On Appeal from the United States Tax Court (Tax Court No. 10472-93)
Before: Greenberg, Alito, and McKEE, Circuit Judges
The opinion of the court was delivered by: Greenberg, Circuit Judge.
Appellant ACM Partnership ("ACM"), through its tax matters partner Southampton-Hamilton Company ("Southampton"), appeals from a decision of the United States Tax Court dated June 12, 1997. The Tax Court's jurisdiction rested on I.R.C. §§ 7442, 6213 and 6226 based on appellant's timely filing of a petition seeking redetermination of a deficiency and review of a Final Partnership Administrative Adjustment. Appellate jurisdiction rests on I.R.C. § 7482(a)(1). Venue is proper pursuant to I.R.C. § 7482(b)(1)(A) as Southampton maintained its principal place of business within this circuit at the time it filed its petition. For the reasons that follow, we will affirm in part, reverse in part, dismiss the Commissioner of Internal Revenue's cross appeal, and remand for further proceedings.
II. FACTUAL AND PROCEDURAL HISTORY
This appeal concerns the tax consequences of a series of transactions executed between November 1989 and December 1991 by appellant ACM, a partnership formed on October 27, 1989, with its principal place of business in Curacao, Netherlands Antilles. Each of ACM's three partners was created as a subsidiary of a larger entity several days before ACM's formation. Southampton was incorporated under Delaware law on October 24, 1989, as a wholly-owned subsidiary of Colgate-Palmolive Company ("Colgate"), an international consumer products company. Kannex Corporation N.V. ("Kannex") was incorporated under Netherlands Antilles law on October 25, 1989, as an entity controlled by Algemene Bank Nederland N.V. ("ABN"), a major Dutch bank. ACM's third partner, Merrill Lynch MLCS, Inc. ("MLCS"), was incorporated under Delaware law on October 27, 1989, as a wholly owned subsidiary of Merrill Lynch Capital Services, an affiliate of the financial services holding company Merrill Lynch & Co., Inc. ("Merrill Lynch"). See ACM Partnership v. Commissioner, 73 T.C.M. (CCH) 2189, 2190, 2197 (1997); app. at 81-84, 89-91.
A. The Proposed Partnership
The concept behind the ACM partnership originated in a proposal which Merrill Lynch presented to Colgate in May 1989. During the previous year, Colgate had reported $104,743,250 in long-term capital gains which were attributable in significant part to the sale of its wholly owned subsidiary The Kendall Company ("Kendall"). See app. at 74-75. Colgate had considered and rejected several proposals to reduce the tax liability arising from those 1988 capital gains, see app. at 664, when Merrill Lynch representative Macauley Taylor approached Colgate's Assistant Treasurer Hans Pohlschroeder in May 1989 and proposed an investment partnership that would generate capital losses which Colgate could use to offset some of its 1988 capital gains. App. at 674-76, 784, 965.*fn1
Pohlschroeder related the plan to Colgate's Vice President of Taxation Steven Belasco, who expressed reservations because the plan entailed substantial costs, might not be recognized for tax purposes, and did not seem to serve Colgate's non-tax business purposes, and thus might not be well-received by Colgate's legal, financial, and accounting departments who would be required to participate in the plan. See 73 T.C.M. at 2191; app. at 1234-36. Colgate consulted a law firm for advice on the proposed transaction, which the law firm summarized as follows:
A (a foreign entity), B, and C form the ABC Partnership (ABC) on June 30, 1989 with respective cash contributions of $75, $24 and $1. Immediately thereafter, ABC invests $100 in short-term securities which it sells on December 30, 1989, to an unrelated party. The fair market value and face amount of the short-term securities at the time of the sale is still $100. In consideration for the sale, ABC receives $70 cash and an installment note that provides for six semiannual payments . . . Each payment equals the sum of a notional principal amount multiplied by the London Interbank Offering Rate (LIBOR) at the start of the semiannual period.*fn2 ABC uses the $70 cash and the first payment on the installment note to liquidate A's interest in ABC and uses the subsequent interest payments to purchase long-term securities.
The law firm advised that the sale of the short-term securities would be reported as a contingent installment sale under the installment method which governs "Dispositions[s] of property where at least 1 payment is to be received after the close of the taxable year in which the Disposition occurs," I.R.C. § 453, and the ratable basis recovery rule which provides that,
[w]hen a stated maximum selling price cannot be determined as of the close of the taxable year in which the sale or other Disposition occurs, but the maximum period over which payments may be received under the contingent sale price agreement is fixed, the taxpayer's basis (inclusive of selling expenses) shall be allocated to the taxable years in which payment may be received under the agreement in equal annual increments.
Temp. Treas. Reg. § 15a.453-1(c)(3)(i).*fn3 Thus, the law firm advised, ABC would recover $25 of its basis in each of the *fn4 taxable years from 1989 through 1992, and ABC would recognize gain to the extent that the payments received in any year exceeded the $25 or loss to the extent that the payments fell below the $25, but only if the loss were carried over to a year with sufficient reported gains against which to offset that loss. See 73 T.C.M. at 2191.
On July 18, Pohlschroeder and Taylor, who had presented Merrill Lynch's proposal to Pohlschroeder's colleagues in Colgate's treasury department, discussed Colgate's concerns about the proposed partnership transaction, including its costs and its potential to serve Colgate's business purposes. Pohlschroeder's handwritten notes of the conversation read as follows:
Based on bus. purpose Economic profit Is this partnership profitable? Every single step to be substantiated invest in your own debt Consolidation of effective control but not majority ownership.
Colgate was interested in the concept of using the proposed partnership to invest in its own debt because of recent developments which had weighted Colgate's debt portfolio toward fixed-rate long-term debt, leaving Colgate vulnerable to a decline in interest rates.4 Moreover, persistent rumors that Colgate was a likely target for a hostile takeover or leveraged buyout had decreased the value of Colgate's debt issues due to the risk that Colgate's credit rating would be downgraded if Colgate became more highly leveraged. Because of these factors, Colgate perceived an opportunity to rebalance its debt profile, thus decreasing its exposure to falling interest rates, by acquiring its long-term debt issues at their presently discounted prices. See app. at 666-68, 880-82, 2762-63, 2765, 2769-70; 73 T.C.M. at 2192.
Colgate and Merrill Lynch discussed the possibility of using the proposed partnership to achieve these objectives. The acquisition of its own debt issues would decrease Colgate's exposure to falling interest rates because by acquiring those debt issues as an asset, Colgate effectively would reap the benefits of receiving the above-market interest payments due on those issues, thus hedging against the burdens associated with owing those payments. See 73 T.C.M. at 2193. Acquiring the debt through the partnership instead of directly would keep the acquisitions off Colgate's books, thus permitting Colgate to carry out its debt acquisition strategy without alerting potential acquirors to the internal accumulation of debt issues which, by increasing the capacity for internal leverage, would increase Colgate's vulnerability to a hostile takeover bid. See 73 T.C.M. at 2192-93; app. at 101, 3249-50, 1921-26, 2793-99, 2810, 2819-20, 3255-61. Thus, the acquisition of Colgate debt through the partnership would allow Colgate to use partnership capital to acquire its debt issues immediately at advantageous prices, then to retire and reissue the debt when market conditions were more favorable. In the interim, the debt effectively would be retired because Colgate would not owe the obligations thereon to third parties, yet the debt would remain outstanding for accounting purposes, reducing Colgate's vulnerability to potential acquirors. See app. at 673; 73 T.C.M. at 2193.
On July 28, 1989, Merrill Lynch presented a proposed partnership transaction summary which incorporated Colgate's debt acquisition objectives into the tax reduction proposal involving the contingent installment sale which Merrill Lynch had presented to Colgate in May 1989. See app. at 678-79. Merrill Lynch revised its proposals throughout the summer and approached ABN about participating in the partnership with Colgate and Merrill Lynch. Merrill Lynch explained to ABN that the partnership would invest in Colgate long-term debt to serve Colgate's debt management objectives, would engage in a contingent installment sale, and would require ABN's participation for no more than 2-3 years. ABN agreed to meet with Colgate representatives in the middle of October 1989. See 73 T.C.M. at 2193-94.*fn5
In a document dated August 17, 1989, Merrill Lynch set forth revisions to the planned partnership transactions which it had presented to Colgate on July 28, 1989. See app. at 275-77. This document, entitled "Revised Partnership Transaction Summary," see app. at 263-67, set forth the following proposal incorporating both the contingent installment sales transaction which Merrill Lynch initially had proposed in May 1989 and the debt acquisitions which Merrill Lynch had incorporated in its July 28 proposal:*fn6
1) A Colgate subsidiary contributes $30 million, A BN contributes $169.3 million and Merrill Lynch contributes $.7 million.
2) The partnership invests its entire $200 million capitalization in short-term, floating rate private placement securities as "Interim Investments prior to the acquisition of [Colgate] debt" which are to "earn a return greater than comparably rated commercial paper or bank deposits."
3) The partnership sells the short-term notes for a combination of cash and LIBOR-based notes and uses the cash to acquire Colgate debt. "The purpose of the LIBOR notes will be to partly hedge the interest rate sensitivity of long-term [Colgate] debt acquired by the Partnership."
4) The partnership exchanges a portion of the long - term Colgate debt for newly issued medium-term Colgate debt, pursuant to a provision which affords Colgate the option of making such exchanges through the partnership.
5) The partnership adjusts its LIBOR note holdings. If the partnership retains a substantial amount of long-term debt, the Partnership "would likely . . . acquire additional LIBOR-based assets or . . . other hedges to reduce interest rate sensitivity of Partnership assets. Alternatively, if a substantial amount of long-term [Colgate] debt is exchanged, the Partnership would likely reduce its holding of LIBOR notes. Such a reduction would be necessary because the Medium-Term Debt, received in exchange for long-term [Colgate] debt, is less interest rate sensitive than the long-term [Colgate] debt. LIBOR Notes may either be sold directly or distributed to one or more Partners in a non-liquidating distribution."
6) If the partnership has not invested all of its capital in Colgate debt and LIBOR instruments, the partnership "may liquidate some or all of the remaining Short-Term Notes and distribute the proceeds to one or more of the partners."*fn7
7) "Possible redemption of [ABN's] Partne rship interest. Commencing one year after formation of the Partnership, [ABN] has the right to have its Partnership interest redeemed by the Partnership . . . . The Partnership may redeem [ABN] in kind with Partnership property of its choosing or in cash. For example, assuming no change in asset values, the Partnership could borrow $169.3 million collateralized by its assets and use the proceeds to redeem [ABN]."
8) "If [ABN] is redeemed, the Partnership must be consolidated with [Colgate] for financial reporting purposes. Accordingly, all assets, including [Colgate] debt . . . will appear on the [Colgate] consolidated balance sheet. The [Colgate] debt will be effectively retired at that time. . . . [I]f the [Colgate] debt were acquired at a premium or a discount, [Colgate] would recognize a loss or gain, respectively, for income statement purposes. It would be most reasonable for the Partnership to sell the LIBOR Note . . . if[ABN] is redeemed. Since the principal asset of the Partnership, other than LIBOR Notes . . . is likely to be [Colgate] debt and [Colgate] would be a 98% partner, the hedge protection provided by the LIBOR Notes . . . is no longer necessary." 9) "After a period of years it might be advanta geous for [Colgate] affiliates to purchase [Merrill Lynch's] Partnership interest. Alternatively, the Partnership might be liquidated with [Colgate] receiving[Colgate] debt as proceeds of the liquidation."
App. at 275-77. The final page of that document addressed the tax considerations of the arrangement and stated,
the liquidation of $200 million of Short-Term Notes in exchange for approximately $140 million of cash and $60 million market value of LIBOR notes should result in approximately $106 million of gain to the Partnership. 15% of such gain, $16 million, will be allocable to [Colgate]. If . . . LIBOR notes are distributed to [Colgate], each $10 million market value of the LIBOR notes distributed should have a tax basis of approximately $28 million. In a succeeding tax year, the Partnership will recognize a loss on sale or at maturity of the remaining LIBOR Notes. 98% of such loss will be allocable to [Colgate] because[Colgate] will be a 98% partner at such time. Combined, losses on sale of LIBOR Notes distributed to [Colgate] and losses on sale of LIBOR Notes by the Partnership should exceed $106 million. Accordingly, [Colgate] should recognize a net loss of approximately $90 million. After discounting and transactions costs . . . the transaction produces over $20 million present value benefits to [Colgate].
A representative of ABN's legal department testified that the partnership, as he understood it, was to:
enter into transactions that would create a capital gain and in a later stage a capital loss, and that . . . depending on the percentage of your participation, you would either take part in the gain or the loss. So by having us being the majority partner at the start, we would take the majority of the gain, while in a later stage one of the other partners would take the loss.
In a memorandum dated October 3, 1989, Pohlschroeder recommended the partnership to Colgate Treasurer Brian Heidtke. See App. at 310-21. Pohlschroeder outlined the advantages of repurchasing outstanding Colgate debt through a partnership, and stated that "[t]he partnership would temporarily invest the funds in some short-term instruments and, at the same time, start the repurchasing program." App. at 312. The memorandum identified three sets of Colgate debt issues targeted for repurchase: 1) a set of 9.625% 30-year notes due in 2017 ("Long Bonds"); 2) a set of Eurodollar debentures due in 1996 ("Euro notes"); and 3) a set of 8.4% private placement notes held by Metropolitan Life Insurance Company ("Metropolitan") and due in 1998 ("Met Notes"). The memorandum stated that "pursuant to an inquiry to Metropolitan, we feel confident that the partnership can purchase sufficient Colgate debt" to carry out the proposed plan. App. at 313-14.*fn8
The memorandum's "Interest Rate Outlook" predicted that although the Federal Reserve Bank was not expected to "quickly lower interest rates in the near future," it was expected to "reduce the . . . rate" by late 1989 or early 1990 to a level that would allow Colgate to "lock in attractive medium term interest rates." App. at 311. The memorandum then analyzed the impact of a one to two percent interest rate increase or decrease on the LIBOR notes and the Colgate debt issues that the partnership expected to acquire. According to the analysis, a given decrease in interest rates would increase the value of the long-term Colgate debt and decrease the value of the LIBOR notes in roughly equal and offsetting amounts because the value of the LIBOR notes was directly dependent on interest rates whereas the value of the fixed-rate debt issues was inversely proportional to interest rates. See app. at 951-52, 313. Thus, the memorandum concluded, "the LIBOR note is an effective hedge of fixed rate assets for the partnership." App. at 313. The memorandum stated that it would be necessary to establish a "Desired Hedge Ratio" of LIBOR holdings to long-term debt holdings, so that the partnership's assets would be "fully hedged" against changes in value due to interest rate fluctuations. App. at 314.
The memorandum recommended that Colgate proceed with the partnership as a means "to actively manage its liability structure," and stated that the "Next Steps" after executing a partnership agreement, establishing the partnership in a "Foreign Jurisdiction" and funding the partnership were the following:
-Short-term investment securities acquired.
- . . . . Disposition of short-term investment securities to fund acquisition of Colgate debt.
In a document marked "REVISED 9/1/89," Merrill Lynch provided Colgate a "Cost Component Analysis," which estimated after-tax costs associated with the proposed acquisition and Disposition of short-term notes and acquisition of LIBOR notes. Merrill Lynch estimated that the short-term notes would entail an "origination" cost of $1.32 million, while the "remarketing" of the LIBOR notes would cost $1.29 million in addition to $.17 million in legal expenses and $1.32 million in Merrill Lynch advisory fees. See app. at 294.
A September 20, 1989 document delineated the details of the proposed partnership transactions and their anticipated tax consequences under I.R.C. § 453 and the ratable basis recovery rule, Temp. Treas. Reg. § 15a.453. See app. at 296-308. The document contemplated using the partnership's $200 million in cash investments to acquire short-term notes, see app. at 303, disposing of the short-term notes in exchange for $140 million in cash and LIBOR instruments which would generate contingent payments with a present value of $60 million, and using the $140 million in cash to purchase Colgate debt. App. at 300-01, 304-05. Because the partnership was to receive payments on the exchange over the course of six years, the $200 million basis in the short-term notes was to be recovered ratably over six tax years in equal increments of $33.3 million per year pursuant to § 15a.453. Thus, according to this document, the transaction would result in significant capital gains in the first year, consisting of the $106.7 million difference between the $140 million cash received that year and the $33.3 million basis recovered that year, and would result in capital losses in each of the ensuing years because the contingent payments received in each of those years considering imputed interest would fall short of the $33.3 million basis to be recovered in each of those years. See app. at 301. The aggregate projected capital losses in the ensuing years equaled precisely the amount of capital gains reported in the first year, and the document stated that the recognition of those losses "may be accelerated in any year subsequent to 1989 by sale of the remaining LIBOR notes." App. at 301.
The document also contemplates Colgate's increasing its share in the partnership from 15% to 97% after the partnership recognized the $106.7 million capital gain in year 1 but before it recognized the capital losses in the ensuing years. See app. at 305-08. According to the document, the LIBOR notes eventually would be sold for a capital loss of $80 million, 97% of which would be allocated to Colgate based on its 97% partnership interest by the time the loss was incurred. See app. at 304, 308-09.
At an October 12, 1989 meeting of Colgate's Board of Directors, the Directors considered the ...