Free Cross Motion [Dispositive] - District Court of Federal Claims - federal

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS MARRIOTT INTERNATIONAL RESORTS, L.P., MARRIOTT INTERNATIONAL JBS CORPORATION, Tax Matters Partner, Plaintiffs, v. THE UNITED STATES, Defendant. ) ) ) ) ) ) ) ) ) ) ) ) ) )

Nos. 01-256T and 01-257T Judge Charles F. Lettow

PLAINTIFFS' OPPOSITION TO DEFENDANT'S MOTION FOR SUMMARY JUDGMENT AND PLAINTIFFS' CROSS-MOTION FOR PARTIAL SUMMARY JUDGMENT

Harold J. Heltzer Robert L. Willmore Alex E. Sadler CROWELL & MORING LLP 1001 Pennsylvania Avenue, N.W. Washington, D.C. 20004 Tel: (202) 624-2915 Fax: (202) 628-5116 March 27, 2008

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TABLE OF CONTENTS

PLAINTIFFS' CROSS MOTION FOR PARTIAL SUMMARY JUDGMENT ...........1 PLAINTIFFS' MEMORANDUM IN OPPOSITION TO DEFENDANT'S MOTION FOR SUMMARY JUDGMENT AND IN SUPPORT OF PLAINTIFFS' CROSS-MOTION FOR PARTIAL SUMMARY JUDGMENT......................................................................................................3 QUESTION PRESENTED ..........................................................................................4 STATEMENT OF THE CASE.....................................................................................4 STANDARD OF REVIEW...........................................................................................9 ARGUMENT ..............................................................................................................10 A. Defendant's Position That The Obligation To Close A Short Sale Constitutes A "Liability" For Purposes Of Section 752 Was First Announced In A 1995 Revenue Ruling Published After The Transactions At Issue Here. That Revenue Ruling, In Which The IRS Implemented A Policy Position Urged By The Treasury Department, States A View Directly Inconsistent With Numerous Judicial Rulings Which Preceded It In Which Courts Adopted The IRS's Argument That Contingent Obligations Are Not "Liabilities" Under Section 752.................10 1. In A Well Established Line Of Cases, The IRS Argued And The Courts Agreed That Contingent Obligations ­ That Is, Obligations Uncertain As To Liability And/Or Amount ­ Are Not Considered "Liabilities" For Purposes Of Code Section 752. .............10 The Obligation To Close A Short Sale Of Borrowed Securities By Purchasing And Then Returning Replacement Securities To The Lender Of Those Securities Is By Its Very Nature A Contingent Obligation Because The Cost Of Closing The Short Sale Cannot Be Determined Until The Replacement Securities Have Been Purchased By The Short Seller............................................................17 In 1995, The IRS At The Urging Of The Treasury Department Issued A Revenue Ruling Holding That The Obligation To Close A Short Sale Is A "Liability" Under Section 752 Even Though The IRS Clearly Understood That This Conclusion Was Inconsistent With Its Position That Contingent Obligations Are Not "Liabilities" Under Section 752. ...................................................21

2.

3.

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4.

Contrary To Defendant's Argument, The Change Of Position Announced In Rev. Rul. 95-26 Was Not Consistent With Either Rev. Rul. 88-77 Or The Definition of Liability In The Treasury Department's 1989 Temporary Regulations, Which Dealt With An Entirely Different Issue Involving Cash Basis Taxpayers. ..........23

B.

Because The Obligation To Purchase And Return Securities Borrowed To Implement A Short Sale Is A Contingent Obligation, That Obligation Cannot Be A "Liability" For Purposes Of Section 752. ...............27 1. In Its Recent Decision In Jade Trading, LLC v. United States, The Court Of Federal Claims Confirmed That Contingent Obligations Do Not Constitute "Liabilities" For Purposes Of Section 752. Other Recent Decisions By Refund Tribunals Have Reached The Same Conclusion. ...........................................................27 Rev. Rul. 95-26 Does Not Evidence Thoroughness Of Consideration, Employs Flawed And Invalid Reasoning, And Is Directly Inconsistent With The Long Line Of Cases In Which Courts Adopted The IRS's Position That A Contingent Obligation Cannot Be A "Liability" For Purposes Of Section 752. Accordingly, Rev. Rul. 95-26 Does Not Have The "Power To Persuade" And Is Not Entitled To Any Skidmore Deference. ............35 Defendant's Basis Mismatch Argument Is A Result-Oriented Principle That The Government Only Emphasizes If And When It Benefits The Government. ...............................................................41

2.

3.

C.

Defendant's Characterization Of The Short Sale Transactions As "Son of BOSS" Transactions Is Unsupported By The Record, Ignores Fundamental Aspects Of The Short Sale Transactions, And Is Completely Irrelevant To The Merits Of The Legal Issues Presented By The Pending Motions.................................................................................43

CONCLUSION...........................................................................................................45 APPENDIX A: Internal Revenue Code of 1986, 26 U.S.C.: § 351...............................................................................................................A-1 § 357(c)...........................................................................................................A-3 § 358(a)(1) ......................................................................................................A-5

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§ 722...............................................................................................................A-5 § 733(1) ..........................................................................................................A-5 § 752...............................................................................................................A-6 § 754...............................................................................................................A-6 § 1233.............................................................................................................A-7 ATTACHMENT Declaration of Harold J. Heltzer with Plaintiffs' Exhibits 1-9

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TABLE OF AUTHORITIES CASES Aeroquip-Vickers, Inc. v. Commissioner, 347 F.3d 173 (6th Cir. 2003) .......... 36 America Online, Inc. v. United States, 64 Fed. Cl. 571 (2005) ........................ 36 Ammex, Inc. v. United States, 367 F.3d 530 (6th Cir. 2004) ........................... 40 Amp Inc. v. United States, 185 F.3d 1333 (Fed. Cir. 1999) ........................ 40-41 Anderson v. Liberty Lobby, Inc., 477 U.S. 242 (1986)........................................ 9 Brountas v. Commissioner, 692 F.2d 152 (1st Cir. 1982) .......................... 15, 34 Cemco Investors, LLC v. United States, 2007-1 USTC ¶ 50,385 (N.D. Ill. 2007), aff'd, 515 F.3d 749 (7th Cir. 2008) .................................. 28-30, 33 Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984)............................................................................................................ 35 Christensen v. Harris County, 529 U.S. 576 (2000) ......................................... 36 COLM Producer, Inc. v. United States, 460 F. Supp. 2d 713 (N.D. Tex. 2006), appeal pending, Kornman & Assoc. Inc. v. United States, No. 06-11422 (5th Cir.).................................................................................. 31-33 Deputy v. du Pont, 308 U.S. 488 (1940)............................................................ 38 Dixon v. United States, 381 U.S. 68 (1965) ...................................................... 35 Dunway v. Commissioner, 124 T.C. 80 (2005) ................................................. 33 Federal Nat'l Mtg. Ass'n v. United States, 379 F.3d 1303 (Fed. Cir. 2004) ........................................................................................................ 36-37 Fox v. Commissioner, 80 T.C. 972 (1983), aff'd sub nom. Barnard v. Commissioner, 731 F.2d 230 (4th Cir. 1984) ........................................ 15, 34 Gibson Prods. Co. v. United States, 637 F.2d 1041 (5th Cir. 1981) .... 15, 32, 34 Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975) ............................passim

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Jade Trading, LLC v. United States, 80 Fed. Cl. 11 (2007) ...... 27-28, 30, 33-34 Klamath Strategic Investment Fund, LLC v. United States, 440 F. Supp. 2d 608 (E.D. Tex. 2006).............................................. 30-31, 33, 34, 41 La Rue v. Commissioner, 90 T.C. 465 (1988) ............................................passim Long v. Commissioner, 71 T.C. 1 (1978), aff'd in part and rev'd in part on other issues, 660 F.2d 416 (10th Cir. 1981).................................... passim Matsushita Elec. Indus. Co. v. Zenith Radio Corp., 475 U.S. 574 (1986) ......... 9 Mingus Constructors, Inc. v. United States, 812 F.2d 1387 (Fed. Cir. 1987) ............................................................................................................... 9 Newman v. Commissioner, 68 T.C. 494 (1977) ................................................ 34 Nico v. Commissioner, 67 T.C. 647 (1977), rev'd on other grounds, 565 F.2d 1234 (2d Cir. 1977) .............................................................................. 33 Officemax, Inc. v. United States, 428 F.3d 583 (6th Cir. 2005) .................. 36-37 Omohundro v. United States, 300 F.3d 1065 (9th Cir. 2002) .......................... 36 Provost v. United States, 269 U.S. 443 (1926).................................................. 38 Salina Partnership L.P. v. Commissioner, 80 T.C.M. (CCH) 686 (2000) .......................................................................................................... 22, 33, 42 Skidmore v. Swift & Co., 323 U.S. 134 (1944) ........................................... 36, 40 St. Louis Bank for Coops v. United States, 624 F.2d 1041 (1980)................... 36 Tedoken v. Commissioner, 84 T.C.M. (CCH) 657 (2002) ................................. 36 USA Choice Internet Serv., LLC v. United States, 73 Fed. Cl. 780 (2006)............................................................................................................ 35 United States v. Cleveland Indians Baseball Co., 532 U.S. 200 (2001) .... 36, 40 United States v. Mead Corp., 533 U.S. 218 (2001)........................................... 36 Western Co. of N. America v. United States, 323 F.3d 1024 (Fed. Cir. 2003) ............................................................................................................. 35

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STATUTES Internal Revenue Code of 1986, 26 U.S.C.: § 351................................................................................................................... 24 § 357(c).......................................................................................................... 24-25 § 358(a)(1) .......................................................................................................... 24 § 722................................................................................................................... 11 § 733(1) .............................................................................................................. 11 § 752............................................................................................................passim § 754................................................................................................................... 42 § 1233................................................................................................................. 18 LEGISLATIVE MATERIALS H.R. Rep. No. 861, 98th Cong., 2d Sess. 856-57 (1984) ................................... 25 TREASURY AND IRS MATERIALS Treas. Reg. § 1.461-1(a)(2)(i)............................................................................. 12 Treas. Reg. § 1.752-1(a)(4)(ii) (2003) ................................................................ 29 Treas. Reg. § 1.1233-1(a)(1) .............................................................................. 18 Treas. Reg. § 601.601(d)(2)(i)(a) ....................................................................... 35 Temp. Treas. Reg. § 1.752-1T(g), T.D. 8237, 1989-1 C.B. 180, 192 (Dec. 30, 1988)........................................................................................ 24, 26 Notice of Proposed Rulemaking, 68 Fed. Reg. 37,434 (June 24, 2003)........... 29 Notice of Proposed Rulemaking, 56 Fed. Reg. 36,704 (July 31, 1991)............ 26 Rev. Rul. 2002-44, 2002-2 C.B. 84 .................................................................... 38 Rev. Rul. 95-26, 1995-1 C.B. 131 ...............................................................passim

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Rev. Rul. 88-77, 1988-2 C.B. 128 ..................................................... 21, 24-26, 37 Rev. Rul. 73-301, 1973-2 C.B. 215 .................................................................... 14 Rev. Rul. 60-345, 1960-2 C.B. 211 ............................................................... 24-25 G.C.M. 33,948 (Oct. 22, 1968)........................................................................... 14 MISCELLANEOUS Alice W. Cunningham, Short-Sale Obligations and Basis in Partnership Interests, 72 Tax Notes 1663, 1669 (1996) ............................ 39 1 William S. McKee, William F. Nelson & Robert L. Whitmire, Federal Taxation of Partnerships and Partners ¶ 7.01[1] (3d ed. 2004) ..... 38-39, 42

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS MARRIOTT INTERNATIONAL RESORTS, L.P., MARRIOTT INTERNATIONAL JBS CORPORATION, Tax Matters Partner, Plaintiffs, v. THE UNITED STATES, Defendant. ) ) ) ) ) ) ) ) ) ) ) ) ) )

Nos. 01-256T and 01-257T Judge Charles F. Lettow

PLAINTIFFS' CROSS-MOTION FOR PARTIAL SUMMARY JUDGMENT For the reasons set forth in the accompanying Memorandum in Opposition to Defendant's Motion for Summary Judgment and in Support of Plaintiffs' CrossMotion for Partial Summary Judgment, Plaintiffs respectfully move for partial summary judgment under Rule 56 of the Rules of the United States Court of Federal Claims. Specifically, Plaintiffs move that the Court rule that the obligation of Marriott International Resorts, L.P. to close the two short-sale hedging transactions at issue in this case is a contingent obligation and, therefore, does not constitute a "liability" within the meaning of section 752 of the Internal Revenue Code (26 U.S.C. § 752). In addition to the aforementioned Memorandum (with Appendix A), Plaintiffs in support of this Motion submit Plaintiffs' Proposed Findings of Uncontroverted

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Facts, Plaintiffs' Response To Defendant's Proposed Findings of Uncontroverted Facts, and exhibits attached to the Declaration of Harold J. Heltzer, filed herewith. Respectfully submitted March 27, 2008 s/Harold J. Heltzer Harold J. Heltzer (Attorney of Record) Robert L. Willmore Alex E. Sadler CROWELL & MORING LLP 1001 Pennsylvania Avenue, N.W. Washington, D.C. 20004 Tel: (202) 624-2915 Fax: (202) 628-5116 Counsel for Plaintiffs
5021578

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS MARRIOTT INTERNATIONAL RESORTS, L.P., MARRIOTT INTERNATIONAL JBS CORPORATION, Tax Matters Partner, Plaintiffs, v. THE UNITED STATES, Defendant. ) ) ) ) ) ) ) ) ) ) ) ) ) )

Nos. 01-256T and 01-257T Judge Charles F. Lettow

PLAINTIFFS' MEMORANDUM IN OPPOSITION TO DEFENDANT'S MOTION FOR SUMMARY JUDGMENT AND IN SUPPORT OF PLAINTIFFS' CROSS-MOTION FOR PARTIAL SUMMARY JUDGMENT Plaintiffs respectfully submit this Memorandum in opposition to Defendant's Motion for Summary Judgment and in support of Plaintiffs' Cross-Motion for Partial Summary Judgment. Both motions address the issue of whether the obligation of Marriott International Resorts, L.P. ("MIR") to close two 1994 short sale hedging transactions was a "liability" within the meaning of Section 752 of the Internal Revenue Code. Defendant, relying largely on a position first articulated by the Internal Revenue Service ("IRS") in a 1995 revenue ruling, contends that this obligation was a "liability" within the meaning of Section 752. Plaintiffs, relying on a long line of cases in which the courts adopted the IRS's position that a contingent obligation cannot constitute a "liability" for purposes of Section 752, contend that, because this obligation was by its very nature a contingent (rather than fixed and

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certain) obligation, it cannot be a "liability" under section 752. For the reasons set forth below, Plaintiffs respectfully request that Defendant's motion be denied and Plaintiffs' cross-motion be granted. QUESTION PRESENTED In 1994, Plaintiffs entered into two short sale transactions involving U.S. Treasury Notes for the purpose of hedging interest rate risks associated with holding a portfolio of fixed-rate mortgages generated through Plaintiffs' time-share business. The legal question presented by both parties' motions is whether the obligation of MIR to close these two short sale hedging transactions by purchasing and then returning replacement Treasury Notes was a contingent obligation (that is, an obligation uncertain as to liability and/or amount), and, therefore, did not constitute a "liability" within the meaning of Section 752 of the Internal Revenue Code. STATEMENT OF THE CASE During the period at issue, Marriott Ownership Resorts Inc. ("MORI"), a wholly-owned subsidiary of Marriott International, Inc. ("Marriott"), was engaged in the business of selling time-share interests in resort properties. (DPF 5.1) As part of that business, MORI offered buyers the opportunity to finance their purchases by having the buyer execute a promissory note, secured by a mortgage on the time1

Defendant's Proposed Findings of Uncontroverted Facts are cited as "DPF," and Plaintiffs' Proposed Findings of Uncontroverted Facts are cited as "PPF." As explained in Plaintiffs' Proposed Findings of Uncontroverted Facts, Plaintiffs will cite to Defendant's Proposed Findings of Uncontroverted Facts to the extent Plaintiffs have agreed to those proposed findings.

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share unit ("Mortgage Notes"). (DPF 6.) These Mortgage Notes bore interest at a fixed rate. (PPF 1.) In this time frame, MORI periodically sold securitized portfolios of its Mortgage Notes to Teachers Insurance and Annuity Association of America ("TIAA") using a bankruptcy remote special-purpose entity. (DPF 7; PPF 4; PPF 5.) The transactions were priced to provide TIAA a yield of 240 basis points (a 2.4% spread) above average yields on U.S. Treasury securities adjusted to a constant maturity of four years. (PPF 2.) Accordingly, in order to provide TIAA with the specified yield over U.S. Treasury securities, the amount to be received by Marriott from TIAA would fall if interest rates rose between the time the Mortgage Notes were issued and the time of the sale to TIAA. (PPF 3.) Marriott International Resorts, LP ("MIR") served as the bankruptcy remote special-purpose entity for the sale of the securitized portfolio of Mortgage Notes to TIAA in 1994. (PPF 6.) Marriott needed to use a bankruptcy remote specialpurpose entity for the sale to TIAA in order to obtain the highest possible credit rating, and thereby the highest possible price, for the securitized portfolio of Mortgage Notes. (PPF 5.) In late 1993, Marriott was spun off from its former parent, Marriott Corporation. (PPF 7.) During 1994, while the new Marriott was determining its financial policies, it decided to hold onto the Mortgage Notes, which were earning an attractive rate of interest. (PPF 8.) Marriott was concerned, however, that during the period it was holding the Mortgage Notes, an increase in interest rates

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could result in Marriott receiving substantially less for those Mortgage Notes when they were ultimately sold to TIAA. (PPF 3; PPF 9.) Early in 1994, one of Marriott's advisers, CS First Boston, provided tax planning advice to Marriott that included a short sale of U.S. Treasury securities. (PPF 15.) While Marriott did not engage in the transaction proposed by CS First Boston (PPF 16), it did thereby become aware that one way in which it could reduce the interest-rate risk of holding the Mortgage Notes was through a hedge involving a short sale of U.S. Treasury securities, and that such a short sale hedge could also provide significant tax benefits. (PPF 15.) Authorization was sought and obtained from Marriott's Corporate Growth Committee on April 22, 1994, to implement an interest rate hedge using a Treasury Note short sale with respect to the then accumulated MORI Mortgage Notes of approximately $65 million. (PPF 10.) Authorization was also sought and obtained for additional possible short sale hedges as MORI accumulated additional Mortgage Notes, but in no event would the short sales exceed MORI's actual mortgage exposure. (PPF 11.) On or about April 25, 1994, MORI sold short ("First Short Sale") five-year U.S. Treasury securities with a face amount of $65,000,000 and received cash proceeds of $63,703,816. (DPF 10, 12.) As noted, the size of the short sale reflected the volume of Mortgage Notes MORI had accumulated. (PPF 8; PPF 10.) These cash proceeds were then invested in repurchase obligations ("Repos") that adjusted to the prevailing 30-day LIBOR rate. (DPF 12.) That is, the interest

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rate reset every 30 days. (DPF 12, n.4.) As a result, the Repos had a constant value, which was unlike the Mortgage Notes, whose value fluctuated with prevailing interest rates. The 1% general partner of MIR was Marriott International JBS Corporation ("JBS"), and the 99% limited partner of MIR was MORI. (DPF 2; DPF 15.) On or about May 6, 1994, MORI contributed to MIR (1) Mortgage Notes with a face amount of approximately $65,200,000 and (2) the Repos. (DPF 16, as counterproposed by Plaintiffs.) MIR assumed MORI's obligation to close the First Short Sale. (DPF 16, as counter-proposed by Plaintiffs.) JBS contributed $1,000,000 to MIR. (DPF 17.) Subsequently, MORI accumulated additional Mortgage Notes. On or about August 15, 1994, MORI sold short ("Second Short Sale") five-year U.S. Treasury securities with a face amount of $10,000,000 and received cash proceeds of $9,463,451 that MORI also invested in Repos. (DPF 18, 20.) On August 16, 1994, MORI contributed to MIR (1) Mortgage Notes with a face amount of approximately $11,900,000 and (2) the Repos. (DPF 21, as counter-proposed by Plaintiffs.) As with the First Short Sale, MIR assumed MORI's obligation to close the Second Short Sale. (DPF 21, as counter-proposed by Plaintiffs.) Five months after the First Short Sale, MIR closed the First Short Sale on September 29, 1994, by purchasing replacement U.S. Treasury securities with a face amount of $65,000,000 at a cost of $62,667,034. (DPF 23.) Two months after the Second Short Sale, MIR closed the Second Short Sale on October 17, 1994, by

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purchasing replacement U.S. Treasury securities with a face amount of $10,000,000 at a cost of $9,279,811. (DPF 23.) As Marriott had anticipated, interest rates in fact rose during this time period. (PPF 13.) The two short sales accomplished their hedging purpose; that is, the gain from the short sales offset the reduction in the sales price of the Mortgage Notes to TIAA caused by the increase in interest rates. (PPF 14.) On October 28, 1994, MORI transferred its 99% partnership interest in MIR to Marriott International Capital Corporation ("MICC"). (DPF 25.) This resulted in a termination of the MIR partnership for Federal income tax purposes. (DPF 26.) Consistent with the then prevailing IRS position and court decisions that indicated that contingent obligations did not constitute "liabilities" under Code Section 752, MORI's basis in MIR reflected the basis of the contributed Mortgage Notes and Repos, but was not reduced by the assumed obligation to close the short sales. In the termination, the basis of MORI (and then MICC) for the MIR partnership interest was transferred to MIR's assets, i.e., the Mortgage Notes. Since this basis was higher than the fair market value of the Mortgage Notes, MIR recognized a loss on the sale of the notes for their fair market value to TIAA. This loss was passed through to MICC and JBS and was reflected in the 1994 Marriott consolidated Federal income tax return. It is this loss that is in dispute in the case.

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STANDARD OF REVIEW Summary judgment is appropriate only "if the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law." RCFC 56(c); Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 247-48 (1986). A "genuine" dispute is one that "may reasonably be resolved in favor of either party." Id. at 250. A "material fact" is one that would affect the outcome of a case. Id. at 248. In determining whether there is a genuine issue regarding a material fact, the court must resolve all inferences in the light most favorable to the non-moving party. Matsushita Elec. Indus. Co. v. Zenith Radio Corp., 475 U.S. 574, 587 (1986). With respect to cross-motions for summary judgment, each motion is evaluated on its own merits and reasonable inferences are resolved against the party whose motion is being considered. Mingus Constructors, Inc. v. United States, 812 F.2d 1387, 1390-91 (Fed. Cir. 1987). To the extent there is a genuine issue regarding a material fact, both motions must be denied. Id.

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ARGUMENT The legal issue presented by the two pending motions is whether a contingent obligation, such as the obligation to close a short sale by returning the borrowed security to the lender of the security, is a "liability" within the meaning of Section 752 of the Code.2 As discussed below, the IRS for many years successfully and repeatedly argued in the courts that a contingent obligation is not a "liability" for purposes of Section 752. Only in 1995 ­ a year after the transactions at issue in this case ­ did the IRS, with respect to short sale transactions, change its position by adopting a revenue ruling urged by the Treasury Department. But this revenue ruling should not be accorded any deference given that it is inconsistent (as the IRS plainly understood at the time) with the broader legal principle which had already been well established in the courts. A. Defendant's Position That The Obligation To Close A Short Sale Constitutes A "Liability" For Purposes Of Section 752 Was First Announced In A 1995 Revenue Ruling Published After The Transactions At Issue Here. That Revenue Ruling, In Which The IRS Implemented A Policy Position Urged By The Treasury Department, States A View Directly Inconsistent With Numerous Judicial Rulings Which Preceded It In Which Courts Adopted The IRS's Argument That Contingent Obligations Are Not "Liabilities" Under Section 752. 1. In A Well Established Line Of Cases, The IRS Argued And The Courts Agreed That Contingent Obligations ­ That Is, Obligations Uncertain As To Liability And/Or Amount ­ Are Not Considered "Liabilities" For Purposes Of Code Section 752.

2

All references to the Code refer to the Internal Revenue Code of 1986, 26 U.S.C., as amended. Copies of pertinent Code sections are included in the Appendix.

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Section 752 is part of subchapter K of the Code, which governs the income taxation of partners and partnerships. The Section provides for adjustments to the tax basis of a partner's interest in a partnership resulting from the assumption of a liability from the partnership or contribution of a liability to the partnership. Specifically, Section 752 provides as follows: (a) INCREASE IN PARTNER'S LIABILITIES.--Any increase in a partner's share of the liabilities of a partnership, or any increase in a partner's individual liabilities by reason of the assumption by such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the partnership. (b) DECREASE IN PARTNER'S LIABILITIES.--Any decrease in a partner's share of the liabilities of a partnership, or any decrease in a partner's individual liabilities by reason of the assumption by the partnership of such individual liabilities, shall be considered as a distribution of money to the partner by the partnership. Pursuant to Section 752, an increase in a partner's share of liabilities is treated as a contribution of money that increases the partner's basis for the partnership interest3 under Code section 722, while a decrease in a partner's share of liabilities is treated as a distribution of money that decreases the partner's basis for the partnership interest under Code section 733(1). The term "liabilities," however, is not defined for this purpose. For decades, the IRS consistently took the position that the term "liability" for partnership tax purposes referred only to the fixed and certain obligations of a partnership, such as indebtedness. In contrast to fixed obligations such as
3

A partner's basis for his partnership interest is commonly referred to as "outside basis," and the partnership's basis for its assets is commonly referred to as "inside basis."

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indebtedness, it was the IRS's longstanding position that contingent obligations ­ that is, where the fact or amount of the taxpayer's obligation was not fixed ­ were not liabilities under Section 752. For example, as discussed below, in La Rue v. Commissioner, 90 T.C. 465 (1988), the IRS successfully argued that a brokerage partnership's obligation to purchase securities for customers' accounts (which is the economic equivalent of closing a short sale) was not a Section 752 liability because the cost of satisfying that obligation was contingent upon future fluctuations in share prices. Id. at 479-80. The IRS's refusal to recognize contingent obligations as partnership liabilities was predicated in large part on the so-called "all-events" test, a fundamental tenet of tax accounting under which an expense cannot be deducted from income until all events have occurred fixing the fact and amount of liability. The "all-events" test thus determines the year in which income and deductions may be taken into account by taxpayers who elect the accrual method of accounting. Under that test, a fixed liability does not exist until the fact of liability is established and the amount is determinable with reasonable accuracy.4 Perhaps not surprisingly, the IRS's position on what type of obligation can constitute a "liability" for purposes of Section 752 invariably worked to the

4

See Treas. Reg. § 1.461-1(a)(2)(i) ("Under an accrual method of accounting, a liability . . . is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability").

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detriment of taxpayers, in that it prevented taxpayers from taking a contingent obligation as an expense against the partnership's taxable income or recognizing the obligation as a liability for partnership tax purposes. The IRS successfully and repeatedly maintained this position in tax disputes before the United States Tax Court and various refund tribunals. A seminal case in this regard is Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975), in which the IRS prevailed on its "liability" position with respect to a partnership's distribution of an option premium. There, a partnership received a cash option premium for granting a call option to a third party, and then distributed the premium to its partners in the same year even though the option had neither been exercised nor expired. The IRS successfully contended that the outside basis should not be increased to reflect the partnership's receipt of the option premium because no Section 752 "liability" existed, even though the inside basis had been increased by the amount of the premium. The Tax Court agreed with the IRS's position in Helmer, notwithstanding the obvious resulting disparity between inside and outside basis. Id. at 730-31. Of particular pertinence to the facts of this case, the Tax Court arrived at this conclusion even though the partnership had a legally enforceable obligation to deliver the optioned property if and when the option was exercised. But, because the taxpayer had neither a fixed liability to repay the funds received nor a fixed

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liability to deliver the optioned property, there was no "liability" within the meaning of Section 752. Id.5 Another frequently cited case in which the IRS prevailed in its Section 752 "liability" position is Long v. Commissioner, 71 T.C. 1 (1978), aff'd in part and rev'd in part on other issues, 660 F.2d 416 (10th Cir. 1981), which dealt with an estate's recognition of taxable gain on the liquidation of the decedent's partnership interest. The question there turned on whether certain claims against the partnership in litigation could be considered "liabilities" includable in the estate's outside basis under Section 752. Because these claims had been in litigation at the time of the decedent's death, the Tax Court held that the claims were not sufficiently definite to be treated as liabilities that could be included in the decedent's outside basis. Id. at 7-8 ("Although they may be considered `liabilities' in the generic sense of the term, contingent or contested liabilities . . . are not `liabilities' for partnership basis
5

The IRS's position that contingent obligations do not constitute Section 752 "liabilities" predates Helmer. In a 1968 General Counsel Memorandum involving the question of whether partners can increase their basis in a partnership by reason of the partnership's obligation to perform under a contract, the IRS stated that "[t]he liabilities referred to in Section 752 of the Code are those liabilities which arise from a debtor-creditor relationship with a sum certain due at a fixed or determinable date of maturity." G.C.M. 33,948 (Oct. 22, 1968). In other words, only debt obligations are "liabilities" under Section 752. This position was subsequently confirmed in a published ruling, Rev. Rul. 73-301, 1973-2 C.B. 215. It also is worth noting that the reason the partners were seeking to increase their basis was because the partnership had distributed progress payments to them for yet to be performed contractual obligations. The G.C.M. thus had the result (as in Helmer) of creating a mismatch between outside and inside basis ­ a result obviously inconsistent with the Government's argument here that outside and inside basis should always match.

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purposes at least until they have become fixed or liquidated. . . . Those liabilities should be taken into account only when they are fixed or paid.").6 The IRS successfully argued for its position regarding what type of obligation constitutes a Section 752 "liability" in many other cases as well; always, of course, to the detriment of the taxpayer. See Brountas v. Commissioner, 692 F.2d 152, 158 (1st Cir. 1982) (Breyer, J.) (holding that nonrecourse obligations to be satisfied only out of oil production payments are contingent obligations that are not liabilities within the meaning of Section 752); Gibson Prods. Co. v. United States, 637 F.2d 1041, 1045 (5th Cir. 1981) (holding that, because a partnership's liability on a nonrecourse note is contingent upon possible future oil and gas production, it is not a liability for purposes of Section 752); Fox v. Commissioner, 80 T.C. 972, 1020 (1983), aff'd sub nom. Barnard v. Commissioner, 731 F.2d 230 (4th Cir. 1984) (holding that nonrecourse notes are too speculative to be considered true liabilities of a partnership because the notes are payable only from the proceeds of book royalties dependent on the success of the books as a commercial enterprise). Perhaps the most instructive of these cases for the two motions before the Court is La Rue v. Commissioner, 90 T.C. 465 (1988), in that the obligations in that case were the economic equivalent of the short sale obligations at issue here. In La Rue, the Tax Court addressed whether reserves reflecting certain "back office"
6

This holding was expressly affirmed by the Tenth Circuit. 660 F.2d at 419 ("[The Tax Court] held that because the lawsuit claims against the partnership were indefinite and contingent liabilities, they should not be recognized for basis adjustment purposes until the exact amounts of the liabilities were established. . . . We agree with this approach and holding.").

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errors of a brokerage partnership were liabilities that could be included in the outside basis of its partners' interests upon the acquisition of their interests by a third party. The partners contended that the reserve for these "back office" errors was a Section 752 liability that increased their outside bases. Id. at 477-78. The "back office" errors at issue in La Rue included the brokerage's failure to execute numerous trade orders by its customers. The brokerage's resulting obligation was identical to that of closing a short sale, i.e., definite securities had to be purchased and delivered by the brokerage. The amount of this obligation was computed just like a short sale: "[g]ain or loss was incurred on these transactions measured by the difference between the customer's contract price [equivalent to short sale proceeds] and what the broker had to pay to obtain the securities." Id. at 468. As noted by the court, "[t]he precise amount of gain or loss was not determinable until the securities in question were actually bought or sold." Id. at 474-75. The Tax Court accepted the IRS's argument that these obligations were not Section 752 liabilities. Citing its opinion in Long, the Tax Court held that the "allevents" test determines when a liability is includible in basis under Section 752. Id. at 478. Under that test, a liability can only be included in basis "for the taxable year in which all the events have occurred which determine the fact of liability and the amount thereof can be determined with reasonable accuracy." Id. The Tax Court concluded that the "all events" test was not satisfied because the amount of the liabilities were not determinable with reasonable accuracy "until the securities

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are actually purchased . . . and the transaction closed." Id. at 479. As the Tax Court explained: Until any missing securities were purchased or excess securities sold, at market price, there was no way of determining the amount of loss, or in some circumstances, gain. .... [T]he exact amount of loss or gain was not determinable until actual purchase or sale. Valuation of the claims may be a purely ministerial matter because of the ready market for securities, but it is not readily determinable until the purchase or sale occurs. . . . Accrual accounting requires that the amount be determinable with `reasonable accuracy.' A loss is not determinable until the securities are actually purchased or sold, and the transaction closed. Id. at 479-80 (footnote omitted; emphasis added). Accordingly, the Tax Court concluded that the reserves were not a fixed obligation that could be included in bases as a Section 752 "liability." Id. It seems beyond reasonable dispute that this holding simply cannot be reconciled with the argument the Government now makes in its Motion for Summary Judgment. 2. The Obligation To Close A Short Sale Of Borrowed Securities By Purchasing And Then Returning Replacement Securities To The Lender Of Those Securities Is By Its Very Nature A Contingent Obligation Because The Cost Of Closing The Short Sale Cannot Be Determined Until The Replacement Securities Have Been Purchased By The Short Seller.

A short sale is a sale of a security that the seller must borrow in order to deliver. The short seller, in turn, has an executory obligation to return the borrowed security to the lender at an unspecified point in the future. Short sales can be done for speculative reasons (i.e., where the short seller expects the value of the security to decline) or, as was the case here, to hedge the risk that the value of an asset held by the short seller will decline. The obligation to close a short sale by 17

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purchasing the replacement security in order to return that security to the lender is by its very nature a contingent obligation because the cost of that obligation cannot be determined until the replacement security has been purchased. A short sale is recognized to be a contingent obligation and treated as such for Federal income tax purposes. The timing and amount of a short sale obligation are not determinable until the borrowed securities are actually returned to the securities lender. Indeed, in some cases there is no need to close a short sale, which may remain open indefinitely. Because the short seller's gain or loss cannot be determined until the short sale is closed, the Code and Treasury Regulations treat short sales as tax-deferred "open" transactions that do not give rise to taxable income or loss until the short sale is closed. See Code § 1233; Treas. Reg. § 1.12331(a)(1) ("For income tax purposes a short sale is not deemed to be consummated until delivery of property to close the short sale."). With respect to the contingent nature of short sales, Plaintiffs refer the Court to the expert witness report submitted in this case by Dr. Owen A. Lamont, a recognized expert on short sale transactions.7 In his expert report, Dr. Lamont (1) explains the mechanics of short selling generally, and (2) offers his opinions regarding the nature of the obligation that is created when a security is borrowed in order to short it. See Plaintiffs' Exhibit 8.
7

Attached as Exhibit 8 to the Declaration of Harold J. Heltzer is the Declaration of Owen A. Lamont attesting to and appending his Expert Witness Report dated October, 2003 ("Lamont Expert Report"). Dr. Lamont was deposed by Defendant's counsel on January 29, 2004, regarding the matters covered in his expert witness report.

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With respect to the mechanics of short selling, at pages 2 through 4 of his expert report Dr. Lamont describes the various steps of a short sale, as well as the purposes for which short sales are typically undertaken (e.g., speculation and hedging). At pages 4 through 9 of his expert report, Dr. Lamont describes the contingent nature of short selling. His opinions are succinctly set forth in his Summary: Borrowing a security and selling it short creates a contingent obligation. The value of the obligation, the timing of the obligation, and how the obligation is fulfilled are uncertain. The value of the loan fluctuates with the price of the borrowed security. The timing of the obligation is also unknown, and is not completely under the control of the short seller. The lender may demand the return of the borrowed security at any time. External events, such as squeezes or adverse price movements that decrease the collateral of the short seller, can force the short seller to close his position. The short seller is obliged to return the security to the lender, but in some cases this may not be necessary. The securities loan can be stretched out indefinitely. If the issuing company goes bankrupt, the loan might be terminated without actually returning the borrowed security. Plaintiffs' Exhibit 8, at 3; Lamont Expert Report, at 2. In this report, Dr. Lamont notes that, with respect to the price risk short sellers face (i.e., the risk that the price of the security will rise), short sellers "never know exactly at what price they will cover [return the replacement security], when they will cover, or what event might force them to cover." Lamont Expert Report, at 4-5.8 In that regard, the short seller does not necessarily control when he will close

8

An additional financial risk the short seller faces is holding costs, which increase the longer he takes to cover. Id.

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the short position. Since short sales are typically day-by-day, the lender can demand that the securities be returned at any point (the "recall risk" or "buy-in risk"). Id. In addition, the short seller may be forced to close the short sale to the extent he cannot (or will not) post additional collateral as the value of the borrowed security rises. Id. at 6.9 In addition, there are some circumstances where a short sale is never closed or is not closed for many years. One such circumstance is where the security ceases to have value, a so-called "terminal short." Id. at 7-8. Another circumstance is where the borrower does not want to close the short sale in order to defer recognition of capital gains tax, and the lender does not demand the return of the security because he is receiving income from the security's loan. In such a situation, the short sale can remain open for years. Id. at 8. Moreover, as discussed above, Defendant's position that the obligation to close a short sale is not a contingent liability because the borrower is obligated to return replacement securities cannot be reconciled with the holding of La Rue. In that case, the brokerage, in order to correct its "back office" errors, had an undisputed legal obligation to purchase and deliver specific securities. The Tax Court was quite clear that, although there was no contingency regarding the fact of liability, the obligation was still a contingent obligation (and thus not a Section 752
9

As Dr. Lamont notes in his expert report, these events can cause a so-called "short squeeze," when many short sellers are required to cover their positions at the same time. Id. at 6. Such a short squeeze apparently occurred in 1991 with respect to two-year Treasury Notes when Salomon Brothers nearly cornered the supply of those securities. Id. at 7.

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"liability") because the cost of the obligation could not be determined until the securities to be delivered were actually purchased. 3. In 1995, The IRS At The Urging Of The Treasury Department Issued A Revenue Ruling Holding That The Obligation To Close A Short Sale Is A "Liability" Under Section 752 Even Though The IRS Clearly Understood That This Conclusion Was Inconsistent With Its Position That Contingent Obligations Are Not "Liabilities" Under Section 752.

In Rev. Rul. 95-26, 1995-1 C.B. 131, issued a year after Marriott engaged in the hedging short sales at issue here, the IRS suddenly reversed its position regarding contingent obligations and held that the obligation to close a short sale would be treated as a "liability" under Code Section 752. The reasoning proffered in Rev. Rul. 95-26 for this outcome was twofold: (1) a short sale creates an "obligation" to return the securities that were borrowed to effect the sale, and (2) the cash proceeds of the short sale create partnership assets, thereby increasing basis and bringing the obligation within the definition of a liability set out in Rev. Rul. 88-77, 1988-2 C.B. 128.10 The ruling's rationale appears to be that, because the short sale proceeds create basis, they create a "liability" even though the proceeds remain untaxed in the recipient's hands until closure of the sale. Apparently, the reason for the IRS's change of its long-standing position in 1995 was that the Treasury Department felt a revenue ruling was needed to invalidate transactions where the contingent nature of the short sale might actually

10

Rev. Rul. 88-77 is discussed in subsection 4, infra.

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benefit taxpayers. As stated in an IRS memorandum produced in this litigation explaining the need to publish Rev. Rul. 95-26: SOURCE: This project was established at the request of Treasury. REASON FOR PUBLICATION: Publication is needed because some taxpayers are engaging in short sales through partnerships with the hope of avoiding a basis increase in their partnership interests. This would enable taxpayers to create gains that can be offset by losses that would otherwise expire. See Exhibit 4 to the Declaration of Harold J. Heltzer. While the transaction described in Plaintiffs' Exhibit 4 is different from the short sale transactions at issue in this case,11 the point remains that the IRS issued Rev. Rul. 95-26 for the explicit purpose of reaching a specific policy result desired by the Treasury Department ­ even though that result was based on reasoning that was directly contrary to a position that the IRS had consistently taken at the expense of countless taxpayers. Through what was essentially an exercise of administrative fiat (but obviously without the benefit of public notice and comment that would have accompanied Treasury Regulations), the IRS simply attempted to change the law with respect to how contingent obligations should be treated ­ at least with respect to short sales ­ for partnership tax purposes. It is not possible to reconcile the position of Rev. Rul. 95-26 with the IRS's interpretation of Section 752 over the previous decades other than to note that both

11

The fact pattern that the Treasury Department was concerned about seems to be similar to that of the Salina case discussed infra.

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positions have the result of serving the Government's interest in increasing taxable income. There is simply no principled distinction, for example, between a short sale obligation and the contingent obligation at issue in La Rue, or, for that matter, the numerous other contingent obligations that the IRS had previously concluded were not partnership liabilities under Section 752. Indeed, the result-driven genesis of Rev. Rul. 95-26 was openly acknowledged in another IRS document produced in this litigation in which the Treasury Department's position was summarized: Treasury wants reach right result re outside basis too: a basis kick-up there too, no matter how get to that result, and only way there is § 752: using it to cram through result: understands it is not an entirely clean way of doing it. See Exhibit 5 to the Declaration of Harold J. Heltzer (emphasis added). Simply put, Plaintiffs' Exhibit 5 shows that the IRS clearly understood that the ruling the Treasury Department was urging was inconsistent with the IRS's long-standing position, but that Treasury wanted to reach that result "no matter how [to] get to that result." And, as noted there, the "only way" to get to that result was through Section 752, which would be used to "cram through [that] result" even though Treasury understood that it was "not an entirely clean way of doing it." 4. Contrary To Defendant's Argument, The Change Of Position Announced In Rev. Rul. 95-26 Was Not Consistent With Either Rev. Rul. 88-77 Or The Definition of Liability In The Treasury Department's 1989 Temporary Regulations, Which Dealt With An Entirely Different Issue Involving Cash Basis Taxpayers.

In its summary judgment brief (at 24-26), Defendant takes the position that Rev. Rul. 95-26 was not in fact a change in position regarding the definition of "liability" under Section 752, but rather was consistent with a definition of

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"liability" provided in a 1988 revenue ruling, Rev. Rul. 88-77, 1988-2 C.B. 128, 129, and repeated in a 1989 Temporary Treasury Regulation, Temp. Treas. Reg. § 1.7521T(g), T.D. 8237, 1989-1 C.B. 180, 192 (Dec. 30, 1988). In relevant part, Rev. Rul. 88-77 and the 1989 temporary regulation defined a partnership liability to include an obligation only if and to the extent that the obligation created or increased basis in partnership assets. Defendant contends that, because the proceeds generated by a short sale create basis in partnership assets, a short sale satisfies this definition. Defendant's argument, however, completely misconstrues Rev. Rul. 88-77 and the 1989 temporary regulation, neither of which had anything to do with the treatment of contingent obligations such as short sales. Rather, both were issued at the specific direction of Congress to limit the scope of what constituted a "liability" when a cash basis taxpayer transferred its accounts payable to a related entity.12 By way of brief background, until 1978 a literal reading of Section 357(c), which covers transfers to controlled corporations, treated such accounts payable as liabilities. The IRS similarly treated accounts payable of cash basis partnerships as Section 752 liabilities. Rev. Rul. 60-345, 1960-2 C.B. 211. This treatment could generate gain to the transferring taxpayer, even though it had never been able to

12

Under Code Section 351, a transfer of property to a corporation controlled by the transferor in exchange for corporate stock is generally tax-free. The transferor takes a basis in the stock equal to the basis of the transferred property. Code Section 358(a)(1). However, if liabilities are assumed by the corporate transferee in connection with the transfer, basis is reduced by the amount of the liabilities assumed. Id. If the assumed liabilities exceed the basis of the transferred assets, the transferor is required to recognize gain to that extent under Code Section 357(c).

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deduct the payables since it used the cash method. This result was widely regarded as harsh and unfair, prompting Congress in 1978 to enact Section 357(c)(3), which provided that deductible liabilities of a cash basis taxpayer were excluded from Section 357(c), except for liabilities that created basis. With respect to partnerships, Congress admonished the IRS in the legislative history accompanying the Tax Reform Act of 1984 to revoke Rev. Rul. 60-345 in favor of an interpretation of Section 752 that was consistent with Section 357(c). See H.R. Rep. No. 861, 98th Cong., 2d Sess. 856-57 (1984), 1984-3 (Vol. 2) C.B. 110, 111. The IRS finally responded to the 1984 legislative history when it issued Rev. Rul. 88-77, 1988-2 C.B. 128, which revoked Rev. Rul. 60-345 and, by analogy to Section 357(c), limited a partnership liability to include an obligation "only if and to the extent that" incurring the liability created or increased basis in partnership assets, gave rise to an immediate deduction, or decreased a partner's basis in his partnership interest. 1988-2 C.B. 128, 129. There is no indication in Rev. Rul. 8877 that the IRS was in any way changing its longstanding interpretation of Section 752 to exclude contingent obligations. Indeed, there is no suggestion that the IRS was doing anything other than modifying the definition of the term "liability" to exclude cash basis payables that did not meet certain conditions. This is confirmed by the holding of Rev. Rul. 88-77: "For purposes of computing the adjusted basis of a partner's interest in a cash basis partnership, accrued but unpaid expenses and accounts payable are not `liabilities of a partnership' or `partnership liabilities' within the meaning of section 752 of the Code." Id.

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A few weeks later, the Treasury Department promulgated Temp. Treas. Reg. § 1.752-1T(g), which included a definition of "liability" that was virtually identical to that in Rev. Rul. 88-77. See T.D. 8237, 1989-1 C.B. 180, 192 (Dec. 30, 1988). There is again absolutely no indication that the IRS was changing its interpretation of Section 752 with respect to contingent obligations. In this regard, the Treasury Department's preamble made no broad statement that the temporary regulation was redefining the term "liability" beyond its traditional parameters, as one would expect if such a significant change had been intended. Moreover, all references to "liability" in the preamble speak in terms of "debt" or payments to "creditors." In short, like Rev. Rul. 88-77, the 1989 temporary regulation dealt only with Congress' mandate to exclude certain cash basis payables from the definition of liabilities under Section 752.13 Accordingly, contrary to Defendant's argument, the obvious purpose of Rev. Rul. 88-77 and the 1989 temporary regulation was not to expand the definition of "liability" under Section 752 to include contingent obligations, but to narrow the definition of "liability" to permit cash method taxpayers to contribute a business to a partnership without risking immediate recognition of taxable income.

13

When the Treasury Department issued proposed regulations under Section 752 in 1991, the temporary regulation's definition of "liability" was omitted without explanation. 56 Fed. Reg. 36,704 (July 31, 1991). The 1991 proposed regulations did not revoke Rev. Rul. 88-77, which remained in effect.

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B.

Because The Obligation To Purchase And Return Securities Borrowed To Implement A Short Sale Is A Contingent Obligation, That Obligation Cannot Be A "Liability" For Purposes Of Section 752. 1. In Its Recent Decision In Jade Trading, LLC v. United States, The Court Of Federal Claims Confirmed That Contingent Obligations Do Not Constitute "Liabilities" For Purposes Of Section 752. Other Recent Decisions By Refund Tribunals Have Reached The Same Conclusion.

In December of last year, Judge Williams of this Court confirmed in Jade Trading, LLC v. United States, 80 Fed. Cl. 11 (2007), that a contingent obligation is not considered to be a "liability" for purposes of Section 752. In that case, the taxpayer entered into a "spread" transaction involving offsetting foreign currency options. The taxpayer contributed its purchased option to Jade Trading (which was treated as a partnership), and Jade Trading assumed the taxpayer's obligation under the sold option. The issue before Judge Williams was whether the obligation assumed by Jade Trading was a "liability" under Section 752. In its consideration of the issue, the Court in Jade Trading expressly rejected the Government's argument that the assumed obligation was a Section 752 "liability." Specifically, the Court observed: In Helmer, the Tax Court held that a contingent obligation such as an option was not a liability under section 752 because a partnership's obligation under the option does not become fixed until the option is exercised. Helmer's reasoning that contingent obligations are not liabilities was applied in subsequent cases. Salina P'ship L.P. v. Comm'r, 80 T.C.M. (CCH) 686, 697 (2000) (recognizing Helmer stands for the general proposition that amounts owed or paid to a partnership in an open transaction for tax purposes do not generate adjustments to the partners' bases in their partnership interests until the transaction is closed and the tax characteristics of the transaction can be determined.); see also LaRue v. Comm'r, 90 T.C. 465, 479-80 (1988) (non-fixed obligations of a partnership could not be used to

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adjust the partners' bases under section 752); Long v. Comm'r, 71 T.C. 1 (1978) (stating that contested or contingent liabilities such as claims were not liabilities within the meaning of section 752); see generally CEMCO Investors, LLC v. United States, No. 04-8211, 2007 U.S. Dist. LEXIS 22246 (N.D. Ill. Mar. 27, 2007), appeal docketed, No. 07-2220 (7th Cir. May 25, 2007) (recognizing that Helmer was good law prior to Notice 2000-44, permitting a taxpayer to ignore a short option as a liability under section 752). Thus, under Helmer and its progeny, the sold call option contributed to Jade would not be considered a liability for purposes of section 752 and the inflated bases resulting from the Ervin LLC's contribution of the spread transaction to Jade complied with section 752. Id. at 44-45 (footnote omitted). In a footnote to this discussion, the Court also addressed the 1995 IRS memorandum discussed in subsection A.3. above: Plaintiffs further rely on an internal IRS memorandum known as the "Helmer/Cram Memo" drafted by former IRS attorney Richard Starke interpreting the decision in Helmer. . . . . Two pages of this memorandum were inadvertently produced in Marriott Int'l Resorts, L.P. v. United States, 63 Fed. Cl. 144, 145-46 (2004), resulting in a subject-matter waiver of the entire document. . . . The IRS memorandum concludes that an option is not a liability for tax purposes, stating: Existing authority is contrary to a position that options create liabilities. Helmer held that no partnership liability is created upon receipt of option payments by a partnership; payments received were without restrictions except that upon exercise of the options the amounts would be applied against the purchase price. Id. at 44, n.65 (citations omitted). In the above quoted passage from Jade Trading, the Court cites Cemco Investors, which arrived at the same conclusion. Cemco Investors, LLC v. United States, 2007-1 U.S.T.C. ¶ 50,385 (N.D. Ill. 2007), aff'd, 515 F.3d 749 (7th Cir. 2008). In Cemco Investors, the District Court, citing Helmer, Long and La Rue (among

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other cases), agreed with the taxpayer that "[u]ntil recently, the law respecting whether an option contract should be treated as a liability under section 752 actually supported [the taxpayer's] position." Id. at p. 87,973. Nonetheless, the Government prevailed in Cemco Investors in light of Treasury Regulations promulgated in 2003 that define the term "liability," and apply that definition retroactively to assumptions of liability by partnerships going back to October of 1999. As discussed in Cemco Investors, this new definition promulgated in 2003 defines the term "liability" to include "any fixed or contingent obligation to make payment without regard to whether the obligation is otherwise taken into account for purposes of the Internal Revenue Code. " Treas. Reg. § 1.752-1(a)(4)(ii) (2003) (emphasis added). As the notice discussing this new definition observes, under this definition, the term liability includes "obligations under a short sale." Notice of Proposed Rulemaking, 68 Fed. Reg. 37,434 (June 24, 2003). Tellingly, the notice also concedes that "[t]he definition of liability contained in these proposed regulations does not follow Helmer v. Commissioner." Id. (emphasis added). It is noteworthy, in this regard, that, during the oral argument in Cemco Investors before a panel of the Seventh Circuit,14 counsel for the Government conceded that the law on the Section 752 "liability" issue prior to the effectiveness of

14

A recording of the oral argument in Cemco Investors is available on the Seventh Circuit's website. The quoted passage can be found at approximately 26 minutes into the argument.

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the new regulations supported the taxpayer's position. As stated there by Government's counsel during the argument: We have to draw a little bit of a distinction between the technical application of the section 752 rules regarding, you know, is a contingent liability taken into account for purposes of 752? That's sort of a technical issue, and prior to the retroactive effective date of these new regulations, the answer to that question--the case law supported the position that section 752 did not apply to contingent obligations. In its recent decision affirming Cemco Investors (515 F.3d 749), the Seventh Circuit did not determine the proper interpretation of the law prior to the adoption of these Treasury Regulations, but instead simply decide