Opinion
Civil Action No. SA-01-CA-0881-XR.
March 31, 2006
FINDINGS OF FACT AND CONCLUSIONS OF LAW
This case emanates from a complex mainframe computer leasing transaction through which Petitioners, International Bancshares Corporation, IBC Subsidiary Corporation, International Bank of Commerce ("IBC"), and IBC Financial Services, Inc., formerly known as Bancor Development Company of Laredo (collectively, the "IBC Defendants"), claimed over $11,000,000 in tax deductions on their consolidated tax returns. The tax losses were generated by Bancor's August 31, 1991 acquisition of a ninety-nine percent (99%) limited partnership interest in TransCapital Leasing Associates 1990-II, L.P. ("TCLA 1990-II"). The Internal Revenue Service ("IRS") challenged TCLA 1990-II's tax returns for the taxable years ending August 31, 1991, December 31, 1991, December 31, 1992, December 31, 1993, and May 31, 1994, resulting in a multi-million dollar tax deficiency for the IBC Defendants. The IBC Defendants' petition seeking to set aside the IRS's adjustments was tried to the Court from August 29, 2005 through September 8, 2005.
At the close of the evidence, the Court allowed the parties unlimited pages for opening post-trial briefs and proposed findings of fact and conclusions of law, but ordered the parties to limit their post-trial response briefs to twenty (20) pages. The Government filed a thirty (30) page response brief, to which Petitioners timely objected and moved to strike the response in its entirety, or alternatively, strike all pages in excess of the allotted twenty. Because the Government violated the Court's order without seeking leave to file a brief in excess of twenty pages, the Court has only considered the first twenty pages of the Government's response brief. The excess ten (10) pages of the Government's response are ORDERED stricken. Petitioners' motion to strike (docket no. 150) is GRANTED as stated herein.
On April 30, 2001, the IRS issued a Notice of Final Partnership Administrative Adjustment (the "FPAA") to TCLA 1990-II. The FPAA reversed TCLA 1990-II's recognition of portfolio interest income and disallowed deductions for rental expenses associated with its investment in an International Business Machines Corporation 3090-400E mainframe computer and a Cray Research, Inc. YMP4/216 supercomputer. The net effect of the FPAA was to disallow approximately $11,000,000 in tax losses reported by TCLA 1990-II's partners.
With the exception of August 1, 1991 through August 31, 1991 and consequently the short-year August 31, 1991 tax return, TCLA 1990-II's partners were Bancor (99% limited partner) and TransCapital Management Associates Limited Partnership IV ("TCMA IV") (1% general partner). TransCapital Leasing Associates 1990-I, L.P. ("TCLA 1990-I") was TCLA 1990-II's 99% limited partner between August 1 and August 31, 1991. Because TCLA 1990-II was a partnership, or "flow through entity", Bancor, TCLA 1990-I, and TCMA IV were allocated the partnership's income and losses during their respective ownership periods. Bancor's partnership allocation was reported on the consolidated tax returns of the IBC Defendants.
TCMA IV, the tax matters partner for TCLA 1990-II, failed to file a petition for readjustment within ninety (90) days of April 30, 2001, the date the IRS issued the FPAA. See 26 U.S.C. § 6226(a). Pursuant to 26 U.S.C. § 6226(b), Bancor, a notice partner of TCLA 1990-II, together with the other IBC Defendants, timely filed a petition seeking a redetermination of the FPAA on September 25, 2001. In compliance with 26 U.S.C. § 6226(e), the IBC Defendants deposited $4,082,835 with the IRS — an amount equal to the IBC Defendants' tax deficiencies under the FPAA.
TCMA IV's failure to file a petition for readjustment is attributable to its dissolution on April 10, 1995.
The FPAA resulted in the IBC Defendants' tax returns being deficient in the following amounts:
$214,933 for the tax year ending 1991; $662,352 for the tax year ending 1992; $763,338 for the tax year ending 1993; and $2,442,212 for the tax year ending 1994.
After careful consideration, the Court finds that judgment should be entered in favor of the United States of America and issues its findings of fact and conclusions of law pursuant to Federal Rule of Civil Procedure 52(a).
At the close of Petitioners' case on September 6, 2005, Petitioners filed a motion for directed verdict. See docket no. 121. Petitioners filed a renewed motion for directed verdict on September 8, 2005 following the close of both parties' evidence. See docket no. 123. The Court took both motions under advisement. The Court construes Petitioners' motions as Federal Rule of Civil Procedure 52(c) motions for judgment on partial findings. See FED. R. CIV. P. 52(c). Based on the Court's findings of fact and conclusions of law, Petitioners' motions are DENIED (docket nos. 121 123).
Background
International Bank of Commerce ("IBC") is a Texas banking association with its principal place of business in Laredo, Texas. In the late-1980s, despite the depressed South Texas economy and increased regulatory scrutiny that had beset most Texas banks, IBC was experiencing a period of rapid deposit growth. IBC's growth, coupled with a lack of suitable business investments in its geographic location, required it to pursue alternative financial transactions to create earning assets. One of the transactions IBC pursued was equipment leasing. IBC's President and Chief Executive Officer, Dennis Nixon ("Nixon"), found equipment leasing allowed IBC to enter into financing transactions with credit-worthy Fortune 500 companies that would have otherwise not worked with IBC on a one-to-one basis. Nixon viewed leasing investments as a credit-related transaction that could increase revenue and provide IBC with tax savings and cash-on-cash returns from the residual values of the leasehold assets. Tr. 51.While evaluating alternative financial transactions in 1988, IBC was introduced to TransCapital Corporation ("TransCapital"). Tr. 224. TransCapital was a Delaware corporation that specialized in the assembly and marketing of mainframe computer and aircraft leasing portfolios. TransCapital actively marketed their leasing portfolios to the banking industry as financing transactions that "provided higher returns as well as [being] very tax efficient." Tr. — .
TransCapital proposed IBC invest in a leasing portfolio of Amdahl and International Business Machines Corporation ("IBM") mainframe computer equipment on lease to ATT affiliates (the "1988 Mainframe Investment"). The transaction offered IBC deferred tax savings together with a residual interest in the equipment when the underlying leases expired.
Prior to 1988, IBC had not invested in an equipment leasing portfolio. Because IBC lacked familiarity with leasing investments, Nixon formed an external leasing team to review the 1988 Mainframe Investment and any other proposed leasing investments (the "IBC leasing team"). Tr. 224. The IBC leasing team was charged with conducting a due diligence review of the 1988 Mainframe Investment. Tr. 68-71, 241. This review focused on the residual value of the Amdahl and IBM equipment. IBC's ability to profit from the investment required the Amdahl and IBM equipment to maintain sufficient residual values after the expiration of the end-user leases. TransCapital derived the investment's forecasted economic and tax benefits from an equipment appraisal by Marshall Stevens, Inc., a national valuation firm, dated March 28, 1988.
The Marshall Stevens appraisal estimated that as of March 31, 1988 the Amdahl equipment had a ten-year economic life with list price and fair market value of $3,847,000. The appraisal estimated the Amdahl equipment's residual values as of December 31, 1991, December 31, 1992, December 31, 1993, December 31, 1994, and December 31, 1995 of $1,231,040 (32% of list price/fair market value), $884,810, (23%), $653,990 (17%), $461,640 (12%), and $384,700 (10%). P-261.19. The Marshall Stevens appraisal estimated that as of March 31, 1988 the IBM equipment had a ten-year economic life with list price and fair market value of $4,903,900. The appraisal estimated the IBM equipment's residual values as of December 31, 1991, December 31, 1992, December 31, 1993, December 31, 1994, and December 31, 1995 of $1,569,248 (32% of list price/fair market value), $1,127,897 (23%), $833,663 (17%), $588,468 (12%), and $490,390 (10%). P-261.19.
IBC chose not to rely solely on the Marshall Stevens appraisal. IBC obtained a separate appraisal of the Amdahl and IBM equipment, dated September 28, 1988, from Arthur D. Little Valuation, Inc., a national valuation firm. P-201.20. The Arthur D. Little appraisal estimated that as of September 28, 1988 the Amdahl equipment had a seven- to eight year economic life with a $3,472,040 list price and $2,925,000 fair market value. The appraisal estimated the Amdahl equipment's residual values as of December 31, 1991, December 31, 1992, December 31, 1993, December 31, 1994, and December 31, 1995 of $877,500 (30% of fair market value), $614,250 (21%), $380,250 (13%), $204,750 (7%), and $58,500 (2%). P-261.20. The Arthur D. Little appraisal estimated that as of September 28, 1988 the IBM equipment had a seven-to-eight year economic life with a $4,869,120 list price and $3,800,000 fair market value. The appraisal estimated the IBM equipment's residual values as of December 31, 1991, December 31, 1992, December 31, 1993, December 31, 1994, and December 31, 1995 of $1,064,000 (28% of fair market value), $760,000 (20%), $494,000 (13%), $228,000 (6%), and $38,000 (1%). P-261.20.
On September 30, 1988, Marshall Stevens re-issued its appraisal report downwardly adjusting the Amdahl equipment's list price and fair market value to $3,467,100 and the IBM's equipment's list price and fair market value to $4,884,000. P-261.19. Even with the downward departures in list price and fair market value, the Arthur D. Little appraisal of the Amdahl and IBM equipment's residual value was significantly less than Marshall Stevens.
Grossman Flask, P.C., a Washington, D.C. law firm, issued a favorable "more likely than not" tax opinion supporting TransCapital's projections. P-261.21. KPMG Peat Marwick's national tax office issued a corroborating tax opinion supporting the conclusions drawn by Grossman Flask. P-261.22.
On September 30, 1988, IBC closed the 1988 Mainframe Investment by purchasing the Amdahl and IBM mainframe computer equipment leasing portfolio from a separate TransCapital entity, TransCapital Funding Corporation. As owner/lessor of the mainframe computer equipment, IBC owned the equipment's residual interest (less a 10% remarketing fee TransCapital secured in the investment) upon the expiration of the ATT end-user lease. IBC would also receive deferred tax savings attributable to the equipment's accelerated depreciation deductions exceeding income in the early years of the investment. These tax savings would be reversed in the later years of the investment when the income generated by the equipment exceeded the decreased depreciation deductions.
Despite the Arthur D. Little appraisal valuing the Amdahl and IBM Equipment with an September 30, 1988 combined fair market value of $6,725,000, IBC agreed to purchase the equipment from TransCapital Funding for $8,710,900 (or $359,800 in excess of Marshall Stevens revised appraisal). P-261.8, P-216.19, P-261.20.
TransCapital Funding had previously acquired the mainframe equipment from the Neptune Computer Group, Inc. and Somerset Investment Services through a sale-leaseback transaction ("Neptune-Somerset Lease") that wrapped-around the underlying ATT end-user lease ("ATT Lease"). Neptune purchased the mainframe equipment from ATT Credit Corporation in August, 1987, subject to the ATT Lease. Neptune financed the purchase through a cash payment and two separate promissory notes issued to Bowery Savings Bank ("Bowery Savings"). The rent due under the ATT Lease was equal in timing and amount to Neptune's debt obligations to Bowery Savings. The ATT Lease required the lessees to submit their rental payments directly to Bowery Savings. Tr. 63-64. On September 30, 1987, Neptune sold a portion of the mainframe equipment under lease to Somerset. That very same day, TransCapital Funding purchased the mainframe equipment from Neptune and Somerset subject to the ATT Lease. TransCapital Funding immediately leased the mainframe computer equipment back to Neptune and Somerset. IBC's rights in the equipment were subject to the ATT Lease and Neptune-Somerset Lease. In conjunction with the purchase agreement, TransCapital Funding proposed being IBC's remarketing agent, i.e. the entity responsible for selling or re-leasing the equipment when the end-user lease expired. Under the remarketing agreement, TransCapital Funding would receive 10% of the proceeds generated from the sale or re-lease of the equipment.
Following the 1988 Mainframe Investment, TransCapital frequently circulated investment offering documents to IBC. Tr. 245. IBC was unsatisfied with the proposals and limited its leasing activities to the 1988 Mainframe Investment. Tr. 245. In April 1991, however, TransCapital proposed an investment that coupled the high residual value potential of a leveraged leased aircraft with permanent tax losses from the assumption of a leasehold position in an existing partnership. G-41, G-42. The April 1991 proposal initiated IBC's evaluation and eventual consummation of the August 1991 investment in a limited partnership owning a right to participate in the residual re-lease rental revenues of an International Business Machines Corporation 3090-400E mainframe computer and a Cray Research, Inc. YMP4/216 supercomputer.
Findings of Fact
A. The IBC Defendants, TransCapital, and IBC's Leasing Team.1. IBC is a Texas banking corporation that operates approximately one hundred eighty branches located in South Texas and Oklahoma. Tr. 220. IBC is the lead bank of Petitioner International Bancshares Corporation.
2. Petitioner International Bancshares Corporation is the parent company in a two-tier holding company structure that also includes Petitioner IBC Subsidiary Corporation. Tr. 44, 47, 220. IBC is the immediate subsidiary of IBC Subsidiary Corporation.
3. Bancor Development Company of Laredo (now known as IBC Financial Services, Inc.) was incorporated in 1977 as a subsidiary of IBC. Bancor, however, remained inactive until IBC sought to employ it as a leasing subsidiary in connection with the 1991 investment in Cray and IBM computer equipment. Bancor is owned by IBC (90%) and TCLA 1990-I (10%).
4. For the relevant time period, the IBC Defendants filed consolidated income tax returns. Tr. 45-46, 103, 244-45.
5. TransCapital was a Delaware corporation that specialized in the assembly and marketing of mainframe computer and aircraft leasing portfolios. Joseph Campagna ("Campagna") and Donald Butler ("Butler"), TransCapital's co-founders, were long-time players in the equipment leasing industry. Campagna testified TransCapital marketed their transactions to investors, such as IBC, that lacked an equipment leasing subsidiary. Tr. — . This allowed TransCapital to develop a continuing business relationship with the investor by serving as the investor's outsourcing leasing expert. Tr. — . Through the 1988 Mainframe Investment, TransCapital became IBC's leasing expert.
6. IBC lacked experience in structuring and executing equipment leasing transactions. In connection with the 1988 Mainframe Investment, IBC formed a leasing team consisting of Nixon, Campagna, Butler, Cox Smith, Inc. (IBC's outside corporate counsel), and Fred Bartz, a tax partner in KPMG Peat Marwick's San Antonio office (IBC's outside tax and accounting firm).
IBC's principal contact at Cox Smith was Cary Kavy. Nixon considered Kavy to be IBC's "general business counselor." Tr. 227, 229-30, 886-88.
7. IBC and TransCapital were clients of KPMG Peat Marwick ("KPMG"). Since 1975, IBC had retained the services of Bartz and Walter Belt (another partner in KPMG's San Antonio office) to preform tax and audit work. TransCapital was the first client of KPMG's Northern Virginia office.
IBC's introduction to TransCapital was facilitated by Bartz after he met Campagna at a Washington, D.C. seminar.
8. Grossman Flask, P.C., a Washington, D.C. tax law firm, served as TransCapital's outside tax counsel in connection with its leasing transactions. Grossman Flask would regularly issue "more likely than not" tax opinions supporting TransCapital's leasing transactions. Jay Zukerman, a Grossman Flask attorney, was TransCapital's principal contact and author of the tax opinions.
9. TransCapital regularly retained the services of KPMG's national tax office to issue corroborating tax opinions in support of its leasing transactions.
B. An Overview of the Aircraft-Lessee Positions Investment.
10. In April 1991, Campagna circulated preliminary financial projections regarding a potential investment in a leasing portfolio consisting of a Boeing 737-200 Advanced Aircraft and $10,000,000 Lessee Positions. P-213. The projections outlined the various reasons the 737-200 was an economically superior investment to a 727-200, including the 737-200's significantly greater residual value. P-213. The lessee positions were neither identified nor described. P-213. TransCapital projected the pre-tax profit from the aircraft and lessee positions to be $4,927,514 ($5,727,514 pre-tax cash flow less $800,000 in fees). The unidentified lessee positions were projected to generate only $300,000 in pre-tax profit. P-213.
11. In May 1991, Campagna circulated formal offering documents, titled "International Bank of Commerce Acquisition of a Leasing Subsidiary: One Boeing Advanced Aircraft on Lease to Southwest Airlines and $10,000,000 Lessee Positions." G-41. Campagna also provided a supplemental document, titled "International Bank of Commerce Supplementary Information: Acquisition of a Leasing Subsidiary." G-42.
12. TransCapital summarized the key features and economic benefits of the transaction:
The leasing of equipment has long been a method used to combine the economic benefits of high revenues and reportable profit with the tax benefits of accelerated depreciation and interest deductions. Most major corporations and financial institutions have a leasing subsidiary.
In summary terms, our proprietary transaction has the following features:
1. The high overall yield provides an economic cash return.
2. Even in a worst case scenario (zero residual revenues), the tax benefits alone will pay back the entire investment and provide a substantial profit.
3. The tax benefits are derived from the assumption of a lessee position in an existing sale-leaseback transaction.
4. The lessee position requires no additional cash investment, as the payments on the note and the lease are equal in timing and amount.
5. The lessee position has the economic potential for cash revenue derived from appraised future sub-lease renewals in the future.
6. The accounting on the income statement is beneficial because the tax benefits increase net income (i.e. the tax expense is reduced dollar for dollar).
7. The equipment in the leasing subsidiary can vary from very highly leveraged computer systems on lease to Fortune 100 companies, to leveraged aircraft on lease to major, credit worthy airlines.
8. The proprietary structure we have developed has been approved by major legal and accounting firms.
Attached is a portfolio comprised of a Boeing 737-200 Advanced aircraft on lease to Southwest Airlines. Such portfolios are being offered only with lessee positions.
With over fifteen years of leasing experience, we can help you acquire and manage a tailored leasing portfolio that meets your criteria of low risk, economic gain and significant income statement and tax benefits.
G-41.
13. The offering documents provided a detailed description of the aircraft investment, including a summary of an appraisal performed by the Airclaims Group. The lessee positions, however, were identified as non-specific computer equipment with pro forma economic benefits. TransCapital summarized the basic transactional steps and economic benefits:
1. Bank (IBC) contributes cash to a new corporation in exchange for 90% stock ownership.
2. Leasing Partnership which has desired assets contributes those assets into new corporation in exchange for 10% stock ownership.
3. The new corporation is now a consolidation subsidiary of the bank for tax and accounting purposes. There are two assets in the subsidiary: one is an aircraft on lease to Southwest Airlines and the other is a portfolio of lessee positions.
4. The aircraft lease is accounted for using standard FASB 13 accounting. The use of a grantor trust is made to shield the Bank from liabilities. Also, the full price of $11,300,000 for cost of the aircraft is paid in a cash investment by the bank of $1,950,000 ($1,650,000 equity and $300,000 fees) and non-recourse debt of $9,650,000. The lease payments from Southwest pay down the loan to a $2,894,984 balloon. The balloon is paid from residual sale revenues at the end of the lease in 66 months. Note that since the debt is non-recourse, the Bank (IBC) has no liability on the loan.
The potential revenue due the Bank after-tax (as appraised) pays back the investment in full and also shows an after-tax profit of $1,965,159.
5. The Lessee Positions Portfolio is in a partnership now 99% owned by the Bank as limited partner. The position of the Bank replaces the original position of a Lease Management Company (LMC). LMC previously completed a sale-leaseback with a tax owner who paid some cash and a note for the property. In this portfolio, the properties are equipment on lease to Fortune 500 companies.
The remaining note payments (3 annual ones) and the rent payments are equal in cash and time when due. Thus, the assumption by the Bank partnership has no cash liability. However . . . there is a very favorable tax benefit of $3,400,000 which accrues to the Bank. Secondly, the investment fee of $500,000 should be repaid in full with a $300,000 cash profit from future sharing with the tax owner of renewal revenues from the equipment users.
G-41.
14. TransCapital's supplemental offering documents discussed the aircraft's "deferred" tax savings and lessee positions' permanent tax benefits. G-42. The aircraft "will generate a net taxable `soft' (i.e., noncash) loss to [the leasing subsidiary] in the early years of the transaction (attributable to the excess of the sum of the depreciation and any interest deductions over the rental income) and a net taxable `soft' (i.e., noncash) income in the later years of the transaction (attributable to the excess of the rental income over any interest and any interest and remaining depreciation deductions)." G-42. Similar to the 1988 Mainframe Investment, the aircraft's early-year tax savings would reverse out in the later years as income exceeded depreciation deductions. G-42. The lessee position "will generate a net taxable `soft' (i.e., noncash) loss to [the leasing subsidiary] attributable to [the leasing subsidiary's] share (99%) of the excess of the rental deductions for rent paid or incurred under the Master Lease by the Partnership over the interest income received or accrued under the Note by the Partnership. . . . [The leasing subsidiary] will also recognize income upon its accrual or receipt of its share (99%) of Sublease rents payable to the Partnership." G-42.
15. Unlike the 1988 Mainframe Investment and aircraft deferred tax savings, the lessee positions' $3,400,000 tax losses would not reverse out in the later years of the transaction. The difference between the rental paid and interest income received would result in permanent tax losses for the leasing subsidiary:
"A partnership will own lessee positions which are comprised of a Note Receivable with an offsetting obligation to make lease payments that equal, in timing and amount, the payments to be received on the note. . . . Lessee Positions will result in permanent tax differences on the books of the leasing subsidiary, which will flow through to the parent. This is caused by tax losses being generated for tax purposes with no income or loss being recognized for book purposes."
G-41. TransCapital's structure bifurcated the partnership's income attributable to rental payments received from the partnership's deductions attributable to rental payments made. This bifurcation was accomplished through manipulating section 708 of the Internal Revenue Code, which requires a partnership to terminate for tax purposes when there has been a greater than fifty percent (50%) change in partnership interest in a twelve-month period. 26 U.S.C. § 708. The leasing subsidiary's acquisition of a 99% limited partnership interest in a partnership which held the lessee positions would effect a tax-purposes only termination of the partnership. The tax-purpose only termination would bifurcate the income and purchase price expense associated with the partnership's acquisition of the lessee positions from the rental deductions, i.e. rental payments made under existing sale-leaseback note. The difference between the rental deductions and the interest received on the partnership note would create permanent tax losses for the partnership and its new partners, i.e. partners after the leasing subsidiary's acquisition of the 99% limited partnership interest.
16. The permanent tax losses were a guaranteed, artificial creation of TransCapital's structure. Disposition of the lessee positions prior to IBC's right to participate in the residual interest would not affect the tax losses: "If the economics of the lease positions dictate the resale of that portion of the portfolio before the end of the term, the total losses remaining on that portion will be accelerated into the year of sale." G-41.
17. Based on Nixon's and IBC's leasing team's initial review of the offering documents, Nixon recommended to IBC's board of directors that the bank pursue the transaction. Tr. 362, 380-81. At the time Nixon made this recommendation, the lessee positions investment only projected a $300,000 pre-tax profit and the computer equipment had not been identified. G-41, G-42.
18. Consistent with TransCapital's "proprietary" leasing subsidiary structure, Nixon also recommended activating IBC's dormant subsidiary, Bancor, to be TransCapital's investment vehicle. Activating Bancor required approval from the Texas Department of Banking (the "Department").
19. On May 14, 1991, Kavy submitted an initial application to activate Bancor based on the information TransCapital provided in the May offering documents. On July 5, 1991, Kavy supplemented IBC's application. The supplement described the transaction in greater detail, including IBC's business relationship with TransCapital, the bundled nature of the investment, the independent structures of the investments, the anticipated tax benefits, and the projected pre-tax profits:
TransCapital marketed the Aircraft and the Lessee Positions together as one leasing program. The benefits to be obtained from ownership of the Aircraft are different from the benefits to be obtained from ownership of the Lessee Positions. It is anticipated that IBC's $500,000 investment in the Lessee Positions will be fully returned from rents received and tax savings generated by the Lessee Positions. In view of IBC's substantial tax liabilities in past years, the tax savings afforded by the Lessee Positions are very attractive. It is also projected that IBC will save $3,400,000 in taxes due to tax savings generated by the Lessee Positions. It is also projected that IBC will receive $800,000 in sublease revenues from the Lessee Positions. IBC will receive a tax opinion from TransCapital's counsel, corroborated by KPMG Peat Marwick, in connection with the transaction.
. . .
Further, the Lessee Positions should not expose IBC to any additional expenses in view of the fact that the Lessee Positions are held through the Limited Partnership Interest by Bancor. Additionally, the lease payments due by the Positions Partnership to the owners of the equipment underlying the Lessee Positions will be equal in amount and due at the same time as the note payments owed by the owners of the equipment to the Positions Partnership.
P-543.
20. On July 8, 1991, Campagna circulated revised offering materials that principally focused on securing the economic benefits of the aircraft investment. The revisions included eliminating TransCapital's 10% remarketing fee in the Aircraft's residual interest in exchange for an equity minority interest in the leasing subsidiary, i.e. Bancor, changing the lessee positions window of opportunity from a one-year period (months 25-36) to a two-year period (months 37-60), and increasing the forecasted pre-tax cash flow. The lessee positions continued to be forecasted on a pro forma basis with the subject equipment not identified.
21. On July 10, 1991, Nixon, Cavy, Bartz, and Campagna met with the Department to discuss IBC's application. Tr. 917-18, G-36.
22. On July 15, 1991, the Department approved IBC's application to activate Bancor as its leasing subsidiary. P-15.
23. On July 31, 1991, the aircraft investment closed ("1991 Aircraft Investment").
24. In early-August 1991, IBC learned for the first time that the lessee positions were a leasing portfolio of a Cray Research, Inc. ("Cray") Y-MP4/216 supercomputer and peripheral equipment ("Cray Equipment") on lease to ARCO Oil and Gas Company ("ARCO") and an International Business Machines Corporation ("IBM") 3090-400E mainframe computer and peripheral equipment (the "IBM Equipment") on lease to The Timken Company ("Timken"). Based on the appraised value of the Cray and IBM Equipment, TransCapital increased IBC's investment fee from $500,000 to $559,947. IBC's investment fee was comprised of a $534,947 capital contribution and $25,000 fee for Grossman Flask's tax opinion.
25. Kavy informed the Department of the increased investment fee. On August 9, 1991, the Department approved the increased investment. P-16.
26. On August 12, 1991, Campagna circulated revised offering materials that for the first time, identified the Cray and IBM Equipment. TransCapital assumed the lessee positions investment would close on August 31, 1991. The 99% limited partnership interest in the Cray and IBM Equipment was forecasted to generate taxable losses totaling $11,758,882 and pre-tax cash flow totaling $1,436,612 over the lifeof the investment. P-84, P-85. TransCapital "assume[d] . . . [IBC's] subsidiary will be a 99% limited partner in a partnership which will acquire a note receivable of $11,312,054. The partnership has an obligation to make lease payments with the present value of $11,312,054 as a result of the acquisition of the note. The difference between the lease payments made and the interest received on the note will result in permanent losses to the note holder. The lease payments made will equal the debt payments received both in timing and amount." P-85.
27. On August 31, 1991, the lessee positions investment closed ("1991 Mainframe Investment").
28. On August 31, 1991, Grossman Flask issued a "more likely than not" tax opinion supporting the 1991 Mainframe Investment. The tax opinion described the 1991 Mainframe Investment's underlying transactions and potential tax effects. Grossman Flask opined that the 1991 Aircraft Investment and 1991 Mainframe Investment should not be "collapse[d]" and considered as a combined transaction because:
(i) they were legally and factually independent; (ii) there was no binding contract on any party to effectuate the [1991 Mainframe Investment] at the time of the [1991 Aircraft Investment] (though TransCapital committed to cause TCLA [1990-I] to identify and offer leasehold positions with certain general characteristics to [Bancor]); (iii) each of the [Investments] was imbued with economic substance (as supported by the respective appraisals rendered in connection with the Exchanges) independent of the other; and (iv) a period of time (albeit short, but nevertheless material, period of time) passed between the two [Investments].
Grossman Flask issued the tax opinion directly to IBC. P-29. IBC expressly waived any conflict of interest that could arise based on Grossman Flask's representation of TransCapital in connection with the 1991 Mainframe Investment. P-27.
P-29. TransCapital paid $25,000 for the Grossman Flask tax opinion. P-27.
29. KPMG's national tax office corroborated Grossman Flask's opinion. P-30.
30. The true nature of the lessee positions' investment program was discussed by Campagna in a February 18, 1992 memorandum to TransCapital employees touting KPMG's support of TransCapital's tax programs. G-172. Attached to the memorandum was a February 17, 1992 KPMG memorandum regarding "Reducing taxes through Leveraged Leasing":
Leasing has been and continues to be a viable tax-advantaged investment for many corporations. . . . Typically, these transactions provide substantial timing benefits which will return the investment from tax savings quickly, often within one year. After-tax yields of such investments, properly structured can be substantial.
A leasing company client of ours, TransCapital Corporation, has developed a proprietary structure that produces permanent tax savings which further increase the tax benefits for each dollar invested. TransCapital has, within the last year, concluded several of these transactions. In some of those we have corroborated the "more likely than not" tax opinion of its law firm.
TransCapital's leasing transactions provide substantial economic benefits to the extent a company takes some risk with respect to the residual value of the equipment. In some instances, the residual value risk is reduced by cash flow collateralized by marketable securities. The equipment utilized varies from computers on lease to Fortune 100 companies to aircraft on lease to creditworthy airlines, with investment levels varying accordingly.
G-172 (emphasis in original). The permanent tax benefits were the key benefit of TransCapital's lessee positions investment. G-172.C. The Cray and IBM Equipment.
31. In May 1991, the Cray and IBM Equipment leasing portfolio was brought to TransCapital by Patton Corrigan ("Corrigan"), president of Equilease Capital Corporation.
See Finding of Fact No. 38 discussing Corrigan and Equilease Capital Corporation.
32. The Neptune Group, Inc. ("Neptune") assembled the Cray and IBM Equipment portfolio through multiple transactions in late-1990 and early-1991. On December 27, 1990, Neptune purchased the Cray Equipment directly from the manufacturer. At the time of Neptune's purchase, the Cray Equipment was on lease to ARCO. The lease, executed on November 30, 1989, ran for a term of forty-eight (48) months — commencing March 7, 1990, the date the Cray Equipment was installed, through March 6, 1994 ("ARCO Lease"). Neptune purchased the Cray Equipment subject to the remaining thirty-seven (37) months of the ARCO Lease. Although the Cray Equipment had a list price of $10,373,000, Neptune purchased the equipment for $7,133,616-$558,554.74 equity payment and $6,575,061.26 non-recourse loan payable over the remaining thirty-nine (39) months of the ARCO Lease in favor of New England Life Insurance Company ("ARCO Debt"). The ARCO Debt was secured by the Cray Equipment and ARCO's obligations to make timely lease payments. ARCO's remaining rent payments were equal in timing and amount to Neptune's loan payments.
Between the execution of the 1988 Mainframe Investment and 1991 Mainframe Investment, Neptune Computer Group, Inc. changed its name to The Neptune Group, Inc.
33. Neptune was also required to pay Cray an administrative and consulting fee in the amount of $1,237,187 plus 10% interest compounded annually. P-64. The administrative and consulting fee was payable from the Cray Equipment's residual proceeds following the expiration of the ARCO Lease through the earlier of December 31, 1997 or payment in full. P-64. Cray was entitled to 75% of the residual proceeds during the first twelve months of the re-lease period, 50% of the residual proceeds thereafter, and/or 60% of all proceeds from the sale of the Cray Equipment. P-64.
34. Between the purchase and fee agreements, Neptune agreed to pay Cray an amount in excess of $8,370,803. Because the ARCO Lease payments were equal in timing and amount to the ARCO Debt payments, Neptune's cash flow was only negatively impacted by the $558,554.74 equity payment.
Cray's $1,237,187 administrative fee did not negatively impact Neptune's cash flow because the fee was an interest that Cray retained in the equipment's residual value. Neptune's vendor relationship with Cray and Cray's retention of a significant interest in the equipment's residual value is reflected in Neptune's $7,133,616 purchase price ($3,239,384 less than the Cray Equipment's $10,373,000 list price).
35. In early-1991, Neptune purchased the IBM Equipment from Computer Leasing, Inc. and Comarco, Inc. for a total price of $1,567,626. P-42, P-45. Neptune re-configured the IBM Equipment for purposes of leasing it to Timken. Shortly thereafter, Timken leased the IBM Equipment for a thirty (30) month term commencing April 1, 1991 and expiring September 30, 1993 ("Timken Lease"). Neptune used the lease payments due under the Timken Lease to acquire a $2,096,833.22 non-recourse loan payable over the thirty (30) month Timken Lease term in favor of Republic National Bank of New York ("Timken Debt"). P-46. Similar to the Cray financing, the Timken Lease payments were equal in timing and amount to the Timken Debt payments.
D. TransCapital's Leasing Partnerships.
36. On July 31, 1991 and August 1, 1991, TransCapital formed two leasing partnerships to implement the aircraft and lessee positions investments, TransCapital Leasing Associates 1990-I, L.P. ("TCLA 1990-I") and TransCapital Leasing Associates 1990-II, L.P. ("TCLA 1990-II"). TCLA 1990-I was formed to be the leasing partnership from which Bancor would acquire the right to purchase the beneficial interest in the aircraft and the 99% limited partnership interest in the partnership holding the lessee positions. TCLA 1990-II was formed to execute a series of sale-leaseback transactions designed to generate the lessee positions for IBC.
37. TCLA 1990-I's partners were TransCapital Management Corporation ("TMC") (1% general partner) and Equitable Leasing — Autochthon Associates ("EL-AA") (99% limited partner). The capital contributions of TMC ($10.00) and EL-AA ($990.00) were deferred until August 31, 1991, the date the 1991 Mainframe Investment closed. P-201.64.
38. EL-AA was a limited partnership formed by Joel Mallin, a New York lawyer and long-time equipment leasing player, to participate in leasing transactions. EL-AA's partners were Equitable Leasing Company (1% general partner) and Autochthon Associates, L.P. (99% limited partner). Autochthon Associates' partners were Autochthon Administration, Inc. (1% general partner), Autochthon Investments, Inc. (0.1% limited partner), and the Mashantucket Pequot Indian Tribe of Connecticut (the "Pequots") (98.9% limited partner).
In addition to EL-AA, Mallin formed numerous other entities under two separate corporate umbrellas, Equitable Leasing Company and Equilease Holding Company. Mallin owns 100% of the stock of Equitable Leasing Company. Tr. 1965. Equilease Holding Company is owned 44% by Mallin and his wife, 44% by Mari Alden, and 12% by Mallin's six children (2% each). Tr. 1969. Equilease Holding Company is the holding company for all Equilease entities, including Equilease Corporation, Equilease Capital Corporation, and Mithril Corporation.
Equilease Capital Corporation, a wholly-owned subsidiary of Equilease Holding Company, was formed in 1991 for the purpose of setting up "big ticket transactions, that is, transactions with major companies which involved leases in excess of $10 million of equipment at a clip." Tr. 1979. Corrigan was entitled to 25% of the profits generated by Equilease Capital.
Mithril Corporation ("Mithril") was also a wholly-owned subsidiary of Equilease Holding Company.
Mallin and Tom Tureen, a lawyer for the Mashantucket Pequot Indian Tribe, formed Autochthon Associates, L.P. in the early-1980s.
39. The Pequots were exempt from federal income taxation. Tr. 1420; 25 U.S.C. § 1751; Rev. Rul. 67-284, 1967 WL 14945.
40. Mallin testified that Corrigan requested he facilitate the involvement of Authochthon Associates in the 1991 Mainframe Investment. Tr. 1982-83, 1989. Mallin further testified:
Q: Did you understand that there was going to be a company involved that for whatever reason wasn't subject to federal income tax?
A: Yes, sir, I did.
Q: Did you know it was going to be the Pequots?
A: Well, it turned out to be the Pequots with respect to this transaction, but it could have been either a company with a loss carry forward, or a foreign company that didn't pay U.S. taxes, or any number of different companies. Mr. Corrigan asked for my help in getting the — in getting Autochthon to participate, and they agreed to do so, but had they not, we could have used somebody else.
Q: Do you know why he wanted Autochthon to be participating?
A: I assume because Autochthon was, in essence, a tax neutral party.
Q: Because of being owned mostly by the Pequot Indians?
A: Yes.
Tr. 1988-89.
41. TCLA 1990-II's partners were TransCapital Management Associates Limited Partnership IV ("TCMA IV") (1% general partner) and TCLA 1990-I (99% limited partner). Similar to TCLA 1990-I, the capital contributions of TCMA IV ($5,403.51) and TCLA 1990-I ($534,947.00) were deferred until August 31, 1991. P-24.
42. Nixon feigned knowledge as to whether he learned of the Pequots involvement before or after the 1991 Mainframe Investment was executed. Kavy testified that the only due diligence review of EL-AA was to confirm that it was TCLA 1990-I's 99% limited partner and to look at the revenue-sharing agreement. Tr. 984. Kavy further testified that she paid more attention to TCLA 1990-I's general partner "who would be controlling the partnership than the passive investment side of the limited partner, especially in view of how the revenue sharing agreement would go." Tr. 983-84. Nixon's and Kavy's testimony lacks credibility. TCLA 1990-I, and each member of its tiered-partnership, including the Pequots, were acquiring an ownership interest in IBC's subsidiary, Bancor. The Court finds that Nixon and IBC knew of the Pequots' involvement prior to executing the 1991 Mainframe Investment.
See Finding of Fact Nos. 60, 61, and 76 discussing the revenue sharing agreement.
43. TCLA 1990-I and TCLA 1990-II were formed solely for the purpose of implementing the aircraft and lessee positions investment. TCLA 1990-II would have dissolved if the lessee positions investment was not made available to IBC on August 31, 1991.
E. The 1991 Aircraft Investment.
44. On July 31, 1991, the aircraft portion of the transaction closed (the "1991 Aircraft Investment"). Bancor acquired the right to purchase the 100% beneficial interest in the aircraft through a series of Internal Revenue Code section 351 "like-kind" exchanges with IBC and TCLA 1990-I. IBC contributed $1,950,000, the total amount of Bancor's required equity investment ($1,650,000) and TransCapital's consulting fee ($300,000), to Bancor in exchange for four hundred fifty (450) shares of voting common stock. Simultaneously, TCLA 1990-I exchanged the option to purchase the aircraft's beneficial interest for fifty (50) shares of Bancor voting common stock. Bancor purchased the Aircraft's beneficial interest for $11,600,271-$1,650,000 equity payment and two non-recourse promissory notes in the amount of $9,650,271. P-118, P-547.
45. The $300,000 consulting fee Bancor paid TransCapital was placed in an escrow account with Grossman Flask. P-201.63. Pursuant to an escrow agreement, the $300,000 consulting fee would be distributed by Grossman Flask on the closing date of the 1991 Mainframe Investment: (1) to TransCapital, if TransCapital caused TCLA 1990-I to make the Lessee Positions available to Bancor, or (2) to IBC, if TransCapital failed to cause TCLA 1990-I to make the lessee positions available to Bancor. P-201.63. IBC was entitled to recover the $300,000 consulting fee (less a $20,000 fee for a Grossman Flask tax opinion and other potential expenses) if the lessee positions' permanent tax savings were not made available to Bancor. P-201.63.
46. The IRS did not challenge the 1991 Aircraft Investment.
F. The 1991 Mainframe Investment.
47. The 1991 Mainframe Investment closed at various dates throughout August 1991. Although the operative transactional documents are dated "as of August 1, 1991" and "as of August 15, 1991", those dates are not instructive of the date the transaction, and all of its discrete parts, were closed. G-43.7. The numerous underlying transactions TransCapital employed to create the lessee positions permanent tax losses took effect only upon IBC's investment on August 31, 1991.
48. On August 1, 1991, Neptune and TCLA 1990-II entered into a sale-leaseback involving the lessee positions' underlying equipment — the Cray and IBM Equipment. While independent of the lessee positions investment, the financial terms of Neptune's acquisition of the Cray and IBM Equipment provided the framework for TransCapital's wrap-lease structure and TCLA 1990-II's window of opportunity to participate in the residual interests. The Neptune-TCLA 1990-II sale-leaseback wrapped around the ARCO and Timken Leases and Debt. TCLA 1990-II purchased the Cray and IBM Equipment from Neptune, subject to the ARCO and Timken Leases and Debt, for $9,165,606 — a cash payment of $285,891 and two non-recourse installment promissory notes for $8,879,715 with ten percent (10%) interest compounded monthly (the "Neptune Debt"). Neptune immediately leased the Cray and IBM Equipment back for a forty-two month term expiring on January 31, 1995 (the "Neptune Lease"). The Neptune Lease wrapped-around the ACRO Lease (expired March 6, 1994) and Timken Lease (expired September 30, 1993). The wrap lease concept created a limited period where all residual proceeds from the Cray and IBM Equipment would flow to Neptune — between March 7, 1994 and January 31, 1995 for the Cray Equipment and between October 1, 1993 and January 31, 1995 for the IBM Equipment.
As discussed in Finding of Fact No. 33, Neptune was required to pay a significant portion of the Cray Equipment's residual proceeds generated during this period to Cray in satisfaction of an administrative and consulting fee.
49. The Neptune Debt required TCLA 1990-II to make annual payments amounting to $261,970 per month for forty-two months. Similarly, the Neptune Lease obligated Neptune to make annual lease payments to TCLA 1990-II amounting to $261,970 per month for forty-two months. The Neptune Debt and Neptune Lease payments were equal in timing and amount. Each party was obligated to pay $11,002,752 over the course of the forty-two month term covered by the agreements.
50. In addition to the Cray and IBM Equipment purchase price, TCLA 1990-II also agreed to pay Neptune lease acquisition and remarketing fees for both the Cray and IBM Equipment. The IBM lease acquisition fee ("IBM LAF") totaled $282,073 with ten percent (10%) interest compounded monthly. The IBM LAF was payable from one hundred percent (100%) of the proceeds Neptune received from the sale or re-lease of the IBM Equipment during the "wrap lease period" — the end of the Timken Lease (October 1, 1993) through the end of the Neptune Lease (January 31, 1995). Neptune's rights to the IBM LAF expired on January 31, 1995 regardless of whether full payment had been received. TCLA 1990-II was also required to pay Neptune a fifteen percent (15%) remarketing fee for Neptune's services in remarketing the IBM Equipment between February 1, 1995 and December 31, 1997 (the "IBM Remarketing Fee"). The IBM Remarketing Fee was payable out of the equipment's gross sale or re-lease proceeds. Similarly, the Cray lease acquisition fee ("Cray LAF") totaled $1,840,260 with ten percent (10%) interest compounded monthly. The Cray LAF was payable from one hundred percent (100%) of the proceeds Neptune received from the sale or re-lease of the Cray Equipment during the "wrap lease period" — the end of the ARCO Lease (March 6, 1994) through the end of the Neptune Lease (January 31, 1995). To the extent the Cray LAF was not paid in full by the end of the Neptune Lease, Neptune was entitled to 100% of the proceeds from the sale or re-lease of the Cray Equipment from February 1, 1995 until the earlier of December 31, 1997, or payment in full. TCLA 1990-II also agreed to pay Neptune a 15% remarketing fee for Neptune's services in remarketing the Cray Equipment between the later of February 1, 1995 or full payment of the Cray LAF, and December 31, 1997 (the "Cray Remarketing Fee"). The Cray Remarketing Fee was payable out of the equipment's gross sale or re-lease proceeds.
51. The Neptune Lease included a fair market value purchase option that would allow Neptune to purchase the Cray and IBM Equipment, at any time prior to the expiration of the Neptune Lease, for its then-existing fair market value ("Neptune Option"). P-7. If Neptune exercised its purchase option, it would be required to pay TCLA 1990-II a termination fee equal to the discounted unaccrued rent remaining for the Neptune Lease term. Neptune's termination fee would be offset by TCLA 1990-II's obligation to pay the remaining balance of the Neptune Debt. Because Neptune's and TCLA 1990-II's rental and debt obligations were equal in timing and amount, Neptune's termination fee and TCLA 1990-II's debt payments were self-cancelling. Neptune's fair market value purchase price would be reduced by TCLA 1990-II's outstanding obligations, if any, under the Cray and IBM LAFs. To the extent the Cray and IBM LAFs exceeded the fair market value, Neptune would be able to reacquire the Cray and IBM Equipment at no cost. Thus, Neptune's decision to exercise its purchase option would not require TCLA 1990-II or Neptune to exchange any money to discharge the their off-setting obligations.
52. Also on August 1, 1991, after the Neptune-TCLA 1990-II sale-leaseback was completed, TCLA 1990-II entered into a similar sale-leaseback with Mithril. Mithril purchased the Cray and IBM Equipment from TCLA 1990-II, subject to the ARCO and Timken Debt, Neptune Lease and Debt, Cray LAF and Remarketing Fee, and IBM LAF and Remarketing Fee, for $11,740,606 — a cash payment of $285,891 and two non-recourse installment promissory notes for $11,454,715 with twelve percent (12%) interest compounded monthly (the "Mithril Debt"). Mithril immediately leased the Cray and IBM Equipment back to TCLA 1990-II for a sixty-month period expiring on July 31, 1996 ("Mithril Lease"). The Mithril Debt and Mithril Lease payments were equal in timing and amount. The Mithril Debt required Mithril to make annual payments amounting to $267,652 per month for sixty months, and the Mithril Lease obligated TCLA 1990-II to make annual lease payments to Mithril amounting to $267,652 per month for sixty months. Each party was obligated to pay $15,859,130 over the course of the sixty-month period covered by the agreements.
Similar to the Neptune Option, the Mithril Lease obligated TCLA-1990-II to pay Mithril a termination fee equal to the unaccrued fixed rent for the remainder of the Mithril Lease in the event that Neptune, Cray, ARCO, or Timken purchased the Cray and IBM Equipment. TCLA 1990-II's termination fee would be offset by Mithril's accelerated obligation to pay the remaining balance of the Mithril Debt. Because TCLA 1990-II's and Mithril's rental and debt obligations were equal in timing and amount, the termination fee and accelerated debt obligations were self-cancelling. If, for example, Neptune exercised the Neptune Option, TCLA 1990-II's and Mithril's concurrent rental and debt payment obligations would terminate without the exchange of any money.
Mithril was also obligated to pay TCLA 1990-II a lease buy-out fee equal to the sum of (1) 100% of the proceeds generated from the exercise of the purchase option up to the outstanding amount of the equipment's LAF, plus (2) 45% of any proceeds exceeding the equipment's outstanding LAF. To the extent the purchase option was exercised after January 31, 1995 (the expiration of the Neptune Lease), the 45% of excess proceeds would be reduced by 1.5% for each expired full calendar month.
53. On August 1, 1991, TCLA 1990-II and Mithril both purchased the Cray and IBM Equipment in separate transactions. Mithril, however, paid TCLA 1990-II $2,575,000 more for the Cray and IBM Equipment than TCLA 1990-II paid earlier in the day. The TCLA 1990-II-Mithril purchase price was not negotiated.
54. The Neptune-TCLA 1990-II sale-leaseback and TCLA 1990-II-Mithril sale-leaseback created an eighteen-month "window of opportunity" from February 1, 1995 through July 31, 1996 for TCLA 1990-II to participate in residual profits generated by the Cray and IBM Equipment (the "Window Period"):
Cray Equipment August 1, 1991 — January 100% of the Neptune Lease rent payments were required 31, 1995 to be applied to the Neptune Debt. (Neptune Lease term) February 1, 1995 — date Neptune entitled to 100% of all renewal or re-lease Cray LAF paid in full rental revenues. Date Cray LAF paid in All renewal or re-lease revenues generated by the Cray full — July 31, 1996 Equipment would be allocated as follows: (expiration of Mithril Lease) TCLA 1990-II: 46.75% Mithril: 38.25% Neptune: 15% (remarketing fee) IBM Equipment August 1, 1991 — January 100% of the Neptune Lease rent payments were required 31, 1995 to be applied to the Neptune Debt. (Neptune Lease term) February 1, 1995 — July All renewal or re-lease revenues generated by the IBM 31, 1996 Equipment would be allocated as follows: (Mithril Lease term) TCLA 1990-II: 46.75% Mithril: 38.25% Neptune: 15% (remarketing fee) 55. In the Neptune-TCLA 1990-II sale-leaseback, TCLA 1990-II agreed to pay only $285,891 for (1) 85% of the Cray and IBM Equipment's residual values between February 1, 1995 (or with regard to the Cray Equipment, the date the Cray LAF was paid in full if a balance remained at end of Neptune Lease) and December 31, 1997 and (2) 100% of the residual values thereafter. The $285,891 reflected the amount of money TCLA 1990-II was willing to pay (in present dollars) for its residual interests in the Cray and IBM Equipment.56. In the TCLA 1990-II-Mithril sale-leaseback, Mithril agreed to pay an identical $285,891 for (1) 38.25% of the Cray and IBM Equipment's residual values between February 1, 1995 (or with regard to the Cray Equipment, the date the Cray LAF was paid in full if a balance remained at end of Neptune Lease) and July 31, 1996, (2) 85% of the residual values from August 1, 1996 through December 31, 1997 and (3) 100% of the residual values thereafter. The $285,891 reflected the amount of money Mithril was willing to pay (in present dollars) for its residual interests in the Cray and IBM Equipment.
57. On August 15, 1991, TCLA 1990-II sold its right to receive the Neptune Lease payments to PSC Leasing Corporation ("PSC Leasing") for $8,815,378 — a cash payment of $25,000 and assumption of TCLA 1990-II's remaining $8,790,378 obligation on the Neptune Debt. PSC Leasing's assumption of the Neptune Debt was $89,337 less than the Neptune Debt's original principal balance.
PSC Leasing was a leasing company Corrigan formed prior to joining Equilease Capital Corporation. Tr. 1788. Corrigan testified that PSC Leasing became involved in the 1991 Mainframe Investment through an unnamed individual's request for PSC Leasing to purchase the Neptune Lease rental stream. Tr. 1789.
58. On August 31, 1991, Bancor acquired TCLA 1990-I's 99% limited partnership interest in TCLA 1990-II through a series of section 351 like-kind exchanges. TCLA 1990-I contributed its 99% limited partnership interest in TCLA 1990-II in exchange for fifteen (15) shares of Bancor voting common stock. Bancor assumed all of TCLA 1990-I's limited partnership obligations, including payment of its $534,947 capital contribution. Simultaneously, IBC contributed $534,947, the exact amount of TCLA 1990-I's required, but unpaid, capital contribution, to Bancor in exchange for one hundred thirty-five (135) shares of voting common stock.
59. Because Bancor's acquisition of TCLA 1990-I's 99% limited partnership interest resulted in a greater than fifty percent (50%) change in ownership of TCLA 1990-II within a one-year period, TCLA 1990-II was required to terminate for tax purposes only, and file a short-year tax return ending August 31, 1991. The $11,390,378 gain TCLA 1990-II received from the sale of the Cray and IBM Equipment to Mithril and PSC Leasing's purchase of the Neptune Lease rental stream would be allocated to TCLA 1990-II's partners on August 31, 1991, i.e. TCLA 1990-I and TCMA IV. Because TCLA 1990-I's ultimate limited partner was the tax-exempt Pequots, 95.96% of the allocated $11,390,378 escaped federal taxation.
60. Based on Bancor's acquisition of TCLA 1990-I's 99% limited partnership interest, the residual revenue generated by the Cray and IBM Equipment during the Window Period would be distributed to Bancor (99% of 46.75%) and TCMA IV (1% of 46.75%). Bancor was required to distribute its residual revenue share based on its shareholders' percentage of ownership, i.e. IBC 90% and TCLA 1990-I 10%. P-23. IBC was entitled to 89.1% of 46.75%. TCLA 1990-I was entitled to 9.9% of 46.75%.
61. TCLA 1990-I's share was required to be distributed to its partners according to their partnership interests, TMC (1%) and EL-AA (99%). EL-AA's residual interest was distributable to its partners, Equitable Leasing Company (1%) and Autochthon Associates (99%). Autochthon Associates' interest was distributable to its partners, Autochthon Administration, Inc. (1%), Autochthon Investments, Inc. (0.1%), and the Pequots (98.9%). Ultimately, the Pequots were entitled to receive 95.96% of TCLA 1990-I's income and deductions.
The IBC Defendants' argument, and Butler's testimony, that a revenue sharing and consulting agreement (the "RSCA") required TCLA 1990-I to pay TransCapital 90% of the residual proceeds TCLA 1990-I received in relation to the Cray and IBM Equipment is without merit. P-565. The RSCA only required TCLA 1990-I to pay TransCapital 90% of "any distribution received or paid by TCLA 1990-I, in its capacity as limited partner of TCLA 1990-II, pursuant to the Partnership Agreement." P-565 (emphasis added). TCLA 1990-I ceased being TCLA 1990-II's limited partner on August 31, 1991. Any residual proceeds TCLA 1990-I received from the Cray and IBM Equipment were not subject to the RSCA. TCLA 1990-I was required to distribute the Cray and IBM Equipment's residual proceeds to its partners, TMC and EL-AA, in proportion to their partnership interests.
62. The difference between the Mithril Lease payments and the interest received on the Mithril Debt created permanent tax losses for TCLA 1990-II. The permanent tax losses were not economically inherent in the 1991 Mainframe Investment, but rather were an artificial creation of a series of transactions whose only purpose was to create tax losses.
The tax losses were permanent because unlike traditional leverage leasing transactions, such as the 1988 Mainframe Investment and 1991 Aircraft Investment, the income from the Neptune Lease was stripped off to TCLA 1990-I and the Pequots. Without any corresponding income, the Mithril Lease's rental expense deductions would never reverse out.
G. The 1991 Aircraft and Mainframe Investments were separate, freestanding investments.
63. The Court finds that the 1991 Aircraft and Mainframe Investments, though marketed as a combined leasing portfolio, were legally independent transactions. The transactions were executed at different times, through separate partnerships, and structured completely separate from one and another. The economic benefits of the investments were divergent. The 1991 Aircraft Investment possessed the potential to generate a significant profit. The 1991 Mainframe Investment, as will be discussed below, was designed to generate permanent tax losses, not residual profits. The 1991 Mainframe Investment's economic and tax benefits bore no relationship or connection with the 1991 Aircraft Investment's economic and tax benefits, and vice versa.
64. Based on the complete lack of continuity between the 1991 Aircraft and Mainframe Investments, the Court finds that its analysis must focus solely on the 1991 Mainframe Investment.
H. The Page Appraisals.
65. IBC's ability to profit from the 1991 Mainframe Investment depended on the Cray and IBM Equipment maintaining sufficient residual values at the expiration of the ARCO and Timken Leases to ensure the equipment would be capable of being re-leased through July 31, 1996.
66. Numerous factors hampered the 1991 Mainframe Investment's profitability: (1) the Cray and IBM Equipment were declining in value at the inception of the ARCO and Timken Leases and would continue to decline in value over the course of such leases; (2) the ARCO and Timken Leases did not expire until March 6, 1994 and September 30, 1993; (3) between March 7, 1994 and January 31, 1995, Neptune was entitled to 100% of the Cray Equipment's residual interests; (4) between October 1, 1993 and January 31, 1995, Neptune was entitled to 100% of the IBM Equipment's residual interests; (5) to the extent the Cray LAF remained unpaid on January 31, 1995, Neptune was entitled to 100% of the Cray Equipment's residual interests until the Cray LAF was paid in full; (6) IBC was only entitled to 89.1% of 46.75% of the Cray and IBM Equipment's residual values; and (7) no lease arrangement with a potential user was in place for the period following the termination of the ARCO and Timken Leases.
67. On August 1, 1991, Ralph Page of Marshall Stevens, a national valuation company, provided TransCapital with written appraisals of the Cray and IBM Equipment (the "Page Appraisals"). P-31, P-32. The Page Appraisals were prepared at the direction of Corrigan and Equilease Capital.
On May 20, 1991, TransCapital requested Marshall Stevens provide an "immediate" June 1, 1991 fair market value appraisal with respect to at least the Cray Equipment. G-43.15. The appraisal request form included "Corrigan's quoted MS [residual] values." G-43.15. There is no evidence confirming TransCapital's receipt of a June 1, 1991 Marshall Stevens appraisal.
68. The Cray YMP4/216 supercomputer, a scientific, mathematic-intense machine used to run probabilities and statistical analyses, was introduced in 1988 with a $10,373,000 list price. The Cray Equipment was special ordered by ARCO in November 1989 and installed in March 1990. Despite the Cray Equipment having been in ARCO's possession for approximately eighteen months at the time of the appraisal, Page estimated the equipment to have a ten-year economic life and fair market value of $10,125,000, a minuscule $248,000 decrease from its $10,373,000 list price. P-31. The Page Appraisals forecasted the Cray Equipment's declining residual value over the course of the 1991 Mainframe Investment:
Cray Equipment
Date Fair Market Value
August 1, 1991 $10,125,000 August 1992 $7,593,750 (75% of $10,125,000) August 1993 $5,771,250 (57% of $10,125,000) August 1994 $4,353,750 (43% of $10,125,000) August 1995 $3,240,000 (32% of $10,125,000) August 1996 $2,328,750 (23% of $10,125,000) August 1997 $1,721,250 (17% of $10,125,000) August 1998 $1,215,000 (12% of $10,125,000)
P-31.
69. The IBM Equipment was introduced in 1987 with a list price of $10,097,135. Page estimated that as of August 1, 1991 the IBM Equipment had a ten-year economic life and fair market value of $1,625,000, or 16.09% of the 1987 list price. P-32. Over the first four years of the IBM Equipment's economic life, it had depreciated 83.91%. Page forecasted the continual decline of the IBM Equipment's residual value over the course of the 1991 Mainframe Investment:
IBM Equipment Date Fair Market Value
August 1, 1991 $1,625,000 August 1992 $1,218,750 (75% of $1,625,000) August 1993 $731,250 (45% of $1,625,000) August 1994 $520,000 (32% of $1,625,000) August 1995 $373,750 (23% of $1,625,000) August 1996 $243,750 (15% of 1,625,000) August 1997 $162,500 (10% of $1,625,000) August 1998 $81,250 (5% of $1,625,000)
P-32.
70. The Page Appraisals did not calculate the Cray and IBM Equipment's re-lease rental values for the Window Period. P-31, P-32. Rather, a formula was provided for estimating the fair rental values. P-31, P-32.
"The fair rental value for the equipment for the projected release periods of two years beginning in year five can be computed by amortizing 80% to 97% of the fair market value of the equipment at the commencement of the release term over the new release term at 10% interest in advance." P-31, P-32.
71. Despite the age of the Cray (approximately eighteen months) and IBM (four years) Equipment, their continual depreciating value and decreasing economic life, and the length of time before the Window Period began, IBC assumed the Page Appraisals were correct without obtaining a second independent appraisal. Tr. 364.
72. Nixon testified that he was comfortable with the Page Appraisals based on the creditworthiness of ARCO and Timken and "the fact that two independent lenders went out and lent millions of dollars on [the Cray and IBM Equipment,] looking only to the same decision that we made in terms of those values." Tr. 414. Nixon and Butler testified that the ARCO and Timken Debt was indicative of the Cray and IBM Equipment's value because lenders, on a non-recourse basis, would not loan an amount in excess of eighty percent (80%) of the equipment's value. Butler testified that based on the 80% debt-value ratio, the Cray Equipment had a fair market value as of December 27, 1990 of $8,218,826, and the IBM Equipment had a fair market value as of March 5, 1991 of $2,621,041.
73. Nixon's and Butler's reliance on the 80% debt-value ratio is misplaced. Steven Chaleff, Neptune's President, testified that the ARCO and Timken Debt was "really a discounting of the underlying user's promise to make payments unconditionally. So we at the leasing company would take the underlying user's lease, go to a lender, essentially discount that paper and receive funds in return which he would use for the purchase price. That created the non-recourse loan, if you will, because what we did is assign the lease payments in connection with that." Tr. 1689-90. Chaleff further testified:
Q: When you went to a lender to ask them to loan you money so you could buy equipment from . . . Cray, did the lender look to your credit worthiness for repayment of that?
A: No, no.
Q: Who did they look to?
A: The source of the payments which was ARCO.
Q: So, the credit worthiness of the end users was the primary determination and probably whether the bank would lend the money or not?
A: It was the sole determinant assuming that the documentation surrounding the transaction was proper. If it was, than that was all they cared about.
Q: My understanding from what you're describing is that virtually one hundred percent of the rental stream was dedicated to pay the senior non-recourse debt?
A: Right.
Tr. 1755-56. Chaleff's testimony is significant because it was his company, Neptune, that acquired the financing for the Cray and IBM Equipment.
74. The Court finds that the ARCO and Timken Debt are reflective of a discounting of the ARCO and Timken Leases rental payment obligations, not the Cray and IBM Equipment's fair market value. The Timken Debt accurately depicts this discounting. Neptune purchased the Equipment for approximately $1,567,626, reconfigured it for Timken's needs, and leased it to Timken for a 30-month period. Based on Timken's creditworthiness and the terms of the Timken Lease, Neptune was able to obtain a $2,096,833.22 loan. Under the IBC Defendants' 80% debt-value ratio theory, the IBM Equipment Neptune purchased for $1,567,626 in January and March 1991 was worth at least $2,621,041 ($2,096,833/.80) on March 5, 1991. Neptune's reconfiguration would have needed to increase the value of the IBM Equipment by over $1,000,000. IBC's 80% debt-value ratio theory undermines the Page Appraisals. Based on the IBM Equipment's 80% debt-value ratio on March 5, 1991 and the Page Appraisals' August 1, 1991 $1,625,000 fair market value, the IBM Equipment would have depreciated 62% in five months. Yet, the Page Appraisals estimated that the IBM Equipment would remain economically useful for another seven years.
75. Based on Chaleff's testimony, the Court finds that Nixon's and Butler's reliance on the 80% debt-value ratio is a post hoc attempt to justify the Page Appraisals' forecasted values.
76. Nixon testified that his faith in the Page Appraisals' forecasted values was strengthened by TransCapital's investment of $61,535.49 in the 1991 Mainframe Investment, which could only be recouped from the Cray and IBM Equipment's residual value. Butler testified that TransCapital was entitled to 10.9% of all residual revenues TCLA 1990-II received during the Window Period based on the RSCA. As the Court previously found, the operative documents only entitled TransCapital (together with its affiliates) to 1.1% of TCLA 1990-II's residual revenues.
TCMA IV was entitled to 1% as TCLA 1990-II's general partner. TMC was entitled to 0.1% as TCLA 1990-I's general partner (1% of TCLA 1990-I's 10% interest in Bancor). See Finding of Fact Nos. 60 and 61 discussing TCLA 1990-II's and Bancor's revenue distributions.
77. In reality, IBC had no incentive to verify the accuracy of the Page Appraisals. Other than IBC's $559,947 investment fee, the 1991 Mainframe Investment did not negatively impact IBC's cash flow. All of the payment obligations due and owing under the Neptune-TCLA 1990-II and TCLA 1990-II-Mithril sale-leasebacks were equal in timing and amount. The 1991 Mainframe Investment's permanent tax losses were a function of the offsetting Mithril Debt and Mithril Lease payment obligations, i.e. the greater the value of the Cray and IBM Equipment, the larger the Mithril Lease payment deductions and permanent tax losses. The Court finds that the direct relationship between IBC's permanent tax losses and the value of the Cray and IBM Equipment removed IBC's incentive to challenge the Page Appraisals' residual value forecasts.
78. The Court finds that IBC failed to adequately investigate the accuracy of the Page Appraisals' forecasted residual values.
79. Neither Page nor a Marshall Stevens employee appeared at trial to testify as to the accuracy of the Page Appraisals or the methodology used.
I. Forecasted Profitability of the 1991 Mainframe Investment.
80. Even assuming TCLA 1990-II would receive 100% of the Page Appraisals forecasted residual values during the Window Period, TCLA 1990-II's investment in the Cray and IBM Equipment projected a $2,092,261 negative cash flow impact:
The IBC Defendants' argument that this analysis fails to account for the $2,575,000 profit TCLA 1990-II recognized, and reported on its August 31, 1991 income tax return, from the sale of the Cray and IBM Equipment to Mithril is misplaced. The $2,575,000 profit is included in the Mithril Debt, i.e. the Mithril Debt exceeded the Neptune Debt by $2,575,000.
81. Although TCLA 1990-II had no possibility of profiting from the 1991 Mainframe Investment, TransCapital forecasted IBC to earn a $720,074 undiscounted, pre-tax profit based on the Cray and IBM Equipment achieving 100% of the Page Appraisals' residual values:
Transaction Description Amount
TCLA 1990-I's Capital Contribution ($534,947) Grossman Flask tax opinion fee ($25,000)
IBC — 89.1% of 46.75% of the Cray and IBM Equipment's $1,280,021
Residual Values from February 1, 1995 through July 31, 1996
Undiscounted, Pre-tax Total $720,074
P-86. The discrepancy in TCLA 1990-II's and IBC's potential profit resulted from TransCapital structuring the 1991 Mainframe Investment to shield IBC from the expenses TCLA 1990-II incurred in acquiring its interest in the Cray and IBM Equipment.
82. Based on IBC's $559,947 investment in the 1991 Mainframe Investment, its undiscounted, pre-tax break-even point was 67.9% of the Page Appraisals.
J. The Page Appraisals' Overstated Residual Values.
83. The IBC Defendants presented Roy Ellegard, an Ernst Young valuation expert, to assess the reasonableness of the Page Appraisals. The Government presented Susan Middleton, an International Data Corporation valuation expert, to do the same.
84. Ellegard's and Middleton's opinions as to the Cray and IBM Equipment's fair market and residual values differed greatly. The experts, however, did establish key valuation principles that govern the Court's valuation of the Cray and IBM Equipment. First, the economic life of the mainframe computer equipment was seven years. Tr. 769, 864. Second, mainframe computers depreciate, and their economic life deteriorates, from the date the manufacturer began shipping the computer system. Tr. 1482.
Page defined "economic life" as "[t]he estimated period of time over which it is anticipated that an asset may be profitably used." P-31, P-32. Similarly, Middleton testified that a mainframe computer equipment's "economic life cycle" is "the term where the equipment still have economic value on the market" or "until the equipment reached salvage." Tr. 1476-77.
85. The Page Appraisals did not comply with these principles. First, the Page Appraisals estimated the Cray and IBM Equipment to have a 10-year economic life. P-31, P-32. Second, the Page Appraisals measured the economic life from August 1, 1991, the date TCLA 1990-II acquired its interest in the equipment, not the date Cray and IBM began shipping the respective systems. P-31, P-32.
In Smoot v. Commissioner, the Tax Court discredited Page's appraisal because the equipment's economic life was measured from the purchase date, rather than the manufacturer's initial shipping/introduction date. 1991 WL 97650 (U.S. Tax Ct. 1991) ("Page, however, did state that a conservative estimate of this equipment's useful life would be 10 years and he acknowledged the general principle that such useful life is measured from the date of introduction, which in this case was approximately 1976. Contrary to his testimony, Page measured the 10-year useful life from the 1983 purchase date." (citations omitted)). The Tax Court ultimately accepted Page's ten-year economic life estimate because, unlike here, there was no evidence supporting a shorter period. Id.
86. With regard to the IBM Equipment, Ellegard opined that the equipment had an August 1, 1991 fair market value of $1,621,300. Ellegard's fair market value estimate was derived from the Daley Marketing Corporation's June 1991 Price Guide. Tr. 741. Based on the Daley price guide, Ellegard found the Page Appraisals' $1,625,000 fair market value to be reasonable. Tr. 743.
The Daley Marketing Corporation's Price Guide is a valuation/pricing guide reference material published by Peter Daley. Although the Daley price guide did not include a list price for the IBM Equipment configuration installed at Timken, it provided fair market value percentages based on the ideal configuration. Tr. 742-43.
87. With regard to the Cray Equipment, Ellegard opined that the equipment had an August 1, 1991 fair market value between $9,000,000 and $11,000,000. Tr. 746. Ellegard's assessment of the Cray Equipment's fair market value came from two phone calls in 2003 with a Cray employee. Tr. 745. Ellegard testified that Cray was the only source of valuation for its computers because "Cray controlled the marketplace completely" and there were no price guides or secondary market for Cray computers. Tr. 745. Ellegard opined that the Page Appraisals' $10,125,000 fair market value was reasonable because it fell near the midpoint of the fair market value range he was provided by Cray. Tr. 746.
88. Ellegard tested the Page Appraisals' residual value forecasts for the Cray and IBM Equipment by comparing the Page Appraisals' forecasted values with a seven-year accelerated depreciation curve. In applying the curves, Ellegard measured the seven-year economic life of the equipment from August 1, 1991, not the date Cray and IBM initially began shipping the respective computer equipment. Ellegard's seven-year depreciation curve closely tracked the Page Appraisals' residual value forecast. Ellegard opined that the Page Appraisals' residual value forecasts for the Cray and IBM Equipment were reasonable.
89. With regard to the IBM Equipment, Middleton opined that the equipment had an August 1, 1991 fair market value of $1,009,384, or 11% of $9,176,215 (its July 1991 list price). Middleton obtained her fair market value from International Data Corporation's June/July 1991 IBM Residual Value Report, which she co-authored. Based on the IBM residual value report, Middleton opined that the IBM Equipment's fair market value on August 1, 1992, August 1, 1993, and August 1, 1994 would be $642,335 (7% of list price), $183,524 (2%), and salvage value. G-299.
International Data Corporation is a market research firm for the information technology industry. Tr. 1446. IDC provides purchasing information for high technology equipment, including residual value analysis, technology trends, fair market values, and overall evaluation of computer equipment. Tr. 1446, 1448. The IBM residual value report was a quarterly report IDC published to keep customers apprised of market trends. Tr. 1511.
Middleton defined "salvage" as "the amount of money obtained from scrap reclamation of metals and parts. From an economic point of view, salvage is defined as no value or very slight value. In many cases, such salvaged equipment is merely junked or destroyed with no realization of any monetary recovery." G-299.
90. With regard to the Cray Equipment, Middleton opined that the equipment had an August 1, 1991 fair market value of $3,941,740, or 38% of its $10,373,000 list price. G-299. Middleton testified that she evaluated the Cray Equipment by researching the limited number of Cray supercomputers in use, Cray's practice to control the used market for its equipment, and the values of IBM, Amdahl, and Hitachi Data Systems equipment of equivalent age. Tr. 1470. Middleton also testified that Cray's introduction of a CMOS technology based computer in 1991 negatively impacted the Cray Equipment's value. Tr. 1472. Middleton forecasted the Cray Equipment's residual value on August 1, 1992, August 1, 1993, August 1, 1994, August 1, 1995, and August 1, 1996 to be $2,282,060 (22% of list price), $1,141,030 (11%), $518,650 (3%), $51,865 (0.5%), and salvage value. G-299.
See Finding of Fact Nos. 121, 122, 123, 124, and 125 discussing the impact CMOS technology had on the residual values of mainframe computer equipment.
91. Both Ellegard and Middleton expressed concern over the lack of a secondary (used) market for Cray supercomputers and limited number of Cray users. Tr. 744. Cray completely controlled the market for its equipment. Tr. 744. Cray's practice was to reserve purchase options in its equipment to allow it to purchase its equipment back from an end-user. Tr. 1715. This significantly lowered the fair market value price for Cray supercomputers. G-43.32. Cray would also undercut any end-user's attempt to sell its equipment in the used market. The limited number of Cray supercomputers (numbered in the hundreds) allowed Cray to exert control over the market for its equipment.
Evidencing the fact is Cray's reservation of a purchase option in the ARCO Lease.
92. With regard to the IBM Equipment, the Court finds that Middleton and Ellegard erred in their residual value calculations. Middleton's values were skewed by her use of a July 1991 list price of $9,176,215, which did not accurately reflect the IBM Equipment's configuration. Ellegard, like the Page Appraisals, incorrectly measured the economic life of the IBM Equipment from the date of the August 1, 1991 sale-leasebacks. Contrary to his testimony that mainframe computers had a seven-year economic life, Ellegard forecasted an economic life for the IBM Equipment of approximately fourteen years. Ellegard's August 1, 1991 fair market value estimate exceeded the price Neptune paid for the IBM Equipment's component parts ($1,567,626) less than eight months earlier. Although Middleton injected the incorrect list price into her analysis, the Court finds Middleton's residual value forecast accurately depicted the seven-year economic life of the IBM Equipment and was more reliable.
93. The Court finds that as of August 1, 1991, the IBM Equipment had a fair market value of $1,110,685 (11% of the $10,097,135 list price). The Court finds the IBM Equipment's residual value on August 1, 1992, August 1, 1993, and August 1, 1994 was $706,799 (7% of list price), $201,943 (2%), and salvage value, respectively. The Court further finds that the IBM Equipment would have produced minimal, if any, residual re-lease rentals during the Window Period because the IBM Equipment reached salvage value prior to the commencement of the Window Period.
94. With regard to the Cray Equipment, the Court finds that neither Middleton nor Ellegard accurately measured the equipment's economic life. Similar to the IBM Equipment, Ellegard measured the Cray Equipment's economic life from the August 1, 1991 sale-leasebacks. Contrary to his testimony that mainframe computer equipment had a seven-year economic life, Ellegard forecasted an economic life for the Cray Equipment in excess of eight years. Middleton measured the Cray Equipment's economic life from 1989, the date Cray initially began shipping the Y-MP4/216 supercomputer series. Because the Cray Equipment could only be acquired by special order, the Court finds that the equipment's economic life should be measured from March 1990, the date the specially manufactured equipment was shipped to ARCO for installation.
95. The Court further finds that Middleton's residual value forecast, when properly measured from the March 1990 shipping date, accurately depicts the Cray Equipment's rapidly declining value based on Cray's introduction of a CMOS based supercomputer in 1991. Ellegard's residual value forecast (and the Page Appraisals) did not take into account CMOS technology's negative impact on the Cray Equipment's residual value.
96. The Court finds the Cray Equipment's fair market value as of August 1, 1991 was $6,846,180 (66% of the $10,373,000 list price). The Court further finds that the Cray Equipment's residual value on August 1, 1992, August 1, 1993, August 1, 1994, August 1, 1995, August 1, 1996, and August 1, 1997 was $3,941,740 (38% of list price), $2,282,060 (22%), $1,141,030 (11%), $311,190 (3%), $51,865 (0.05%), and salvage value.
After correcting Middleton's residual value forecast for the Cray Equipment, her analysis failed to provide a fair market value percentage as of August 1, 1991. The Court compared Middleton's, Ellegard's, and the Page Appraisals' valuations to assess the Cray Equipment's August 1, 1991 fair market value. Based on this comparison, the Court found that the Cray Equipment had an August 1, 1991 fair market value of 66% of the 10,373,000 list price. This number reflects the Cray Equipment's eighteen-month age as of the valuation date and the rapid technological obsolescence created by Cray's introduction of a CMOS supercomputer. The 66% of list price fair market value also reflects the Page Appraisals forecasted residual value after eighteen months.
97. Based on the Court's evaluation of Ellegard's and Middleton's expert testimony, the Court finds that the Page Appraisals significantly overstated the August 1, 1991 fair market value and forecasted residual values for the Cray and IBM Equipment.
98. The Court finds that the Cray and IBM Equipment's residual values were insufficient to produce a reasonable possibility of profit for IBC.
99. The Court's valuation of the Cray and IBM Equipment is supported by the minimal amount of consideration Neptune, TCLA 1990-II, and Mithril paid or received in exchange for an interest in the equipment's forecasted re-lease rents and residual sales proceeds. P-529. The Government's expert, Dr. David LaRue, a professor at the University of Virginia's School of Commerce, opined that "[i]n an arm's length exchange between unrelated and economically self-interested parties, the value of the consideration given up should bear a reasonably close relationship to the value of the consideration received." P-529.
100. Chaleff's testimony confirmed Dr. LaRue's analysis: "if [Neptune was] buying a lease that was halfway through its life, the single most important number for us to consider was what's that residual value and when is it likely to be available to us. And what are we willing to pay for it today. And that is the maximum amount of money that we would put into a transaction over and above the present value of the remaining lease payments." Tr. 1720
101. In the Neptune-TCLA 1990-II sale-leaseback, Neptune sold its right to 85% of the Cray and IBM's residual value between February 1, 1995 (subject to the Cray LAF) and December 31, 1997, and 100% thereafter, for $285,891. P-529. Based on 100% of the Page Appraisals, Neptune's 85% residual value interest had a pre-tax, present value of $3,299,613. P-529.
102. In the TCLA 1990-II-Mithril sale-leaseback, TCLA 1990-II sold its right to 38.25% of the equipment's residual value between February 1, 1995 (subject to the Cray LAF) and July 31, 1996, 85% of the equipment's residual value from August 1, 1996 through December 31, 1997, and 100% of the equipment's residual value after December 31, 1997 for $285,891. P-529. Based on 100% of the Page Appraisals, the residual interest TCLA 1990-II sold to Mithril had a pre-tax, present value of $2,448,514. P-529.
103. The enormous discrepancy between the consideration and forecasted residual values demonstrates Neptune's, TCLA 1990-II's, and Mithril's expectation that the Cray and IBM Equipment would generate minimal residual values after the expiration of the Neptune Lease and the likelihood that Neptune would exercise its purchase option.
K. The Purpose of the August 1, 1991 Sale-Leasebacks and PSC Leasing's Rental Stream Purchase.
104. Nixon testified that outside of ensuring the underlying transactions were properly documented, the IBC leasing team was not concerned with what happened "before" Bancor acquired its interest in TCLA 1990-II. Nixon's testimony belies the purpose of the August 1, 1991 sale-leasebacks and PSC Leasing's purchase of the Neptune Lease rental stream.
105. The August 1, 1991 sale-leasebacks and PSC Leasing's purchase of the Neptune Lease rental stream were orchestrated solely to inflate the "phantom losses" the IBC Defendants would report as rental expense deductions.
106. The Court finds the TCLA 1990-II-Mithril sale-leaseback was a non-negotiated, pre-arranged transaction designed to artificially inflate the Cray and IBM Equipment's purchase price. The inflation of Mithril's purchase price was necessary to maximize IBC's permanent tax losses. Mithril purchased the Cray and IBM Equipment for $2,575,000 more than TCLA 1990-II paid on the same date. The IBC Defendants' argument that the price did not actually increase by $2,575,000, but rather, merely reflects the Cray and IBM LAFs is illogical. The Cray and IBM LAFs actually decreased the value of the Cray and IBM Equipment. Mithril was purchasing Cray and IBM Equipment burdened with the $2,133,333 (plus ten percent interest) combined LAFs. The Cray and IBM LAFs (and Neptune Remarketing Fee) reflected Neptune's retention of significant interests in the equipment's residual value.
The IBC Defendants essentially claim that Mithril agreed to purchase the Cray and IBM Equipment subject to the Cray and IBM LAFs and pay an additional $2,575,000. The Court disagrees. The Cray and IBM LAFs were not other consideration that TCLA 1990-II gave up in the Neptune-TCLA 1990-II sale-leaseback for which it should have been compensated for in the TCLA 1990-II sale-leaseback.
107. The Court finds that the August 1 sale-leasebacks had no binding economic impact on any of the parties involved. The circular flow of rental payments and debt obligations, Mithril's inflated purchase price, and deferral of both sale-leasebacks identical $285,891 cash equity payment and PSC Leasing's $25,000 equity payment until Bancor acquired its 99% limited partnership interest establishes that the August 1 sale-leasebacks were not independent arm's length transactions freely entered into for economic gain.
108. TCLA 1990-II's $285,891 equity payment due to Neptune under the Neptune-TCLA 1990-II sale-leaseback was deferred until August 31, 1991. G-43.18. The deferral agreement allowed Neptune and TCLA 1990-II to cancel and annul the Neptune-TCLA 1990-II sale-leaseback if the 1991 Mainframe Investment was not made available to IBC. G-43.18.
109. Mithril's identical $285,891 equity payment due TCLA 1990-II under the TCLA 1990-II-Mithril sale-leaseback was deferred until August 31, 1991. G-43.28. The deferral agreement allowed TCLA 1990-II and Mithril to cancel and annul the TCLA 1990-II-Mithril sale-leaseback if the 1991 Mainframe Investment was not made available to IBC. G-43.28.
110. The $285,891 equity payment obligation TCLA 1990-II owed Neptune and Mithril owed TCLA 1990-II was ultimately paid by Mithril directly to Neptune on August 30, 1991. G-43.8, G-43.9.
111. PSC Leasing's August 15, 1991 purchase of the Neptune Lease rental stream from TCLA 1990-II was contingent upon the IBC acquiring the lessee positions. G-277, G-278. On August 29, 1991, Equilease Corporation transmitted PSC Leasing's $25,000 equity payment with instructions to hold the money in escrow pending the closing of the 1991 Mainframe Investment. G-278.
112. TMC's and EL-AA's capital contributions were deferred until August 31, 1991. On August 29, 1991, Equilease Corporation transmitted EL-AA's $990 capital contribution with instructions to hold the money in escrow pending the closing of the 1991 Mainframe Investment. G-278.
113. TCMA IV's and TCLA 1990-I's capital contributions for TCLA 1990-II were deferred until August 31, 1991. TCLA 1990-I never made its $534,947 capital contribution. Bancor, through IBC's cash payment, assumed TCLA 1990-I's obligation to make the $534,947 capital contribution in exchange for TCLA 1990-I's 99% limited partnership interest in TCLA 1990-II.
114. The Court finds that if TransCapital did not make the lessee positions available to IBC, all of the underlying transactions involving Neptune, TCLA 1990-II, Mithril, and PSC Leasing would have been cancelled and the 1991 Mainframe Investment would have unraveled.
115. As discussed in Finding of Fact No. 45, the failure to make the lessee positions available to IBC would require TransCapital to forfeit the $300,000 investment fee (less certain expenses) held in the Grossman Flask escrow account to IBC.
L. The Fee Agreements.
116. On August 1, 1991, TCLA 1990-II entered into a consulting agreement with TransCapital. Under the consulting agreement, TCLA 1990-II was required to pay TransCapital $565,350.51 for investment banking and consulting services provided in connection with the TCLA 1990-II-Mithril sale-leaseback. The consulting fee was deferred until August 31, 1991. The $565,350.51 was payable from Bancor's payment of TCLA 1990-I's $534,937 capital contribution, TCMA IV's $5,403.51 capital contribution, and PSC Leasing's $25,000 cash payment for purchasing the Neptune Lease rental payments.
117. On August 1, 1991, TransCapital and LS Leasing, Inc. executed an Investment Banking Agreement requiring TransCapital to pay a $626,886 fee to LS Leasing for services it performed in connection with the TCLA 1990-II-Mithril sale-leaseback. The agreement instructed TransCapital to pay the fee on or before August 31, 1991 from: (1) $565,350.51 from TCLA 1990-II's consulting fee and (2) $61,535.49 from the Grossman Flask escrow account. G-32. Despite the language of the agreement, LS Leasing provided no services in connection with the TCLA1990-II-Mithril sale-leaseback. The Investment Banking Agreement was a conduit for TransCapital's payment to Joel Mallin-related entities for locating the Cray and IBM Equipment leasing portfolio and supplying the tax-exempt entity.
LS Leasing was a Florida corporation owned by Preston Golden. Mallin represented Golden for over thirty years.
118. On September 3, 1991, LS Leasing disbursed $320,886 to Equilease Capital Corporation, $286,000 to Equilease Corporation, $10,000 to Equitable Leasing Company, and $10,000 to Joel Mallin.
The Court notes that the $286,000 paid to Equilease Corporation is nearly identical to the $285,891 equity payment Mithril, a subsidiary of Equilease Holding (Equilease Corporation's parent company), paid Neptune.
M. The Neptune Option.
119. On May 16, 1994, Neptune notified TCLA 1990-II that it was exercising the Neptune Option with regard to the Cray and IBM Equipment, effective May 31, 1994. G-43.32. Because the Cray LAF ($2,412,266.73 remaining unpaid) and IBM LAF ($369,750.68 remaining unpaid) exceed the fair market value of the Cray and IBM Equipment, Neptune was not required to pay anything for the equipment. G-43.32. Neptune estimated the Cray Equipment had a fair market value of $1,000,000 if sold to an end-user, however, "[e]nd-user transactions for this product are extremely infrequent due to competition from new Cray products and softness in the overall economy. We feel the best avenue for remarketing this unit at this time will be to sell it back to Cray. This type of transaction will result in significantly less tha[n] the $1,000,000 potential value of this equipment." G-43.32. Neptune estimated the IBM Equipment had a fair market value of $75,000. G-43.32.
120. On June 10, 1994, Zukerman notified Kavy of Neptune's decision to exercise the Neptune Option. G-38. "Since the current fair market value of such equipment is far below the outstanding balance of the deferred lease acquisition fees owed to Neptune, no cash is payable to [Bancor]. . . . On the positive side, however, the early termination results in [Bancor] accelerating $4,534,153 of tax deductions ($6,977,571 realized versus $2,443,418 scheduled)." G-38.
121. The IBC Defendants argue that Neptune's exercise of the Neptune Option was a result of a precipitous cliff in mainframe computer values during 1993 and 1994. Numerous witnesses testified that the introduction of CMOS air-cooled mainframe computer technology, which allowed for unprecedented increases in memory and speed from much smaller machines, significantly impacted the value of mainframe computer equipment. Tr. 684-85, 747-49. The IBC Defendants claim the rapid decrease in value was unforeseeable.
The Cray and IBM Equipment were ECL water-cooled mainframe computer technology that required spacious, air-conditioned "glass house" rooms.
122. IBM introduced its first CMOS based computer in 1994.
123. Cray introduced its first CMOS based computer in 1991.
124. The Court finds that IBM's introduction of CMOS technology in 1994 was not foreseeable in August 1991. The Court finds, however, that the introduction of IBM's CMOS technology had little effect on the residual value of the IBM Equipment. In 1994, the IBM Equipment was already seven years old and approaching salvage value.
125. The Court finds that Cray's introduction of CMOS technology in 1991 was foreseeable in August 1991. The Court finds that Cray's CMOS technology computer began to negatively impact the residual value of the Cray Equipment in 1991.
126. Neptune's exercise of the Neptune Option terminated the 1991 Mainframe Investment. Because Neptune exercised its purchase option prior to the beginning of the Window Period, IBC never received any residual revenue from the Cray and IBM Equipment.
N. TCLA 1990-II's Tax Returns.
127. On its short-year August 31, 1991 tax return, TCLA 1990-II reported an $11,317,188 gain from the sale of the Cray and IBM Equipment to Mithril, PSC Leasing's purchase of the Neptune Lease rental stream, and interest income received form the Mithril Debt. P-162. The income and deductions flowed through to TCLA 1990-II's partners at that time, TCMA IV (1%) and TCLA 1990-I (99%). The Pequots were allocated approximately $10,859,974.
128. On its year-end December 31, 1991 tax return, TCLA 1990-II reported $469,758 of rental income and $1,108,299 of rental deductions. The income and deductions flowed through to TCLA 1990-II's partners at that time, TCMA IV (1%) and Bancor (99%). P-163.
129. On its year-end December 31, 1992 tax return, TCLA 1990-II reported $1,357,124 of rental income and $3,324,896 of rental deductions. The income and deductions flowed through to TCLA 1990-II's partners at that time, TCMA IV (1%) and Bancor (99%). P-164. 130. On its year-end December 31, 1993 tax return, TCLA 1990-II reported $1,121,901 of rental income and $3,324,896 of rental deductions. The income and deductions flowed through to TCLA 1990-II's partners at that time, TCMA IV (1%) and Bancor (99%). P-165.
131. On its short-year May 31, 1994 tax return, TCLA 1990-II reported $344,633 of rental income and $7,392,864 of rental deductions. The income and deductions flowed through to TCLA 1990-II's partners at that time, TCMA IV (1%) and Bancor (99%). P-166.
132. Despite not receiving any residual revenue, IBC was still able to obtain over $11,000,000 in "phantom" tax losses.
O. The FPAA.
133. On April 30, 2001, the IRS issued the FPAA to TCLA 1990-II for the tax years ending August 31, 1991, December 31, 1991, December 31, 1992, December 31, 1993, and May 31, 1994. The FPAA provided three alternative theories for challenging TCLA 1990-II's tax returns:
It is determined that the amounts of Net Income (Loss) From Other Rental Activities and Interest Income are not allowable because they emanate from transactions that lack economic substance, were prearranged and predetermined, and were without legitimate business purpose. In addition, you have not shown that the amounts otherwise meet the requirements to be recognized or deducted under the Internal Revenue Code.
Alternatively, it is determined that the August 15, 1991 transaction in which TransCapital Leasing Associates 1990-II purported to sell to PSC Leasing Corp. the right to receive rental income from the Neptune Group, Inc. was not in substance a sale. As a result, it is determined that the income TransCapital Leasing Associates 1990-II reported from the transaction during its year ended August 31, 1991 is properly spread over the periods to which the rental income relates rather than recognized in full in the year ended August 31, 1991.
Alternatively, it is determined that the $11,518,795 of rental income reported by TransCapital Leasing Associates 1990-II in its year ended August 31, 1991 must be reported by Bancor Development Co. because the transactions that produced the rental income were an interrelated series of transactions designed to shift income to a tax neutral entity while allowing Bancor Development Co. to claim the related deductions.
P-513.
134. The FPAA's disallowance of TCLA 1990-II's rental expense deductions associated with the 1991 Mainframe Investment resulted in the IBC Defendants incurring a $4,082,835 tax deficiency.
Conclusions of Law
1. Any finding of act herein above which also constitutes a conclusion of law is adopted as a conclusion of law. Any conclusion of law herein made which also constitutes a finding of fact is hereby adopted as a finding of fact.
A. Jurisdiction.
2. The Court has jurisdiction over this matter pursuant to 26 U.S.C. §§ 6226(a) and (e) and 28 U.S.C. § 1346(e). TransCapital Leasing Assocs., 1990-II, L.P. v. United States, 398 F.3d 1317, 1320 (Fed. Cir. 2005).
B. Burden of Proof.
3. An IRS FPAA is the functional equivalent of a notice of tax deficiency. Sealy Power, Ltd. v. Comm'r, 46 F.3d 382, 385-86 (5th Cir. 1995). The IRS's determination of deficiency is presumed to be correct. Id. at 386. This presumption places the burden on the taxpayer to produce "evidence showing that the [IRS's] determination is incorrect." Id. (citations omitted). In cases involving unreported income, some courts have not given effect to the presumption of correctness and shifted the burden from the taxpayer to the IRS when the notice of deficiency is determined to be arbitrary or excessive. Id. (citing Portillo v. Comm'r, 932 F.3d 1128, 1132 (5th Cir. 1991); Donley v. Comm'r, 791 F.2d 383, 384 (5th Cir. 1986)). The burden shifting does not apply where an FPAA challenges the taxpayer's right to tax deductions:
The burden of overcoming the presumption of correctness in a deduction case properly rests with the taxpayer, who is the best source of information for determining entitlement to the claimed deductions. In a deduction case, therefore, we apply the general rule of not looking behind the notice of deficiency to determine whether it is arbitrary.Id. at 387. Here, the FPAA challenged the IBC Defendants' right to claim rental expense deductions associated with the 1991 Mainframe Investment, not the failure to report income. Accordingly, the FPAA is presumed to be correct and the IBC Defendant's bear the burden of producing evidence that establishes their entitlement to the rental expense deductions.
C. Uncoupling the 1991 Aircraft Investment and 1991 Mainframe Investment.
4. "A taxpayer cannot avoid the requirements of economic substance simply by coupling a routine economic transaction generating substantial profits . . . to a unique transaction that otherwise has no hope of turning a profit." Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122, 183 (D. Conn. 2004). The relevant inquiry is whether the transaction from which the deductions arose had economic substance. Nicole Rose Corp. v. Comm'r, 320 F.3d 282, 284 (2d Cir. 2003).
5. The combined economic benefits of the 1991 Aircraft Investment and 1991 Mainframe Investment are not relevant. The Court's analysis must focus solely on the 1991 Mainframe Investment.
D. The Sham Transaction Doctrine.
6. The Government's primary challenge to the 1991 Mainframe Investment is based on the sham transaction doctrine, i.e. the IBC Defendants' claimed rental expense deductions "emanate[d] from transactions that lack economic substance . . . and were without legitimate business purpose." P-513.
7. The fundamental premise underlying the Internal Revenue Code is that taxation is based upon a transaction's substance rather than its form. Freytag v. Comm'r, 904 F.2d 1011, 1015 (5th Cir. 1990). The sham transaction doctrine is a common law "substance over form" doctrine created by the United States Supreme Court in Gregory v. Helvering, 293 U.S. 465 (1935). A transaction will not be treated as a sham unless it is shaped solely by tax-avoidance features. Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1978) ("[W]here . . . there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties."). "[S]ham transactions are not recognized for tax purposes, and losses allegedly generated by such transactions are not deductible." Freytag, 904 F.2d at 1015. Courts applying the principles of Gregory and Frank Lyon have developed parallel analyses focusing on the transaction's objective economic substance and the taxpayer's subjective business purpose.
8. In Rice's Toyota World, Inc. v. Commissioner, the Fourth Circuit held Frank Lyon required a rigid two-prong analysis:
To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purpose other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of profit exists.752 F.2d 89, 91 (4th Cir. 1985).
9. In ACM Partnership v. Commissioner, the Third Circuit, applying the principles of Gregory, held that a transaction's economic substance and business purpose were related factors, not a two-prong test:
In applying [ Gregory's] principles, we must view the transactions "as a whole, and each step, from the commencement . . . to the consummation . . . is relevant. The inquiry into whether the taxpayer's transactions had sufficient economic substance to be respected for tax purposes turns on both the "objective economic substance of the transactions" and the "subjective business motivation" behind them. However, these distinct aspects of the economic sham inquiry do not constitute discrete prongs of a "rigid two-step analysis," but rather represent related factors both of which inform the analysis of whether the transaction had sufficient substance, apart from its tax consequences, to be respected for tax purposes.157 F.3d 231, 247 (3d Cir. 1998).
10. The Fifth Circuit declined to adopt either Rice's Toyota World's two-prong analysis or ACM Partnership's factors test as the appropriate standard for the sham transaction doctrine. Compaq Computer Corp. v. Comm'r, 277 F.3d 778, 781 (5th Cir. 2001). In Compaq, the court recognized the tension between Rice's Toyota World and ACM Partnership, but declined to adopt either view "[b]ecause the ADR transaction in this case had both economic substance and a business purpose." Id. at 781-82.
11. A fair reading of Compaq requires the Court to disregard the 1991 Mainframe Investment only if the transaction was entered into without a legitimate business purpose and lacked economic substance. See id.
1. Business Purpose.
12. The business purpose inquiry concerns the taxpayer's subjective motive for entering the transaction, including whether the taxpayer was motivated by no business purpose other than obtaining tax benefits in entering the transaction. Compaq, 271 F.3d at 781 (citing Rice's Toyota World, 752 F.2d at 91). This gives effect to Frank Lyon's mandate that "a transaction cannot be treated as a sham unless the transaction is shaped solely by tax avoidance considerations." Id. (quoting Rice's Toyota World, 752 F.2d at 92)
13. It is significant, however, that neither Compaq nor Rice's Toyota World involved a taxpayer's investment in a partnership. This is important because measuring the transaction's business purpose from the partnership's perspective versus the taxpayer partner's perspective could render divergent results. "[I]n the context of a limited partnership, the entity engaging in the transaction and the taxpayer are entirely different, and the lack of economic substance of the partnership transaction that led to the partner's substantial underpayment of taxes in fact may be completely unknown to the taxpayer-partner." Weiner v. United States, 255 F. Supp. 2d 673, 679 (S.D. Tex. 2002); aff'd in part, rev'd in part on other grounds, and remanded for further proceedings, 389 F.3d 152 (5th Cir. 2004).
14. The Fifth Circuit has not addressed this issue in the specific context of the sham transaction doctrine. The Fifth Circuit, however, repeatedly looked to the business purpose of the taxpaying partner when determining whether an enhanced interest penalty was proper under former Internal Revenue Code section 6621(c). Chamberlain v. Comm'r, 66 F.3d 729, 732 (5th Cir. 1995) ("In determining a profit motive we focus on the intent of the taxpayer, not that of the underlying entity or activity."). Former section 6621(c) allowed the imposition of additional interest where there was a substantial underpayment of tax attributable to a tax motivated transaction. See Lukens v. Comm'r, 945 F.2d 92, 99 (5th Cir. 1991). A tax motivated transaction included "transactions that were not entered into for profit and are without economic substance." Lukens, 945 F.2d at 99. The sham transaction standard under former section 6621(c) is identical to the Compaq analysis.
15. In evaluating whether the 1991 Mainframe Investment had a legitimate business purpose, other than tax avoidance, it must focus on the subjective intent of IBC. The business purpose inquiry focuses on the subjective intent of IBC to fund Bancor's acquisition of TCLA 1990-I's 99% limited partnership interest in TCLA 1990-II.
16. IBC's participation in the 1991 Mainframe Investment was motivated solely by tax avoidance.
17. The Cray and IBM Equipment's residual value would have been the crucial due diligence inquiry for a person with a legitimate business purpose for making a profit from the 1991 Mainframe Investment. The IBC Defendants, however, failed to adequately evaluate whether the Cray and IBM Equipment would have sufficient residual value during the Window Period.
18. The minimal steps IBC took to verify the accuracy of the Page Appraisals were misplaced. Neither the ARCO Debt nor Timken Debt were measures of the Cray and IBM Equipment's fair market values. TransCapital's $61,535 payment in satisfaction of the LS Leasing investment banking fee was not an investment in the residual value of the transaction. TransCapital was paying a fee to Equilease and the other Mallin-related entities for providing the tax-exempt Pequots, the Cray and IBM Equipment leasing portfolio, and Mithril to pay the over-inflated purchase price.
19. IBC had no incentive to verify the accuracy of the Page Appraisals. The Page Appraisals' overstated residual values for the Cray and IBM Equipment inured to IBC's benefit. The only number the IBC Defendants were interested in was the amount of the Mithril Debt ($11,454,715), which was derived from the overstated Page Appraisals ($11,750,000). The Page Appraisals were the justification for Mithril's purchase price magically inflating to $2,575,000 more than TCLA 1990-II paid Neptune for the same equipment.
Mithril's $285,891 equity payment and $11,454,715 debt acquisition totaled $11,740,606, or $9,394 less than the Page Appraisals.
20. TransCapital's offering documents touted the permanent tax benefits of the 1991 Mainframe Investment, not its profit potential. The permanent tax losses were not an economic function of the IBC Defendants' investment in the Cray and IBM Equipment's residual value during the Window Period. "Even in a worst case scenario (zero residual revenues), the tax benefits alone will pay back the entire investment and provide a substantial profit." G-41.
21. Unlike Compaq, the 1991 Mainframe Investment minimized, and effectively eliminated, all risk attendant with the transaction. 277 F.2d at 787 ("The absence of risk that can legitimately be eliminated does not make a transaction a sham."). Each discrete step of the transaction occurred in a market controlled by TransCapital and/or Equilease Capital. The August 1 sale-leasebacks were not arm's length transactions executed on a public market. Rather, each discrete step was a pre-arranged transaction designed to create permanent tax losses for IBC. The tax losses were a guaranteed function of the investment. There was no risk that the tax losses would not be made available to the IBC Defendants because the Mithril Debt and Lease involved circuitous payments that never required any money to exchange hands. IBC's tax deductions mounted with the mere passage of time.
Nixon's testimony that the permanent tax losses were at risk because there was no guarantee IBC would have taxable gains for the losses to offset lacks credibility. "A sensible taxpayer would have engaged in such a transaction only if it had a . . . gain against which to offset the . . . losses the taxpayer knew would result from the transaction." Compaq, 277 F.3d at 786 n. 8.
22. The Court is cognizant that whether the Cray and IBM Equipment maintained sufficient residual value to produce an economic profit was a risk the 1991 Mainframe Investment could not completely eliminate. This risk, however, was insignificant because Neptune, TCLA 1990-II, and Mithril placed little value on the Cray and IBM Equipment's residual interests after the expiration of the Neptune Lease. IBC had no expectation of profiting from the residual values. The Court finds that this risk was further minimized by the transaction economics, i.e. diminished Cray and IBM Equipment's residual value coupled with the significant Cray and IBM LAFs, mandated Neptune exercise its purchase option. See Rice's Toyota World, 752 F.2d at 93. Neptune's purchase option benefitted IBC by accelerating the Mithril Lease rental expense deductions.
TransCapital's offering documents highlighted IBC's tax acceleration benefit: "If the economics of the lease positions dictate the resale of that portion of the portfolio before the end of the term, the total losses remaining on that portion will be accelerated into the year of sale." G-41.
23. IBC's sole motivation for entering the 1991 Mainframe Investment was to achieve over $11,000,000 in permanent tax losses. In finding that IBC's subjective business purpose was shaped solely by tax avoidance, the Court is not "ignor[ing] the reality that the tax laws affect the shape of nearly every business transaction." See Frank Lyon Co., 735 U.S. at 580; Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934 (Hand, J. Learned) ("Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes."). The reality is that the rental expense deductions claimed by IBC "were `not economically inherent in' the transactions but rather were `created artificially' by machinations whose only purpose and effect was to give rise to the desired tax consequences." ACM Partnership, 157 F.3d at 245.
2. Economic Substance.
24. The economic substance prong of the sham transaction doctrine "requires an objective determination of whether a reasonable possibility of profit from the transaction existed apart from the tax benefits." Rice's Toyota World, 752 F.2d at 94.
25. The 1991 Mainframe Investment had no possibility of earning the IBC Defendants a profit unless the Cray and IBM Equipment maintained sufficient residual value to produce re-lease rentals in excess of $1,344,273 during the Window Period for IBC to recover its $559,947 investment.
The $1,344,273 break-even profit point is based on IBC only being entitled to 89.1% of TCLA 1990-II's 46.75% Window Period interest in the Cray and IBM Equipment's residual value.
26. Based on the Court's finding that the Cray and IBM Equipment had August 1, 1994 (six months before the Window Period commenced) fair market values of $1,141,030 and salvage value, respectively, the Cray and IBM Equipment's residual value was not sufficient to produce a profit.
27. Neither the ARCO and Timken Debt nor TransCapital's $61,535 payment to LS Leasing were objective indicators of the 1991 Mainframe Investment's profitability.
28. The $285,891 equity payment TCLA 1990-II and Mithril agreed to pay in exchange for an interest in the Cray and IBM Equipment's residual values is indicative of the likelihood that neither party expected to recover any residual values. Mithril satisfied its, and TCLA 1990-II's, $285,891 equity payment obligation by paying Neptune. Mithril's $285,891 payment was reimbursed through LS Leasing's distribution of $286,000 of the investment banking fee to Equilease Corporation, a subsidiary of Mithril's parent corporation, Equilease Holding Company. Equilease Corporation received this payment despite not being involved in the 1991 Mainframe Investment. This circuitous flow of funds evidences the 1991 Mainframe Investment's lack of economic purpose.
29. The 1991 Mainframe Investment's sole economic benefit was the tax benefits dollar-for-dollar increase of IBC's net income. The transaction's permanent tax benefits were achieved despite TCLA 1990-II and Mithril not exchanging any real money to satisfy the Mithril Debt and Lease payment obligations.
30. The 1991 Mainframe Investment "generated only a `phantom loss' that was not `economically inherent in the object of the [transaction]' and did not have `economic substance separate and distinct from [the] economic benefit achieved solely by tax reduction." ACM Partnership, 157 F.3d at 249.
31. The 1991 Mainframe Investment had no reasonable possibility of profit and lacked a legitimate non-tax business purpose. The transaction was a mere formality concocted in a controlled market devoid of any real risk of loss.
32. Accordingly, the IBC Defendants were not entitled to claim rental expense deductions related to the 1991 Mainframe Investment on their consolidated tax returns dated, December 31, 1991, December 31, 1992, December 31, 1993, and May 31, 1994.
33. "Where a transaction is properly determined to be a sham, the [Government] is entitled to ignore the labels applied by the parties and tax the transaction according to its substance." Rice's Toyota World, 752 F.2d at 95. IBC's investment in the 1991 Mainframe Investment was not a purchase of 89.1% of 46.75% of the Cray and IBM residual interests during the Window Period. IBC, rather, purchased a 20:1 guaranteed tax write-off.
E. PSC Leasing's Purchase of the Neptune Lease Rental Stream.
34. The Government's first alternative theory asserts that TCLA 1990-II's sale of the Neptune Lease rental stream to PSC Leasing was not in substance a sale, but a financing of the payments over the course of the investment. Under the Government's financing versus sale theory, the $8,815,378 reported from the PSC Leasing transaction on TCLA 1990-II's short-year August 31, 1991 tax return should be recognized over the course of the investment, i.e. recognized when the income was received.
35. A transfer of a right to receive future income is a sale if the transfer is made for valuable consideration, the transfer constitutes a complete and valid assignment, and the buyer bears the risk of not receiving the future income. See Estate of Stranahan v. Comm'r, 472 F.2d 867, 871 (6th Cir. 1973). Where a future income secured by non-recourse debt is sold, the assumption of non-recourse debt accelerates the reporting of a reciprocal amount of gain. See Crane v. Comm'r, 331 U.S. 1, 14 (1947). The receipt of pre-paid income must be reported when received. Schlude v. Comm'r, 372 U.S. 128, 137 (1963).
36. TCLA 1990-II transferred the right to receive the Neptune Lease rental stream to PSC Leasing pursuant to a valid assignment agreement. PSC Leasing paid $25,000 in cash and assumed $8,790,378 of the Neptune Debt for the right to receive the Neptune Lease rental stream. PSC Leasing bore the risk that the rental income would not be paid. Accordingly, PSC Leasing's purchase of the Neptune Lease rental stream was in substance a sale.
Although the Neptune Lease and Debt payments were equal in timing and amount and real money exchanged hands, PSC Leasing did not assume the entire principal balance of the Neptune Debt. PSC Leasing assumed only that portion of the Neptune Debt due and owing as of August 15, 1991, which amounted to $8,790,378, or $89,337 less than the original principal balance of the Neptune Debt. Tr. 1792, P-17. PSC Leasing bore the risk that it would not receive this $89,337 difference. Corrigan testified that the $89,337 figure less the $25,000 equity payment reflected PSC Leasing's profit potential in the transaction. Tr. 1792.
The Court rejects the Government's argument that Corrigan and PSC Leasing were reimbursed the $25,000 equity payment through LS Leasing's disbursement of the investment banking fee and Corrigan's stake in Equilease Capital Corporation. Unlike Mithril and Equilease Corporation, PSC Leasing was not housed under Mallin's Equilease Holding or Equitable Leasing corporate umbrellas. PSC Leasing was a separate company Corrigan formed prior to his involvement with Mallin and Equilease Capital.
37. The Court finds that TCLA 1990-II's receipt of PSC Leasing's $25,000 cash payment coupled with PSC Leasing's assumption of the remainder of the Neptune Debt was receipt of future income. TCLA 1990-II was required to accelerate the $8,815,378 gain and report it as received on August 15, 1991. TCLA 1990-II's reporting of the $8,815,378 gain on its August 31, 1991 tax return was proper.
F. The Step-Transaction Doctrine.
Contrary to the IBC Defendants' argument, the Government did not abandon its step-transaction theory at trial. Tr. 1652.
38. The Government's second alternative theory applies the "step transaction doctrine" to collapse each discrete step of the 1991 Mainframe Investment and reallocate the "$11,518,795 of rental income reported by TransCapital Leasing Associates 1990-II in its year ended August 31, 1991 . . . [to] Bancor . . . because the transactions that produced the rental income were an interrelated series of transactions designed to shift income to a tax neutral entity while allowing Bancor . . . to claim the related deductions."
39. Similar to the sham transaction doctrine, the step transaction doctrine is a "substance over form" taxation theory. See Security Indus. Ins. Co. v. United States, 702 F.2d 1234, 1244 (5th Cir. 1983). The step transaction doctrine determines the tax consequences of an interrelated series of transactions by viewing each of them as component parts of an overall plan. Id. (citing Crenshaw v. United States, 450 F.2d 472, 475 (5th Cir. 1971). "The individual tax significance of each step is irrelevant, however, if the steps when viewed as a whole amount to a single taxable transaction." Id.
40. Under the Internal Revenue Code's partnership taxation rules, a "partnership item" can only be determined at the partnership level. 26 U.S.C. § 6233. A "partnership item" is "with respect to a partnership, any item required to be taken into account for the partnership's taxable year under any provision of subtitle A to the extent regulations prescribed by the Secretary provide that . . . such item is more appropriately determined at the partnership level than at the partner level." As such, TCLA 1990-II's income and loss allocation for the tax year ending August 31, 1991 can only be determined at the partnership level. 26 U.S.C. § 6233(b).
41. The partnership taxation rules limit a district court's subject matter jurisdiction "to determin[ing] all partnership items of the partnership for the partnership taxable year to which the [FPAA] relates, the proper allocation of such items among partners, and [certain penalties]." 26 U.S.C. § 6226(f); Andantech L.L.C. v. Comm'r, 331 F.3d 972, 980 (3d. Cir. 2003). 26 U.S.C. § 6233 and Treasury Regulation 301.6233-1 extend the district court's limited jurisdiction to determine that a putative partnership that files a partnership return is not a valid partnership and to determine that there are no partnership losses for the putative partners to deduct. The extension of jurisdiction is not unlimited: "Any [FPAA] or judicial determination . . . may include a determination that the entity is not a partnership for such taxable year as well as determinations with respect to all items of the entity which would be partnership items, as defined in section 6231(a)(3) . . . if such entity had been a partnership in such taxable year. . . ." Treas. Reg. 301.6233-1(a).
42. The FPAA relates to TCLA 1990-II's tax years ending August 31, 1991, December 31, 1991, December 31, 1992, December 31, 1993, and May 31, 1994. TCLA 1990-II's partners as of August 31, 1991 (TCMA IV and TCLA 1990-I) differed from its partners in the remaining tax years (TCMA IV and Bancor). The Government's theory would require the Court to disregard TCLA 1990-II's pre-August 31, 1991 form and find Bancor, a non-partner at that time, to be a putative partner, by collapsing each of the 1991 Mainframe Investment's transactions in a single transaction. The Court's jurisdiction does not extend so far. The Court cannot "fictionally," for tax purposes only, make Bancor a partner in a partnership in which it was not a partner. As of August 31, 1991, Bancor had no interest in TCLA 1990-II. The Court's jurisdiction, with respect to this issue, is limited to allocating income and loss between TCLA 1990-II's partners as of August 31, 1991.
43. The Court finds that it lacks subject matter jurisdiction to apply the step transaction doctrine for purposes of reallocating $11,518,795 of rental income reported on TCLA 1990-II's August 31, 1991 tax return to Bancor.
Conclusion
This case presents a complex fact pattern through which IBC, for a $559,947 fee, received over $11,000,000 in tax deductions without any corresponding income. This 20:1 tax write-off was an artificial creation of a tax avoidance structure that bifurcated "phantom" income from "phantom" loss.
Applying Compaq's sham transaction analysis, the Court finds that IBC had no legitimate business purpose other than tax avoidance for entering into the 1991 Mainframe Investment and there was no reasonable expectation of profit. The 1991 Mainframe Investment was a transaction solely shaped by tax avoidance objectives and completely lacking in profit potential.
Accordingly, the Court finds that judgment should be entered in favor of the Government and the FPAA sustained with regard to the Government's sham transaction theory. The IBC Defendants should take nothing. The Court will issue a separate judgment pursuant to Rule 58.
For the reasons stated herein, Petitioners' motion and renewed motion for directed verdict (docket nos. 121 123) are DENIED and Petitioners' motion to strike the Government's post-trial response brief (docket no. 150) is GRANTED as to each page in excess of the Court-ordered twenty page limit.