Judgment summary
The Commissioner issued a Notice of Final Partnership Administrative Adjustment (FPAA) to the tax matters partner of SIH Partners, LLLP (SIHP) for the tax year ending 31 December 2012, reducing SIHP's qualified dividend income (QDI) by $170,764,863, reclassifying that amount as ordinary dividend income, and reducing SIHP's foreign tax credit (FTC) by $25,614,729 on the basis of section 246(c)(4) and accompanying Treasury regulations.
The two issues for decision were whether SIHP's $170,764,863 of QDI should be reclassified as ordinary dividend income, and whether SIHP's foreign tax credit should be reduced by $25,614,729.
The court held that the Substantial Overlap Test in Treasury Regulation § 1.246-5(c)(1)(iii) was met, but the Anti-Abuse Rule in Treasury Regulation § 1.246-5(c)(1)(vi) applied. As a result, SIHP was not entitled to QDI treatment under I.R.C. §§ 1(h)(11)(B)(iii)(I) and 246(c), and had not satisfied all statutory requirements to qualify for the FTC. Decision was entered for the respondent.
Background
SIHP is a Delaware limited liability partnership organised on 2 April 2007, classified as a TEFRA partnership. SIHP wholly owns Susquehanna International Holdings, LLC (SIH), which owns CVI Holdings LLC (CVIH), which wholly owns Capital Ventures International (CVI), a Cayman Islands company. SIH, CVIH and CVI were disregarded entities of SIHP for US federal income tax purposes [paras under 'SIHP'].
SIHP is affiliated with Susquehanna International Group, LLP (SIG), a global trading firm and market maker founded in 1987. SIG maintained a longstanding unhedged short position called the Firm Hedge, in existence since 1987, which in 2012 consisted of three indexes: SPX, IWM, and FXI, and which had lost approximately $1.25 to $2.5 billion.
In 2010, Morgan Stanley approached SIG proposing to move the Firm Hedge to Morgan Stanley entities for a lower margin rate, and to enter into a complex portfolio swap centred on four Swiss equities: Novartis, Roche, Nestle and Swisscom (the Swiss Equities). Mr Jeff Cohen of SIG led the transaction and produced pretax profit and loss analyses in 2010 and 2012 (Cohen's Analyses).
SIHP entered an ISDA master agreement with Morgan Stanley on 13 April 2010. The transaction involved SIHP purchasing the Swiss Equities through Credit Suisse for delivery to a Morgan Stanley prime brokerage account, while simultaneously entering a portfolio swap giving SIHP identical short positions in the same equities and other market indices, including the Firm Hedge. The transaction ran from April 2010 to October 2013.
For the 2012 tax year SIHP reported $170,764,863 in QDI from the Swiss Equities and transferred $130,175,828 in substitute dividends to Morgan Stanley. Foreign taxes of $59,767,702 were withheld by the Swiss Federal Tax Authority (SFTA). SIHP reported an FTC of $25,614,729, being 15% of the gross dividend, anticipating a reclaim reducing withholding from 35% to 15% under the US-Swiss Income Tax Treaty. The SFTA had not accepted SIHP's (via CVIH) reclaim claims for 2010, 2011 or 2012 as at the time of judgment.
On 5 December 2019 the IRS issued the FPAA for the 2012 tax year. Explorer Partner Corp., as notice partner, timely petitioned the Tax Court on 10 July 2020 under section 6226(d)(1).
Core dispute
The dispute centred on whether SIHP's position in the Swiss Equities, when combined with the Firm Hedge and other indexes in the Morgan Stanley portfolio swap, constituted 'substantially similar or related property' (SSRP) under I.R.C. § 246(c)(4) and Treasury Regulation § 1.246-5, such that SIHP's holding period should be reduced, disqualifying it from QDI treatment and the FTC.
Respondent argued that the transaction should be recharacterised under the substance-over-form doctrine as a collection of separate individual short positions on each Swiss equity, rather than a single portfolio position, so that the Nonportfolio Rules of Treasury Regulation § 1.246-5(c)(1)(v) would apply instead of the Portfolio Rules. Respondent further argued that, even if the Portfolio Rules and the Substantial Overlap Test applied, the transaction violated the Anti-Abuse Rule in Treasury Regulation § 1.246-5(c)(1)(vi).
Petitioner argued that the transaction's form matched its substance, that the entire portfolio (including the Firm Hedge) should be tested together, that it complied with the Substantial Overlap Test, and that it was entitled to QDI treatment under I.R.C. § 1(h)(11)(B)(iii) and to the FTC under section 901(k).
Expert evidence was heard from Dr Luc Faucheux, Dr Michael Cragg, James Kermisch and Dr Thomas Brennan for petitioner, and Dr David DeRosa and Dr Israel Nelken for respondent, principally addressing the structure of the transaction, expected pretax profit, and the Virtual Tracking Test under the Anti-Abuse Rule.
Court findings
The court declined to apply the substance-over-form doctrine to disaggregate the Firm Hedge from the transaction, finding that the inclusion of the Firm Hedge within the portfolio swap was a conventional and common industry practice, and that SIHP's chosen form matched the substance of the transaction. It found that SIHP had created a portfolio of stocks, in both substance and form, comprising 20 or more unrelated issuers, so the Portfolio Rules under Treasury Regulation § 1.246-5(c)(1)(ii) through (iv) applied, not the Nonportfolio Rules.
Applying the Substantial Overlap Test, the court found that on a testing date of 24 April 2012, SIHP's Portfolio Position consisted of a 64% overlap, below the 70% threshold in Treasury Regulation § 1.246-5(c)(1)(iii), so the transaction did not qualify as SSRP under that test.
However, the court found that the Anti-Abuse Rule in Treasury Regulation § 1.246-5(c)(1)(vi) applied. It rejected both parties' interpretations of the Virtual Tracking Test under paragraph (c)(1)(vi)(A) as, respectively, too broad (respondent's implicit reading) or too narrow (petitioner's reading distinguishing Portfolio and Nonportfolio Positions), and also rejected Dr Brennan's proposed 5% deviation threshold as not supported by the regulation's text. It found that SIHP's short positions in the Swiss Equities were reasonably expected to virtually track its long positions.
On the second element of the Anti-Abuse Rule, the court found tax savings of more than $25 million (adopting Dr Nelken's conclusion), and an expected pretax economic profit ranging from a loss of $31 million (Dr Nelken's low end) to a profit of $2.4 million (Cohen's 2012 Analysis high end). The court rejected Dr Cragg's inclusion of a $121 million Firm Hedge benefit as unreasonably subjective, and found inconsistencies in Dr DeRosa's calculations. It concluded that the tax savings were significantly in excess of the expected pretax economic profits, satisfying Treasury Regulation § 1.246-5(c)(1)(vi)(B).
Accordingly, the court held that the Anti-Abuse Rule applied and that SIHP's position in the Swiss Equities was SSRP, notwithstanding compliance with the Substantial Overlap Test.
Outcome
The court held that SIHP was not entitled to QDI treatment under I.R.C. §§ 1(h)(11)(B)(iii)(I) and 246(c) because the Swiss Equities were SSRP under the Anti-Abuse Rule of Treasury Regulation § 1.246-5(c)(1)(vi).
The court further held that, because SIHP diminished its risk of loss by holding positions in SSRP, SIHP was barred from claiming the foreign tax credit under I.R.C. § 901(a) and (k)(1), and had not satisfied all statutory requirements to qualify for the FTC.
Respondent's proposed adjustments in the FPAA were sustained, and decision was entered for the respondent.
Major issues / areas of contention
- Whether SIHP's $170,764,863 of qualified dividend income should be reclassified as ordinary dividend income.
- Whether SIHP's foreign tax credit should be reduced by $25,614,729.
- Whether the substance-over-form doctrine permitted disaggregation of the Firm Hedge from the Swiss Equities within the transaction.
- Whether the transaction should be tested under the Portfolio Rules or the Nonportfolio Rules of Treasury Regulation § 1.246-5(c)(1).
- Whether SIHP's position satisfied the Substantial Overlap Test in Treasury Regulation § 1.246-5(c)(1)(iii).
- Whether the Anti-Abuse Rule in Treasury Regulation § 1.246-5(c)(1)(vi) applied, including the Virtual Tracking Test and the comparison of tax savings to expected pretax economic profits.
- Whether SIHP satisfied the holding period and other statutory requirements under I.R.C. § 901(k)(1) to claim the foreign tax credit.