On Friday, the Ninth Circuit Court of Appeals affirmed the Tax Court’s decision to disallow a capital loss deduction on the ground that the underlying transaction lacked economic substance and was designed to create substantial capital losses. Reddam v. Commissioner, No. 12-72135 (9th Cir. Jun. 13, 2014).

The case involved the founder of DiTech, a home mortgage company that was sold to GMAC Mortgage. That sale generated $48,500,000 in capital gains, and the taxpayer entered into the Offshore Portfolio Investment Strategy (“OPIS”) transaction marketed by KPMG in an attempt to offset those gains. On his 1999 tax return, the taxpayer claimed an offsetting loss of $50,200,000 related to the OPIS transaction, which involved a series of structured transactions designed to generate a large tax loss.

The IRS disallowed the claimed capital losses which resulted in a deficiency of $8,000,000, which the Tax Court sustained. The Ninth Circuit panel agreed with the Tax Court’s determination that the transaction lacked economic substance. The panel applied a two-prong economic substance doctrine inquiry “addressing the objective nature of the transaction (whether it has economic substance beyond tax benefits) and the subjective motivation of the taxpayer (whether the taxpayer had a non-tax business purpose for the transaction).”

With regard to the subjective inquiry, the panel noted that the timing of the OPIS transaction provided compelling evidence of the taxpayer’s purpose of offsetting the substantial capital gains from the sale of DiTech. The panel found that the taxpayer’s failure to investigate the scheme did not comport with a profit-making motive, and noted that the taxpayer ignored KPMG’s recommendations that he seek independent advice regarding the investment portions of OPIS.

For the objective inquiry, the panel reiterated that the fundamental question was whether the transaction had any practical economic effects other than the creation of a tax loss, and stated that the application of the economic substance doctrine turned not only on the percentage of possible profit or loss, but also the likely corresponding magnitude of those possible profits or losses. While there was a theoretical possibility that the transaction would generate a net economic gain, that gain was dwarfed by the magnitude of the tax loss that the transaction was designed to generate.

The panel concluded that:

. . . we do not read the Tax Court as holding that a transaction with a ten to twenty-five percent chance of generating a profit always lacks economic substance. Instead, we read the Tax Court as properly holding that, in this case, the evidence is overwhelming that no objective investor or taxpayer would enter into the OPIS transaction for its profit making potential. Rather, the overall structure of the OPIS transaction compels the conclusion that it would be purchased solely for its ability to create capital losses.