In Peking Investment Fund LLC et al. v. Commissioner, the Tax Court rejected the Internal Revenue Service's (IRS or government) motion for summary judgment that a loss generated on a "Distressed Asset/Debt" or "DAD" transaction should be disallowed. The court rejected both of the government's arguments that either: (1) the partnership involved in the transaction should be disregarded under the sham partnership doctrine as a matter of law or (2) Section 482 allows the IRS to reduce tax basis in the assets contributed to the partnership such that no loss should be recognized on the subsequent disposal of the partnership interest received in exchange for those assets. In reaching its conclusion, the court cited insufficient evidence in support of the IRS's motion and rejected the IRS's argument that Commissioner v. Culbertson, 337 U.S. 733 (1949) should, as a matter of law, require that the asset exchange partnership be disregarded under the sham partnership doctrine.

Facts

In 2001, China Cinda Asset Management Corporation (Cinda) contributed an 11.06836% interest in a portfolio of China Construction Bank (CCB) nonperforming loans (NPLs and the CCB NPL portfolio) to Peking Investment Fund LLC (PIF) in exchange for a 99% interest in PIF. Chenery Management Incorporated (CMI), an entity controlled by the same party who marketed the investment program that ultimately attracted a group of US investors, retained the remaining 1% interest in PIF. Cinda received a capital account credit of $774,999 and agreed to act as servicer of the CCB NPL portfolio. The value of the loan portfolio contributed was negotiated in part based on a third-party valuation of the NPL portfolio and by taking into account limited diligence procedures performed by a law firm on the documentation and enforceability of the loans in the NPL portfolio.

Within two weeks of Cinda's contribution of the CCB NPL portfolio to PIF, Cinda contributed a 98% interest in PIF to another partnership, Peking Investment Holdings LLC (PIH), in exchange for a 99% interest in PIH. On the same day, Cinda sold its entire interest in PIH to a small group of US investors for an aggregate purchase price of $767,170 ($774,999 × 98%/99%).

Two days later, PIF exchanged its interest in the CCB NPL portfolio for interests in Korean Development Bank NPLs (the KDB NPL portfolios) and then exchanged the KDB NPL portfolios for an interest in a portfolio of NPLs originated by Bank of China (the Bank of China NPL portfolio).

On its 2001 partnership return, PIF reported a loss of $26,903,619 from its exchange of its interest in the CCB NPL portfolio for its interests in the KDB NPL portfolios. The claimed loss represented the excess of a claimed basis of $27,678,617 in PIF's interest in the CCB NPL portfolio over an amount realized of $774,998.

Sham partnership analysis

In its motion for summary judgment, the IRS argued that PIF should be disregarded as a sham partnership based on the principles set forth in Culbertson. In Culbertson, the Supreme Court stated that "[t]o form a genuine partnership for federal tax purposes, the parties must 'in good faith and acting with a business purpose' intend 'to join together in the present conduct of the enterprise.'" In support of its motion that the Culbertson test had not been met, the IRS made three alternative arguments. First, the IRS asserted that PIF and PIH were formed to implement a "tax scheme" to allow the US investors to claim tax losses without any economic risk of loss. As evidence for its assertion, the IRS referenced two letters written by Chenery's Managing Director to potential US investors, which claimed that the investments owned by the fund partnership at the time of purchase could be sold or exchanged before December 31, 2001, without economic risk of loss.

Second, the IRS argued that Cinda did not intend to become a partner in PIF or PIH or to conduct the business of collecting NPLs, as evidenced by Cinda's sale of its PIH interest shortly after acquiring such interest and Cinda's inaction regarding collection of the NPLs, even though Cinda was contractually obligated to take such action as the servicer of the loans. Additionally, the IRS argued that Cinda's 1% partnership interest was "fleeting, nominal … and had no real participation in the profits or activities of PIF," thus demonstrating that Cinda did not intend to become a partner. Third, the IRS argued that none of PIF's or PIH's partners intended to conduct the business of collecting the NPLs and that certain transactions were undertaken by the US investors to increase their outside tax basis in the partnership such that they could take advantage of tax losses allocated to them.

The court rejected the government's motion that, as a matter of law, PIF should be disregarded as a sham. In doing so, the court stated that "[e]ven if the generation of tax losses is the primary purpose for a partnership's formation, the partnership may also have as a secondary purpose the conduct of a business enterprise." Thus, to prevail, the IRS "must establish that carrying out a business of collecting NPLs was so minimal a factor in the decision to form the partnership that it can be dismissed." Finding that the IRS had failed to establish that the partners who formed PIF and PIH had no intent of subjecting themselves to the portfolio's risk of loss, the court concluded that the government did not establish that the parties did not intend to conduct a business enterprise. Thus, the court held that regardless of whether the generation of tax losses was a primary motive for forming PIF and PIH, neither should be disregarded as sham partnerships under the principles of Culbertson as a matter of law. The court pointed to the fact that the parties had engaged third-party valuation services and performed due diligence procedures on the loan portfolio, and that the valuation took into account the questionable legal enforceability of certain loans. The court also cited as insufficient the evidence of the letter provided to investors stating that their economic risk of loss in the initial pool of NPLs would be limited as a result of their ability to exchange the pool of NPLs for other assets, since there was no protection against risk of loss should collections on the exchanged portfolio of NPLs fall short of expectations.

The court rejected the IRS's second argument that because Cinda's partnership interest was "fleeting" and "nominal," it had no intent to participate as a partner. The court stated that such a position would assume that a 1% interest in a partnership is too small to be recognized, though no statute establishes a per se rule to that effect. The court pointed to Revenue Procedure 89-12, 1989-1 C.B. 798, which provided entity classification guidelines prior to the current check-the-box regulations, in which the IRS required a general partner of a limited partnership interest to maintain at least a 1% interest in each material item of partnership income, gain, loss, deduction, or credit, stating that the revenue procedure's guidelines provide historical support for the notion that a 1% interest in a partnership cannot be disregarded as de minimis.

Finally, as to the IRS's third argument, the court merely stated that "accepting that the [US] investors were interested in tax losses does not establish that they had no other intent in joining PIH" and that if the PIF and PIH partners were also motivated to an appreciable extent by the prospect of benefitting from the collection of the NPLs, Culbertson would not require that PIF be treated as a sham. In making this statement, the court noted that the evidence provided by the IRS failed to support its assertion as to the partners' intentions.

Based on the foregoing, the court denied the IRS's motion based on its sham partnership argument.

Section 482 adjustment to basis

Section 482 allows the Secretary to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among two or more organizations owned or controlled directly or indirectly by the same interests if it is determined to be necessary to prevent evasion of taxes or clearly reflect the income of any such organizations, trades or businesses. For this purpose, tax basis is treated as an "allowance" subject to adjustment under Section 482.

As an alternative to its sham partnership argument, the IRS argued that both Cinda and CCB were controlled by the People's Republic of China, and that the price Cinda paid for the CCB NPL portfolio exceeded arm's length price. Accordingly, in the IRS's view, the tax basis of the NPL portfolio should have been adjusted downward to the price negotiated for the loan portfolio, which would result in no loss recognition on the subsequent exchange transactions.

The petitioner argued that Section 482 was made inapplicable by the fact that neither party involved in the transaction subject to adjustment was a US taxpayer.

Stating that because the government had failed to clearly establish as a factual matter that the claimed "amorphous" state ownership of Cinda and CCB yielded common ownership within the meaning of Section 482, the court similarly denied the IRS's motion based on the application of Section 482.

Implications

Although the court's summary judgment decision was, to a large extent, mandated by its determination that the IRS had failed to provide sufficient evidence to support its motion that the partnership should be disregarded as a matter of law based on Culbertson, this case is significant in regard to standards that must be met to support a sham partnership argument based on the principles of Culbertson. Additionally, the court's statement that a 1% partnership interest is meaningful for purposes of countering an argument that such a partner ought to be disregarded, is notable. Whether and to what extent Culbertson established a participation requirement has been the subject of litigation in other important cases (see, e.g., Castle Harbour and Historic Boardwalk Hall).

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