Russian Ruble's Collapse Didn't Result in Loss Windfall for Funds' Partner

(Parker Tax Publishing March 2017)

The Federal Circuit affirmed a lower court holding that a 2005 FPAA properly disallowed $50 million of losses resulting from structured partnership transactions aimed at recouping investments losses after the collapse of the Russian ruble and that had flowed through to a major individual partner on her 2001 U.S. individual income tax return. The court also upheld the IRS's assessment of a 40 penalty on the underpayment of tax involved. Russian Recovery Fund Limited v. U.S., 2017 PTC 112 (Fed. Cir. 2017).

Background

Nancy Zimmerman co-founded Bracebridge, a management company. Bracebridge created Russian Recovery Fund Limited (RRF), a hedge fund. Bracebridge also manages FFIP, L.P., another fund. All three - Bracebridge, RRF, and FFIP - are partnerships. Zimmerman is a direct partner of FFIP, and FFIP is a direct partner of RRF.

In 1998, Russian sovereign debt was traded exclusively on the Moscow Interbank Currency Exchange (MICEX). Non-Russian investors could not invest directly in Russian sovereign debt on the MICEX; however, they could invest in derivative instruments known as credit-linked notes (CLNs) sold by certain authorized banks. When Russia defaulted on its sovereign debt in August 1998, the Russian ruble collapsed, and CLNs lost nearly all of their value. These assets also became extremely illiquid. The Russian Central Bank imposed currency exchange limitations that prevented the ruble from being freely traded, and the Russian government only allowed authorized banks to access the debt and trade in rubles. These events had serious consequences for Tiger Management, LLC (Tiger), one of the world's largest managers of hedge funds. Two of Tiger's funds, foreign partnerships that did not pay U.S. taxes, had purchased CLNs through Deutsche Bank for more than $230 million. After the collapse, those CLNs were worth less than 10 percent of their original value. And Tiger overall was in bad straits: in 1998, Tiger managed $22 billion; but by 2000, that amount had dropped to $6 billion as a result of heavy losses in Russian debt, Asian debt, and an investment in US Airways.

As a result, Tiger needed cash to redeem the shares of investors who wanted out, but the capital controls on Russian debt hampered Tiger's ability to sell its devalued CLNs. Zimmerman believed that she could make money for herself and investors by obtaining devalued Russian debt at pennies on the dollar in anticipation of a recovery of the ruble and hence something approaching face value of debt instruments. Bracebridge established RRF and sought holders of Russian securities to contribute CLNs or cash in exchange for shares of RRF.

When RRF largely failed to obtain investors, an internal Bracebridge email discussed a potential contribution of CLNs from an entity through Deutsche Bank. Given concerns that RRF needed partners to attract the potential investor, it was proposed that Bracebridge-controlled entities become RRF partners. In April 1999, FFIP contributed the first assets to RRF. Zimmerman was subsequently advised that RRF should not allow corporations to join because "it could possibly impair one of our most valuable assets," i.e., "the built-in losses in Russian depreciated assets that might end up in RRF." This was because the presence of corporations could preclude later resale since individuals interested in buying tax losses don't want to transact with corporations. A series of transactions followed, each of which was orchestrated by Deutsche Bank.

First, in late May 1999, RRF's first two substantial outside investors - both funds operated by Tiger - contributed CLNs to RRF in exchange for an ownership interest in RRF. In response to a request from Tiger, RRF reduced a three-year lock-up period to allow Tiger to redeem its shares on or after July 1, 1999, in exchange for cash or assets "in kind," and RRF excluded the usual representation that Tiger was purchasing the shares "for investment purposes only" from the subscription agreement. Second, approximately two weeks after the first transaction, Tiger sold all of its RRF partnership shares at an $800,000 discount to FFIP for approximately $14.1 million. Third, on June 22, 1999, RRF sold 77.18 percent of the Tiger CLNs to General Cigar Corporation (General Cigar) for cash and General Cigar preferred stock. Finally, in 2000, RRF sold the remaining 22.82 percent of the Tiger CLNs on the open market.

When RRF filed its 2000 tax return, it allocated a loss to FFIP, including a loss of approximately $50 million from the sale of the 22.82 percent of the Tiger CLNs. RRF claimed the balance of the Tiger built-in losses - approximately $171 million - on its 2004 return upon redeeming its preferred stock in General Cigar in 2004. FFIP then reported losses for the 2000 and 2001 tax years, much of which were attributable to the loss claimed by RRF in 2000. FFIP's 2001 losses flowed through FFIP to Zimmerman who, on her 2001 individual tax return, reported a substantial amount of RRF's loss. Thus, the bulk of the losses RRF allocated to FFIP in 2000 were not passed through in 2000, but were retained by FFIP until 2001, at which point the losses impacted Zimmerman's 2001 return. In 2005, the IRS audited FFIP's 2001 partnership return, which ultimately resulted in the issuance of a "no adjustments letter" to FFIP. However, in October 2005, the IRS issued a final partnership administrative adjustment (FPAA) to RRF for its 2000 tax year. The IRS disallowed the loss RRF claimed for the sale of the Tiger CLNs and, under Code Sec. 6662 imposed a 40 percent gross valuation misstatement penalty. RRF disputed the IRS's assessments and took its case to the Federal Claims court where a trial was held.

The trial addressed the merits of the FPAA, namely, whether RRF was entitled to claim built-in losses on the disposition of securities derived from Russian sovereign debt. At the time those assets were placed into the partnership, they had built-in losses of approximately $223 million and RRF had claimed those losses for itself, relying on Code Sec. 721. The FPAA asserted, in general, that the exchange of partnership shares for those assets was not bona fide. Also at issue in the trial was whether, assuming the FPAA was upheld, the IRS's imposition of penalties was correct.

Court of Federal Claims' Decision

The Court of Federal Claims (2015 PTC 279 (Fed. Cl. 2015)) sided with the IRS and upheld the disallowance of the losses and the imposition of penalties. The court found that, as early as April 1999, Tiger's contribution of the CLNs to RRF was part of a plan to move highly depreciated assets to RRF via Deutsche Bank in a way that preserved their tax characteristics. In other words, the court said, both players knew before the first transaction that Tiger would sell its CLNs for cash and that RRF would obtain CLNs with massive built-in losses. According to the court, Tiger had no real intention of becoming a partner in RRF and RRF had reason to know that. Instead, the Court of Federal Claims found that the contributions of CLNs to RRF was a sham transaction, that the transaction lacked economic substance, that the contribution could be ignored, and that the transaction should be characterized as a sale.

The Court of Federal Claims also concluded that the 2005 FPAA validly suspended the statute of limitations for assessing taxes and that the RRF had no reasonable cause for avoiding the 40 percent penalty. RRF appealed to the Federal Circuit.

RRF's Position on Appeal

On appeal, RRF argued that any attempt by the IRS to collect tax from FFIP partners, such as Zimmerman, in 2001 and later years based on FFIP partnership items was time-barred because the IRS failed to issue an FPAA to FFIP for those years. According to RRF, the 2005 FPAA tolled the period for assessing tax attributable to RRF's 2000 partnership items, not FFIP's 2001 partnership items, because the 2005 FPAA could not apply to either two partnerships (i.e., RRF and FFIP) or two tax years (i.e., 2000 and 2001).

RRF alternatively argued that (1) an item can only be a partnership item of a single partnership because permitting a "partnership item" to be attributable to multiple partnerships would disregard Congress's intent to simplify the procedures for partnership tax proceedings; and (2) the court's interpretation of Code Sec. 6229 would violate the tax system's bedrock annual accounting principle that taxes are to be determined on an annual basis.

Federal Circuit's Decision

The Federal Circuit affirmed the lower court's decision, holding that the Court of Federal Claims correctly determined that the losses claimed on Zimmerman's 2001 tax return were "attributable to" the loss claimed in RRF's 2000 tax return, the limitations period for which was suspended by the 2005 FPAA.

The court noted that the central issue in the case was whether the losses that FFIP allocated in 2001 to partners such as Zimmerman were "attributable to" the loss reported by RRF in 2000 under Code Sec. 6229. This was a question of statutory interpretation for the court and it noted that various other courts have construed the phrase according to its plain meaning, which is understood to be "due to, caused by, or generated by." Applying that definition of "attributable to" in the instant case, the court agreed that the 2005 FPAA suspended the statute of limitations period for assessing any tax against Zimmerman that was "due to, caused by, or generated by" any partnership item on her 2001 individual tax return.

The Federal Circuit also agreed with the Court of Federal Claims's factual findings that RRF and Tiger did not form a bona fide partnership, citing the fact that both RRF and FFIP were Bracebridge-managed funds, and Deutsche Bank worked closely with both RRF and FFIP to orchestrate each of the relevant transactions.

The court also rejected RRF's alternative arguments, finding them unpersuasive.

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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