United States: California State Board Oaffirms Use Of Non-Economic Substance Penalty On Tax Shelter Ttransaction

The California State Board of Equalization (SBE) has upheld an action of the Franchise Tax Board (FTB) decision which disallowed a flow-through loss generated by a tax shelter transaction, disregarded a Nevada corporation as a separate entity, and imposed a 40 percent noneconomic substance transaction (NEST) penalty for California personal income tax purposes.1


The taxpayer, a Nevada resident, engaged in a complex series of transactions in 2001 involving the purchase and sale of foreign currency options that essentially offset one another, but resulted in the taxpayer recognizing a loss for federal income tax purposes without realizing much, if any, economic loss or detriment.2 Similar transactions have been a subject of considerable controversy with the Internal Revenue Service (IRS) and some of them have been referred to as "Son of BOSS" tax shelter transactions.

The taxpayer was the sole shareholder of Mantra, an S corporation for federal and state income tax purposes, which was incorporated in 1998 and engaged in the business of film production and distribution. Mantra conducted business only in California. The taxpayer was also the sole shareholder of Sands, which was incorporated in Nevada in 2001 and was also an S corporation for federal and state income tax purposes. Sands purportedly acquired advertising and media time in 2001 on behalf of Mantra pursuant to a "Media Placement Agreement" which provided that Mantra pay a commission of 10 percent of the "gross media invoices" as well as an unspecified amount as a "consulting commission." According to the evidence presented, Sands charged Mantra a 750 percent mark-up on the cost of media purchased. Mantra did not make any payments for media purchases other than through Sands, and Sands did not receive payments from any other entity. The IRS challenged the transactions for federal income tax purposes, and the taxpayer ultimately entered into a stipulated settlement agreement with the IRS.3 As for the California income tax treatment of the transactions, Mantra filed a California return reporting a significant amount of "media" expenses and reporting net taxable income of approximately $1.8 million in net income subject to tax at the S corporation level. Sands did not file a California tax return for 2001, but reported net taxable income of $22 million for federal income tax purposes.

The taxpayer was audited by the FTB for tax year 2001 and assessed tax of more than $2 million as well as penalties of $1.6 million. The taxpayer protested the assessment. At issue in the appeal were: (i) whether the taxpayer demonstrated that the FTB erred by disallowing a $23 million flow-through loss generated by the transactions and by allocating a gain generated by the entity used to facilitate the transactions; (ii) whether the taxpayer showed that the FTB erred in disregarding Sands as a separate entity and allocating its income to Mantra, which flows through to the taxpayer as California-source income; and (iii) whether the taxpayer demonstrated that the NEST penalty was improperly imposed. The taxpayer presented a copy of a tax opinion letter issued by an accounting firm discussing the tax consequences of offsetting foreign currency option transactions followed by contributions to a partnership. In the letter, the taxpayer certified that he entered into the transactions for "substantial non-tax business reasons, including the intent to produce an overall economic profit from price movement of the property referenced by the [o]ptions."

Applicable Burden of Proof and Economic Substance Doctrine

In applying the law, the SBE first noted the presumption of correctness regarding the FTB's determinations as to issues of fact. To overcome this presumption, the taxpayer bore the burden to support his assertions with evidence, without which the FTB's determinations would be upheld.4

The SBE also described the economic substance doctrine, which has been articulated by federal courts as a means of disregarding transactions that comply with the language of the Internal Revenue Code (IRC) but lack true economic substance, noting that the burden of proving that a transaction has economic substance falls on the taxpayer.5 Federal courts have focused on two factors when considering whether a transaction lacks economic substance: (i) whether the taxpayer has demonstrated a business purpose for engaging in the transaction other than tax avoidance; and (ii) whether the taxpayer has shown that the transaction had economic substance beyond the creation of tax benefits.6 Finally, the SBE noted that the question of economic substance "is not one of whether the taxpayer believed the transaction was a real transaction capable of creating a profit or affecting the taxpayer's financial situation, but whether the transaction in fact objectively was a real transaction capable of either of those two possibilities."7

Application of Economic Substance Doctrine to Taxpayer

Though the taxpayer asserted that he entered into the transactions with the intent of producing an overall economic profit, the SBE noted that the maximum profit potential from the transaction was limited to the amount of the "spread" between the offsetting economic positions, which was less than the transaction expenses incurred by the taxpayer. No evidence was presented by the taxpayer to imply that this calculation, which demonstrated that the taxpayer would certainly incur a loss, was incorrect. Based on this understanding, the SBE held that the taxpayer did not meet his burden of proof of demonstrating any subjective factors indicating that the transactions would yield financial profit or other economic benefit other than the benefit of the anticipated generated tax losses. Viewed from an objective standpoint, the transactions at issue would not produce a reasonable economic profit, so the SBE concluded that the taxpayer did not satisfy the economic substance test with regards to the transaction. Thus, the SBE held that the FTB properly disregarded the transaction for California personal income tax purposes.

The SBE also concluded that the taxpayer failed to meet his burden of proof to demonstrate that Sands had economic substance. Specifically, the SBE noted the lack of evidence demonstrating the taxpayer's purported reasons for establishing Sands, which included: (i) separating Mantra's "profit center of media buying" from Mantra's potential liability to various creditors; (ii) owning a media-buying business to eliminate the mark-up of third-party buyers and to obtain media directly from various outlets; and (iii) facilitating the accounting of cost versus profits to calculate third-party profit splits because Sands purchased media for other entities.

Evidence presented by the FTB showed that the media buying arrangement between Sands and Mantra was not in any objective sense an arrangement that was potentially profitable or affected the taxpayer's financial situation in any way other than as a means of shifting income from California to Nevada's taxing jurisdiction. The taxpayer offered no explanation for the reason behind instituting a 750 percent mark-up charged by Sands to Mantra for media purchases. Evidence also indicated that Mantra's employees performed the media buying activities that Sands allegedly performed. Notably, Mantra's Vice President of Media represented to the FTB that she, along with two other employees (all located in California), performed all of the media buying for Mantra. Therefore, the SBE found that the taxpayer failed to show that there existed a business purpose for the formation of Sands. Additionally, the SBE found that transactions between Sands and Mantra lacked economic substance.

Imposition of NEST Penalty

California law provides for a NEST understatement penalty equal to 40 percent of the amount of that understatement.8 However, if a taxpayer meets certain requirements, the penalty is reduced to 20 percent of the amount of the understatement.9 Specifically, in order to qualify for the reduced penalty amount, the taxpayer must adequately disclose the relevant facts affecting the tax treatment of the item in the return or a statement attached to the return. The term "noneconomic substance transaction" is statutorily defined and includes both amounts that would be considered understatements under IRC Section 6662A(b)10 as well as "the disallowance of any loss, deduction or credit, or addition to income attributable to a determination that the disallowance or addition is attributable to a transaction or arrangement that lacks economic substance including a transaction or arrangement in which an entity is disregarded as lacking economic substance. A transaction shall be treated as lacking economic substance if the taxpayer does not have valid nontax California business purpose for entering into the transaction."11

In this instance, the SBE found that the options transaction lacked economic substance, so the related claimed loss attributable to the transaction was disallowed for the taxpayer. Further, Sands was disregarded as an entity due to a lack of economic substance. As a result, the SBE concluded that the NEST penalty was properly applied on the amount of each NEST understatement. As no evidence was presented by the taxpayer to support the application of the reduced 20 percent penalty amount, the taxpayer was subject to a NEST penalty of 40 percent of the amount of the understatement.


This matter highlights a fact pattern which in the view of the SBE clearly met the requirements for imposition of the 40 percent California NEST penalty. If the facts were somewhat less egregious than those in this matter (i.e., if the transaction did not constitute a federal income tax listed transaction), the Board might not have chosen to impose the heightened penalty. Although the NEST penalty was applied with respect to personal income taxes in this matter, the same provisions could be used to apply the penalty equally for corporate income tax purposes.

It would be interesting to see how this fact pattern would be treated by other jurisdictions. Though the NEST penalty provision is unique to California, other jurisdictions could use existing laws to disregard Sands as an entity, eliminate the intercompany transactions between Sands and Mantra, or force the taxpayers to file a combined report given a similar fact pattern.

The decision also demonstrates what can happen when a planned tax strategy is not implemented in the manner originally specified. The comments of a high-level employee to a state tax official relating to the activities actually performed by an entity (in contrast to the activities intended to be performed by such entity) provided, in this instance, strong evidence to support disregarding the entire existence of that entity. Particularly where a special purpose entity is being created, federal and state tax authorities are requiring taxpayers to show that the employees in such entity are performing activities for that entity, not a related entity. Contemporaneous documentation of existing agreements between related entities and evidence of payment with respect to the related charges is also expected.

In conclusion, this decision is notable in that it sets forth the first available clear guidance from the SBE regarding application of the economic substance transaction doctrine and the NEST penalty provisions.12 While the fact pattern at issue may not be common, the guidance provided could assist others in avoiding the imposition of the entire 40 percent NEST penalty.


1. Francis, California State Board of Equalization, No. 523692, May 22, 2013, released Dec. 2013.

2. The foreign currency options, once purchased, were then contributed to a partnership, which was partially owned by the taxpayer. The purchased options were treated as an asset that increased the contributing partner's basis, but upon their sale were not treated as a liability reducing the same partner's basis in the partnership. Further steps were taken to dispose of the options in a manner which resulted in the partner recognizing a loss for federal income tax purposes without realizing much, if any, economic loss or detriment.

3. For federal income tax purposes, the taxpayer entered into a "Stipulation of Settlement" with the U.S. Tax Court in the matter of JRF Investments 2001 LLC, et al. v. Commissioner, Docket No. 5699- 07, in which the parties stipulated that the issues raised are "substantially the same, if not identical" to the issues raised in Fidelity International Currency Advisor A Fund LLC v. United States (Fidelity), 661 F. 3d 667 (1st Cir. Mass. 2011). Fidelity affirmed the district court's holding that the option transactions were designed to cancel each other out and were merely reported to generate paper losses to reduce the partner's tax liability. For purposes of resolving all of the issues in the taxpayer's case, the parties agreed to be bound by the final judgment of the federal courts in Fidelity.

4. Citing Appeal of Oscar D. and Agatha E. Seltzer, 80-SBE-154, June 29, 1980.

5. Coltec Industries, Inc. v. United States, 454 F. 3d 1340 (Fed. Cir. 2006).

6. Citing Casebeer v. Commissioner, 909 F. 2d. 1360 (9th Cir. 1990), Coltec Industries, Inc. v. United States, 454 F. 3d 1340 (Fed. Cir. 2006), and Gregory v. Helvering, 293 U.S. 465 (1935).

7. Jade Trading, LLC v. United States, 80 Fed. Cl. 11 (2007); Coltec Industries, Inc. v. United States, 454 F. 3d. at 1359.

8. CAL. REV. & TAX. CODE § 19774(a).

9 . CAL. REV. & TAX. CODE § 19774(b)(1).

10. CAL. REV. & TAX. CODE § 19774(c)(1).

11. CAL. REV. & TAX. CODE § 19774(c)(2).

12. In Chief Counsel Ruling 2008-1, California Franchise Tax Board, Aug. 11, 2008 (released June 2009), the FTB determined that a prior version of the NEST penalty did not apply to a non-taxable distribution under IRC Section 355 because the IRS determined that the transaction was nontaxable.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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