LTCM Loses Tax Shelters Case Against IRS

by Mike Godfrey, Tax-News.com, New York

01 September 2004

Long Term Capital Management (LTCM), the hedge fund which famously threatened the international financial system when it went belly-up in 1998, lost its claim for US$40m in tax refunds last week when a US judge upheld the IRS's rejection of 'improper' tax deductions made by the fund.

Federal judge Janet Bond Arterton in Connecticut closed a 30-day trial, issuing a 200-page ruling which explained why she believed tax shelters employed by LTCM failed the 'economic substance' test and were therefore illegal. Judge Arterton ruled that the fund engaged in at least nine complex leasing transactions that didn’t have economic substance and were instead designed mainly to create losses of $106 million to offset LTCM’s tax burden. According to the ruling, LTCM must pay almost $16 million in IRS penalties, being 40% of the $40 million LTCM had been trying to reclaim.

In 1996, LTCM swapped a stake in the fund for the preferred stock of five US companies, owned by UK-based LLC Onslow Trading & Commercial, giving it access to tax losses through what are known as lease-stripping and sale-lease-back transactions.

LTCM's partners, including Nobel Prize winner Robert Merton, who is now on the faculty of Harvard University's Graduate School of Business Administration, are not expected to face criminal charges. Myron Scholes, who shared the Nobel Prize with Mr. Merton, and was a moving spirit behind LTCM's use of tax shelters, was criticized by the Judge, who said that he and LTCM's chief tax planner were: "well aware of the tax requirements of economic substance and business purpose and discussed the need therefore to figure out a reason independent of taxes for Long Term to engage in a transaction."

The Treasury Department and the IRS have made much of their current determination to attack tax shelters, and will have been encouraged by the Judge's ruling against LTCM.

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