Tax shelter lacked nontax business purpose.

• Author: O'Driscoll, David

In 1990, M approached AHP (as it had also approached other Fortune 500 companies) with a scheme to shelter large capital gains. The scheme essentially allowed a newly formed foreign partnership to claim a massive tax gain, which is allocated to the nontaxable foreign partner, and a massive tax loss, which the U.S. corporate partner (AHP) keeps for itself. After meeting with M's representatives, AHP's vice-president for taxes prepared a memorandum that outlined the proposal, including the relevant portions below:

1. Formation of partnership The partnership will be formed in a favorable tax jurisdiction (e.g., the Netherlands Antilles) under the New York general partnership law. The partnership members will be S, an AHP domestic subsidiary and XYZ, an unrelated foreign financial institution. S will contribute $110 million (representing a 10% ownership); XYZ will contribute $990 million. Under the partnership agreement, all of the partnership's income, gain, expense and loss will be allocated among the members in proportion to their capital accounts.

2. Purchase of corporate bonds. The partnership will invest $1.057 billion in corporate bonds.

3. Installment sale. The partnership will sell the bonds to a financial institution for $898.5 million in cash and $158.5 million at fair market value (FMV), five-year London Interbank Offering Rate (LIBOR) installment notes.

4. Increase of S's partnership interest. Following Step 3, S will purchase a 45.5% interest in the partnership from XYZ for $500 million, bringing its total interest to 55.5% and XYZ's interest down to 44.5%.

5. Contribution of assets to partnership. S will then contribute assets with a FMV of $200 million to the partnership, further increasing its partnership interest to 62%.

6. Partial redemption of partnership interest. The partnership will distribute a $159 million FMV installment note to S and $96 million to XYZ.

7. Sale of installment note. S will sell the note for $159 million, resulting in a $723.2 million capital loss.

AHP decided to accept the proposal. In late May 1990, the partnership sold over $1 billion of the bonds for $880 million in cash and indefinite debt instruments (LIBOR notes).This sale generated transaction costs of $13 million to AHP; the partnership received less than $7 million in interest on its $1.1 billion investment.

The partnership treated the transaction as an installment sale under Sec. 453(b), and claimed a short-term capital gain of over $721 million...