Nature of the Case
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Facts
Each of P's three partners was created as a subsidiary of a larger entity several days before ACM's formation. Southampton was incorporated as a wholly-owned subsidiary of Colgate-Palmolive Company (Colgate). The other two partners were subsidiaries of Algemene Bank Nederland N.V. (ABN), and Merrill Lynch. This was all cooked up by Merril Lynch. During the previous year, Colgate had reported $104,743,250 in long-term capital gains. Colgate considered proposals to reduce the tax liability arising from those capital gains. Merrill proposed an investment partnership that would generate capital losses which Colgate could use to offset some of its 1988 capital gains. The transaction is detailed as follows: A (a foreign entity), B, and C form the ABC Partnership (ABC) with respective cash contributions of $75, $24, and $1. Immediately thereafter, ABC invests $100 in short-term securities which it sells on December 30, 1989, to an unrelated party. The fair market value and face amount of the short-term securities at the time of the sale are still $100. In consideration for the sale, ABC receives $70 cash and an installment note that provides for six semiannual payments. Each payment equals the sum of a notional principal amount multiplied by the London Interbank Offering Rate (LIBOR) at the start of the semiannual period. ABC uses the $70 cash and the first payment on the installment note to liquidate A's interest in ABC and uses the subsequent interest payments to purchase long-term securities. Colgate put a twist on it in that it would be Colgate’s debt that would be purchased. Colgate was vulnerable to a decline in interest rates and perceived an opportunity to rebalance its debt profile, thus decreasing its exposure to falling interest rates, by acquiring its long-term debt issues at their presently discounted prices. The acquisition of its own debt issues would decrease Colgate's exposure to falling interest rates because by acquiring those debt issues as an asset, Colgate effectively would reap the benefits of receiving the above-market interest payments due on those issues, thus hedging against the burdens associated with owing those payments. The acquisitions would be off Colgate's books, thus permitting Colgate to carry out its debt acquisition strategy without alerting potential acquirors to the internal accumulation of debt issues which, by increasing the capacity for internal leverage, would increase Colgate's vulnerability to a hostile takeover bid. Colgate would use partnership capital to acquire its debt issues immediately at advantageous prices, then to retire and reissue the debt when market conditions were more favorable. The debt would remain outstanding for accounting purposes, reducing Colgate's vulnerability to potential acquirors. Merrill got ABN to sign on as the foreign interest. Colgate would contribute $30 million, ABN $169.3 million, and Merrill $.7 million. The partnership invests its entire $200 million capitalization in short-term, floating-rate private placement securities. It then sells the short-term notes for a combination of cash and LIBOR-based notes and uses the cash to acquire Colgate debt. The partnership exchanges a portion of the long-term Colgate debt for newly issued medium-term Colgate debt, pursuant to a provision that affords Colgate the option of making such exchanges through the partnership. The tax consequences were as follows: The liquidation of $200 million of Short-Term Notes in exchange for approximately $140 million of cash and $60 million market value of LIBOR notes should result in approximately $106 million of gain to the Partnership. Of that $16 million, will be allocable to [Colgate]. If . . . LIBOR notes are distributed to [Colgate], each $10 million market value of the LIBOR notes distributed should have a tax basis of approximately $28 million. In a succeeding tax year, the Partnership will recognize a loss on sale or at maturity of the remaining LIBOR Notes. 98% of such loss will be allocable to Colgate because Colgate will be a 98% partner at such time once ABN is liquidated from the partnership. The combined, losses on sale of LIBOR Notes distributed to [Colgate] and losses on sale of LIBOR Notes by the Partnership should exceed $106 million. Colgate should recognize a net loss of approximately $90 million. After discounting and transaction costs the transaction produces over a $20 million present value benefits to Colgate. The transaction would result in significant capital gains in the first year, consisting of the $106.7 million difference between the $140 million cash received that year and the $33.3 million basis recovered that year, and would result in capital losses in each of the ensuing years because the contingent payments received in each of those years considering imputed interest would fall short of the $33.3 million basis to be recovered in each of those years. The aggregate projected capital losses in the ensuing years equaled precisely the amount of capital gains reported in the first year, and the document stated that the recognition of those losses 'may be accelerated in any year subsequent to 1989 by sale of the remaining LIBOR notes.' On its 1989 tax return, Southampton reported a net 1989 capital loss of $13,521,432 and did not report any net tax liability on its share of ACM's gain from the disposition of Citicorp notes. For its tax year ended December 31, 1991, ACM reported a capital loss of $84,997,111 from its December 17, 1991 sale of the BOT LIBOR notes. This loss consisted of the difference between the $10,961,581 that ACM received for those notes and the remaining $95,958,692 basis in those notes. Because Colgate, together with its subsidiary Southampton, by that time owned 99.7% of the partnership, Colgate claimed 99.7% of the $84,997,111 capital loss on its 1991 return for a total capital loss of $ 84,537,479. Colgate then filed an amended 1988 return reporting this loss as a carryback pursuant to I.R.C. § 1212 to offset a portion of its 1988 capital gains. D said no way. It disallowed the $84,997,111 capital loss deduction which ACM reported in 1991. It held that the transactions involving the purchase and sale of the Citicorp notes in exchange for cash and LIBOR notes, 'were shams in that they were prearranged and predetermined. . .. Said transactions were devoid of economic substance necessary for recognition for federal income tax purposes and were totally lacking in economic reality. The transactions were created solely for tax-motivated purposes without any realistic expectation of profit.' P filed a petition in the Tax Court contesting the adjustments. The court held that 'a taxpayer is not entitled to recognize a phantom loss from a transaction that lacks economic substance.' The claimed losses 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. P appealed.
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