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Baxter v. Commissioner of Internal Revenue Service

United States Court of Appeals, Fourth Circuit

December 7, 2018

GUY R. BAXTER; LONNIE C. BAXTER, Petitioners - Appellants,
v.
COMMISSIONER OF INTERNAL REVENUE SERVICE, Respondent - Appellee.

          Argued: October 31, 2018

          Appeal from the United States Tax Court. (Tax Ct. No. 016835-08)

         ARGUED:

          David Decoursey Aughtry, CHAMBERLAIN, HRDLICKA, WHITE, WILLIAMS & AUGHTRY, Atlanta, Georgia, for Appellants.

          Jennifer Marie Rubin, UNITED STATES DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee.

         ON BRIEF:

          Jasen D. Hanson, CHAMBERLAIN, HRDLICKA, WHITE, WILLIAMS & AUGHTRY, Atlanta, Georgia, for Appellants.

          Richard E. Zuckerman, Principal Deputy Assistant Attorney General, Gilbert S. Rothenberg, Arthur T. Catterall, Tax Division, UNITED STATES DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee.

          Before KING, DUNCAN, and WYNN, Circuit Judges.

          WYNN, CIRCUIT JUDGE.

         Taxpayers Lonnie Curtis Baxter ("Ms. Baxter") and her husband Guy R. Baxter (collectively, with Ms. Baxter, "Taxpayers") appeal an opinion and decision of the United States Tax Court imposing back taxes and penalties attributable to Taxpayers' use of what appellee Commissioner of Internal Revenue (the "Commissioner") deemed to be an unlawful tax shelter. See Curtis Inv. Co., LLC v. Comm'r, 114 T.C.M (CCH) 141, 2017 WL 3314283 (2017). On their 2000 tax return, Taxpayers claimed substantial capital losses attributable to a Custom Adjustable Rate Debt Structure ("CARDS") transaction, which Taxpayers relied on to offset capital gains attributable to the sale of their family business. The Commissioner argued-and the Tax Court agreed-that the CARDS transaction lacked "economic substance" and therefore that the Taxpayers improperly relied on the transaction to offset their capital gains. After careful review, we affirm the Tax Court's order and decision in its entirety.

         I.

         A.

         Ms. Baxter is the great-granddaughter of Henry Russell Curtis, the founder of American Business Products, Inc. ("ABP"), a successful printing company. Prior to the transactions giving rise to the present dispute, Ms. Baxter directly held several shares of ABP stock. In 1961, the family formed Curtis Investment Company, LLC ("Curtis Investment"), to hold the family's ABP stock as well as to engage in other investments. Ms. Baxter also held a beneficial interest in ABP stock by virtue of her ownership interest in Curtis Investment. In 1986, Ms. Baxter became the managing member of Curtis Investment. Ms. Baxter's son, Henry J. Bird ("Bird"), succeeded Ms. Baxter as managing member of Curtis Investment in 1998, and formed an investment committee- on which Ms. Baxter continued to serve-to oversee Curtis Investment's investment strategy.

         In late February 2000, Curtis Investment and Ms. Baxter sold their ABP stock as part of the sale of ABP. Ms. Baxter's sale of her ABP stock generated a $2, 444, 383 long-term capital gain and a $18, 895 short-term capital gain. Faced with the prospect of a sizable tax bill attributable to this sale, Ms. Baxter and Curtis Investment's investment committee considered multiple approaches to sheltering the gain. One of Taxpayers' accountants, Barbara Coats, learned of the CARDS shelter and met with Roy Hahn, founder of Chenery Associates, Inc. ("Chenery Associates"), who marketed the CARDS shelter.

         Coats and another accountant at her firm, Matt Levin, presented the CARDS transaction to Bird. Bird asked Coats and Levin and two lawyers, Thomas Rogers and Ann Watkins, to review the transaction and its promoters. To that end, the advisers hired a private investigator to investigate Chenery Associates and Hahn. As part of its CARDS package, Chenery Associates marketed a model tax opinion letter prepared by R.J. Ruble of Brown & Wood LLP, who also served as a reference for Hahn. Taxpayers' advisers spoke with Ruble on several occasions regarding the model opinion letter. After reviewing many, but not all, of the authorities cited in the letter, but without conducting additional research, Taxpayers' accountants "independent[ly]" advised the Taxpayers that they "thought the tax effects were as outlined in the tax opinion letter." J.A. 2914. Neither Taxpayers' accountants nor their tax lawyers provided Taxpayers with separate opinion letters, however. Rogers walked through the tax effects of the CARDS transaction with Bird, who then conveyed his understanding of those effects to Ms. Baxter. Based on this review, Taxpayers decided to move forward with the CARDS transaction.

         Taxpayers' CARDS transactions-like all CARDS transactions, see Kerman v. C.I.R., 713 F.3d 849, 853 (6th Cir. 2013)-proceeded in the following stages: origination, assumption, operation, and unwinding, Curtis Inv., 2017 WL 3314283, at *4-6.

         At the origination stage, two residents of the United Kingdom (and, therefore, not subject to U.S. tax law)-Elizabeth Sylvester and Michael Sherry-organized a Delaware, LLC: Caledonian Financial Trading, LLC ("Caledonian"). Sylvester and Sherry participated in a similar manner in several other CARDS transactions. On December 14, 2000, Caledonian entered into a credit agreement with Hypo-Und Vereinsbank, AG ("HVB")-a German bank that regularly facilitated CARDS transactions[1]-pursuant to which HVB loaned Caledonian €2.9 million. Caledonian's credit agreement with HVB had a 30-year term, but HVB retained the right to call the loan at the end of each year. Interest accrued annually at a rate equal to 12-month euro LIBOR plus 0.5 percent. Under the credit agreement, the €2.9 million loan was more-than-fully collateralized-if Caledonian's collateral consisted of cash, the agreement obliged Caledonian to deposit 102% of its loan obligations with HVB, and if Caledonian's collateral consisted of other assets, the agreement obliged Caledonian to deposit assets valued at 108% of its obligations.

         HVB deposited eight-five percent (85%) of the proceeds of the loan in an HVB time-deposit account with a one-year term that HVB established for Caledonian. Under the then-applicable dollar-to-euro exchange rate, eighty-five percent of the €2.9 million loan closely approximated Taxpayers' approximately $2.4 million expected capital gain from Ms. Baxter's sale of her ABP stock. HVB dispersed the remaining loan proceeds- which amounted to fifteen percent (15%) of the loaned funds-in the form of a one-year promissory note to Caledonian. Caledonian then pledged the promissory note and the time deposit-i.e. the entire proceeds it received from the loan-as collateral. Interest on both the time deposit and the promissory note accrued at a rate equal to 12-month LIBOR, meaning that interest accrued on the time deposit and the promissory note- Caledonian's entire proceeds from the loan-at a lower rate than Caledonian paid to borrow those proceeds (4.885% interest rate on time deposit and promissory note versus 5.335% interest on Caledonian loan). The loan agreement barred Caledonian from making withdrawals from its newly-form HVB account without providing substitute collateral. Caledonian further contracted not to request release of the collateral.

         At the assumption stage, in late December 2000, Ms. Baxter acquired the promissory note HVB issued to Caledonian, which promissory note amounted to fifteen percent (15%) of the loan proceeds. As part of her acquisition of the promissory note, Ms. Baxter further agreed to assume 100% of Caledonian's liability under its loan with HVB on a joint and several basis. The parties agreed that the funds in Caledonian's time deposit at HVB would serve as the first source of payment for Caledonian's obligations under the loan. On December 28, 2000, Ms. Baxter-who had no prior relationship with HVB-redeemed the promissory note she purchased from Caledonian, depositing €435, 000 into a newly formed HVB account in her name. Ms. Baxter then asked HVB to change the denomination of the funds in her account from euros to dollars, at the then-applicable dollar-to-euro exchange rate of 0.924, yielding approximately $401, 000.

         Ms. Baxter further entered into a forward exchange contract with HVB, pursuant to which she was obligated to exchange approximately $442, 000 for approximately €469, 000 slightly less than one-year later, on December 14, 2001, the first-year call date for HVB's loan to Caledonian. That approximately €469, 000 figure was nearly identical to the amount Caledonian, and therefore Ms. Baxter, would have to repay HVB if it exercised its contractual right to recall the loan after one year.

         A taxpayer's currency exchange and note redemption are taxable events. Relying on Ms. Baxter's assumption of joint and several liability with Caledonian for 100% of the loan proceeds, Taxpayers claimed a $2, 277, 660 loss (€2.9 million in assumed liability less the €435, 000 in loan proceeds she obtained, converted to dollars at the then-applicable exchange rate) on their 2000 tax return, offsetting nearly all their capital gain resulting from Ms. Baxter's sale of her ABP stock.

         At the operational phase, Canadian Imperial Bank of Commerce ("CIBC")-with which Taxpayers had a long-standing relationship-issued to Curtis Investment a $6.7 million letter of credit, with a stated termination date of December 27, 2001. Pursuant to the terms of the agreement, Curtis Investment was obliged to keep at least $6.7 million in its accounts at CIBC, meaning that the letter of credit was fully collateralized. CIBC charged Curtis Investment $241, 000 for the letter of credit. Ms. Baxter then substituted the letter of credit as collateral for Caledonian's loan-pledging to HVB a first priority lien and security interest in the letter of credit-and in return HVB dispersed $401, 940 to Ms. Baxter. Notwithstanding that Taxpayers had business relationships with CIBC and several other banks before they considered engaging in the CARDS transaction, Taxpayers did not approach any of those banks about obtaining a loan.

         Finally, the process to unwind the transaction began on November 13, 2001, when HVB notified Ms. Baxter of its intent to call its loan to Caledonian. Caledonian's time deposit at HVB covered most of the outstanding loan balance, with Ms. Baxter required to pay to HVB approximately €470, 000 to retire Caledonian's loan. On December 14, 2001, pursuant to her forward exchange contract, Ms. Baxter exchanged approximately $442, 000 for approximately €469, 000, which she then applied against her obligation under the loan and assumption agreement. That exchange covered all but approximately €826 of Ms. Baxter's obligation to retire Caledonian's loan. Taxpayers unsuccessfully sought replacement loans from several other banks. Ms. Baxter paid Chenery Associates $154, 375 in fees to facilitate her CARDS transaction. Put differently, aggregating CIBC's and Chenery Associates' fees, the Tax Court found that Taxpayers paid approximately forty-five percent (45%) of the loan proceeds in fees.

         B.

         On April 8, 2008, the Commissioner issued a notice of deficiency to Taxpayers for tax years 2000 and 2001, asserting, inter alia, that Taxpayers could not claim a taxable capital loss deduction as a result of the CARDS transaction because, in the Commissioner's view, the transaction lacked economic substance. The Commissioner further stated that Taxpayers were liable for forty-percent accuracy-related penalties for making gross valuation misstatements. Taxpayers timely filed a petition with the Tax Court.

         Following a four-day trial, during which the parties introduced lay and expert testimony and evidence, Tax Court Chief Judge L. Paige Marvel held that Ms. Baxter's CARDS transaction lacked "economic substance." Curtis Inv., 2017 WL 3314283, at *9-12. In particular, the Tax Court found that the transaction did not provide Taxpayers "with a reasonable possibility of profit" and that Taxpayers' purported investment motive was "not credible." Id. at *10-11. The Tax Court further concluded that the Commissioner properly imposed the accuracy-related penalty because Taxpayers failed to show that there was a "reasonable cause" for their ...


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