Fidelity High Tech v. United States

United States Court of Appeals
For the First Circuit

No. 10-2421

FIDELITY INTERNATIONAL CURRENCY ADVISOR A FUND, LLC,
by the Tax Matters Partner,

Plaintiff, Appellant,

v.

UNITED STATES OF AMERICA,

Defendant, Appellee.

APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF MASSACHUSETTS

[Hon. F. Dennis Saylor IV, U.S. District Judge]

Before
Torruella, Boudin and Thompson,
Circuit Judges.

William F. Nelson with whom Ronald L. Buch, Jr., David J.
Curtin, Kiara L. Rankin and Bingham McCutchen LLP were on brief for
appellant.
Judith A. Hagley, Tax Division, Department of Justice, with
whom Richard Farber, Tax Division, Department of Justice, Gilbert
S. Rothenberg, Acting Deputy Assistant Attorney General, and Carmen
M. Ortiz, United States Attorney, were on brief for appellee.

October 21, 2011
 BOUDIN, Circuit Judge. Fidelity International Currency

Advisor A Fund ("Fidelity") seeks review of a district court

judgment resolving a controversy between Fidelity and the Internal

Revenue Service ("IRS"). In substance, the district court

sustained IRS adjustments to Fidelity's partnership returns for the

two tax years at issue and upheld a 40 percent penalty for tax

underpayment. Fid. Int'l Currency Advisor A Fund, LLC v. United

States, 747 F. Supp. 2d 49 (D. Mass. 2010).

The litigation arises out of the following events.

Richard Egan was the founder of EMC Corporation, a manufacturer of

computer storage devices, and in the early years of this ultimately

successful business, Egan received non-qualified options to acquire

EMC stock. When he exercised those options in 2001, they generated

$162 million of ordinary income for him and his wife; it was

estimated this could create a tax liability of over $63 million.

Prior to exercising the options, Egan met with various

accounting and law firms to discuss methods of reducing the

potential tax liability. Ultimately, the plan adopted and put into

effect required Egan to form a partnership with a foreign national;

that partnership would engage in transactions that would generate

largely offsetting gains and losses without net risk; the gain

component would be principally allocated to the foreign national;

the loss component would be principally allocated to Egan and used

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on his individual return to offset gains on his exercise of the EMC

stock options, virtually eliminating tax on those gains.

To this end, in July 2000 Egan formed Fidelity as a

limited liability company federally taxed as a partnership. Egan

was one partner; the other principal partner was Samuel Mahoney,

who was an Irish citizen. Common shares were initially assigned 93

percent to Mahoney and 5 percent to Egan; Egan contributed $2.7

million in cash and certain interest rate options valued at $1.6

million, and Mahoney contributed $651,000 in cash.

Then, in October 2001, Fidelity entered into a set of

transactions whereby it purchased and sold options, related to

foreign currency exchange rates and configured in pairs: the terms

set for each pair (as to premium, strike price, maturity dates, and

possible payout) assured that a loss on one option in a pair would

be offset by a corresponding gain on the other. In substance, the

transaction would provide virtually no opportunity for a net gain

but also no risk of a net loss.1

One week later, Fidelity terminated four of the options

that had gained in value due to fluctuations in the currency

exchange rates. The offsetting options in the pairs,

correspondingly reduced in value, were not terminated. Instead,

1
Imagine two bets placed on the temperature next Wednesday,
such that the wagerer would earn $1 on the first bet but also pay
$1 on the second if the temperature was above the date's historic
average. If instead the temperature fell below that average, the
wagerer would lose $1 on the first bet and win $1 on the second.

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the proceeds from the terminated options were used to purchase

replacement options that would ensure that the eventual losses

taken by the partnership when it terminated the original options

that had lost value and the replacement options would offset the

gains initially realized.

This generated net taxable gains on Fidelity's books of

about $174 million from the options that had been terminated. But

under the tax laws Fidelity pays no taxes; rather its gains and

losses are assigned to the partners in accordance with their

ownership shares in the partnership and taxed to the partners on

their own returns. 26 U.S.C. §§ 701-702 (2006). Because of the

then-existing 5 and 93 percent share allocation, Egan was assigned

$7.1 million net gain and Mahoney $163.3 million net gain.

Then, a week later, in early November 2001, Egan bought

88 percent of the common partnership interest from Mahoney for

$325,500 and so owned 93 percent with Mahoney being reduced to 5

percent. A month later, in early December, Fidelity terminated the

four remaining original foreign currency options as well as the

replacement options acquired immediately after the October

termination. Not surprisingly in light of the design of the option

pairs, the December loss ($178.1 million) only modestly exceeded

the original gain.

Fidelity now allocated the $178.1 million loss in

proportion to the reallocated ownership shares: Egan was allocated

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$165.8 million in loss and Mahoney $8.8 million. The net economic

loss to the partnership from all the offsetting foreign currency

options was just over half a million dollars; advisory fees brought

the total cost to $4.1 million--a cost dwarfed by the potential tax

benefits for Egan.

The gains and losses from the currency option

transactions were reported on the 2001 partnership return and the

associated forms allocating to Fidelity's partners the gains or

losses for the transactions. Almost all the losses were assigned

on the schedule to Egan. An attached schedule reflecting "Other

income (loss)" pertaining to each closed-out transaction--say, the

purchase and ultimate disposition of an option by Fidelity--showed

a "cost or other basis" for the option (such as the premium paid to

acquire it), the associated revenue generated (the price received

on its sale) and the difference (the net gain or loss on the

purchase and sale).

The ultimate effect of these 2001 currency option

transactions was to give Egan a net loss on paper of $158.6 million

(comprising 5 percent of the gain from the foreign currency

options, 93 percent of the loss, and fees) and Mahoney a net gain

of $154.5 million (including 93 percent of the gain, 5 percent of

the loss, and fees). Egan's net loss was reported on his 2001

personal return to offset gain on the nearly $163 million in income

realized from the exercise of his EMC options in the same year.

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 These 2001 foreign currency options transactions were the

core means of generating the loss for Egan, but a related set of

transactions was also necessary. Under the tax laws, a partner may

deduct his share of a partnership's losses only to the extent of

his adjusted "outside" basis in the partnership at the end of the

year in which the loss occurred. 26 U.S.C. § 704(d). This outside

basis refers to the partner's investment in the partnership (as

opposed to the "inside" basis of investments made by the

partnership in carrying on its own business).

To establish this necessary large outside basis, Egan in

2000 had become a partner not only of Fidelity but of a second

vehicle called Fidelity World, which in early October 2001 entered

into two pairs of offsetting options keyed to interest rates.

Fidelity World contributed them to Fidelity, reporting as a capital

contribution by Egan the $150 million cost of premiums paid to

secure the future interest rates options (and ignoring largely

offsetting premiums received for the sale of the other two

options).

In 2001, Fidelity closed out the contributed interest

rate options by purchasing a set of offsetting options that locked

in any existing gain or loss to protect against any future changes.

When these options were all terminated in 2002, the transactions

produced a very modest net loss of $1.9 million, due primarily to

advisor fees; nearly $1.8 million was proportionally allocated to

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Egan on Fidelity's 2002 return and reported by him to shield other

income on his own 2002 tax return.

In 2005 and 2006, the IRS notified Fidelity that it was

making adjustments to Fidelity's 2001 and 2002 partnership tax

returns. Under the governing regime, the partnership return items

may be adjusted by the IRS and contested changes may be judicially

reviewed in a district court proceeding (or, the Tax Court or Court

of Federal Claims) addressed only to partnership items. 26 U.S.C.

§ 6226(a). These include "the proper allocation of such items

among the partners, and the applicability of any penalty . . .

which relates to an adjustment to a partnership item." Id. §

6226(f).

In this case, the IRS disallowed all of Egan's claimed

contributions to Fidelity, reduced Egan's claimed "outside

partnership basis" to zero for 2001 and--most importantly--

disallowed the losses on Fidelity option transactions that Egan had

used on his personal returns for 2001 and 2002 to shield his non-

Fidelity income. The adjustments rested on the IRS's determination

that the option transactions, and Egan's contribution, lacked

economic substance. The IRS also disregarded the partnership as a

sham and lacking in economic substance.

Tax considerations are permissibly taken into account by

taxpayers in structuring their financial transactions, but where a

transaction has no economic purpose other than to reduce taxes, the

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IRS may disregard the reported figures as fictions and look through

to the underlying substance.2 Here, the IRS found (and the

district court later agreed) that Fidelity's option transactions

were designed to cancel each other out and were merely reported to

generate paper losses to use on Egan's return. The shift in

partnership ownership part way through was a counterpart device to

allocate most losses to Egan and most gains to Mahoney.

Congress has adopted a graduated set of penalties for

overstating on a return the value or basis of property, and the IRS

invoked a provision adding a 40 percent penalty to the portion of

a tax underpayment that is "attributable to" a "gross valuation

misstatement." 26 U.S.C. § 6662(a), (b), (e), (h). A gross

valuation misstatement occurs when

the value of any property (or the adjusted
basis of any property) claimed on any return
of tax . . . is 400 percent or more of the
amount determined to be the correct amount of
such valuation or adjusted basis (as the case
may be) . . . .

Id. § 6662(e)(1)(A), (h)(2)(A)(ii)(I). Under the regulations, a

gross valuation misstatement exists when the correct or adjusted

basis of property is zero. 26 C.F.R. § 1.6662-5(g) (2011).

The losses that Fidelity attributed to individual

transactions were calculated by assigning each option transaction

2
See 26 U.S.C.A. § 7701(o) (West 2011); Gregory v. Helvering,
293 U.S. 465 (1935); Dewees v. Comm'r, 870 F.2d 21, 29-30 (1st Cir.
1989).

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a cost basis or value to set against any revenue obtained from the

transaction. Absent a cost basis or value, the transaction could

not generate a loss. And when the IRS found that the transactions

lacked economic substance, it not only disallowed the loss but

invoked penalties for misstating the basis of the options.

To understand the target of the penalty, a simplified

example may help. Basis, in a typical business purchase and sale

transaction, equates to the cost (reduced by any depreciation).

Thus, a taxpayer might claim that the cost of a widget was $10--

when its actual cost was $1--and report its sale for $1.

Overstating the cost of the widget allowed the taxpayer to claim a

loss of $9, then used to reduce taxes on other income. So falsely

asserting, or increasing, a basis translates into reducing gain or

enlarging loss by the amount falsely asserted or increased.

Similarly, in this case, the reported basis in the

options transactions allowed Fidelity to report a loss (which it

allocated to Egan). An excerpt from a table attached to Fidelity's

Form 1065 to show "Other Income/(Loss)" read as follows (the line

below references a single option transaction):

Date Date Sold Gross Sales Cost or Gain/(Loss)

Acquired Price Other Basis
10/22/2001 12/03/2001 163,405,260 199,865,888 (36,460,628)

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The huge loss taken by Egan on his own return was comprised of the

sum of a number of such losses listed in the partnership return and

allocated to him.

Here, the IRS concluded that the 40 percent penalty

applied. On judicial review, the district court upheld this and

other determinations, making numerous factual findings and legal

determinations. Fid. Int'l, 747 F. Supp. 2d 49. Having agreed

with the IRS that the option transactions lacked economic

substance, the court held that the losses attributed to Egan were

properly disallowed. The 40 percent penalty rested on

determinations that the correct basis of those transactions was

zero, and that tax underpayments were attributable to those

overstatements. Id. at 239 ¶ 68k.

Fidelity's present appeal is narrow. Apart from a throw-

away line or so in its brief, Fidelity does not seriously contest

the district court's basis adjustment under the economic substance

doctrine. Nor does it appeal the applicability of alternative

lower penalties based on the spurious paper losses generated.

Instead, its arguments are directed only to the 40 percent penalty.

Although Fidelity is the nominal private party, this is effectively

a controversy between the Egan estate and the government.

The three issues Fidelity presents are legal and our

review is de novo. See Keller v. Commissioner, 556 F.3d 1056,

1058-59 (9th Cir. 2009). The first claim is that there was no

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"misstatement" of basis in the partnership returns. Second,

Fidelity argues that no underpayment of tax was "attributable to"

a basis misstatement, even if a misstatement existed. Finally,

Fidelity says that the 40 percent penalty is inconsistent with

congressional tax policy as evidenced by a new penalty provision.

The "No Misstatement" Claim. Fidelity's position on the

first issue has two separate strands. One is that there was no

improper statement of loss on the partnership return because the

net economic loss of $4.1 million reported on its 2001 return was

almost identical to the true net economic loss as computed by the

district court. But this is merely to say that any misstatements

of individual transactions might not have had any effect on

Fidelity's taxes if it were the taxpayer.

Here, the misstatements of concern are not the net effect

of the transactions taken together but the claimed bases on

individual options transactions. These bases, and the allocation

of the resulting losses to an individual partner, are themselves

partnership items subject to the IRS's adjustment power in

reviewing the partnership return.3 It was these individual

transactions that allowed Egan to offset ordinary income on his own

3
IRS regulations state that "[c]ontributions to the
partnership" and a partner's share of "income, gain, [and] loss"
are partnership items, 26 C.F.R. § 301.6231(a)(3)-1 (2011). See
also Stobie Creek Invs. LLC v. United States, 608 F.3d 1366, 1380
(Fed. Cir. 2010).

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returns; and the individual transactions were just those that the

IRS found to lack economic substance.

The fact that gains and losses would inevitably balance

out is just what made the transactions lack economic substance for

Fidelity. There might or might not have been different counter-

parties to the individual transactions who could therefore suffer

"real" gains or losses themselves. But for Fidelity, the

transactions had no function but to create artificial paper gains

on some transactions (principally assigned to Mahoney) and losses

on others (principally assigned to Egan).

Fidelity's second-strand argument seeks to distinguish

between factually false transactions--ones that never occurred--and

the present case in which the transactions actually occurred but,

taken together, had no economic substance for Fidelity. In the

latter case, says Fidelity, the economic substance doctrine allows

the IRS to disregard the transactions but the reported figures

remain accurate recordations of each transaction and are not

misstatements, although (it says) a "legal dispute" might arise as

to their significance.

Congress singled out for stiff penalties a misstated

basis or value that improperly reduces taxes; the apparent reason

is that the misstated figures directly impair tax collections and

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prove difficult to resolve (and presumably are easy to fabricate).4

Here, the figures are misstatements precisely because the

transactions lacked any economic purpose for Fidelity other than to

generate purported losses to reduce Egan's taxes. Purpose, at

least in this case, is an issue of fact quite as much as whether an

option was bought or sold.

Relatedly, Fidelity argues that the valuation

misstatement penalty only applies in cases where the economic

substance doctrine is triggered because basis or value is

misstated, and not where the basis for the transaction is reduced

to zero after a finding of lack of economic substance. But this is

a distinction without a difference; and in any case, the statute by

its terms applies the penalty to a misstatement, and given the

policy concerns Congress had no reason to care about the nature of

the falsity.

The "Attributable To" Issue. Under the penalty statute,

the 40 percent penalty applies only to "a portion of the

underpayment . . . attributable to one or more gross valuation

misstatements." 26 U.S.C. § 6662(h)(1). Fidelity argues that the

underpayment of taxes by Egan--the partnership pays none for

itself--would have occurred without the misstatements of value and

4
See Todd v. Commissioner, 862 F.2d 540, 542 (5th Cir. 1988);
Clearmeadow Investments, LLC v. United States, 87 Fed. Cl. 509, 531
n.27 (2009); H.R. Rep. No. 97-201, at 243 (1981).

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therefore cannot be "attributable to" any supposed gross valuation

misstatement.5

Fidelity says that even without the misstatements of

bases, the losses Fidelity claimed and allocated to Egan would have

been disallowed based on other determinations made by the IRS and

the district court. Specifically, these included determinations--

stemming from the same central finding that the transactions lacked

economic purpose and was designed purely for tax avoidance--that

Fidelity was not a true partnership, that Egan's outside basis was

zero, that Mahoney (the Irish national) was not a partner, and that

the transactions were not entered into for profit, 26 U.S.C. §

165(c)(2). Fid. Int'l, 747 F. Supp. 2d at 244.

Thus, given the lack of economic substance, the IRS had

various statutory grounds for disallowing the same losses. Dual

cause issues arise in various contexts throughout the law, e.g., W.

Page Keeton et al., Prosser and Keeton on Torts §§ 41-42 (5th ed.

1984), and the varying solutions depend primarily on context and

underlying policy. Here, Congress' phrase "attributable to" is

5
The district court only had jurisdiction over "the
applicability of any penalty . . . which relates to an adjustment
to a partnership item," 26 U.S.C. § 6226(f), and Egan's personal
liability will be assessed in a separate, partner-level proceeding,
but the IRS must issue a notice to the partnership before making
assessments against individual partners. Id. § 6225(a). Courts
seem willing to assume that a partnership adjustment is likely to
produce an underpayment at the partner level. See, e.g., Am. Boat
Co. v. United States, 583 F.3d 471, 473 (7th Cir. 2009).

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easily read to cover the role of the misstatements in lowering

Egan's taxes and that reading serves the underlying policy.

To repeat, the heavy penalty for gross misstatements of

value or basis reflects their resulting harm and difficulty in

detection. See note 4, above. The misstatements were the vehicle

for generating the spurious Fidelity losses carried over to Egan's

return to shield his income. That (in this case) alternative

grounds with lower or no penalties existed for disallowing the same

claimed losses hardly detracts from the need to penalize and

discourage the gross value misstatements.

Indeed, one might think that it would be perverse to

allow the taxpayer to avoid a penalty otherwise applicable to his

conduct on the ground that the taxpayer had also engaged in

additional violations that would support disallowance of the

claimed losses. Cf. Gilman v. Comm'r, 933 F.2d 143, 150 (2d Cir.

1991), cert. denied, 502 U.S. 1031 (1992). Most circuit courts

that have confronted variations on Fidelity's argument in the lack

of economic substance context have rejected it.6

The only unimpaired circuit precedents favoring

Fidelity's position are from the Fifth Circuit. In Todd v.

6
Compare Merino v. Comm'r, 196 F.3d 147 (3d Cir. 1999); Zfass
v. Comm'r, 118 F.3d 184 (4th Cir. 1997); Illes v. Comm'r, 982 F.2d
163 (6th Cir. 1992), cert. denied, 507 U.S. 984 (1993); Gilman v.
Comm'r, 933 F.2d 143 (2d Cir. 1991) cert. denied, 502 U.S. 1031
(1992); Massengill v. Comm'r, 876 F.2d 616, 619-20 (8th Cir. 1989)
with Keller v. Comm'r, 556 F.3d 1056 (9th Cir. 2009); Heasley v.
Comm'r, 902 F.2d 380 (5th Cir. 1990).

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Commissioner, 862 F.2d 540 (5th Cir. 1988), later summarily

followed by Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990),

the court accepted the position that an overvaluation underpinning

claimed tax benefits should go unpenalized because other grounds

also existed for imputing the same higher income to the taxpayer.

We think Todd rests on a misunderstanding of the sources relied on.

The court reached its result not by considering how the

"attributable to" language should be read in light of its purpose

(in fact, it admitted that its reading "ascribe[s] an intent to

Congress which might, at first blush, seem inequitable," Todd, 862

F.2d at 545) but rather because it glossed that requirement by

reading language in a congressional tax document generated to

explain the predecessor penalty to section 6662 passed in 1981.

This document's key language reads as follows:

The portion of a tax underpayment that is
attributable to a valuation overstatement will
be determined after taking into account any
other proper adjustments to tax liability.
Thus, the underpayment resulting from a
valuation overstatement will be determined by
comparing the taxpayer's (1) actual tax
liability (i.e., the tax liability that
results from a proper valuation and which
takes into account any other proper
adjustments) with (2) actual tax liability as
reduced by taking into account the valuation
overstatement. The difference between these
two amounts will be the underpayment that is
attributable to the valuation overstatement.

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Todd, 862 F.2d at 542-43 (quoting Staff of the Joint Committee on

Taxation, General Explanation of the Economic Recovery Tax Act of

1981, at 333 (Comm. Print 1981)).

In our view, that language is designed to avoid

attributing to a basis or value misstatement an upward adjustment

of taxes that is unrelated to the overstatement but due solely to

some other tax reporting error (for example, if Egan had also

falsely claimed a charitable contribution on his return). This is

surely what the quoted language means in excluding from the

overstatement penalty increased taxes due to "any other proper

adjustments." This is quite different from excusing an

overstatement because it is one of two independent, rather than the

sole, cause of the same under-reporting error.

Although the Ninth Circuit followed Todd's misreading in

Gainer v. Commissioner, 893 F.2d 225 (9th Cir. 1990), a later

decision of the court conceded that Gainer was a vulnerable

precedent in conflict with other circuits; but the panel felt

compelled to follow prior circuit precedent. Keller, 556 F.3d at

1061. We follow without hesitation the dominant view of the

circuits that have addressed this issue.

The Supposedly Conflicting Penalty Provisions. Fidelity

finally points to Congress' recent provision adding transactions

lacking economic substance to the list of tax underpayments to

which accuracy-related penalties apply. 26 U.S.C.A. § 6662(b)(6)

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(West 2011). This new provision, applying only to transactions

entered into after March 31, 2010, Health Care and Education

Reconciliation Act of 2010, Pub. L. No. 111-152, § 1409(e)(2), 124

Stat. 1029, 1070 (2010), applies a 40 percent penalty to those

transactions which are not disclosed and reduces it to 20 percent

for those that are, 26 U.S.C.A. § 6662(i) (West 2011).

Here, the individual Fidelity transactions at issue were,

in one sense at least, disclosed. On this premise, Fidelity

alleges a potential conflict created by reading the gross valuation

misstatement penalty to cover a disclosed transaction that lacks

economic substance: the incentive to disclose created by the new

provision is greatly reduced because the government could

presumably seek the 40 percent penalty under the gross valuation

misstatement provision for a fully disclosed transaction that

lacked economic substance.

The new statute was enacted after the transactions that

are in issue in this case, and Fidelity does not claim that it

governs those transactions. So this is not even a case in which

one can argue that two provisions apply simultaneously to the same

transaction and that one provision's language should be

reinterpreted to avoid an unreasonable result. Fidelity is in

effect arguing that the language in the earlier statute should be

re-read because of other changes by a later Congress.

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 Anyway, the new provision is not limited solely to

misstatements of basis or value, which Congress earlier singled out

in imposing the higher penalty without regard to disclosure. And

the new penalty is a strict liability provision, while the gross

valuation misstatement penalty allows taxpayers to raise reasonable

cause and good faith defenses. 26 U.S.C. § 6664(c)(1)-(2) (West

2011). The two penalty provisions are designed differently but

create no such conflict as would lead us to tamper with

straightforward language of the 40 percent penalty provision.

Affirmed.

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