United States: Court Of Federal Claims Disallows Losses From DAD Transaction

On August 12, 2015, the Court of Federal Claims issued a decision, in Russian Recovery Fund Ltd. v. U.S.,33  which sustained an IRS adjustment that disallowed approximately  $50 million in losses on a partnership's tax return from a distressed asset debt  transaction ("DAD"). The Claims Court also sustained a 40 percent gross valuation  misstatement penalty pursuant to Section 6662. The issue at trial was whether Russian  Recovery Fund Ltd. ("RRF") was entitled to claim built-in losses on disposition of  securities derived from Russian sovereign debt.

Background

RRF was created in 1998 as a Cayman Islands limited liability corporation to invest in  distressed Russian assets. At the time the Russian Federation defaulted on all of its  sovereign debt obligations which caused the ruble to collapse, and significantly depressed  the value of Russian debt (most had lost over 90 percent of their value). One of RRF's  investors was Jaguar and Ocelot, two hedge funds managed by Tiger Management. In  May 1999, the Tiger funds contributed to RRF credit-linked notes ("CLN"), which were  derivatives of Russian sovereign debt. At the time of the transfer to RRF, the CLNs had a  market value of approximately $15 million, but had a basis of over $230 million. At the  time, the RRF Subscription Agreement required each investor to wait three years to  redeem the investment. However, RRF and Tiger executed a "side letter" which permitted  Tiger to redeem its shares on or after July 1, 1999. Almost immediately after makings its  investment in RRF, Tiger made efforts to dispose of its new partnership shares to FFIP,  an investor in RRF and a fund created by Bracebridge Capital.34 Tiger sold all of its RRF  partnership shares to FFIP on June 3, 1999. The effect of the sale was that, pursuant to  Section 721, FFIP could move into Tiger's shoes with respect to its contribution of  Russian securities to RRF. FFIP now had whatever basis in the CLNs contributed by Tiger  to RRF. On June 22, 1999, RRF sold the majority of the CLN's to General Cigar for  approximately $21 million, (the CLN's had built in tax loss of approximately  $178 million). General Cigar paid $17.9 million in cash and the balance paid in preferred stock in General Cigar, value at $3.2 million. RRF sold its remaining 22.8 percent of the  CLN's in the open market in 2000 generating a profit of over $7.4 million. However, RRF  claimed a loss on its 2000 partnership tax return on the sale of the CLN securities in the  amount of $49 million (reflecting the loss associated with the 22.8 percent sale). Later, in  2004, RRF claimed the balance of the loss ($170 million) on its redemption of its  preferred stock in General Cigar.

In 2005, following an audit, the Service issued an FPAA for tax year ending December 31,  2000 disallowing the $49 million losses claimed by RRF. The Service also issued an  FPAA disallowing RRF's partnership tax return for 2004, which claimed a loss of  $170 million. The Service challenged the losses under the sham transaction, economic  substance and step transaction doctrines. The Service argued that Tiger had no business  purpose in acquiring shares through a contribution in-kind to RRF, that Tiger was never  a real partner in RRF and that the swap of assets for partnership shares should be ignored  so that what emerges is a sale of the CLNs by Tiger to FFIP. RRF argued that the  transactions properly followed the Code. Thus, the Tiger funds, Jaguar and Ocelot,  sustained large unrealized losses on their Russian assets and transferred those assets,  along with their negative basis, in exchange for partnership interests in RRF. The losses  did not need to be recognized on that exchange and become associated with the assets  then acquired by RRF. FFIP, an RRF investor, then stood in Tiger's shoes when those  losses were later dispersed when the assets were sold, in part to General Cigar.

Economic Substance Analysis

The Claims Court framed the issue as follows: "[d]id Tiger's losses travel intact through  the series of transactions at issue and legitimately flow to RRF's partners by way of the  K-1 forms, or, as defendant [IRS] asserted, did the built-in loss vanish immediately at  Tiger's transfer to RRF because this was a disguised sale."35  The Claims Court found that  Tiger and RRF were not partners and that their transaction was a sham, that the  transaction lacked economic substance, that Tiger's contribution can be ignored and that  the transaction should be characterized as a sale.36

The Claims Court found that RRF was created for a legitimate business purpose—to make  money following the collapse of the Russian bond market—and that its initial marketing  efforts were genuine to fund investors. However, the Court could not reach the same  conclusion for the Tiger transaction. The Court concluded, based on the testimony of  various employees of Tiger, that Tiger had no interest in becoming a partner in RRF and  that RRF was aware early on that Tiger had no real interest in becoming a partner and  considered the transfer of its CLNs as a cash "sale." The Court also cited to various  written communications which demonstrated RRF's desire to move the highly  depreciated assets to RRF in a way that preserved their tax characteristics, and the taxpayer's admission that preserving tax losses was a RRF goal prior to Tiger's entry into  the partnership.

On the issue whether RRF should be subject to the gross valuation misstatement penalty,  RRF argued that it had reasonable cause by relying on tax advice provided by E&Y. But  the Court rejected RRF's claim, because E&Y provided no tax advice other than preparing  RRF's tax returns. The Court found that there were "no back-up memos or records of  conversations concerning the propriety of claiming the built-in losses."37 The Court  rejected RRF's assertion that E&Y, by signing off on the tax returns, provided advice on  whether it was appropriate to take the loss deduction. Accordingly, the Claims Court held  that RRF was liable for the penalty because RRF did not reasonably rely on any objection  advice from a tax professional based on all the pertinent laws, facts and circumstances.

Footnotes

33 Russian Recovery Fund Ltd. v. U.S., No. 06-30T (Ct. Cl., August 12, 2015).

34  Bracebridge Capital also created RRF.

35  Slip Opn. at 30.

36  Slip Opn. at 31.

37  Slip Opn. at 41.

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