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Currency Option Trades Lacked Economic Substance; Resulting Losses Are Disallowed

(Parker Tax Publishing December 2019)

The Federal Circuit held that the Tax Court did not clearly err when it concluded that partnerships engaged in buying currency option trades from Deutsche Bank had fixed the forward exchange rates, ensuring that they could predict the precise amount that the winning and losing trades would pay - and ensuring that the trades had no future profit potential. Because the transactions lacked any legitimate nontax business purposes, the losses generated from those transactions were disallowed. Endeavor Partners Fund v. Comm'r, 2019 PTC 463 (Fed. Cir. 2019).

Andrew Beer was in the tax shelter business. His enterprise, called "the Delta Group" or "Bricolage," sold customers the chance to claim large, artificial losses to offset their income and reduce their taxes. Partnerships controlled by Beer bought pairs of currency option trades from Deutsche Bank. Each option trade within the pair amounted to a bet on whether a target currency would appreciate or depreciate within a week. Together, the two options in each pair yielded a net gain or loss of zero. Whichever trade won generated a large gain for a partnership in one year; the losing trade created a corresponding loss in a subsequent year. An accommodating party absorbed the partnerships' gains, while Beer's customers took advantage of the losses. Three sets of trades in November and December, 2001, generated $144 million in losses a year later.

The IRS subsequently challenged these transactions on the basis of their lack of economic substance and made adjustments to the partnerships' income that exceeded $300 million in the aggregate.

In Endeavor Partners Fund, LLC v. Comm'r, T.C. Memo. 2018-96, the Tax Court agreed with the IRS and held that the transactions at issue lacked economic substance and were nothing more than shams designed to look like real world trades without any of the risk or concomitant opportunity for profit. Thus, the partnerships could not deduct the losses generated from the transactions. The court noted that, though the option trades nominally cost tens of millions of dollars each, Deutsche Bank financed almost all the scheme on credit.

According to the Tax Court's findings, the parties structured the transactions to guarantee that, regardless of which trade "won," the options always paid an amount exactly equal to the costs of the Deutsche Bank loan. One half of an option pair paid out in Danish kroner, while the other paid out in euros. These two currencies are functionally the same since the former is "pegged" to the latter. However, as the Tax Court noted, currency markets are not perfectly efficient and the currencies did not move identically on the open market. Thus, the court observed, to avoid any residual risk that the krone and the euro might fluctuate relative to one another, Deutsche Bank and the partnerships agreed in advance to use seven-day forward exchange rates to convert the euro or krone winnings into the currency necessary to pay off the Deutsche Bank loan. To the Tax Court, this meant that the trades posed zero risk. No matter which option trade won, the partnerships knew they would receive exactly enough money to pay off the Deutsche Bank loans.

The partnerships appealed the Tax Court's decision to the Federal Circuit. On appeal, the partnerships argued that the Tax Court bore the burden of proving that the parties agreed in advance on the exact rates to be used in determining earnings and losses under the option agreements. The partnerships contended that the pattern of no-profit-or-loss trades could not provide evidence of an agreement to rig the rates unless (at a minimum) it could not be explained by anything else. In addition, the partnerships argued that their trades possessed an independent business purpose, aside from offsetting taxes. According to the partnerships, before the IRS started cracking down on the practice, the Delta Group had planned to profit from the tax losses by selling them in its tax shelter business.

The Federal Circuit affirmed the Tax Court's decision. The court concluded that the Tax Court correctly ruled that the allocation of the burden of proof is immaterial because the governing standard is the preponderance of the evidence. The Tax Court did not clearly err, the Federal Circuit said, when it concluded the parties fixed the forward exchange rates, ensuring that they could predict the precise amount that the winning and losing trades would pay - and ensuring that the trades had no future profit potential. According to the court, the trades lacked any other legitimate nontax business purposes.

The Federal Circuit noted that the Tax Court relied primarily on three items of evidence. First, it found that the partnerships and Deutsche Bank exchanged spreadsheets that included the mutually agreed rate for converting kroner to euro and kroner and euro into dollars. Second, when Deutsche Bank closed the trades at issue, it did not use the prevailing market exchange rates. Instead, Deutsche Bank settled the trades using the same rates listed in the spreadsheets. Third, not once did the partnerships object to the use of the fixed exchange rate instead of the prevailing market spot rate. The Federal Circuit found that the Tax Court's reliance on this evidence was reasonable.

Finally, the Federal Circuit found the partnerships' argument that the trades possessed an independent business purpose to be "a splendid new example of chutzpah." According to the court, the business purpose test looks to whether a transaction has any purpose independent of the resulting tax savings. If profits from marketing tax losses could be viewed as "independent," the court said, the sham transaction rule would apply only to unsophisticated creators of sham transactions.

For a discussion of the economic substance doctrine, see Parker Tax ¶99,710.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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