One prong, two prong, many prongs: a look into the economic substance doctrine.

AuthorYoder, Amanda L.

Klamath Strategic Investment Fund ex rel. St. Croix Ventures v. United States, 568 F.3d 537 (5th Cir. 2009).


    Almost every federal circuit, as well as Congress, has weighed in on the economic substance doctrine and attempted to clarify its boundaries. The economic substance doctrine deals with transactions that, although technically in accord with the Internal Revenue Code (the Code or I.R.C.), were originally structured solely for tax avoidance purposes. (1) The Internal Revenue Service and courts dislike these transactions because they thwart the general intent of Congress in enacting certain tax-saving Code provisions. (2) Until recent amendments to the I.R.C., the federal circuits were split between two different approaches to tax avoidance transactions, yet the application of the two approaches was slightly unique in each circuit. (3) There were many, albeit unsuccessful, attempts to codify the economic substance doctrine in the past ten years. (4) Although there were several proposed bills, (5) the language in each proffered version was largely the same--effectively the same language that appears in the newly codified economic substance doctrine. The pertinent portion reads:

    (o) clarification of economic substance DOCTRINE.--(1) APPLICATION OF DOCTRINE.--In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if--(A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction. (6) These proposed bills, and now the newly codified doctrine, specify certain factors to be considered (such as profit potential) (7) and the requirements needed to find economic substance. (8)

    Although there was a majority forming as to which test to use, the circuit split was creating unrest among the lower courts. At times, even knowing which test a specific circuit used was not particularly helpful in guiding a taxpayer. In addition, if a taxpayer planned incorrectly, he or she may have faced severe tax penalties. (9) Moreover, the different standards applied at the appellate level made it difficult for the tax and district courts to assess particular transactions because the test applied by the court changed depending on where the appeal was heard. (10) Thus, the economic substance issue created uncertainty for both taxpayers and courts and most recently surfaced in the U.S. Court of Appeals for the Fifth Circuit case Klamath Strategic Investment Fund ex rel. St. Croix Ventures v. United States. (11)


    Klamath Strategic Investment Fund involved two partners who "represented the State of Texas in litigation against the tobacco industry." (12) The outcome of this litigation provided the two partners, Cary Patterson and Harold Nix, with a substantial increase in income--approximately thirty million dollars each. (13) Because of this influx of income, Nix and Patterson looked into potential investment opportunities. (14) Nix had previously developed an interest in investing in foreign currency transactions that were both high risk and high reward investments. (15) Patterson also became interested in these foreign currency transactions and sought the counsel of a highly experienced businessman, Ed Cox, who frequently dealt with these types of complex investment strategies. (16) "Thereafter, Nix and Patterson jointly decided to pursue ... foreign currency" investments. (17) Their primary motivation in these transactions was to earn a profit. (18) The district court made note of Nix and Patterson's delay in getting into these foreign investment strategies. (19) The court felt that if their primary motivation had been tax avoidance only, then Nix and Patterson would have begun their investments in 1999, when they recognized the first of their substantial increases in income from the tobacco litigation, instead of in 2000, when they actually began these transactions. (20)

    After making the decision to invest, Nix and Patterson sought the help of an accounting firm. (21) This accounting firm held itself out as competent to provide the type of investment advice the partners required. (22) Nix and Patterson began to rely heavily on the accounting firm for their investment matters. (23) The accounting firm identified an investment advisory firm to help with Nix and Patterson's investments. (24) This advisory firm, Presidio Advisory Services (Presidio), specialized in the foreign currency transactions that Nix and Patterson wanted to pursue. (25) Presidio structured a transaction that would take place in three stages. (26) Each stage required the partners to invest a greater amount of capital than the previous stage, which subsequently increased the risk and return available to them. (27) The three stages were spread out over seven years. (28) The investors were allowed to exit at the end of stage one and every sixty days thereafter. (29)

    To carry out this investment strategy for Nix and Patterson, Presidio formed two limited liability companies (LLCs), Klamath and Kinabalu (the Partnerships). (30) This move was significant because limited liability companies are not automatically taxed as corporations, but instead are allowed to choose the type of federal taxation classification that they will assume. (31) Presidio chose to have Klamath and Kinabalu taxed as partnerships. (32) Presidio then formed two single-member LLCs, (33) St. Croix and Rogue, which were disregarded for federal income tax purposes and instead treated as sole proprietorships. (34) Nix and Patterson each owned one hundred percent of his respective single-member LLC. (35) In turn, each single-member LLC owned ninety percent of its respective Partnership, Klamath or Kinabalu, with the remaining ten percent owned by subsidiaries of Presidio. (36)

    In order to provide a portion of the funding needed for these investments, Nix and Patterson each contributed $1.5 million to his respective individual Partnership. (37) To provide the remaining capital needed for the initial investments, Nix and Patterson entered into credit agreements with National Westminster Bank (NatWest). (38) NatWest loaned Patterson and Nix each $66.7 million in capital. (39) This loan amount was comprised of $41.7 million as the stated principal amount and $25 million as a loan premium. (40) The loan premium was designated as an "exchange" for paying an above-market interest rate on the principal. (41) The $25 million loan premium was required to be repaid if Nix or Patterson paid off the loan early, but if they paid over the seven-year life of the loan, they would not have to repay the loan premium. (42) The $66.7 million that each partner withdrew from NatWest was contributed to their respective Partnerships, and the corresponding loan obligations were assigned to the Partnerships. (43) Each Partnership then made investments in short-term forward contracts on foreign currencies. (44)

    To execute these investments, the Partnerships deposited the capital provided into accounts controlled by NatWest. (45) NatWest then invested in the foreign currencies on behalf of the Partnerships. (46) The foreign currency investments earned interest that NatWest paid to the Partnerships, and, in turn, the Partnerships paid NatWest interest on the loans assumed from Nix and Patterson. (47) However, the interest paid to the Partnerships on the currency investments was less than the interest payments due on the loans from NatWest. (48) Thus, the Partnerships realized "negative carry" costs on these investments. (49) Although this may have been reason enough to exit the investments, Patterson had other investments at the time that made him reconsider his dealings with Presidio. (50)

    Prior to investing with Presidio, Patterson had invested in a local bank. (51) This banking investment was going to require Patterson to invest additional capital. (52) Due to the burden of the additional capital investments required by the Presidio investment and the local bank obligation, Patterson opted to withdraw from his foreign currency investments. (53) Nix followed suit. (54)

    From 2000 through 2002, Patterson, through Klamath's activities, claimed total losses of $25,277,202; Nix, through Kinabalu's activities, claimed losses of $25,272,344.55 The foreign currency transactions that Nix and Patterson had entered into also caused significant losses to the Partnerships; however, a partner can claim losses only up to the partner's basis, which is the capital that he or she has invested in the partnership. (56) If a partnership also assumes the liabilities of the partner, the amount of the liabilities assumed is subtracted from the partner's basis. (57) In this case, Nix and Patterson each contributed a total of $68.2 million to his respective Partnership; however, each Partnership also assumed the liabilities from NatWest. (58) In making the basis calculations, Nix and Patterson did not consider the $25 million loan premiums as liabilities, and thus only subtracted the $41.7 million principal amounts. (59) Accordingly, each claimed a basis in his respective Partnership interest of approximately $25.3 million. (60) This allowed Patterson to deduct all of his $25.2 million in losses from the foreign currency transactions. (61)

    The Internal Revenue Service (the Service) disagreed with Patterson's interpretation of section 752 of the Internal Revenue Code. (62) The Service argued that according to I.R.C. [section] 752, the loan premium received by Patterson should have been included in the liabilities assumed by the Partnership. (63) The Service contended that the entire $66.7 million that Patterson received from NatWest was a liability and should have been treated as such when calculating Patterson's basis in the Partnership...

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