US Court Denies USD1.1bn 'DAD' Tax Shelter Loss

by Glen Shapiro, LawAndTax-News.com, New York

28 August 2009

A US federal judge has decided that a wealthy banker cannot take a USD1.1bn tax deduction, the first court ruling concerning a type of tax shelter involving the purchase of foreign debt.

US district judge Ed Kinkeade stated in his 159-page decision that Andrew Beal, owner of Texas-based Beal Bank, was not entitled to take the full tax deduction claimed on his tax returns for investing in distressed Chinese debt because the transaction “lacked economic substance” and therefore must be disregarded for tax purposes.

This is the first time that a court has ruled definitively against the use of a so-called ‘distressed asses/debt’ tax shelter, otherwise known as DAD, whereby a tax indifferent party, usually a foreign company, transfers economic losses to a US taxpayer, who then attempts to offset the losses against their US income.

According to an Internal Revenue Service issue paper published in April 2007, a DAD transaction typically involves the use of a limited liability company, taxed as a partnership, to shift losses among partners entering and exiting the partnership. The partnership typically, but not always, contributes the asset to another partnership. Then the foreign party transfers within a short period of time its interest in the upper-tier partnership to a US taxpayer, who may be acting through a pass-through entity. The US taxpayer contributes other property or money to the upper-tier partnership in order to create basis in the taxpayer’s partnership interest. The lower-tier partnership sells (or exchanges) the high-basis, low-value asset to another entity related to the promoter, resulting in a significant tax loss that is allocated to the US taxpayer/partner.

Beal, who is ranked 321st on the Forbes list of the 400 richest Americans with a reputed net worth of USD1.5bn, owns 100% of Beal Bank through Beal Financial Corp. He has structured the business as an S corporation, meaning that all profits (and losses) are reported on his individual income tax return.

Beal had attempted to use the DAD losses to offset income earned in the tax years from 2002 to 2004, but was prevented from doing so by the IRS, which said that the entrepreneur was only entitled to a deduction of USD10m relating to transaction costs incurred in acquiring the Chinese debt.

While Beal has paid the taxes that the IRS believes he owes, he may be entitled to a refund of the 40% penalty he paid on the back taxes because, according to judge Kinkeade, he acted in “good faith” by obtaining two independent legal opinions on the legitimacy of the transactions. Furthermore, it was noted that Beal did not purchase an ‘off the shelf’ DAD shelter, but structured the transaction in partnership with his long-time accountant, using his experience of buying and selling the distressed debt of other US banks.

Several other cases of this type involving foreign debt instruments are said to be pending in US court.

The economic substance doctrine used by US courts to determine whether a transaction is structured with the sole intent of avoiding tax could be codified under Democratic plans to raise money to pay for President Obama’s healthcare reforms.

Up to now, courts have not applied the doctrine uniformly, but the health reform legislation would clarify the manner in which the principle should be used by the courts.

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