GERBER, Judge:
Respondent determined a deficiency in petitioners' Federal income tax in the amount of $56,133 and liability for the increased rate of interest under section 6621(c) for taxable year 1981. In an amended answer, respondent also asserted that petitioners are liable for the section 6653(a)(1) and (2) additions to tax for negligence or intentional disregard of rules and regulations. The issues for our consideration are (1) whether purchases of U.S. Treasury Bills financed by repurchase agreements were ficti tious, (2) whether the transactions lacked economic substance, (3) whether the transactions should be characterized for Federal income tax purposes as forward contracts for purchases at future dates, and (4) whether petitioners are liable for the section 6653(a)(1) and (2) additions to tax and the section 6621(c) increased rate of interest because of those transactions.
FINDINGS OF FACT
The parties have entered into a stipulation of facts, along with attached exhibits, sill of which are incorporated herein by this reference.
Petitioners resided in Englewood, New Jersey, when they filed their petition. On May 6, 1981, Government Securities Dealers II (GSDII) was formed as a limited partnership under New York law. At all relevant times, the general partners of GSDII were Joseph Blumstein and petitioner Steven Sheldon (petitioner Ellen G. Sheldon is a petitioner due to her filing a joint Federal income tax return with her husband for 1981).
According to its limited partnership agreement, GSDII was formed "to act as a broker, dealer and market maker in United States Government securities, [in] other interest bearing and interest oriented instruments and in metals." Before forming GSDII, petitioner and Mr. Blumstein each had several years of experience in the trading and selling of U.S. Government securities and other financial investments.
The general partners of GSDII, petitioner and Mr. Blumstein, contributed initial partnership capital in the amounts of $26,000 and $34,000, respectively. GSDII's 28 limited partners collectively contributed initial capital in the total amount of $1,356,250. Besides the above-indicated initial cash contributions, each GSDII limited partner also agreed to be personally liable for recourse obligations of the partnership up to the amount of three times the initial cash contribution.
GSDII began general operations on November 24, 1981, and reported its income for Federal tax purposes using the accrual method of accounting and a calendar year end. For the 1981 taxable year, GSDII reported income and expenses on its U.S. Partnership Return of Income, as follows:
Interest income from securities purchased under agreement to resell. $13,447
Interest expense from securities sold under agreement to repurchase. (5,675,708)
Trading gain from U.S. Treasury note. 283
Guaranteed payments to general partners ($40,000 each).. (80,000)
Other expenses. (35,715)
Net loss. (5,777,693)
On its 1982 partnership return, GSDII claimed an additional $3,776,829 as interest on the above-described 1981 repo transactions. Additionally, GSDII entered into similar repo transactions at the end of 1982 and claimed $5,490,533 of repo interest for its 1982 taxable year regarding T-Bills purchased late in 1982 and maturing in January 1983.
In the statutory notice of deficiency respondent increased petitioners' 1981 taxable income by $104,195, representing petitioner's share of GSDII's 1981 claimed $5,675,708 deduction for interest accrued under repurchase agreements involving U.S. Treasury Bills (T-Bills).
T-Bills
T-Bills are short-term noninterest-bearing securities issued by the U.S. Government that mature no more than 1 year from the date of issue. T-Bills are not issued with stated coupon rates of interest; rather, they are issued in public auction at a discount from their face value at maturity. The difference between the discount price at which T-Bills are issued and their maturity or face value is, in effect, the interest on the debt obligation paid by the U.S. Government.
Since 1979, T-Bills have not been issued in physical or tangible form, but have existed intangibly (only in book-entry form) by means of computerized files maintained by the 12 Federal Reserve Banks (the Fed). The Fed's book-entry system is a securities safekeeping arrangement between the Fed and a relatively small and limited number of "depository institutions" which act as securities-safekeeping-account customers (book-entry DI's). Those customers repre sent the primary or first level in a tiered system of markets and accounts involving Government securities. Book-entry DIs, in turn, maintain accounts for their customers (secondary customers), which include other depository institutions which do not have a book-entry (primary) securities account with the Fed. Many of those secondary customers, in turn, may maintain accounts for their customers who may, in turn, maintain accounts for their customers, and so on.
"Book-entry securities" are transferred through the "Fedwire," a computer network which links the 12 Federal Reserve Banks and primary depository institutions. The Fedwire is used by these institutions to transfer both funds and book-entry securities to accounts of other primary institutions. A transfer of securities between customers of a single book-entry DI need not be reflected on the Fedwire; and may only be reflected in the records of the book-entry DI and its customer. Similarly, transactions at or below the secondary level, such as a dealer's retaining securities after a sale of such securities that is concurrent with an agreement to repurchase similar securities from the buyer at a later date, may result in entries in the secondary dealer's and its customer's records and no entry may be made in the records of a book-entry DI or the Fed. Transactions, such as the example described above, when cleared outside of the Fedwire, are referred to as "pairoffs." It is termed a "pairoff" because a primary or secondary entity clears the transactions by matching or pairing offsetting transactions together with a resulting entry on its record for the customer of any net difference between the transactions. Clearing trades by pairoff at the lowest level may save time and clearing costs and it is not unusual for dealers to settle offsetting trades by pairoffs and "difference checks." Of course, pairoffs and difference checks may not be used if the parties to the particular transaction are unwilling to use that method.
When a T-Bill matures, the Fed pays the face amount of the T-Bill to the book-entry DI who is listed in the Fed's book-entry accounts as the owner. It is then the responsibility of the book-entry DI to reflect the Fed's payment in its account for the customer and the customer is responsible for crediting the account for its customer, and so on, if the T-Bill was sold to a lower-tier entity(ies).
Repurchase Agreements
The essence of the transactions in issue, from an economic perspective, is that GSDII "purchased" T-Bills and financed its T-Bill purchases by using T-Bill repurchase agreements (repos), which served the function of short-term loans collateralized by the purchased T-Bills. In all but one of the transactions, GSDII's repos were opposite (entered into with) the same contra-party (the dealer on the other side of the transaction) from whom GSDII bought the T-Bills.
Although people in the repo market generally view repos as financing transactions or loans, in form a repo consists of two distinct transactions between two parties, who might be referred to as a "borrower" (GSDII in the transactions in issue) and a "lender" (GSDII's contra-parties). The two parts of a T-Bill repo are: (1) The borrower sells to the lender T-Bills at a specified price, with immediate payment and delivery; and (2) the borrower agrees to buy from the lender identical T-Bills at the same price plus interest thereon (repo interest), with payment and delivery either upon demand (an open repo) or at a specified future date.. The rate of interest to be paid on the repo at maturity is not based on the yield of the underlying T-Bill, but upon the prevailing market rates for debt transactions of similar duration and risk. For more in-depth discussions of repo transactions, see Securities & Exchange Commission v. Miller, 495 F. Supp. 465, 466-473 (S.D.N.Y. 1980), and In re Bevill, Bresler & Schulman Asset Management Corp., 67 Bankr. 557, 566-571 (D.N.J. 1986).
The market value of the securities used in a repo typically will be slightly in excess of the specified price at which the borrower sells the securities to the lender. This excess of value over price is known as the "margin" or "haircut" and provides the lender a measure of protection against decline in the value of the underlying securities. There is no standard haircut used in repos; rather, the amount of the haircut varies, depending upon, inter alia:
—the borrower and its creditworthiness;
—the type of securities used as collateral and the creditworthiness of the issuer of those securities; and
—the length of time until the underlying securities mature and the volatility of the market for those securities.
In the marketplace the terms "repo" and "reverse repo" describe the same transaction viewed from opposite perspectives. A party engaging in a repo is, of necessity, opposite a party engaging in a reverse repo on the same transaction.
Transactions in Issue
The 11 transactions in issue for the 1981 taxable year are similar and a review of the specific terms of one such transaction will assist in understanding all of them. The only documents providing the specific terms for the transactions in issue are the trade confirmations and trade tickets used by GSDII and its contra-parties, but that is consistent with market practice during the early 1980's. At that time, parties generally entered into repos only on the basis of oral agreements with follow-up written confirmations from contra-parties. Subsequent to the taxable year in issue, parties to repo transactions commonly began using formal written agreements to memorialize the terms of their transactions.
The transaction between GSDII and Jesup & Lamont Holding Co. (J&L) was a representative transaction. GSDII purchased T-Bills maturing 1/14/82 in the principal amount of $60 million in a transaction having a "trade date" of Friday, November 27, 1981, and a "settlement date" of Monday, November 30, 1981. (Parties in the repo market treat the settlement date as the effective date of a T-Bill purchase or repo. For purposes of this opinion we shall treat the settlement date as the effective date.) GSDH's purchase price for the $60 million of T-Bills was $59,244 million. The discount below par value of $756,000 correlates to a yield to maturity on the T-Bills of approximately 10.21 percent (based on 45 days from settlement (11/30/81) to maturity (1/14/82) and a 360-day year). To settle the $59,244 million purchase from J&L, GSDII paid a net amount of $6,000 by check dated November 30, 1981, and, on that same date, entered into a repo with J&L for the balance of the purchase price — $59,238 million.
The terms of the repo were 14 days, 10.50 percent, and a principal amount (purchase price) of $59,238 million. In other words, GSDII on the settlement date (11/30/81) sold to J&L $60 million of 1/14/82 T-Bills at a purchase price of $59,238 million, promising to buy from J&L $60 million of 1/14/82 T-Bills 14 days later at a price of $59,238 million plus interest at a rate of 10.50 percent.
In essence, GSDII simultaneously "purchased" $60 million of T-Bills from J&L and simultaneously financed the purchase of the T-Bills by entering into a repo with J&L. Under the repo, GSDII "sells" the same $60 million of T-Bills back to J&L in exchange for the "cash" to buy the T-Bills from J&L. As part of the repo, GSDII agrees to repurchase the same or similar T-Bills from J&L.
No cash changed hands and no interest was paid at the maturation of the 14-day repo on December 14, 1981; instead, the maturing 14-day repo was replaced by a 31-day repo. The 31-day repo was structured like the 14-day repo, but its specific terms were $59,238 million principal amount at a rate of 10.18 percent for 31 days. Thirty-one days was the time remaining from the date of the second repo (12/14/81) until the underlying $60 million of T-Bills matured (1/14/82). Thus, this 31-day repo is referred to as a "repo to maturity." On December 14, 1981, the results of GSDU's T-Bill purchase/repos with J&L were known, barring a failure by either GSDII or J&L to perform its contractual obligations. J&L and GSDII were only exposed to each other's credit risk and no market risk existed on the transaction after December 14, 1981. At the 1982 T-Bills maturity date and conclusion of the repo agreement, GSDII was entitled to $756,000 (the discount on its T-Bill purchase), and J&L was entitled to interest on the two repos, calculated as follows:
$59,238 million X 10.50% X 14/360 = $241,888.50
$59,238 million X 10.18% X 31/360 = 519,286.89
761,175.39
Thus, the net of the transaction was:
GSDII owed J&L. $761,175.39
GSDII was due. (756,000.00)
GSDII's loss. (5,175.39)
Since GSDII initially paid J&L $6,000 in cash and GSDII's net loss on the transaction was only $5,175.39, J&L issued a check in the amount of the difference ($824.61) to GSDII, closing out the transaction. That check was issued on January 14, 1982, the maturity date of the T-Bills and the second repo. On its Federal income tax returns, GSDII reported the $761,175 interest expense from the two repos partly on its 1981 return ($543,410) and partly on its 1982 return ($217,765) — allocating the expense between the years in accordance with an apportioned accrual of interest on the repos. GSDII reported the $756,000 T-Bill discount entirely on its 1982 tax return as interest income. If the income and expense of this transaction were both reported in the same taxable period GSDII would only be entitled to a net loss in the amount of $5,175.39. The tax benefit of the transaction lies in the mismatching of income and expenses. The mismatching also permits a taxpayer to defer the reporting of other unrelated income from one taxable year to another.
GSDII would have profited from the transaction if the interest that it owed J&L under the repos had been less than the discount on the purchased T-Bills. The transaction, as structured, however, locked in a loss as of Decembér 14, 1981. The weighted-average interest rate GSDII owed J&L under the repos was approximately .10.28 percent (10.50 X 14/45 + 10.18 X 31/45). The $756,000 discount on GSDII's T-Bill purchase, however, translated into a yield to maturity on the $59.244 million purchase price of 10.2086 percent. For GSDII to have profited on this transaction, the weighted-average repo interest rate had to be lower than 10.2097 percent. Accordingly, the transaction resulted in a loss for GSDII because the average interest rate under the repos was approximately 10.28 percent, instead of lower than the break-even average rate of approximately 10.21 percent.
As demonstrated by the foregoing calculations, small changes in interest rates can cause a transaction to be profitable or unprofitable. This representative transaction also demonstrates that net profit or loss from a transaction ($5,175 in this example) is small compared to the par amount of the T-Bills involved ($60 million) and to the $761,175 interest expense claimed and $756,000 interest income eventually reported.
Ten of the 11 transactions in issue, including the J&L transaction, each: (1) Involved the purchase of T-Bills in late 1981 (between November 30 and December 18) simultaneous with the entry into a repo for T-Bills of the same par amount; (2) involved T-Bills maturing in January 1982; (3) involved an up-front cash payment by GSDII ($6,000 in the example) equal to the difference between the price of the T-Bills purchased ($59,244 million) and the principal price of the repo ($59,238 million), i.e., the so-called "haircut"; (4) ended with a repo to maturity entered into during December 1981; and (5) showed a net loss for GSDII because the average interest rate under the repos was between 0.02 percent and 0.10 percent higher than the yield to maturity on the T-Bills. In addition, none of the transactions was cleared over the Fedwire; all were cleared via pairoff, with no actual delivery of T-Bills to GSDII or to the contra-parties pursuant to the repos. Four of the 10 transactions utilized a third, intermediary repo in addition to the initial repo and the repo to maturity, but those transactions were like the other 10 in all other respects.
The eleventh of the transactions in issue varied somewhat from the others. On December 16, 1981, GSDII purchased T-Bills with a par value of $10 million from New York Hanseatic (NYH). GSDII was to pay for the T-Bills on December 17, 1981, by entering into a 1-day repo with R.M. Hobson (HOB). On December 17, 1981, however, NYH failed to deliver the T-Bills to GSDII. GSDII, as a result, was unable to deliver the T-Bills to HOB, as required under the 1-day repo. The market refers to a party's failure to deliver securities as a "fail." On December 18, 1981, GSDII paid HOB $3,367.73, which petitioners characterize as interest under the 1-day repo and respondent characterizes as a fee for GSDII's fail. Also on December 18, 1981, GSDII entered into a repo to maturity with NYH in order to finance the T-Bills purchase from them. The repo rate was 10.88 percent, while the T- Bills had a yield to maturity of 10.42 percent. GSDII also paid NYH $1,376.84, an amount equal to GSDII's net loss on the transaction (without regard to the amount paid to HOB). The net result of GSDII's transaction with NYH is calculated as follows:
Interest on repo due to NYH.$101,710.17
Discount on T-Bills purchased 12/17/81 . 100,333.33
GSDII net loss. 1,376.84
GSDII dealt with six contra-parties on the transactions in issue: J&L, Stuart Bros. (STU), Newcomb Securities Corp. (NSC), Cowen & Co. (COW), NYH, and HOB. Balance sheets from certain of those entities show their total assets as of specific dates, as follows:
Entity Date Total assets
NSC Jan. 31, 1981 (audited) $5,102,512
NSC Jan. 31, 1982 (audited) 158,684,897
J&L May 31, 1981 (unaudited) 22,720,406
J&L Sept. 24, 1982 (audited) 84,941,000
COW June 26, 1981 (audited) 214,246,255
The following chart summarizes the 11 transactions in issue, showing: GSDII's contra-party; par value of T-Bills purchased; yield to maturity of those T-Bills; number of days outstanding and interest rate of each repo relating to the purchased T-Bills; up-front cash payment by GSDII (which petitioners assert was a haircut); closing cash payment by or to GSDII; and GSDII's net loss on the transaction:
T-Bill purchase Rep os Up-front Closing GSDII's
Par value Yield to No. of From (million) maturity days Rate paid by + paid by = GSDII (to) GSDII net loss
J&L $60 10.21 14 10.50 $6,000.00
31 10.18 $(824.61) $5,175.39
J&L 50 10.25 7 10.50 8,944.25
25 10.27 45 10.30
25 10.29 (260.83) 8,683.42
STU 70 10.47 1 11.00 3,889.20
7 10.50
50 10.53 2.774.42 6.663.62
T-Bill purchase Repos Up-front Closing GSDII's
From Par value (million) Yield to maturity No. of days Rate paid by + GSDII paid by (to) GSDII net loss
NSC 85 10.53 7 10.875 6,611.30
36 10.55 533.45 7,144.75
NSC 75 10.46 1 11.375 7,500.00
7 10.60
28 10.48 (2,386.89) 5,113.11
NSC 80 10.65 4 11.375 6,266.40
7 10.75
38 10.64 454.98 6,721.38
J&L 80 10.57 3 11.50 4,888.80
14 10.75
38 10.50 1,079.21 5,968.01
J&L 75 10.44 7 11.00 5,916.75
37 10.40 (1,115.89) 4,800.86
COW 30 10.41 7 11.125 4,050.00
42 10.38 (66.66) 3,983.34
NYH 10 10.42 34 10.88 1,376.84 1,376.84
HOB 1 12.25 3,367.73 3,367.73
J&L 25 10.78 4 11.875 520.75
37 10.69 171.74 692.49
690 55,964.29 3,726.65 59,690.94
All of the T-Bills purchased by GSDII were 26-week T-Bills issued during July 1981 and maturing on January 7, 14, 21, or 28, 1982. The par value of T-Bills purchased by GSDII in December 1981 compared with the total par value of all 26-week T-Bills issued by the Treasury Department and maturing on the same dates (according to the December 1981 Treasury Bulletin, p. 57) is as follows:
Maturity date Purchased by T-Bills issued GSDII percent of GSDII (millions) (millions) issued T-Bills
II 7/82 $75 $4,042 1.9
1/14/82 145 4,062 3.6
1/21/82 265 4,053 6.5
1/28/82 205 4,349 4.7
Total 690 16,506
In the latter part of 1982, GSDII once again entered into transactions consisting of T-Bill purchases accompanied by repos, which we shall describe as the "82-83 transactions." (It should be noted that the 82-83 transactions are not in issue in this case.) Similar to the 1981-82 transactions, the 82-83 transactions involved purchases in 1 year (1982) of of T-Bills maturing in January of the next year (1983), along with simultaneous entries into repos involving T-Bills of the same par value and maturity. The 82-83 transactions are summarized below (contra-parties are J&L; REFCO Interest Rate Associates (REF); Kiel, Baeder & Co. (KB); and World Trade Securities (WT)):
T-Bills Repos
Par value Yield to (million) maturity No. of days Rate GSDII's net gain (loss)
REF $35 9.15 14 9.00
106 9.15 $2,292.32
J&L 28 8.76 8 9.00
97 8.75 (802.10)
KB 60 8.67 10 8.75
WT 97 8.65 (1,731.52)
REF 50 8.10 11 8.70
80 7.90 13,168.53
REF 55 8.08 14 8.75
59 7.92 157.32
J&L 65 8.53 21 8.75
44 8.38 3,495.65
REF 55 8.43 10 8.50
56 8.40 1,371.37
REF 12 8.02 14 8.50
360 30 7.75 429.04
18,380.61
The 82-83 transactions, unlike the 1981-82 transactions, resulted in net gains for GSDII. On the average, the yields to maturity on the 82-83 T-Bills were .02 percent, or 2 basis points (a basis point is 1/100 of a percent), greater than the interest rates on the repos financing those T-Bills. The approximate weighted average rates of the 82-83 transactions were 8.52 percent on the T-Bills and 8.50 percent on the repos. The approximate weighted-average rates for the 1981-82 transactions, however, were 10.46 percent on the T-Bills and 10.53 percent on the repos, or a negative spread of 7 basis points.
Price Waterhouse, GSDII's auditors, treated the transactions in issue normally and without questioning their form. According to GSDII's audited income statements and the Price Waterhouse work papers, GSDII's income and expenses for financial statement purposes for the periods ending December 31, 1981 and 1982, were reflected as follows:
1981 1982
Trading gains $65,299
Interest income:
T-Bills in issue 3,779,217 $5,613,629
T-Bills: 82-83 transaction 5,492,239
Reverse repos 2,834,689 13,447
Miscellaneous 5,191
Investment account: gains/losses 294,053
Investment account: coupon interest 435,668
5,627,076 12,841,057
Interest expense:
Repos in issue 5,675,708 3,776,828
Repos: 82-83 transactions 5,490,533
Matched book repos 2,708,977
Other 12,665
Investment account interest 727,045
5,675,708 12,716,048
Net trading revenue (loss) (48,632) 190,308
Less: General partners' salaries 80,000 135,850
Other expenses 35,965 217,405
Net loss (164,597) (162,947)
As is apparent from the following schedule, GSDll's reporting of the 11 transactions in issue differed for tax purposes and accounting purposes only as to the timing of the interest income from the purchased T-Bills:
Tax Accounting
1981 Income $5,613,629
1981 Expense 5,675,708 5,675,708
1981 Net income (loss) (5,675,708) (62,079)
1982 Income 9,392,846 3,779,217
1982 Expense 3,776,828 3,776,828
1982 Net income (loss) 5,616,018 2,389
Actual net loss (59,690) (59,690)
GSDll's $59,690 net loss from 1981 repo transactions may be more simply summarized, as follows:
T-Bills (face value) $690,000,000
Less: Purchase price 680,607,154
Discount 9,392,846
Less: Repo interest claimed on partnership return for taxable year-
1981 $5,675,707
1982 3,776,829 9,452,536
Net loss from transaction (59,690)
GSDII was the second in a series of limited partnerships formed by petitioner and Mr. Blumstein, all of which engaged in similar transactions involving interest-based investments. The first such partnership was Government Securities Dealers, later known as Government Securities Dealers I (GSDI)), which was organized in November 1980 and began business in December 1980. GSDII, as noted above, began operations on November 24, 1981. A third partnership, Government Securities Dealers III (GSDIII), commenced operations on November 16, 1982. In late 1983, a fourth such partnership, Government Securities Dealers IV (GSDIV) began operations. On March 1, 1984, the aforementioned partnerships all became partners in another newly-formed partnership, Government Securities Dealers (GSD). After GSD was formed, the type of business generally transacted through the other four partnerships was generally transacted through GSD. The partnership interests in GSD were as follows:
GSDI. 19.870%
GSDII. 23.490
GSDIII. 35.960
GSDIV. 20.670
Petitioner. .005
Mr. Blumstein. .005
Total. 100.000
OPINION
Although the concepts and transactions involved are somewhat esoteric and complex, the simple question here is whether the transactions resulted in an interest deduction for petitioner. If the transactions in issue had begun and been completed in the same taxable year, petitioner's claimed interest deduction would have been offset by a relatively equivalent amount of interest income. Only the net difference between the interest income and interest deduction would have been deductible from or includable in income. As the facts reveal, the net amount of interest (income or deduction) would be relatively insignificant in comparison to the amounts in controversy. For example, GSDII, for the 1981-82 transactions, claimed a $5,675,708 deduction for interest, whereas the net overall loss from the transaction (essentially from interest differential) was only $59,690. The tax benefit here is facilitated by the mismatching of "income" and "deductions," thereby permitting the offset and deferral of current income to a future year.
Respondent advances three distinct arguments for disallowing GSDll's claimed 1981 interest deduction of $5,675,708. First, respondent contends that the T-Bill purchases and repos were fictitious, i.e., that GSDII and the contra-parties merely documented nonexistent transactions in order to substantiate the interest deduction. Price v. Commissioner, 88 T.C. 860 (1987). Second, respondent contends that the transactions, even if real, lacked tax-independent consequences or motives and, therefore, lacked economic substance. A transaction will be disregarded for Federal income tax purposes if it is either fictitious or lacking in economic substance. James v. Commissioner, 87 T.C. 905, 918 (1986), affd. 899 F.2d 905 (10th Cir. 1990); Goldstein v. Commissioner, 364 F.2d 734, 740 (2d Cir. 1966), affg. 44 T.C. 284 (1965). Third, respondent contends that GSDU's T-Bill purchases from the contra-parties, combined with repos involving T-Bills of the same par amount with the same contra-parties, constituted, in substance, forward contracts for the purchase of T-Bills at future dates by GSDII. If, with respect to any of the transactions, we decide either of respondent's first two positions in his favor, it will not be necessary to reach the third issue.
Respondent's notice of deficiency contained a deficiency determination based upon respondent's first two arguments, as follows: "The transactions at issue were either shams or devoid of the substance necessary for recognition for Federal income tax purposes." Consequently, petitioners bear the burden of proving that the challenged transactions (1) were real and (2) had economic substance. Rule 142(a); Brown v. Commissioner, 85 T.C. 968, 998 (1985), affd. sub nom. Sochin v. Commissioner, 843 F.2d 351 (9th Cir. 1988). On the other hand, respondent's notice of deficiency did not contain a reference to the third argument or theory. Accordingly, respondent bears the burden of proving that the transactions constituted forward contracts. Rule 142(a); Achiro v. Commissioner, 77 T.C. 881, 890 (1981).
Fictitious or Real
We first address whether the transactions involving the purported T-Bill and repo transactions were fictitious or real. We conclude that petitioners have sustained their burden of proving that 10 of the 11 transactions in issue were real. Petitioners offered direct documentary evidence of the transactions (trade tickets and confirmations) and petitioner's testimony corroborated by the testimony of contra-party employees. One of petitioners' experts, Dr. David I. Meiselman, reported that the T-Bill purchases and repos were "executed in accordance with accepted industry practice."
Respondent's expert, Steven Dym, opined that the failure to add accrued repo interest to the prices of the intermediate and subsequent repos indicates that the transactions were irregular. On that point, however, the evidence was conflicting. One of petitioners' experts, Dr. Marcia Stigum, testified that such practice was consistent with industry custom.
Respondent relies heavily upon Price v. Commissioner, 88 T.C. 860 (1987). In that case, we described the taxpayer's strategy as attempting "to defer the recognition of income (by generating paper losses) from an earlier year (year 1) to a later year (year 2) through the use of Treasury bill straddles while obtaining interest deductions through the use of repurchase agreements." Price v. Commissioner, 88 T.C at 882. In Price, we relied upon a combination of three factors in deciding that purported T-Bill purchases and repos were fictitious:
(1) The size of the transactions and the lack of an apparent ability of the dealers involved to acquire, own, or possess the amount of the securities allegedly sold; (2) the prearranged nature of the transactions to provide a specified loss ; and (3) the relatively small amount of margin deposits required in comparison to the magnitude of the alleged trades. [88 T.C. at 884. Fn. ref. omitted.]
Although Price involved straddles in conjunction with repos and the tax benefits claimed were in the form of losses, rather than solely from interest as in this case, the cases are sufficiently similar to warrant a thorough evaluation.
Size of the Transactions — The record supports our finding that the size of the transactions or trades in issue was common in the 1981 T-Bill market. Additionally, on brief, respondent requested that we find that short maturity T-Bills, such as those in issue, were commonly traded in lots of $50 million to $100 million. One of petitioners' experts, Frank Pennisi, further confirmed the regularity of the size of the trades by indicating that it is insufficient profit for traders to deed in T-Bill repo transactions with face amounts of $10 million or less because the potential gain or loss is too small. Mr. Pennisi explained that a one-basis-point change in the interest rate on a T-Bill 45 days from maturity results in a change in profit of only $12.50 per million dollars of face amount.
Prearranged Nature of Transaction — With respect to the apparent ability of the contra-parties to acquire the amounts of the T-Bills sold to GSDII, the balance sheets of the two major sellers of the T-Bills in issue (J&L and NSC), on their face, indicate that those respective dealers' total assets were substantially less than the face value of the T-Bills they sold to GSDII. J&L's total assets, as of dates a few months before and after the transactions in issue, approximated $23 million and $85 million, respectively, while J&L purported to sell GSDII $340 million of T-Bills in late 1981. Similarly, NSC's balance sheets, before and after the purchases in issue, reflect total assets of approximately $5 million and $159 million, respectively, at a time when NSC purportedly sold $240 million of T-Bills to GSDII. Approximately $148 million of the $159 million of total assets reflected on NSC's January 31, 1982, balance sheet consisted of securities purchased under repos, and approximately $149 million of $152 million of total liabilities involved securities purchased under repos.
These asset levels appear to indicate that J&L and NSC were not financially able to own the amounts of T- Bills that they supposedly sold to GSDII. Traders in the T-Bill market, however, are not required to possess assets or capital equal to the values of the T-Bills they purchase. Mr. Pennisi stated that "no [T-Bill] dealer, even the largest, is generally in a position to finance its own purchases of securities"; rather, traders rely on repos as a means of financing T-Bill acquisitions. Accordingly, the amount of assets reflected on NSC's and J&L's balance sheets is of less significance in the setting of this case. Considering that T-Bills could be purchased by using repos and paying little or no margin, we find that GSDll's contra-parties had the ability to acquire the T-Bills sold to GSDII in the transactions in issue.
More significantly, this case is distinguishable from Price, at least with respect to 10 of the 11 transactions, due to the absence of any prearrangement of results between GSDII and the contra-parties. The prearranged transaction here concerns the T-Bill purchase from NYH and the repo to maturity used to finance that purchase. That transaction has a loss fixed for GSDII from the outset. The prearranged nature of the NYH transaction, however, is not evidence that the other 10 transactions were fictitious.
Respondent contends that the profit or loss on each transaction was prearranged when the parties first entered into the transactions. Respondent points out on brief that "There is no specific market information available on repo rates for the T-Bills used by the parties. The repo rate is negotiated for each transaction and depends upon the size of the transaction, the needs of the parties and the securities involved." The absence of evidence to corroborate the repo terms, similar to sales price corroboration of publicly traded shares of stock, leaves us without a standard against which the validity of the transactions' terms may be checked. The lack of independently reported trade information does not, by itself, show the transactions were prearranged. Although the transactions were not prearranged as between GSDII and contra-parties, the transactions were planned and arranged by GSDII to appear regular and, at least with respect to the 1981-82 transactions, to have a fixed loss in an amount approximating the up-front payments to contra-parties.
GSDIl's profit or loss was subject to the risks of the repo market for the limited time from purchase until GSDII entered into repos to maturity. Any losses on those transactions were sustained because repo interest rates did not decline far enough after the initial entry into the transactions. Respondent's contentions that the transactions were prearranged and that the "net losses" actually were preset fees are not sufficiently supported in the record.
Relative Size of Margin to Amount of Trades — No industry standards or limitations existed regarding the amount of margins on repo-financed T-Bill purchases. T-Bills were purchased with little or no margin paid. The up-front payments by GSDII were small in comparison to the par amounts of T-Bills purchased, ranging from approximately .002 percent to .0135 percent of the T-Bill par value. Similarly, the potential for profit or loss on leveraged T-Bill purchases is relatively small compared to the T-Bill values involved. The up-front payments GSDII made on the transactions were larger than the net losses incurred by GSDII in about half those transactions. This aspect raises some question about the transactions. The transactions may appear prearranged where the parties are able, with relatively finite accuracy, to estimate (at the front end of the transaction) the amounts necessary to close out the T-Bill transactions at the maturity. This factor does not automatically cause the transaction to be fictitious, but may have some bearing on the economic substance of the transactions. Although there are some aspects of these transactions which cast doubt on their regularity, we find that 10 of the 11 transactions were not fictitious.
Respondent also suggests that GSDII's failure to take delivery of any of the T-Bills in issue precludes a finding that GSDII ever acquired any T-Bills. Respondent argues, in essence, that the settling of the transactions by pair-offs, instead of by deliveries to and from GSDII, causes the transactions to be fictitious. Settlement by pair-offs does not automatically render the transactions fictitious. See First National Bank of Las Vegas, New Mexico v. Estate of Russell, 657 F.2d 668, 674 n. 18 (5th Cir. 1981). The use of a third party in repo transactions, may help ensure the genuineness of a transaction, but the lack of a third party does not conversely require a finding that a transaction is fictitious or illusory. As several of the witnesses noted, one of the obvious sources for T-Bill financing is the party selling the T-Bills. During 1981, seller financing of repos was not an unusual practice in that market.
The use of pair-offs in the setting of these particular transactions permitted GSDII to acquire and finance T-Bills without any potential for "delivery" by itself or the contra-party. Without the need for "delivery," the advance of a small amount of capital permits an appearance of ownership of a substantial dollar amount of T-Bills for purposes of these transactions. The ownership of the T-Bills and the obligation under the repo are essential to the deductibility of the interest. Based upon the record in this case, petitioner has shown that transactions of the type under consideration were common during the period under examination. Although there is some legal uncertainty and factual doubt as to whether these transactions represent sales or secured collateralized loans, our ultimate holding (that the transactions lacked economic substance) obviates the need to decide that aspect.
Respondent, on brief, argued that substantial evidence indicates that "no T-Bills existed." We have examined respondent's contentions with regard to whether the T-Bill and repo transactions were fictitious and find that petitioner has adequately shown that 10 of the 11 transactions were not fictitious. On the other hand, it is apparent that the transactions were, in many respects, preconceived by GSDII and, to some extent, contrived. It is clear that the repos were designed to be transacted near yearend to facilitate the interest deduction in the first year and the mismatched reporting of the related income in the next. Also, GSDII began operations at yearend (as did separately created "GSD entities" in other years) to focus their efforts upon obtaining tax benefits for partners in the form of interest deductions approximating about four times their yearend cash investment. Additionally, GSDII locked in losses and eliminated market risks with respect to the 1981 transactions, prior to the end of 1981. These factors are more appropriately discussed in the next subdivision concerning economic substance.
Economic Substance
In general, a transaction has economic substance and therefore will be respected for Federal income tax purposes if it is "imbued with tax-independent considerations." Frank Lyon Co. v. United States, 435 U.S. 561, 572 (1978); Hulter v. Commissioner, 91 T.C. 371, 388 (1988). Similarly, loans or other financing transactions will merit respect and give rise to deductible interest only if there is some tax-independent purpose for the transactions.
All but one of the 11 T-Bill purchases involved two or three repos each, i.e., a purchase was accompanied by an initial financing transaction and then followed by one or two refinancing transactions resulting in a fined refinancing to the maturity of the T-Bill. At the termination of each initial repo, with the exception of the "NYH transaction," GSDII became entitled to T-Bills and, also, obligated to pay the respective contra-party the repo price plus interest. In all such instances, GSDII did not receive T-Bills or pay the respective contra-party the repo price plus interest. Instead, GSDII entered into new repos involving the same T-Bills, but for different durations and at different interest rates. Each of the repos subsequent to the initial repos involved a separate negotiation of term and rate. Although there were 11 separate transactions involved, they all have similar characteristics and together present a pattern of conduct on behalf of GSDII. Accordingly, we will examine the repos separately and in conjunction with each other in order to analyze whether any or all of the transactions had economic substance. In some cases where transactions are analyzed regarding their economic substance, the focus is upon profit objective or the potential for profit. See, e.g., Levy v. Commissioner, 91 T.C. 838, 854 (1988), involving a sale and leaseback transaction. Where a taxpayer's claimed deduction concerns an interest expense, the need for a profit objective may be of little or insignificant importance. Section 163, as in effect for the 1981 taxable year, "allowed as a deduction all interest paid or accrued within the taxable year on indebtedness." Unlike sections 162 and 165 which, at least to some extent, require that claimed deductions or losses be incurred in a trade or business, section 163 does not contain that specific requirement.
Interest, however, is not deductible if the underlying transaction is a sham. Price v. Commissioner, 88 T.C. 860 (1987); see also Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir. 1985), affg. in part and revg. in part 81 T.C. 184 (1983) (affirmed with respect to interest claimed on nonrecourse debt but reversed with respect to interest actually paid on recourse debt). Nor is interest deductible if it is incurred in a transaction "that can not with reason be said to have purpose, substance, or utility apart from their anticipated tax consequences." Goldstein v. Commissioner, 364 F.2d 734, 740 (2d Cir. 1966), affg. 44 T.C. 284 (1965); Knetsch v. United States, 364 U.S. 361 (1960).
Having found that 10 of the 11 repos and related transactions were not fictitious, we must now consider whether, within the meaning of Goldstein, any of the transactions had economic substance. Goldstein has sufficient similarity to this case to warrant an in-depth analysis. The Court of Appeals for the Second Circuit, in affirming our opinion, found that the transactions were not fictitious, but that they lacked economic substance.
Goldstein involved a 70-year-old woman who won the Irish Sweepstakes. Her son, an accountant, formulated a plan to use section 163 to obtain interest deductions to reduce his mother's tax burden on her sweepstakes winnings. The plan was to purchase relatively large amounts of Treasury notes bearing 1 Mi-percent interest by means of funds borrowed at 4 percent. The 4-percent interest on the borrowed funds was to be prepaid and deducted in the taxable year of the sweepstakes winnings. The loans were secured by the Treasury notes and it was contemplated that the overall transactions would result in economic losses, but that the net result would be tax benefits.
In our Goldstein opinion we disallowed the deduction of interest using the following language:
In the instant case, we have concluded that this case is indistinguishable on principle from the above-cited Knetsch and Bridges cases; and that (to adopt the words of the Fourth Circuit) "the principles laid down by the Supreme Court [in the Knetsch case] are not only applicable, but controlling, in the determination of the instant case." We have further concluded and have heretofore found as an ultimate fact, that (as we said in the Bridges case), "As payments of interest, the transactions [with the banks here involved] were shams." [Goldstein v. Commissioner, 44 T.C. at 298.]
In affirming our Goldstein opinion, the Court of Appeals for the Second Circuit noted that the affirmance was only on one of the two grounds described in our opinion. The Circuit Court stated that "In large part [the Tax Court's] holding rested on [its] conclusion that both loan transactions were 'shams' that created 'no genuine indebtedness.' " Goldstein v. Commissioner, 364 F.2d at 737. The Circuit Court, agreeing with the dissent from our Goldstein opinion, held that the loan transactions were "regular and indistinguishable from any other legitimate loan transaction contracted for the purchase of Government securities." Goldstein v. Commissioner, 364 F.2d at 737.
The Circuit Court went on to hold that section 163 "does not permit a deduction for interest paid or accrued in loan arrangements that can not with reason be said to have purpose, substance, or utility apart from their anticipated tax consequences." 364 F.2d at 740. Our holding and that of the Circuit Court rested upon the principle established in Knetsch v. United States, 364 U.S. 361 (1960). In that case, the U.S. Supreme Court affirmed the lower court's disallowance of interest deductions stemming from seller-financing of an annuity and borrowings against the cash value of the annuity. The Court reasoned, "it is patent that there was nothing of substance to be realized by Knetsch from this transaction beyond a tax deduction." 364 U.S. at 366.
Further elaborating on that concept the Second Circuit reasoned that Congress intended through the broad language of section 163 to permit an interest deduction to encourage—
purposive activity to be financed through borrowing In other words, the interest deduction should be permitted whenever it can be said that the taxpayer's desire to secure an interest deduction is only one of mixed motives that prompts the taxpayer to borrow funds; or, put a third way, the deduction is proper if there is some substance to the loan arrangement beyond the taxpayer's desire to secure the deduction. [Goldstein v. Commissioner, 364 F.2d at 741.]
With these principles in mind, we find that the 11 repo transactions, although 10 of them are not fictitious, lacked tax-independent purpose. We therefore hold that interest claimed on all repos may not be deducted. On the other hand, GSDII should not be treated as the owner of the T-Bills financed by those repos during the terms of those repos and should not recognize the relatively small amounts of interest income for 1981 or the "roll-over" amounts in 1982 attributable to such T-Bills.
Ten of the 11 T-Bill purchases initially were financed by relatively short-term repos. Those repos each bore an interest rate higher than the yield of the corresponding T-Bill. Although one might argue that GSDII now owned the T-Bill and it could hold the positions until repo interest decreased, the situation in form and substance is no different from that in Goldstein. As already noted, the NYH transaction involved an initial repo to maturity and thus did not afford any potential for profit.
After the initial purchase with repo interest in excess of T-Bill interest, four of the transactions involved intermediate repos that were entered into before repos to maturity (STU — $70 million; NSC — $75 million, $80 million; J&L — $80 million). We find these intermediate repos to be no different from the Goldstein situation for the same reasons as the initial repos. Six of the repos to maturity (J&L — $60 million, $80 million, $75 million, $25 million; NSC — $80 million; COW — $30 million) fixed GSDll's overall losses from given T-Bill transactions although they provided some carry (the market refers to a favorable differential as "carry"), partially reducing some of the losses from the unfavorable interest rate differentials of prior repos.
The remainder of the repos were even more clearly without substance. The NYH transaction involved an initial repo to maturity that bore a higher interest rate than the yield of the corresponding T-Bills. The transaction could only result in a fixed loss for GSDII, as evidenced by the fact that GSDII paid NYH the exact amount of the preordained loss at the outset of the transaction. Tax benefits could be the only purpose behind borrowing money at 10.88-percent interest in order to earn 10.42-percent interest. Thus, interest accruing on the repo with NYH may not be deducted.
Four other repos to maturity also clearly lacked substance and do not give rise to deductible interest. The contra-parties involved, the durations of the repos, and their interest rates were as follows:
Duration Contra-party (in days) Rate
J&L 45 10.30
STU 50 10.53
NSC 36 10.55
NSC 28 10.48
Those repos to maturity bore interest rates higher than the yields of the corresponding T-Bills, without affording GSDII any potential for future profit. Instead, the repos added to whatever losses GSDII had already suffered from repos involving unfavorable interest, rate differentials. Ac cordingly, all 11 series of repos, at some point prior to the end of 1981, resulted in fixed losses from T-Bill transactions, with the minor exception that some of them had some amount of carry which partially reduced losses.
We are aware that the repo rates apply to somewhat smaller balances than do the T-Bill yields, because the repo prices equal the T-Bill prices less the haircuts paid. In spite of this, the following table demonstrates that each of the repos caused GSDII to incur interest expense in excess of the interest income attributable to the term of the repo:
Purchase Repo to maturity Pro rata portion interest of T-Bill discount Loss
J&L-$100m $1,268,573.75 $1,264,375.17 $4,198.58
STU-$70m 1,006,704.56 1,001,388.62 5,315.94
NSC-$85m 885,540.63 883,999.84 1,540.79
NSC-$75m 604,944.90 603,750.00 1,194.90
Instead of entering into the four repos to maturity which exacerbated its losses, GSDII could have sold purchased T-Bills upon the expiration of initial or intermediate repos. Petitioners' explanations for GSDII's failure to sell a single T-Bill prior to maturity are wholly unpersuasive. In then-reply brief, they argue (1) that "Weill Street Journal prices are not necessarily reflective of the prices at which a dealer can execute a transaction," (2) that "different dealers may have access to different information," and (3) that "quotations do not take into account intra-day interest rate changes." Essentially, all three justifications amount to a claim by petitioners that GSDII lacked access to market information and, therefore, could not determine whether it made sense to sell T-Bills rather them enter into unfavorable repos to maturity. We reject petitioners' explanations as having no merit. Dr. Meiselman reported that T-Bills appreciated throughout December 1981, reflecting a demand generated by the tax advantages of earning income in 1 year and recognizing the income in a subsequent year. GSDII could have cut its losses or even profited by selling T-Bills. Its decision to refinance, in four instances, betrayed an exclusive concern for tax benefits, i.e., a willingness to intentionally incur losses in order to defer the reporting of interest income until 1982 under section 454(b) by not selling the T-Bills.
It could be argued that GSDII entered into the five repos to maturity in order to profit from T-Bill appreciation. Assuming that T-Bills may be sold by their owner during the time they are "repoed out," we find such an argument unconvincing given petitioners' claim that GSDII was ignorant of market conditions. We believe that GSDII could have monitored the market, but did not, because GSDH's singular pursuit of tax benefits did not require knowledge of or a concern about T-Bill prices.
Distortion of taxable income occurs by allowing deductions for repo interest in a year prior to the year in which T-Bill income is recognized. Petitioner and Mr. Blumstein also apparently appreciated the 1-year income deferral available from the leveraged purchase of T-Bills. It was no coincidence that GS1}I, GSDII, GSDIII, and GSDIV all began operations in the latter part of 4 consecutive years. Although the partnerships may have engaged in some Government securities trading in addition to the transactions in issue, we feel confident that a new partnership was formed late in each year specifically to take advantage of first-year income deferral under section 454(b).
There was tax motivation in the timing of the partnerships' formation and their leveraged purchase of T-Bills maturing in January. Congress, in enacting section 1281 and other special rules for debt instruments in 1984, acknowledged that under pre-1984 law, "interest on indebtedness incurred to purchase or carry obligations eligible for an exception [such as section 454(b)] can be deducted currently against ordinary income to generate a one-year tax deferral." H. Rept. 98-861 (Conf.) (1984), 1984-3 C.B. (Vol. 2) 61. Congress enacted sections 1281 through 1283 to eliminate the 1-year mismatching of income and expense for transactions like those in issue, but Congress did not make those provisions applicable to T-Bills and similar obligations that were acquired before 1984. Pub. L. 98-369, sec. 44(d), 98 Stat. 494, 560. Congress, by enacting sections 1281 through 1283, however, did not address the type of sitúa tion we are dealing with in this case — where the transaction was without substance.
Our holding also includes the $3,367.73 paid to HOB which may not be deducted as interest or otherwise. Although petitioners characterize the sum as interest, it is apparent that the sum was instead a fee for GSDII's fail. The payment does not meet the definition of interest— "compensation for the use or forbearance of money" — as HOB lent no amount to GSDII and did not extend credit in any other maimer. Goldstein v. Commissioner, 44 T.C. 284, 296 (1965), affd. 364 F.2d 734 (2d Cir. 1966).
An overall comparison of this case with Goldstein, in concept and essence, reveals no material difference. Petitioner here, in conjunction with Mr. Blumstein (both of whom had some expertise in Government securities markets), caused GSDII to enter into T-Bill purchases and repos near the end of each year in order to generate approximately a four-to-one deduction of interest for themselves and limited partners. Although petitioner and Mr. Blumstein may have had expertise in T-Bills and other Government securities, they, nevertheless, did not (on behalf of GSDII) make significant purchases, if any, of T-Bills or enter into repos in order to profit from haircuts, carry, or interest differentials during other parts of 1981. As to the transactions in question, the only focus and obvious goal was to create an entity or vehicle at each year's end to generate interest deductions for themselves and the limited partners. The transactions under consideration are not part of a continuum of trading which just happened to occur at yearend. Instead, they clearly and succinctly represent transactions which each yearend were structured solely for the tax benefit and without any regard or apparent concern for the profit or loss factor or any other "purposive" reason.
That is not to say that people do not or cannot make profits in this type of transaction. We also recognize that taxpayers may structure their transactions so as to obtain the maximum benefit legally obtainable. Gregory v. Helver-ing, 293 U.S. 465 (1935). Here, however, the sole objective was to obtain the interest deduction. This is abundantly evidenced by the use of repos to market with locked-in losses in the transactions with no potential for any profit. In instances where intermediate repos could have or did generate some gain from the carry, these amounts were nominal, either fixed or short-term and stable and, in any event, merely reduced the fixed losses by relatively insignificant amounts. Accordingly, although a limited number of the short-term intermediate repos had a small potential for gain, the overriding and clear intent was to seek the interest deduction. We must bear in mind that neither an objective to make a profit nor the need for a trade or business, at least in 1981 and 1982, was a requirement for an interest deduction and are not the direct focus of our inquiry. We have analyzed the profit potential as part of the overall inquiry into whether these transactions had "purpose, substance, or utility apart from their anticipated tax consequences." Goldstein v. Commissioner, 364 F.2d at 740; Knetsch v. United States, 364 U.S. 361, 366 (1960).
Petitioners emphasize the use of the word "solely" in the Goldstein holding and argue that if there is any potential for profit the transaction has substance. Although there was no apparent potential for any gain, other than tax benefits, in Goldstein, we do not understand the principle of that case to, in any manner, exalt form over substance. The principle of that case would not, as petitioners suggest, permit deductions merely because a taxpayer had or experienced some de minimis gain. Goldstein, to the contrary, holds that the transactions, in form, were real, but that they lacked substance. That test was not a profit objective test. In explaining its rationale the Circuit Court stated:
In other words, the interest deduction should be permitted whenever it can be said that the taxpayer's desire to secure an interest deduction is only one of mixed motives that prompts the taxpayer to borrow funds; or, put a third way, the deduction is proper if there is some substance to the loan arrangement beyond the taxpayer's desire to secure the deduction. [Goldstein v. Commissioner, 364 F.2d at 741. Emphasis supplied.]
We see no essential or real difference between Goldstein and this case. Clearly, petitioner's and Mr. Blumstein's expertise permitted them to structure these deals using real transactions (with one exception). The fact that they permitted open positions for limited periods of time was obviously not for the objective of gain, but to formulate the appearance of potential for gain or loss. If the transactions had been fully offset, straddled, or hedged to obviate the possibility of any loss or gain, the form of the transaction could have been more readily attacked by respondent. The potential for "gain" here, however, is not the sole standard by which we judge, and in any event, is infinitesimally nominal and vastly insignificant when considered in comparison with the claimed deductions. Moreover, there was insufficient potential in any gain to offset the losses locked in for the 1981 transactions.
Petitioners argue that the 82-83 transactions resulted in net gains without considering tax benefits and that those gains should be considered in evaluating the potential for gains in 1981 transactions. Looking at the 82-83 net gains in a vacuum, one might conclude that an $18,380.61 gain on over $1 million capital investment reflects that the transaction has profit potential. But that would be like permitting one tree to block the view of the forest. Petitioner, Mr. Blumstein, and the limited partners were content with locking in about a $60,000 loss for 1981-82 transactions or locking in an $18,000 profit on the 82-83 transactions. They were content because the $60,000 was a small "price" to pay for the more than $5 million in interest deductions that permitted offset against their ordinary income and deferral of that income to the next taxable year, when a new plan of deferral could be employed at yearend. These yearend deferrals may result in a limited amount of incidental gain or loss depending upon whether the interest rates were falling or rising. But the transactions were structured so that their full potential for such gains or losses was limited, either by the short-term exposure to some risk or by arranging the repo to market and fixing the position, be it an incidental gain or loss. We "have never held that the mere presence of an individual's profit objective will require us to recognize for tax purposes a transaction which lacks economic substance." Cherin v. Commissioner, 89 T.C. 986, 993 (1987), which was cited with approval in Shriver v. Commissioner, 899 F.2d 724, 727 (8th Cir. 1990), affg. a Memorandum Opinion of this Court.
In summary, the timing of the transactions here was critical and of overriding importance. The transactions were intentionally and cleverly structured to be and are real, but are without substance within the meaning of established case precedent. The transactions occurred at yearend to create deferral for tax purposes irrespective of whether they resulted in gain or loss, which, as structured, were destined to be de minimis in amount.
Due to our finding that 10 of the 11 repo transactions in this case were real and that all of the transactions were without substance, it is unnecessary to consider whether the transactions should be characterized as forward contracts or secured loans. It is also unnecessary to consider the interest income issue raised under section 454(b).
Negligence Additions
Respondent seeks additions for negligence. Under section 6653(a)(1), "If any part of any underpayment is due to negligence or intentional disregard of rules or regulations," an addition to tax of 5 percent of the entire underpayment is imposed. Further, section 6653(a)(2) imposes an addition to tax equal to 50 percent of the interest due on the portion of the underpayment "which is attributable to the negligence or intentional disregard." We have defined negligence as the lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances. Neely v. Commissioner, 85 T.C. 934, 947 (1985). Because respondent first asserted the negligence additions in an amendment to answer, respondent bears the burden of proving that the additions should be imposed. Rule 142(a).
The record discloses that GSDII, of which petitioner was a general partner, intentionally entered into loss-producing repos in order to generate and claim tax benefits. Petitioners' only response to respondent's request for the negligence additions is that such request is "frivolous" in view of the merits of their position on the main issues. Under the circumstances, we find that respondent has sustained his burden and that it is appropriate to impose the negligence additions.
Section 6621(c) Increased Interest
Section 6621(c)(1) provides for an increased interest rate on "any substantial underpayment attributable to tax motivated transactions." Section 6621(c)(3)(A) itemizes certain transactions that are deemed "tax motivated" within the meaning of the subsection. Among the listed transactions are those that are "sham or fraudulent." Sec. 6621(c)(3)(A)(v). In Patin v. Commissioner, 88 T.C. 1086, 1128-1129 (1987), affd. without published opinion sub nom. Hatheway v. Commissioner, 856 F.2d 186 (4th Cir. 1988), affd. sub nom. Skeen v. Commissioner, 864 F.2d 93 (9th Cir. 1989), affd. without published opinion 865 F.2d 1264 (5th Cir. 1989), affd. sub nom. Gromberg v. Commissioner, 868 F.2d 865 (6th Cir. 1989), we held that "economic shams," i.e., transactions which are disregarded for Federal income tax purposes because they lack economic substance, fall within section 6621(c)(3)(A)(v). Accordingly, petitioners are liable for increased interest.
To reflect the foregoing,
Decision will be entered under Rule 165.
Reviewed by the Court.
Nims, Chabot, Parker, Shields, Hamblen, Wright, Parr, and COLVIN, JJ., agree with the majority opinion.
RUWE, J., did not participate in the consideration of this opinion.
All section references are to the Internal Revenue Code of 1954 as amended, and all Rule references are to the Tax Court Rules of Practice and Procedure.
Subsec. (d) of sec. 6621 was redesignated subsec. (c) and amended by the Tax Reform Act of 1986, Pub. L. 99-514, sec. 1151(c)(l)(AHC), 100 Stat. 2744. We use the reference to sec. 6621 as redesignated and amended.
Respondent has rounded this amount to $3,776,829, whereas petitioners have rounded it to $3,776,828. Due to the relatively small difference, no attempt was made to reconcile it.
Commercial banks use repos to temporarily finance some or all of the Government securities in their portfolio. By using a repo, the bank can "sell" the security with an agreement to repurchase in order to temporarily convert securities to cash. The cash may be used for investments, obligations, etc. Dealers in Government securities may also hold an inventory of Government securities, which unlike a commercial bank, may be financed through repos arranged with the dealer's customers, nonfinancial corporations, State and local governments, and others. The repo arrangements in these instances provide an opportunity for the dealer's customers and others to earn short-term interest on cash, which otherwise would not draw interest. This form of transaction is considered relatively safe because the underlying security is an obligation of the U.S. Government.
Break-even interest amount ($756,000) -r by principal ($59.238 million) X 360 days/45 days.
On Nov. 30, 1981, GSDII made three separate purchases from J&L of 1/21/82 T-Bills in an aggregate par value of $100 million. GSDII also entered into repos with J&L for $100 million of 1/21/82 T-Bills on Nov. 30, 1981, and Dec. 7,1981.
Although the repo confirmations specify an interest rate of 10.40 percent, the parties later agreed on and computed the closing of the repo using a 10.38-percent rate.
Cash paid upon closing the COW and J&L ($25 million) transactions differed from amounts owed according to trade tickets by 20‡ and 8<t, respectively.
Weighted with respect to (1) number of days to maturity (for T-Bills) or outstanding (for repos) and (2) par value of the T-Bills involved.
In a memorandum to its files dated Mar. 26, 1982, Price Waterhouse, GSDII's auditors, summarized the transactions in issue and their treatment on the 1981 financial statements as follows:
During the short period that GSDII traded, approximately 10 T-bill positions (averaging $70 million each) were opened and all were exposed to market risk (i.e., T-bill maturity date extended past the repo maturity date). [Price Waterhouse apparently did not consider the $10 million NYH/HOB transaction to be a T-bill position which was open and exposed to market risk.] In 9 out of the 10 positions GSDII was able to refinance the repos at rates below the original repo. In 6 of these they were able to refinance at more than 50 basis points (.5%) below such rates.
The accounting for repurchase trans[ac]tions ([according to] the Proposed Audit Guide, Audits of Brokers and Dealers in Securities dated April 15, 1981) is to treat them as financing transactions and not as sales of trading or investment positions. GSDII is entitled to the interest earned on the T-Bills and must accrue interest expense on the repo financing.
When the repo is not to the maturity of the T-Bill, the interest earned is calculated by marking the T-Bill to market which accounts for the changes in interest rates. As of December 31, 1981, GSDII had eliminated its market risk by refinancing all such positions to maturity. Marking to market would not adequately reflect their financial position because repos cannot generally be closed out before maturity and therefore the risks associated with holding the T-Bills have no significance.
While the [Proposed Audit] guide does not specifically address the accounting for repos financed to the collaterals' maturity, a generally accepted practice in the industry is to record the asset (T-Bill) at cost plus accrued (accreted) interest and the liability (repo) at contract value (contract amount plus acc[ru]ed interest).
Petitioner, by claiming the interest deduction in 1981 (which was generated by a transaction structured late in 1981) and reporting the corresponding income in 1982 (which was structured to occur very early in 1982), does not have to report unrelated 1981 income which was offset by the interest deduction until Apr. 15, 1983. Accordingly, unrelated income received early in 1981 may not be taxed until more than 2 years after it was received.
Although fictitious transactions or those lacking in economic substance have, in different cases, been alternately labeled as a "sham," in this opinion the term "fictitious" will refer to nonexistent transactions and transactions lacking economic substance will be so described. Moreover, if petitioner (through the next generation of "GSD entity") enters into similar sized transactions at the end of 1982 and subsequent years, the original unrelated gain may be rolled over many times and the deferral would continue, possibly unabated. As explained, infra, however, Congress enacted a provision which specifically prohibited the mismatching for 1984 and later taxable years.
$1 million X .0001 X 45/360 days. E.g., on a 45-day T-Bill, a change of 10 basis points in the interest rate (say from 10.50 percent to 10.60 percent), which would be greater than the spread between the T-Bill yield and the average repo rate on 10 of the 11 transactions in issue and seven of the eight 82-83 transactions, would result in a net change in profit or loss on T-Bills with a par amount of $10 million of only $1,250 (10 [basis points] X $12.50 X 10 [million dollars par]).
That is not to say, however, that any of the contra-parties or GSDII were in a position to "deliver" T-Bills at maturity. The unique circumstances of a repo transaction permit extremely leveraged margin positions in order for traders to attempt to gain from the relatively small amounts that may be generated from changes in interest rates. The relatively small potential gains cause investors to trade in large quantities. Although the parties to the transactions "own" the underlying T-Bill for purposes of the transaction, technically, they are not being called upon to deliver unless they are involved in a repo to maturity with a third party. The essence of these transactions lies in the offsetting of the T-Bill against the obligation with a resultant gain or loss on the interest. The net difference in these transactions is infinitesimal in comparison to the market value of the underlying assets.
Respondent's brief contained the following contentions:
1. The Petitioner in late November and on Dec. 1 and 2, 1981, agreed to purchase $470 million (face value) of T-Bills from Jesup, Stuart Brothers & Newcomb before GSD II opened a clearing account to receive delivery of the alleged T-Bills.
2. No T-Bills were delivered to or from GSD II's clearing account at SP after it was opened on Dec. 3, 1981, for the disputed T-Bill transactions.
3. Only GSD II and the contra dealers were involved in the disputed two-party T-Bill transactions.
4. The contra dealers did not acquire, purchase, borrow, or own any T-Bills for the disputed T-Bill transactions.
5. The contra dealers did not hold T-Bills for the benefit of GSD II in connection with the disputed T-Bill transactions.
6. GSD II did not acquire, purchase, borrow, or own any T-Bills for the disputed T-Bill transactions.
7. GSD II did not hold T-Bills for the benefit of the contra dealers in connection with the disputed T-Bill transactions.
8. There was no need for the T-Bills to be owned by GSD II or the contra dealers for the disputed two party "mirror image" T-Bill transactions. The agreements to purchase and sell T-Bills under GSD II's repos were "paired off' (offset) on the cash settlement dates without delivery of any T-Bills.
9. GSD II did not acquire a present interest in the ownership of the disputed T-Bills on the initial cash settlement dates.
10. On the maturity dates of the T-Bills, the Federal Reserve, as fiscal agent of the Treasury, did not pay GSD II or the contra dealers the $690 million (face value) for the disputed T-Bills.
The purchase from NYH involved a single repo to maturity.
The vitality of Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966), affg. 44 T.C. 284 (1965), although nearly 25 years old, is undiminished. See, for example, Julien v. Commissioner, 82 T.C. 492, 509 (1984), where we disallowed the deduction of interest paid on a debt incurred in connection with a commodity straddle which had been arranged to produce a fixed loss.
The facts in Knetsch v. United States, 364 U.S. 361 (1960), also reflect circumstances which are strikingly similar to this case. In Knetsch the taxpayer purchased from an insurance company $14 million in deferred annuity savings bonds for $4,000 cash and $4 million in nonrecourse annuity loan notes. Because the transaction, was, in effect, an insurance contract, the bonds had a cash loan value of $100,000 over face each year. The taxpayer borrowed $99,000 against the loan value each year to make the interest payments so that the cash loan value of the contract increased only $1,000 per year. The interest deductions were not allowed for income tax purposes because "what was done, apart from the tax motive, was [not] the thing which the statute intended." Knetsch v. United States, 364 U.S. at 365. The Supreme Court explained that the transaction was in essence "a fiction, because each year Knetsch's annual borrowings kept the net cash value, on which any annuity or insurance payments would depend, at the relative pittance of $1,000. Plainly, therefore, Knetsch's transaction with the insurance company did 'not appreciably affect his beneficial interest except to reduce his tax....' Gilbert v. Commissioner, 248 F.2d 399, 411 (dissenting opinion)." (Fn. ref. omitted.) Knetsch v. United States, supra at 366.
These figures were computed by multiplying the applicable repo prices by the repo rate and by a fraction, the numerator of which was the term of the repo (in days) and the denominator of which was 360.
These figures were computed by multiplying the applicable T-Bill discount by the ratio of the repo term (in days) to the total number of days from T-Bill purchase to maturity.
Petitioner invested capital or cash of $26,000 in GSDII and respondent disallowed $104,195 as petitioner's share of GSDII's accrued interest on the T-Bill/repo transactions. (104,195 -r by 26,000 = 4.0075)
A review of the 1981 financial information in the record reveals little if any gain or loss from securities transactions other than those which are in issue in this case. As an example, respondent disallowed $104,195 of petitioners' total claimed loss of $106,069. Accordingly, only $1,874 or .017668 of the claimed loss could have represented loss from transactions other than the ones in issue.
We do not question whether other dissimilar transactions of GSDII were with or without substance or whether GSDII was otherwise active and/or successful in the repo market. We only look to these yearend transactions which were structured for tax benefits.
The 82-83 transactions (eight in number) altogether resulted in $18,380.61 of net gain. Of that amount, $13,168.50 was attributable to one transaction. The remaining seven transactions resulted in net gains and losses which were in amounts well within the "haircut" payments which were paid on the front end of the transactions.
Accordingly, 18 of the 19 transactions resulted in net gains or losses which were either smaller than or within a small percentage of approximately the haircut. With the one exception in the 82-83 transactions, the results were substantially comparable and, overall, reflect structured results. The results were designed to appear (and are with one exception) real for the sole purpose of generating an interest deduction due to mismatched income and deductions.
We have found 10 of the 11 transactions to be "real.1