Total: $ L
On the first day of each calendar quarter, beginning Date 2, Year 5, and ending Date 3, Year
21, the Contracts obligated BrokerSPE to deliver to HoldingSPE bonds of a certain face
amount or their cash equivalent, and HoldingSPE was obligated to pay an additional strike
price of $M.8 The transactional documents refer to BrokerSPE’s payment obligation as the
quarterly “Bond Delivery Face Amount,” and the Contracts’ Confirmation Statements compute
7
This deferral created original issue discount (“OID”). IRC § 1273(a)(1) and (a)(2).
8
As explained, infra, neither HoldingSPE nor its successors in interest to the Transaction ever pay the
strike price out-of-pocket.
7
the face amount of bonds to be delivered (or their cash equivalent) to HoldingSPE on the
payment dates as follows:
Bond Delivery Face Amount = The Notional Amount times {(1 + [MAXIMUM (Protected
Rate, Market Rate)/4]) x [1 + (LIBOR Rate/4)]}, for the LIBOR Rate on such Bond
Delivery Date.
Where,
Notional Amount: $N
Strike Price: $M
Protected Rate: For each of the four Contracts, O%, P%, Q%, and R%9
Market Rate: Determined at the Observation Date (a single date occurring shortly
before effective date of each of the Forward Contracts)
The formula for computing the Bond Delivery Face Amount thus compares the then-
current market interest rate to the Contracts’ Protected Rates, and uses the higher rate
to compute a quarterly interest rate, which is added to one, and then multiplied by the
$N notional amount, resulting in a product.10 Consequently, if the Market Rate
increases above the amount of the Protected Rate, HoldingSPE would receive an
additional Bond Delivery Amount. If the Market Rate remains below the Protected Rate,
HoldingSPE is assured of a Bond Delivery Amount based upon the Protected Rate,
which functions as a floor. The Contracts thus provide for a payout (or delivery) formula
tied to two discrete factors: (1) the face amount of the bonds times a guaranteed
Protected Rate that was set in excess of LIBOR when HoldingSPE and BrokerSPE first
entered into the Contracts (hereafter, the “Protected Rate Payment”); and (2) a potential
additional payment of interest, multiplied by the same face amount, if the Market Rate
exceeds the Protected Rate (hereafter, the “Additional Payment”).
The net Bond Delivery Amount payable to HoldingSPE on the payment date would be
the Bond Delivery Face Amount, less HoldingSPE’s strike price in the amount of $M.
The Protected Rated added to one, then multiplied by the notional amount ($N), then
less the strike price ($M), will always yield an amount equal to the quarterly payments
on the Loan, as set forth in Table I. Accordingly, the parties fashioned the Contracts so
that the net Bond Delivery Amount will at least be equal to, and will offset, HoldingSPE’s
obligation under the Loan. In this regard, the Loan’s terms permit BrokerSPE to offset
its required net Bond Delivery Face Amount Payments against HoldingSPE’s Loan
9
The 3-month LIBOR rate in Month 1, Year 1 (the month in which the parties entered into the
Transaction) was S%. Thus, the parties set the Protected Rates (i.e., the rate that HoldingSPE was
assured of receiving) between T and U basis points higher than then-current LIBOR rates.
10
For example, it the Notional Amount is $100, the Protected Rate is 5%, and the Protected Rate is
higher than the Market Rate, the Bond Delivery Face Amount will be $100 x (1 + .05) = $105.
8
payments. The Loan specifically provides that the payments due and receivable on the
Contracts and the Loan will be deemed paid upon the parties’ making appropriate
entries in their books and records. The Loan’s terms also provide that BrokerSPE has
the right to assign all or part of the loan to any financial institution.
Broker required that it have no transaction risk. Under the terms of the Contract,
however, Broker was potentially liable for Additional Payments to HoldingSPE were
interest rates to increase above the Protected Rate. To eliminate Broker’s transaction
risk, Advisor offset Broker’s payment risk by arranging a series of four swaption
contracts written by Foreign Bank.11 Written to match the Contracts’ payment terms, the
swaption contracts’ terms reference the same Market Rates, Protected Rates, and
notional amount specified in the Contracts. Thus, swaption payments due from Foreign
Bank to BrokerSPE were expected to match the amount and timing of any Additional
Payments due from BrokerSPE to HoldingSPE under the Contracts.
The swaption contracts’ contingent payments are determined as follows:
{(Market Fixed Rate – Fixed Rate) * $N (the Notional Amount) * [3] * [30/360]}.
Where,
The Fixed Rate is equal to the Protected Rate specified by the Contracts.
The swaption contracts were entered into on the same day that the Loan and Contracts
were entered into, and the total cost for the swaption contracts was $V, which reflects
only .W% of both the prepayment cost under the Contract and the amount that
HoldingSPE borrowed through the Loan in order to finance the Contract’s prepayment.
Stated otherwise, of the amount that HoldingSPE borrowed and prepaid for the
Contracts, only .W% was attributable to the potential that the Contracts would make
Additional Payments in excess of the Protected Rate. Although BrokerSPE was the
nominal buyer of the swaption contracts, the $V purchase price for the swaption was
provided by HoldingSPE as part of its out-of-pocket costs that it incurred at the outset of
the Transaction.12
Accordingly, upon execution of the Transaction, BrokerSPE held two assets: the Loan
and the swaption contracts. As noted, payments from these assets exactly offset
BrokerSPE’s payment obligation under the Contracts, both in timing and amount. The
present value of the cash flow from BrokerSPE’s assets (the Loan and the swap) will be
equal to the present amount of its liability under the Contracts, such that the assets and
liabilities net to zero. Consequently, for GAAP purposes, BrokerSPE reported a net
11
A swaption is an option that grants the purchaser the right, but not the obligation, to enter into an
interest rate swap where a specified fixed rate is exchanged for a floating rate. Hull, supra, at 790.
12
The swaption contracts’ aggregate purchase price equals the difference between the aggregate value of the
Contracts, ($ L) and the amount borrowed under the Loan ($ A). Thus, HoldingSPE’s payment for the Contract
included an out-of-pocket payment to Broker equal to the cost of the swaption.
9
zero balance sheet result with respect to the Loan, swaptions, and Contracts. Likewise,
upon execution of the Transaction, HoldingSPE held one asset (the Contracts) and one
liability (the Loan). Again, for GAAP purposes, the Contracts and Loan offset one
another, resulting in HoldingSPE reporting a net zero balance sheet result.
When creating the Transaction, Advisor developed a number of complex computational
spreadsheets that depicted the operation and inter-related nature of the payments on
the Contracts, Loan, and swaption contracts. Advisor’s spreadsheets confirm that the
Transaction achieved its desired results and the elimination of Broker’s payment risk.
One spreadsheet reflects that the executed Transaction generates $X of interest
expenses and $Y of capital gains over its expected 20-year life.13 Approximately AA%,
(or $BB) of the interest expense arises within ten years of the Transaction’s inception,
while approximately CC% (or $ DD) of the gains arise in Transaction years eight
through twenty. Beginning in Year 13, the spreadsheet reflects that the Transaction
generates capital gains that will exceed annual interest expenses until the Transaction
is completed in Year 21.
As noted, HoldingSPE made an out-of-pocket payment at the outset of the Transaction
in the amount of $V to pay for BrokerSPE’s swaption. HoldingSPE made an additional
$EE payment to BrokerSPE as an advisory fee. Other than HoldingSPE’s one-time
payment to BrokerSPE, there is no record or indication that the parties to the
Transaction ever exchanged cash payments or any other type of consideration. Thus, at
the outset of the transaction, HoldingSPE’s only out-of-pocket costs were for: (1)
transaction fees; and (2) the cost of the swaption contracts.
Promoter’s Acquisition of the Transaction
HoldingSPE ceased all business activity and liquidated its business operations in Year
- HoldingSPE, by and through its successor interest holder, HoldingSPE2, sold its
entire interest in the Contract to Promoter and three Promoter-controlled limited liability
corporations (together referred to as “PromoterLLCs”) over a one year period, as shown
in Table III below.Table III Purchase Period % Ownership Buyer of Transaction Price Date 4, Year 5 $ FF GG% PromoterLLC1 Date 5, Year 6 $ HH II% PromoterLLC2 Date 6, Year 6 $ JJ KK% PromoterLLC3 Date 4, Year 6 $ LL MM% Promoter
13
Thus, the spreadsheet reflects that anticipated interest expenses exceed the expected gains by $ Z.
Advisor, however, has provided several revised computations of expected gain inherent in the Contract.
10
14
Total $ NN 100%
The sale agreements provided as follows: (1) HoldingSPE, by and through the
successor interest holder HoldingSPE2, would assign to Promoter and PromoterLLCs
its right, title, and interest under the Contracts; (2) Promoter and PromoterLLCs would
assume HoldingSPE’s obligations under the Loan; and (3) BrokerSPE would grant its
consent to such assignment and assumption.
Once Promoter and PromoterLLCs began acquiring an interest in the Transaction,
representatives of Promoter began marketing participations in the Transaction by
marketing membership interests in each PromoterLLC to investors.
Individuals’ Investment in the Transaction
- Marketing Materials
Promoter’s marketing of the Transaction in Year 5 began through seminars to the
investing public. Promoter renamed the Transaction as “[Promoter] Shield”. Promoter’s
representatives marketed the Transaction as a tax strategy with no risk, although the
marketing materials also mention the Transaction’s effectiveness as protection against
rising interest rates. For example, potential investors received a “Risk Management
Consulting Technical Discussion,” which describes the transaction as follows:
For the initial price you pay for the Forward Contract, it only pays profits, and
never requires Client to come out of pocket for any additional money. The loan is
fixed for the entire term, and the loan payments are matched to the minimum
payments guaranteed by the Forward Contract. The Client will never have a
negative cash flow event.
[Emphasis added]. Slides in a PowerPoint marketing presentation from a Month 3, Year
5 seminar explain the transaction as follows:
Wealth Protection
Not an “investment”
No market risk
Only pays owner if risk materializes
More like “Wealth Insurance”
14
Given that the total paid by Promoter and PromoterLLCs closely approximates the amount that
HoldingSPE paid for the swaption in Year 1, we assume that Promoter’s cost for acquiring the
Transaction is the approximate value of the swaption contract as of the date of purchase.
11
Leveraged Forward Contract:
Long-term protection against risk
Positive Cash Flow after one year
$Millions of benefits through term
Even if interest rates never rise
“Hit lottery” if interest rates do rise
The slides also set forth tables explaining how the annual return from the Contract will
always provide for payments on the Loan, and will provide potential additional payments
if LIBOR rates increase above the Contracts’ Protected Rate. One slide contains “Fixed
Schedules of Interest & Gains” where aggregate interest accruing on the Loan over
sixteen years offsets aggregate capital gains generated by the Contracts, except that
the interest is front loaded in the earlier years, while the capital gains are reported in
later years. The presentation emphasizes the “positive cash flow” and the “$Millions of
benefits through term,” even if interest rates never rise, thus indicating that Promoter
marketed the Transaction as providing cash flow through tax benefits, rather than
through the Contracts’ “lottery” payments (i.e., Additional Payments).
The slides also explain the “Tax Attributes” of the Loan as generating ordinary
deductions in the amount of interest expenses, and of the Contract as generating long-
term capital gain attributable to amounts received from the Contracts. A slide sets forth
projected “Net After-Tax Cash Flow (if interest rates never exceed [Oo]%),” and projects
“Net Cash Flow” in the amount of $PP, due solely to the difference between the “Income
Tax Savings” from the Loan interest deducted against ordinary income at an assumed
35% tax rate, and the “Capital Gain Tax” imposed on the Contract’s payments at a 15%
rate. This expected after-tax cash flow far exceeds the investor’s upfront cost.
Accordingly, the promotional materials emphasize how investors in the Transaction are
expected to receive a return on their investment primarily through tax benefits, rather
than through potential Additional Payments from the Contract if Market Rates exceed
the Protected Rate.
- How the Individual Investors Participated
Promoter marketed the Transaction to individual professionals (e.g., teachers, doctors,
lawyers). Investors seeking to participate could do so in one of two ways. First, the
investor could sign a subscription agreement and become a limited partner in one of the
PromoterLLCs. The LLCs were partnerships for tax purposes and Promoter was the
managing member of the LLCs. The LLCs reported items of income, deduction, gain or
loss attributable to the Transaction directly to LLC members. Alternatively, investors
seeking to participate after Date 7, Year 6 were required to “directly” invest in the
Transaction by owning a ratable share of the Contract and assuming a ratable portion of
12
the Loan’s liability.15
Investors received a one-tenth of one percent (0.1%) interest in the Transaction for
every $QQ paid to Promoter. For example, an investor could acquire a 0.7% interest in
the Transaction for $RR. Thus, during the period in which Promoter and PromoterLLCs
were purchasing elements of the Transaction from HoldingSPE2 for a total of $NN,
Promoter was marketing and selling the Transaction and its accompanying tax benefits
for a total of $M, more than ten times Promoter’s and PromoterLLCs’ purchase price.
To enter into the Transaction, each investor had to execute four documents: a
Participation Agreement, a Nominee Agreement, a Co-Ownership Agreement, and an
Assignment, Assumption, and Consent Agreement.
The Participation Agreement formalized the investor’s intent to enter the transaction,
and contains a risk analysis assessment performed by Advisor. The Nominee
Agreement appointed Agent as the investor’s exclusive representative with respect to
the transaction. Agent acts as nominee for the investor in all matters concerning the
Contracts, the Loan, and any other matter relating to the Transaction. The Co-
Ownership Agreement states that the Transaction will not be treated as a corporation or
a partnership, but that all proceeds, benefits, profits and losses, will be distributed by
Agent, as nominee, to the investor for the investor’s pro rata ownership share of the
Transaction. The Assignment Agreement sets out the investor’s percent interest in the
Transaction, and provides BrokerSPE’s and HoldingSPE’s consents to assign to the
investor an ownership interest in the Transaction.
For a hypothetical investor with a baseline annual income of $270,000, Advisor
recommended the purchase of a SS% interest in the transaction for $70,000, which was
allocated as follows: accounting $7,800, (11%); acquisition consulting: $8,400 (12%);
commission: $600 (1%); legal: $13,200 (19%); placement fee: $3,000 (4%); risk
analysis: $9,000 (13%); structural consultation: $18,000 (26%). The remaining $10,000
(14%) was the purported cost of the Contracts. Thus, for every dollar paid by the
investors, only fourteen cents went to purchase an ownership interest in the
Transaction.
- Taxpayers’ Participation in the Transaction
Taxpayers (referred separately as “Taxpayer-X” and “Taxpayer-Y”) were married and
filed a joint income tax return for Year 6, the taxable year in issue. Taxpayer-X was a full
time a manager at a manufacturing plant in Year 5, and was laid off in Year 6.
Taxpayer-Y reported Schedule C activities on the Year 6 return for both voice-over work
15
On or about Date 7, Year 6, the largest of PromoterLLCs dissolved, due to Promoter’s concern that the
LLC would be treated as an “Investment Company” under the Investment Company Act of 1940, Pub. L.
No. 76-768. Upon such dissolution, each former member of the LLC now held his or her interest in the
Transaction directly by assignment, rather than indirectly through a partnership. Promoter continued to
market the Transaction, but sold the Transaction to investors through a purported direct co-ownership in
the Loan and the Contracts.
13
and for officiating over weddings. In Year 5, Taxpayer-Y became interested in real
estate investment, and attended a real estate investment seminar. Taxpayer-Y learned
about Promoter and the Transaction when one of Promoter’s employees made a
presentation regarding asset protection during the seminar.
Taxpayers considered the Transaction for a year, and decided to participate. One of
Promoter’s principals advised that Taxpayers first form a single member LLC (a
disregarded entity) through which Taxpayers could invest in the Transaction. Promoter
assisted Taxpayers by transferring ownership of TaxpayerLLC, and Taxpayers used the
LLC to purchase a TT% interest in the Transaction.16 Accordingly, Taxpayers paid $UU
for a TT% interest in a transaction that HoldingSPE had entered into in Year 1 for a total
cost of $V, and which HoldingSPE had sold to Promoter in Years 5 and 6 for a total cost
of $NN. Thus, Taxpayers paid more than ten times for their portion of the Transaction
than Promoter had paid during the previous year, and more than seven times the
amount that HoldingSPE paid in Year 1.
Taxpayers’ individual note schedule illustrated the payment offsets of the Loan and the
Contract from Date 4, Year 6 through the expected end of the Transaction on Date 4,
Year 21. The schedule sets forth the amount of Taxpayers’ expected tax savings from
their first four years of participation in the Transaction as follows on Table IV:17
Table IV
Year Tax Savings18
Year 6 $ VV
Year 7 $ WW
Year 8 $ XX
Year 9 $ YY
Total $ ZZ
Thus, Promoter marketed the transaction to Taxpayers so that Taxpayers could expect
to recoup the cost of the Transaction through tax savings alone within the first two years
of the Contract, and would more than triple their investment within four years, again,
solely due to expected tax savings.
Taxpayers committed to purchase their interest on or about Date 8, Year 6,19 and
funded the purchase in full on Date 7, Year 6 with a wire transfer from an IRA account
16
Promoter had formed TaxpayerLLC, a State B company, several months before Taxpayers entered into
the Transaction. One of the Promoter’s principals emphasized to Taxpayer-Y through a webinar that the
most tax efficient vehicle to deduct the interest from the Transaction would be to use a flow through entity
such as a single member LLC.
17
The Examination team has not determined why the offset schedule shows the capital gain income at
ordinary rates in Year 6 whereas the Transaction documents refer to the income from the Contract as
capital gain. We assume that this is because Promoter at that time held the Transaction for less than one
year, and all gains from the Contracts would be short term capital gains. § 1222(1).
18
This assumes the highest Federal income tax rate for Year 6, i.e., 35%.
14
to Promoter. Consistent with other investors in the Transaction, Taxpayers never made
any additional payments once they completed the upfront investment; their obligations
under the Loan and rights to payments under the Contracts offset, dollar for dollar.20
Taxpayers received a year-end statement from Promoter showing their share of interest
expense and capital gain for Year 6. Taxpayers were allocated income and interest
expenses from the Transaction from the day Promoter purchased the Transaction on
Date 4, Year 6, although Taxpayers did not purchase their participation in the
Transaction until Month 2 Year 6, seven months later. Consistent with other direct
investors in the Transaction, Taxpayers reported the following items from the
Transaction on Schedule C of their individual income tax returns for Year 6:
Gross receipts $ AAA
Other Interest expense $ BBB
Legal and professional fees $ CCC
With respect to “Legal and professional fees,” Taxpayers allocated $DDD of their $UU
upfront investment cost to “Legal and Risk Management Consultation Expense,”
pursuant to a letter dated Date 9, Year 6 from Promoter’s President. This is consistent
with the discussion, supra, that Advisor arranged the Transaction so that investors
would typically allocate 14% of their upfront investment to the actual purchase of the
Transaction.
Taxpayers still owned their interest in the Transaction in Year 7, but did not include the
Transaction’s items of income and deductions on their Federal income tax return. In
early Year 8, Taxpayers sold their interest in the Transaction back to Promoter.
The Legal Opinions Regarding Tax Consequences of the Transaction
Taxpayers purportedly relied on the following two legal opinion letters, provided as part
of the “[Promoter] Shield Subscriber Book”: (1) an unsigned draft opinion by LawFirm
LLP, a large international law firm, and (2) an opinion by a solo practitioner, SoloP LLC.
The LawFirm letter is dated Year 2, well before Promoter or Taxpayers purchased an
interest in the Transaction, while the SoloP letter is dated Year 5, the year in which
Promoter began marketing the Transaction to individual investors. The letters are not
addressed to Taxpayers, nor do the letters specifically address Taxpayers’ situation.21
With regard to the investors’ motivation for entering into the transaction, the LawFirm
letter explains:
19
Few of Taxpayers’ agreements or contracts for the Transaction are dated.
20
The Market Rate during Year 6 was less than the Protected Rate, so Taxpayers were not entitled to
any Additional Payments under the Contracts.
21
The tax opinion letters by LawFirm and SoloP were written for other parties whose names are been
redacted.
15
We understand that you are concerned that an increase in interest rates will
decrease your income from [a hedge fund investment] and will reduce the
relative value of the income you receive. You have also indicated that you are
concerned that increased interest rates will significantly increase the expense of
the mortgage on the [left blank]; reducing the net cash flow you receive from that
investment.
Likewise, the SoloP letter explains:
Due to your concern about the increasing threat of high interest rates due to a
significant rise in the money supply and the detrimental effect that rising interest
rates would have on [Transaction investor’s company], you engaged a financial
consultant with an expertise in risk mitigation, [Advisor], to analyze your situation
and the available means of reducing those risks.
Each letter contains the same or similar legal conclusions on four issues:
1. It is “more likely than not” that [the Loan] will be treated as indebtedness for
Federal income tax purposes, and original issue discount on the Secured Loan
will be deductible as it accrues.
2. It is “more likely than not” that no taxable income will be recognized on [the
Contract] until the forward sales are executed or it is disposed of in a taxable
transaction, and that any gain or loss recognized on forward sales or termination
of [the Contract] will be capital gain or loss.22
3. It is “more likely than not” that [the Contract] will be treated as part of [another
Transaction investor’s] investment or business activity for purposes of the at-risk
rules of section 465, and that, for purposes of determining whether deductions
for expenses relating to [the Contract] and [the Loan] are limited by the at-risk
rules, you may take into account your entire investment.
4. It is “more likely than not” that the deduction of interest expense expected to
result from the combination of [the Loan] and [the Contract] will be respected
and that their separate treatment not be disallowed under the economic
substance doctrine.23
22
The LawFirm letter used the term “accrue,” rather than “recognize,” and refers to the “termination” of
the Contract rather than the execution of forward sales. The legal opinions’ discussion of the issue
focuses on applicability of section 1258.
23
The LawFirm letter does not mention the “separate treatment” of the Loan and the Contract in its
conclusions. We are currently considering application of the economic substance doctrine to this case,
and may issue supplemental advice.
16
Taxpayers also consulted with attorney SoloPP, who does not have any special tax
knowledge or experience. In the consultation with SoloPP, Taxpayers did not disclose
all of the facts regarding the transaction, and SoloPP provided no written advice.
LAW AND ANALYSIS
Issue 1: Whether the Service may use the substance-over-form doctrine to recast the
form of the Transaction in order to disregard the Loan and the portion of the Contract
that offsets the Loan?
The substance of a transaction, not its form, governs its tax treatment. Commissioner v.
Court Holding Co., 324 U.S. 331, 334 (1945). The Supreme Court has explained that
“[a] given result at the end of a straight path is not made a different result because
reached following a devious path.” Minn. Tea Co. v. Helvering, 302 U.S. 609, 613
(1938). “In applying the doctrine of substance over form, the Court has looked to the
objective economic realities of a transaction rather than to the particular form the parties
employed.” Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978). The Supreme
Court has further explained that “the simple expedient of drawing up papers” is not
“controlling for tax purposes when the objective economic realities are to the contrary.”
Id. (citing Commissioner v. Tower, 327 U.S. 280, 291 (1946)).
Section 163(a) allows as a deduction all interest paid or accrued within the taxable year
on indebtedness. Due to the Transaction’s design to produce circular flows of cash
through the offsetting Loan and Contracts, the Transaction raises the question as to
whether the Loan and Contracts should be respected as separate transactions for tax
purposes. Particularly, where a transaction involves a purported loan that is offset by
another element within the transaction, courts have addressed whether the loan is
genuine indebtedness, or whether the form of the purported loan should be either
disregarded or recast to reflect the objective economic realities of the transaction.
A. Whether the Loan is genuine indebtedness
In Blue Flame Gas Co. v. Commissioner, 54 T.C. 584 (1970), the taxpayer leased
assets to a lessee that simultaneously purported to loan money back to the taxpayer.
The parties structured the terms of the lease and the terms of repayment of the loan so
that the taxpayer’s payments due on the loan would offset the lessee’s rent due on the
lease; no cash would actually change hands, and the respective payments were mere
bookkeeping entries. The Tax Court concluded that the proceeds from the purported
loan were, in reality, prepaid rent. In so doing, the court noted that the loan was in the
exact amount of rent due under the leases, and that the repayment dates of loan and
rental payments were intentionally designed to coincide. Id. at 596.
More recently, courts in the “lease-in, lease-out” (“LILO”) and “sale-in, lease-out”
(“SILO”) line of cases have refused to acknowledge the genuineness of purported loans
17
that are entirely offset by other components of a larger transaction.24 In BB&T Corp. v.
United States, 523 F.3d 461 (4th Cir. 2008), the taxpayer claimed tax benefits
associated with a LILO transaction whereby the taxpayer purported to lease property
from a lessor that then subleased the property back from the taxpayer. The taxpayer
paid $18.2 million at the outset of the transaction, of which $6.2 reflected a fee to the
lessor and $12 million was placed in an account that invested in government bonds for
the taxpayer’s benefit. The taxpayer also financed its obligation under the lease by
borrowing $68 million and immediately placing the proceeds of the purported loan into
an escrow account at a bank that was affiliated with the lending bank; the loan was
nonrecourse and the taxpayer could not access the proceeds in the escrow account.25
The lessor netted its right to receive rent from taxpayer through the lease and its
obligation to pay rent to the taxpayer through the sublease, such that “[t]he net result is
that no funds change hands during this period; only a circular intrabank transfer
occurred. Id. at 468. The court summarized the facts as follows:
The practical effect of this scenario would be no different than if [the taxpayer]
had invested in the treasury bonds directly, except that [the taxpayer] paid
roughly $6 million to [the lessor] as incentive for participating in the transaction,
as well as various transaction fees, and would have received tax deductions for
rent, interest, and amortization of transaction-related fees . . . .”
Id.
The court in BB&T, employing substance-over-form principles, rejected the form of the
transaction, including the taxpayer’s claims for deductions with respect to rent and
interest. In rejecting the taxpayer’s claims for interest expenses under section 163(a)
with respect to the $68 million loan, the court concluded that the loan did not constitute
“genuine indebtedness.” Id. at 476. In so doing, the court explained as follows:
Despite the loan documents providing that [the taxpayer] had a legal obligation to
repay $68,008,236 to [the bank], the transaction does not in fact require the
taxpayer to pay any money to [the bank]. [The taxpayer], having immediately
returned a sum equal to the amount [the bank’s parent] supplied in furnishing the
[bank] loan to a deferred account at [bank parent], has relieved itself of any
further repayment obligations.
24
The Service addressed LILO transactions in Rev. Rul. 2002-69, 2002-2 C.B. 760, modifying and
superseding, Rev. Rul. 99-14, 1999-1 C.B. 835. LILOs involve taxpayers obligated under leases of
property that the taxpayer finances through loans, but where the taxpayer’s obligations under the leases
and loans are offset through subleases of the property. The ruling, relying upon the substance over form
doctrine, holds that claimed deductions for rent and interest are not allowable. The ruling explains:
“Where parties have in form entered into two separate transactions that result in offsetting obligations, the
courts often have collapsed the offsetting obligations and recharacterized the two transactions as a single
transaction.” Id. at 762.
25
The bank that held the proceeds in escrow also provided the proceeds for the loan on behalf of its
affiliated bank, so that the bank was “actually paying itself.” BB&T, 523 F.3d at 468.
18
Id.26 The court further explained that the taxpayer neither compensated the bank for
“the use or forbearance of money,”27 nor did the bank actually forebear any money,
because the purported loan was nonrecourse and the taxpayer immediately returned
the proceeds back to the lending bank, who then accounted for the loan off of its
balance sheet. Id. With respect to the $18.2 million that the taxpayer paid out-of-pocket
at the outset of the transaction, the court noted: “All [the taxpayer] has done is paid [the
lessor] approximately $6 million dollars to sign documents meeting the formal
requirements of a lease and sublease, arranged in a circular transfer of funds from and
then back to [the bank], and invested approximately $12 million in government bonds.”
Id. at 475. Thus, the fact that the taxpayer had the potential to earn an interest-like
return on a small component of the transaction did not confer substance upon the
purported loan that the taxpayer used to finance the lease.
In Wells Fargo v. United States, 641 F.3d 1319 (Fed. Cir. 2011), the court likewise
rejected a SILO transaction28 on substance-over-form grounds. The facts are similar to
those in BB&T: The taxpayer purported to lease property from a tax exempt entity and
prepaid the purported rent in part by borrowing money through a nonrecourse loan. The
taxpayer’s obligations under the lease and the loan were offset by the tax exempt
entity’s agreement to sublease the property back from the taxpayer. The portion of the
taxpayer’s prepayment that was attributable to proceeds from the nonrecourse
borrowing was set forth in a restricted “debt portion” account that the tax exempt entity
used to make payments on its sublease. The term of the sublease and sublease
payments were structured to meet taxpayer’s debt service obligations under the
nonrecourse loan. In this regard, the court referred to the debt portion account as “loop
debt,” and described the funds in the account as existing “for the purpose of paying off
the debt.” Wells Fargo, 641 F.3d at 1321. The taxpayer also used its own funds to
make a portion of the prepayment, which was placed into an “equity portion” account
that invested in high-grade debt for the taxpayer’s benefit. The court observed that “[t]he
net result is the same as if the taxpayer had simply invested its equity portion account in
high-grade debt, receiving a predictable return on that investment over the life of the
sublease. Id.
The court in Wells Fargo, in denying the taxpayer’s claimed deductions for interest
incurred on the nonrecourse loan, explained as follows:
[W]e are left with purely circular transactions that elevate form over substance.
The only flow of funds between the parties to the transaction was the initial lump
26
The court in BB&T declined to address whether the transaction as a whole lacked economic substance,
but held that “the Government was entitled to recognize [the transaction] for what it was, not what [the
taxpayer] professed it to be.” BB&T, 523 F.3d at 477.
27
The Supreme Court has defined “interest on indebtedness” as “compensation for the use or
forbearance of money.” Deputy v. du Pont, 308 U.S. 488, 498 (1940).
28
A SILO differs from a LILO in that the initial lease is for a term lasting longer than the useful life of the
leased asset; thus, the Service treats the initial lease as a sale of the asset for tax purposes. Wells Fargo,
641 F.3d at 1321.
19
sum given to [the seller and lessee] as compensation for its participation in the
transaction. [Text omitted]. These transactions were win-win situations for all of
the parties involved because free money – in the form of previously unavailable
tax benefits utilized by [the taxpayer] – was divided among the parties.
Id. at 1330. That the taxpayer received a safe, interest-like rate of return on a portion of
its prepayment did not affect the court’s conclusion that the SILO transactions ran afoul
of the substance-over-form doctrine. Specifically, with respect to the taxpayer’s claim for
interest deductions, the court noted that the debt “only existed on a balance sheet.” Id.
In Altria Group, Inc. v. United States, 658 F.3d 276 (2d Cir. 2011), the court relied upon
both the substance-over-form and the economic substance doctrines in rejecting the
taxpayer’s claimed deductions attributable to SILO and LILO transactions that were
structured similarly to those described in BB&T and Wells Fargo. The court refused to
recognize that the nonrecourse loans, which taxpayer used to finance a portion of its
prepayment under a lease, were “genuine.” Altria, 658 F.3d at 290. The court noted
that although the loan balance was less than the value of the collateral security, the
transaction eliminated any possibility that the taxpayer would default on the loans, the
parties’ obligations were circular, and the taxpayer never obtained use of “the
purportedly loaned funds.” Id. at 290-91. The court “agree[d] with the district court that,
as here, ‘[a] pointlessly complex transaction with a tax-indifferent counterparty that
insulates the taxpayer from meaningful economic risk of loss or potential for gain cries
out for [substance over form] treatment.’” Id. at 291 (citing Altria Group, Inc. v. United
States, 694 F. Supp. 2d 259, 272 (S.D. N.Y., 2010)).
Turning to the Taxpayers’ claim for interest deductions arising from the Transaction,
Taxpayers must first establish that the Loan was genuine indebtedness for the use or
forbearance of money. Considered in light of the opinions in Blue Flame, BB&T, Wells
Fargo, and Altria Group, the characteristics of the Loan, together with the Contract, lead
to the conclusion that the Taxpayer never incurred genuine indebtedness for tax
purposes. In so doing, we note the following similarities between the Transaction and
the applicable case law: (1) the Loan and the Contracts together were netted as
bookkeeping entries with no cash actually being exchanged and no proceeds actually
borrowed; (2) the Loan and the Contracts were circular insofar as the original parties to
the Transaction structured it so payments on the Loan and the Contracts would match
precisely in both timing and amount over the Transaction’s duration; (3) the Loan was
effectively nonrecourse since the assets that secured the Loan (the Contracts) made all
Loan payments; (4) there was no risk of default on the Loan; and (5) the Loan and the
Contracts together added needless complexity to a transaction that could have provided
the parties with identical results in a cheaper and more straightforward fashion.
The fact that Taxpayers had the opportunity to obtain a potential return based upon the
Contract’s Additional Payment provisions confers no more genuineness upon the Loan
than did the taxpayers’ interest-based rate of return on a portion of their out-of-pocket
investments in the LILO and SILO cases. Like the taxpayers in BB&T and Wells Fargo,
20
Taxpayers made a relatively small out-of-pocket payment for an arguably profitable
element of the Transaction, and then claimed interest deductions on the Loan that far
exceeded Taxpayer’s out-of-pocket payment. Indeed, at the outset of the Transaction
in Year 1, the value of the possibility that the Contract would make additional “lottery”
payments (if Market Rates increase beyond the Protected Rate) was reflected in the
value of the swaption, an amount that was only .W% of the Loan’s initial principal
balance. Like the taxpayers in BB&T and Wells Fargo, Taxpayer used no portion of the
Loan to acquire the arguably profitable component of the Transaction; rather, Taxpayers
paid out-of-pocket for their share of the swaption held by BrokerSPE.29
Accordingly, the practical effect of this transaction is no different than if Taxpayer had
simply purchased the swaption directly from Foreign Bank, except that Taxpayer paid
substantial fees to Promoter to access interest deductions that would be otherwise
unavailable. See Wells Fargo, 641 F.3d at 1330. Therefore, the Loan must be
disregarded, regardless of whether other components of the transaction, such as the
potential for Additional Payments, are respected. When disregarded, there is no
genuine indebtedness, and therefore, Taxpayers are not permitted to claim interest
deductions on the Loan.
B. Whether the Contracts must be respected
In form, the Contracts were styled as forward contracts. Given the Contracts’ intended
operation to offset the Loan, we turn to whether the form of the Contracts should be
respected for tax purposes.
Case law defines a forward contract as “an executory contract calling for the delivery of
property at a future date in exchange for a payment at that time.”30 Anschutz v.
Commissioner, 135 T.C. 78, 81 (2010), aff’d, 664 F.3d 313 (10th Cir. 2011); see also
Hull, supra notes 3 and 4. A forward contract does not result in a taxable event until the
future sale referenced in the contract is actually executed. Lucas v. North Texas
Lumber, 281 U.S. 11, 13 (1930). The potential gain or loss inherent in a forward
contract reflects the difference between the contract’s agreed-upon sales price for the
asset and the asset’s current value (the “spot price”). See Hull, supra note 3, at 5. If
the form of the Contracts as forward contracts is respected in this case, then gain
attributable to the quarterly Bond Delivery Face Amount payments may be taxed as
capital gain and may be deferred until the Contract’s actual payment dates.31
29
Likewise, the out-of-pocket amounts that HoldingSPE and Promoter paid when entering into the
Transaction similarly reflected the value of the swaptions.
30
The Service has recognized that certain forward contracts may be prepaid while retaining the tax
treatment of a forward contract (rather than as a current sale). Rev. Rul. 2003-7, 2003-1 C.B. 363.
31
Even if the Contracts are treated as forward contracts, however, some or all of the gains (assuming the
amounts otherwise qualify as gain for Federal income tax purposes) should be treated as ordinary income
under section 1258. See Argument for Issue 3, infra.
21
The Contracts reference, as the assets to be sold, short-term bonds (which the
transactional documents also refer to as “certificates of deposit”) that have LIBOR-
based variable yields. The Contracts, however, provide for a two discrete payouts: (1)
the guaranteed Protected Rate Payments that offset all Loan payments; and (2)
Additional Payments that are only due if the Market Rate exceeds the Protected Rate.
The Protected Rate Payments were designed to serve no economic function for
investors in the Transaction other than to provide a quarterly payment stream that was
guaranteed to offset, dollar for dollar, the investors’ obligations under the Loan. The
promotional materials reflect that investors in the Transaction had no upside potential or
downside risk from this portion of the Contracts, other than the upside of the resulting
tax benefits. We have concluded, with ample authority under case law, that the Loan
lacked genuineness due to the Loan being offset by the Contracts. Likewise, we
conclude that the Contracts’ Protected Rate Payment component lacks genuineness for
its intended purpose of offsetting the Loan, and may be disregarded.
We also note that the Contracts fail to function as forward contracts.32 The referenced
assets in the Contracts are bonds that are both short-term and yield a LIBOR-based
variable rate that adjusts with market conditions, i.e., assets that are not expected to
fluctuate in value. The Protected Rate Payment provision in the Contracts, however,
guarantees payments that were set at a rate in excess of LIBOR when the Contracts
were entered into, thus providing a payment stream that is unrelated to the value of the
Contract’s referenced assets. 33 Whereas payments upon execution or termination of a
forward contract should reflect fluctuations in the value of the referenced asset, the
guaranteed Protected Rate Payments from the Contracts indicate that the Contracts are
not forward contracts. The function of the Protected Rate Payment provision is to
provide a guaranteed payment stream to offset the Loan, rather than to obligate the
parties to purchase or sell identified assets in the future at a predetermined price. In
this vein, the Contracts’ guaranteed Protected Rate Payments are more akin to
payments on a fixed rate loan that mirrors and offsets Taxpayers’ obligation under the
Loan.
After disregarding both the Loan and the Protected Rate portion of the Contracts, we
are left with the only portion of the Transaction that has any substance, i.e., the
Taxpayers’ right to receive Additional Payments if the Market Rate exceeds the
Protected Rate. Not surprisingly, the parties who have purchased an interest in the
Transaction since its inception have paid a price that approximates the value of this
right, which is reflected in the value of the swaption that Broker holds to meet its
obligation under the Contracts. The objective economic reality is that Taxpayers
actually purchased an interest in a swaption contract, and nothing more. Taxpayers
cannot alter this “given result” by taking a “devious path.” Minn. Tea Co, 302 U.S. at
32
Neither of the legal opinions provided to Taxpayers addresses whether the Contracts qualify as forward
contracts for tax purposes.
33
Accordingly, even if the Transaction was not recharacterized as the mere right to receive swaption
payments, no inference should be drawn that the Service considers any portion of the Contract’s quarterly
payments to be “gain” for Federal income tax purposes.
22
- Additional Payments from the Contracts, if Taxpayers receive any, are payments
from a swaption and will generally be subject to the rules governing notional principal
contracts. See Treas. Reg. § 1.446-3(c)(1)(i) (defining “notional principal contract” as
providing “for the payment of amounts by one party to another at specified intervals
calculated by reference to a specified index upon a notional principal amount in
exchange for specified consideration or a promise to pay similar amounts”).C. Rev. Rul. 2003-97, 2003-2 C.B. 380, is not applicable
Rev. Rul. 2003-97 addresses the deductibility of interest on a five-year note issued as
part of a "unit" that also included a three-year forward contract to purchase stock of the
note’s issuer (Corporation X). Holders must make an initial payment to acquire the unit,
and must pledge the note they receive to secure their obligation to pay on the forward
contract. The ruling explains that “[a]ll of the interest payments on all of the Notes will
be made in cash.” The Holder could separate the note from the forward contract by
pledging other collateral, and it is “substantially certain” that the notes will be
remarketed and remain outstanding after the forward contract is settled. The ruling
holds that the note and forward were separable instruments, that the note qualifies as
debt for tax purposes, and that the interest that Corporation X paid on the notes is
deductible.
The legal opinions provided to Taxpayers cite the ruling for the proposition that the Loan
and Contracts in the Transaction must be honored separately. The legal opinions focus
on Broker’s right to sell or assign the Loan to a third party. Moreover, the “Risk
Management Consulting Technical Discussion” that potential investors in the
Transaction received analyzes the ruling as follows:
The fact that [the Transaction] is highly leveraged does not in any way change its
nature or its tax characteristics. Revenue Ruling 2003-97 addresses a similar
Leveraged Forward Contract and affirms that the Forward Contract and the Note
must each be taxed according to their own individual character.
The legal opinions and Technical Discussion fail to address the distinctions between the
facts in the ruling and the facts surrounding Taxpayers’ purchase of the Transaction. In
the ruling, the holder of the note pays out-of-pocket for the note, and receives quarterly
interest payments from Corporation X in cash. Thus, the ruling does not describe
offsetting circular flows of cash comparable to those that are present in the Transaction,
and it is those circular flows of cash that serve as the primary basis for our disregarding
the genuineness of the Loan.34 Moreover, the ruling explains that that the note is
expected to remain outstanding even after the forward is settled, whereas the
34
The holder of the forward contract in the ruling is also the holder, rather than the borrower, under the
note. Actual money changes hands in the ruling when the note is issued because the holder is not
borrowing to collateralize its obligation under the forward contract. In contrast, Taxpayers are the
borrowers under the Loan, which means that Taxpayers are effectively borrowing the amount that they
pledge under the Contract and never pay that amount out of pocket.
23
Transaction was designed so that the Loan and the Contract would make offsetting
payments for an identical term, expiring together. In addition, it is also highly unlikely
that the Loan and the Contract would ever be separated, since no rational investor in
the Transaction would ever post substitute collateral for the Loan in lieu of the Contract,
and few could afford to do so, given the principal balance of the Loan. Likewise, the
fact that BrokerSPE could theoretically sell the Loan to a third party is irrelevant, since
no rational investor would purchase the Loan unless it was secured by the Contract or
similar collateral.
Given these factual differences, Rev. Rul. 2003-97 is not controlling. The Loan and the
Contracts in this case were designed to offset, requiring no payments by any investor,
except for fees and the cost of a swaption that served as the only real part of the
Transaction. As explained, Taxpayers merely purchased the right to a return under
swaption contracts (albeit paid indirectly by BrokerSPE), and should be treated as such
for tax purposes.
Issue 2: Alternatively, whether the “at-risk” rules set forth in section 465 apply to limit
Taxpayers’ losses claimed in connection with the Transaction
Some or all of Taxpayers’ claimed deductions may be disallowed under the at-risk rules
set forth in section 465.
Section 465(a)(1) provides that, in the case of individuals and certain C corporations
that are personal holding companies under section 542, any loss from an activity shall
be allowed “only to the extent of the aggregate amount with respect to which the
taxpayer is at risk . . . for such activity.” Section 465(b)(1) provides that a taxpayer shall
be considered at risk for an activity with respect to the amounts including (A) the
amount of money and the adjusted basis of the property contributed by the taxpayer to
the activity, and (B) amounts borrowed with respect to such activity. Section 465(b)(2)
provides that a taxpayer shall be considered at risk with respect to amounts borrowed
for use in an activity to the extent that he (A) is personally liable for the repayment of
such amounts, or (B) has pledged property, other than property used in such activity, as
security for such borrowed amount.
Section 465(c)(3) provides that this section applies to each activity engaged in by the
taxpayer in carrying on a trade or business or for the production of income. A broad
reading of the term “activity” thus results in a taxpayer having more amounts at risk.
The terms of the Loan in this case provide that the borrowers are personally liable for
repayment but, due to the structure of the Transaction, the Loans are effectively
nonrecourse. Since the Loan is collateralized with a Contract that is created to make all
payments on the Loan, investors in the Transaction will never be personally liable to
repay the Loan. This is consistent with the promotional materials’ characterization of
the Transaction as “Not an ‘investment’,” with “No market risk,” and as never requiring
the investor “to come out of pocket for any additional money.” Accordingly, Taxpayers
24
cannot include the Loan for purposes of determining the amount they have at risk in the
Transaction.
The legal opinions provided to the Taxpayers were not addressed to Taxpayers, nor do
the opinions address Taxpayers’ business or income producing activities when
Taxpayers invested in the Transaction. Moreover, the opinions implicitly concede that
the loans are nonrecourse by not addressing the issue. Rather, the opinions focus on
the scope of the investors’ “activities.” For the LawFirm opinion letter, the activity in
issue is the investor’s activity of “managing an investment portfolio,” and the opinion
includes the Transaction as part of that activity. In the SoloP opinion letter, the activity in
issue is the investor’s “results-based marketing company,” and the opinion includes the
Transaction as part of the investor’s trade or business.
With respect to Taxpayers’ participation in the Transaction, we note that the
determination of a taxpayer’s activities under section 465(c)(3) depends upon the
specific facts of each case. We understand that Promoter marketed the transaction to
individual professionals, such as doctors, lawyers, and teachers. Taxpayer-X was a
recently laid-off manager at a manufacturing plant, while Taxpayer-Y reported self-
employment income for activities as a voice over artist and for officiating over weddings.
Although section 465(c)(3)(B) provides for aggregation of activities that constitute a
trade or business, Taxpayers’ participation in the Transaction is not in furtherance of
any of Taxpayers’ trade or business activity, and should not be aggregated with those
activities for purposes of avoiding the at-risk limitations of section 465.
Accordingly, the at-risk rules will limit Taxpayers’ deductions claimed with regard to the
Transaction, subject to additional factual development regarding Taxpayers’ activities.
Issue 3: Alternatively, whether the Contract is a “conversion transaction” pursuant to
section 1258
Section 1258(a) provides that gain recognized on the disposition or other termination of
any position held as part of a conversion transaction is treated is ordinary income (to the
extent such gain does not exceed the applicable imputed income amount).35 Section
1258(c)(1) defines a “conversion transaction” as any transaction “substantially all of the
taxpayer’s expected return from which is attributable to the time value of the taxpayer’s
net investment in such transaction,” and section 1258(c)(2) further requires that
transactions must fall into one of four categories in order to be treated as conversion
transactions. Among those categories is any transaction “which is marketed or sold as
producing capital gains from a transaction described in [section 1258(c)(1)].” Section
1258(c)(2)(C). The legislative history explains the focus of section 1258 as follows: “In
a conversion transaction, the taxpayer is in the economic position of a lender – he has
an expectation of a return from the transaction which in substance is in the nature of
35
Section 1258(b) defines “applicable imputed income amount” as effectively taxing as ordinary income
an amount equal to the amount of interest that would have accrued on the taxpayer’s net investment.
25
interest and he undertakes no significant risks other than those typical of a lender.”
H.R. Rep. No. 103-111, at 637 (1993).
If the Contracts qualify as conversion transactions, then gains recognized from the
Contract are taxed as ordinary income to the extent such gains do not exceed the
amount that Taxpayers would have earned if their net investment in the Transaction
yielded 120 percent of the applicable federal rate. “Net investment” in the Transaction
includes the principal amount of the Loan. See Id. at 638 (including borrowed amounts
as an example of net investment in a conversion transaction).
As discussed, the guaranteed Protected Rate Payments from the Contracts matched
the principal and interest on the Loan. The Protected Rate Payments represented a
return of Taxpayers’ net investment in the Contract, payable at a fixed interest rate.
Therefore, we conclude that Taxpayers’ expected gain from the Contracts (to the extent
allocable to the Protected Rate Payment) is solely attributable to the time value of
money for purposes of section 1258(c)(1). In so doing, we note that the Contract is
consistent with transactions that Congress intended to target when it enacted section
1258; Taxpayers expected an interest-like return, and they undertook “no significant
risks other than those typical of a lender.” H.R. Rep. No. 103-111, supra, at 637.
With regard to whether the Transaction falls into one of the four categories enumerated
in 1258(c)(2), the legal opinions provided to Taxpayers contain the following factual
assumption:
You have represented . . . that no party described or marketed to you the
Forward Contract or the combination of the Forward Contract and the Secured
Loan as a means of obtaining capital gain treatment for gain that is attributable to
the time value of your net investment in the Forward Contract and Secured Loan.
This representation is contradicted by the marketing materials, which explain that there
is “[n]o market risk” and that “loan payments are matched to the minimum payments
guaranteed by the Forward Contract.” The materials further project “After-Tax Net Cash
Flow” due solely to exploiting the difference between deducting payments of interest on
the Loan at ordinary rates (assumed to be 35%), and including in income the matching
receipts under the Contracts as long-term capital gains (assumed to be taxed at a 15%
rate). We conclude that, for purposes of section 1258(c)(2)(C), the Transaction was
marketed or sold as producing capital gains out of a transaction described in section
1258(c)(1).
Accordingly, we conclude that section 1258 applies to the Taxpayers’ participation in the
Transaction, and any gain from the Transaction, up to the applicable imputed income
amount, will be taxed as ordinary income.
26
CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS
This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.
Please call (202) 317-6842 if you have any further questions.
By: _____________________________
Robert A. Martin
Senior Technician Reviewer, Branch 1
(Financial Institutions & Products)
cc: Deputy Division Counsel, Operations
(Large Business & International)
27
Get today's answer for your situation
You just read what the IRS ruled for one taxpayer in 2015, and it can't be cited as precedent. Ezel checks the current Internal Revenue Code and IRS guidance and answers your specific situation, with citations.
Opens in Ezel Pro. Every answer cites the authority it relies on.