Fidelity International v. US

Filing

OPINION issued by Juan R. Torruella, Appellate Judge; Michael Boudin, Appellate Judge and Rogeriee Thompson, Appellate Judge. Published. [10-2421]

Case: 10-2421

Document: 00116280030

Page: 1

Date Filed: 10/21/2011

Entry ID: 5589974

United States Court of Appeals
For the First Circuit
No. 10-2421
FIDELITY INTERNATIONAL CURRENCY ADVISOR A FUND, LLC,
by the Tax Matters Partner,
Plaintiff, Appellant,
v.
UNITED STATES OF AMERICA,
Defendant, Appellee.
APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF MASSACHUSETTS
[Hon. F. Dennis Saylor IV, U.S. District Judge]
Before
Torruella, Boudin and Thompson,
Circuit Judges.
William F. Nelson with whom Ronald L. Buch, Jr., David J.
Curtin, Kiara L. Rankin and Bingham McCutchen LLP were on brief for
appellant.
Judith A. Hagley, Tax Division, Department of Justice, with
whom Richard Farber, Tax Division, Department of Justice, Gilbert
S. Rothenberg, Acting Deputy Assistant Attorney General, and Carmen
M. Ortiz, United States Attorney, were on brief for appellee.

October 21, 2011

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BOUDIN, Circuit Judge.

Date Filed: 10/21/2011

Entry ID: 5589974

Fidelity International Currency

Advisor A Fund ("Fidelity") seeks review of a district court
judgment resolving a controversy between Fidelity and the Internal
Revenue

Service

("IRS").

In

substance,

the

district

court

sustained IRS adjustments to Fidelity's partnership returns for the
two tax years at issue and upheld a 40 percent penalty for tax
underpayment.

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

States, 747 F. Supp. 2d 49 (D. Mass. 2010).
The litigation arises out of the following events.
Richard Egan was the founder of EMC Corporation, a manufacturer of
computer storage devices, and in the early years of this ultimately
successful business, Egan received non-qualified options to acquire
EMC stock. When he exercised those options in 2001, they generated
$162 million of ordinary income for him and his wife; it was
estimated this could create a tax liability of over $63 million.
Prior to exercising the options, Egan met with various
accounting

and

law

firms

to

discuss methods

of

reducing

the

potential tax liability. Ultimately, the plan adopted and put into
effect required Egan to form a partnership with a foreign national;
that partnership would engage in transactions that would generate
largely offsetting gains and losses without net risk; the gain
component would be principally allocated to the foreign national;
the loss component would be principally allocated to Egan and used

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on his individual return to offset gains on his exercise of the EMC
stock options, virtually eliminating tax on those gains.
To this end, in July 2000 Egan formed Fidelity as a
limited liability company federally taxed as a partnership.

Egan

was one partner; the other principal partner was Samuel Mahoney,
who was an Irish citizen. Common shares were initially assigned 93
percent to Mahoney and 5 percent to Egan; Egan contributed $2.7
million in cash and certain interest rate options valued at $1.6
million, and Mahoney contributed $651,000 in cash.
Then, in October 2001, Fidelity entered into a set of
transactions whereby it purchased and sold options, related to
foreign currency exchange rates and configured in pairs: the terms
set for each pair (as to premium, strike price, maturity dates, and
possible payout) assured that a loss on one option in a pair would
be offset by a corresponding gain on the other.

In substance, the

transaction would provide virtually no opportunity for a net gain
but also no risk of a net loss.1
One week later, Fidelity terminated four of the options
that had gained in value due to fluctuations in the currency
exchange

rates.

The

offsetting

options

in

the

correspondingly reduced in value, were not terminated.

1

pairs,
Instead,

Imagine two bets placed on the temperature next Wednesday,
such that the wagerer would earn $1 on the first bet but also pay
$1 on the second if the temperature was above the date's historic
average. If instead the temperature fell below that average, the
wagerer would lose $1 on the first bet and win $1 on the second.
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the proceeds from the terminated options were used to purchase
replacement options that would ensure that the eventual losses
taken by the partnership when it terminated the original options
that had lost value and the replacement options would offset the
gains initially realized.
This generated net taxable gains on Fidelity's books of
about $174 million from the options that had been terminated.

But

under the tax laws Fidelity pays no taxes; rather its gains and
losses are assigned to the partners in accordance with their
ownership shares in the partnership and taxed to the partners on
their own returns.

26 U.S.C. §§ 701-702 (2006).

Because of the

then-existing 5 and 93 percent share allocation, Egan was assigned
$7.1 million net gain and Mahoney $163.3 million net gain.
Then, a week later, in early November 2001, Egan bought
88 percent of the common partnership interest from Mahoney for
$325,500 and so owned 93 percent with Mahoney being reduced to 5
percent. A month later, in early December, Fidelity terminated the
four remaining original foreign currency options as well as the
replacement

options

acquired

immediately

after

the

October

termination. Not surprisingly in light of the design of the option
pairs, the December loss ($178.1 million) only modestly exceeded
the original gain.
Fidelity

now

allocated

the

$178.1

million

loss

in

proportion to the reallocated ownership shares: Egan was allocated

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$165.8 million in loss and Mahoney $8.8 million.

Entry ID: 5589974

The net economic

loss to the partnership from all the offsetting foreign currency
options was just over half a million dollars; advisory fees brought
the total cost to $4.1 million--a cost dwarfed by the potential tax
benefits for Egan.
The

gains

and

losses

from

the

currency

option

transactions were reported on the 2001 partnership return and the
associated forms allocating to Fidelity's partners the gains or
losses for the transactions.
on the schedule to Egan.

Almost all the losses were assigned

An attached schedule reflecting "Other

income (loss)" pertaining to each closed-out transaction--say, the
purchase and ultimate disposition of an option by Fidelity--showed
a "cost or other basis" for the option (such as the premium paid to
acquire it), the associated revenue generated (the price received
on its sale) and the difference (the net gain or loss on the
purchase and sale).
The

ultimate

effect

of

these

2001

currency

option

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

5

percent

of the

gain

from the

foreign

currency

options, 93 percent of the loss, and fees) and Mahoney a net gain
of $154.5 million (including 93 percent of the gain, 5 percent of
the loss, and fees).

Egan's net loss was reported on his 2001

personal return to offset gain on the nearly $163 million in income
realized from the exercise of his EMC options in the same year.

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These 2001 foreign currency options transactions were the
core means of generating the loss for Egan, but a related set of
transactions was also necessary. Under the tax laws, a partner may
deduct his share of a partnership's losses only to the extent of
his adjusted "outside" basis in the partnership at the end of the
year in which the loss occurred.

26 U.S.C. § 704(d).

This outside

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

to

the

"inside"

basis

of

investments

made

by

the

partnership in carrying on its own business).
To establish this necessary large outside basis, Egan in
2000 had become a partner not only of Fidelity but of a second
vehicle called Fidelity World, which in early October 2001 entered
into two pairs of offsetting options keyed to interest rates.
Fidelity World contributed them to Fidelity, reporting as a capital
contribution by Egan the $150 million cost of premiums paid to
secure the future interest rates options (and ignoring largely
offsetting

premiums

received

for

the

sale

of

the

other

two

options).
In 2001, Fidelity closed out the contributed interest
rate options by purchasing a set of offsetting options that locked
in any existing gain or loss to protect against any future changes.
When these options were all terminated in 2002, the transactions
produced a very modest net loss of $1.9 million, due primarily to
advisor fees; nearly $1.8 million was proportionally allocated to

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Egan on Fidelity's 2002 return and reported by him to shield other
income on his own 2002 tax return.
In 2005 and 2006, the IRS notified Fidelity that it was
making adjustments to Fidelity's 2001 and 2002 partnership tax
returns.

Under the governing regime, the partnership return items

may be adjusted by the IRS and contested changes may be judicially
reviewed in a district court proceeding (or, the Tax Court or Court
of Federal Claims) addressed only to partnership items.
§ 6226(a).

26 U.S.C.

These include "the proper allocation of such items

among the partners, and the applicability of any penalty . . .
which relates to an adjustment to a partnership item."

Id. §

6226(f).
In this case, the IRS disallowed all of Egan's claimed
contributions
partnership

to

basis"

Fidelity,
to

zero

reduced
for

2001

Egan's

claimed

and--most

"outside

importantly--

disallowed the losses on Fidelity option transactions that Egan had
used on his personal returns for 2001 and 2002 to shield his nonFidelity income. The adjustments rested on the IRS's determination
that the option transactions, and Egan's contribution, lacked
economic substance.

The IRS also disregarded the partnership as a

sham and lacking in economic substance.
Tax considerations are permissibly taken into account by
taxpayers in structuring their financial transactions, but where a
transaction has no economic purpose other than to reduce taxes, the

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IRS may disregard the reported figures as fictions and look through
to the underlying substance.2

Here, the IRS found (and the

district court later agreed) that Fidelity's option transactions
were designed to cancel each other out and were merely reported to
generate paper losses to use on Egan's return.

The shift in

partnership ownership part way through was a counterpart device to
allocate most losses to Egan and most gains to Mahoney.
Congress has adopted a graduated set of penalties for
overstating on a return the value or basis of property, and the IRS
invoked a provision adding a 40 percent penalty to the portion of
a tax underpayment that is "attributable to" a "gross valuation
misstatement."

26 U.S.C. § 6662(a), (b), (e), (h).

A gross

valuation misstatement occurs when
the value of any property (or the adjusted
basis of any property) claimed on any return
of tax . . . is 400 percent or more of the
amount determined to be the correct amount of
such valuation or adjusted basis (as the case
may be) . . . .
Id. § 6662(e)(1)(A), (h)(2)(A)(ii)(I).

Under the regulations, a

gross valuation misstatement exists when the correct or adjusted
basis of property is zero.
The

losses

that

26 C.F.R. § 1.6662-5(g) (2011).
Fidelity

attributed

to

individual

transactions were calculated by assigning each option transaction

2

See 26 U.S.C.A. § 7701(o) (West 2011); Gregory v. Helvering,
293 U.S. 465 (1935); Dewees v. Comm'r, 870 F.2d 21, 29-30 (1st Cir.
1989).
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a cost basis or value to set against any revenue obtained from the
transaction.

Absent a cost basis or value, the transaction could

not generate a loss.

And when the IRS found that the transactions

lacked economic substance, it not only disallowed the loss but
invoked penalties for misstating the basis of the options.
To understand the target of the penalty, a simplified
example may help.

Basis, in a typical business purchase and sale

transaction, equates to the cost (reduced by any depreciation).
Thus, a taxpayer might claim that the cost of a widget was $10-when

its

actual

cost

was

$1--and

report

its

sale

for

$1.

Overstating the cost of the widget allowed the taxpayer to claim a
loss of $9, then used to reduce taxes on other income.

So falsely

asserting, or increasing, a basis translates into reducing gain or
enlarging loss by the amount falsely asserted or increased.
Similarly, in this case, the reported basis in the
options transactions allowed Fidelity to report a loss (which it
allocated to Egan). An excerpt from a table attached to Fidelity's
Form 1065 to show "Other Income/(Loss)" read as follows (the line
below references a single option transaction):
Date

Date Sold

10/22/2001

12/03/2001

Cost or

Price

Acquired

Gross Sales

Other Basis

163,405,260

199,865,888

-9-

Gain/(Loss)

(36,460,628)

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The huge loss taken by Egan on his own return was comprised of the
sum of a number of such losses listed in the partnership return and
allocated to him.
Here, the IRS concluded that the 40 percent penalty
applied.

On judicial review, the district court upheld this and

other determinations, making numerous factual findings and legal
determinations.
with

the

IRS

Fid. Int'l, 747 F. Supp. 2d 49.
that

the

option

transactions

Having agreed

lacked

economic

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

disallowed.

The

40

percent

penalty

rested

on

determinations that the correct basis of those transactions was
zero,

and

that

overstatements.

tax

underpayments

were

attributable

to

those

Id. at 239 ¶ 68k.

Fidelity's present appeal is narrow. Apart from a throwaway line or so in its brief, Fidelity does not seriously contest
the district court's basis adjustment under the economic substance
doctrine.

Nor does it appeal the applicability of alternative

lower penalties based on the spurious paper losses generated.
Instead, its arguments are directed only to the 40 percent penalty.
Although Fidelity is the nominal private party, this is effectively
a controversy between the Egan estate and the government.
The three issues Fidelity presents are legal and our
review is de novo.

See Keller v. Commissioner, 556 F.3d 1056,

1058-59 (9th Cir. 2009).

The first claim is that there was no

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"misstatement" of basis in the partnership returns.

Entry ID: 5589974

Second,

Fidelity argues that no underpayment of tax was "attributable to"
a basis misstatement, even if a misstatement existed.

Finally,

Fidelity says that the 40 percent penalty is inconsistent with
congressional tax policy as evidenced by a new penalty provision.
The "No Misstatement" Claim.

Fidelity's position on the

first issue has two separate strands.

One is that there was no

improper statement of loss on the partnership return because the
net economic loss of $4.1 million reported on its 2001 return was
almost identical to the true net economic loss as computed by the
district court.
of

individual

But this is merely to say that any misstatements
transactions

might

not

have

had

any

effect

on

Fidelity's taxes if it were the taxpayer.
Here, the misstatements of concern are not the net effect
of

the

transactions

taken

together

individual options transactions.

but

the claimed

bases on

These bases, and the allocation

of the resulting losses to an individual partner, are themselves
partnership
reviewing

items

the

subject

partnership

to

the

return.3

IRS's
It

adjustment
was

these

power

in

individual

transactions that allowed Egan to offset ordinary income on his own

3

IRS
regulations
state
that
"[c]ontributions
to
the
partnership" and a partner's share of "income, gain, [and] loss"
are partnership items, 26 C.F.R. § 301.6231(a)(3)-1 (2011). See
also Stobie Creek Invs. LLC v. United States, 608 F.3d 1366, 1380
(Fed. Cir. 2010).
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returns; and the individual transactions were just those that the
IRS found to lack economic substance.
The fact that gains and losses would inevitably balance
out is just what made the transactions lack economic substance for
Fidelity.

There might or might not have been different counter-

parties to the individual transactions who could therefore suffer
"real"

gains

or

losses

themselves.

But

for

Fidelity,

the

transactions had no function but to create artificial paper gains
on some transactions (principally assigned to Mahoney) and losses
on others (principally assigned to Egan).
Fidelity's second-strand argument seeks to distinguish
between factually false transactions--ones that never occurred--and
the present case in which the transactions actually occurred but,
taken together, had no economic substance for Fidelity.

In the

latter case, says Fidelity, the economic substance doctrine allows
the IRS to disregard the transactions but the reported figures
remain accurate recordations of each transaction and are not
misstatements, although (it says) a "legal dispute" might arise as
to their significance.
Congress singled out for stiff penalties a misstated
basis or value that improperly reduces taxes; the apparent reason
is that the misstated figures directly impair tax collections and

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

the

figures

are

misstatements

precisely

because

the

transactions lacked any economic purpose for Fidelity other than to
generate purported losses to reduce Egan's taxes.

Purpose, at

least in this case, is an issue of fact quite as much as whether an
option was bought or sold.
Relatedly,

Fidelity

argues

that

the

valuation

misstatement penalty only applies in cases where the economic
substance

doctrine

is

triggered

because

basis

or

value

is

misstated, and not where the basis for the transaction is reduced
to zero after a finding of lack of economic substance.

But this is

a distinction without a difference; and in any case, the statute by
its terms applies the penalty to a misstatement, and given the
policy concerns Congress had no reason to care about the nature of
the falsity.
The "Attributable To" Issue.
the

40

percent

penalty

applies

only

Under the penalty statute,
to

"a

portion

of

the

underpayment . . . attributable to one or more gross valuation
misstatements."

26 U.S.C. § 6662(h)(1).

Fidelity argues that the

underpayment of taxes by Egan--the partnership pays none for
itself--would have occurred without the misstatements of value and

4

See Todd v. Commissioner, 862 F.2d 540, 542 (5th Cir. 1988);
Clearmeadow Investments, LLC v. United States, 87 Fed. Cl. 509, 531
n.27 (2009); H.R. Rep. No. 97-201, at 243 (1981).
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therefore cannot be "attributable to" any supposed gross valuation
misstatement.5
Fidelity says that even without the misstatements of
bases, the losses Fidelity claimed and allocated to Egan would have
been disallowed based on other determinations made by the IRS and
the district court.

Specifically, these included determinations--

stemming from the same central finding that the transactions lacked
economic purpose and was designed purely for tax avoidance--that
Fidelity was not a true partnership, that Egan's outside basis was
zero, that Mahoney (the Irish national) was not a partner, and that
the transactions were not entered into for profit, 26 U.S.C. §
165(c)(2).

Fid. Int'l, 747 F. Supp. 2d at 244.
Thus, given the lack of economic substance, the IRS had

various statutory grounds for disallowing the same losses.

Dual

cause issues arise in various contexts throughout the law, e.g., W.
Page Keeton et al., Prosser and Keeton on Torts §§ 41-42 (5th ed.
1984), and the varying solutions depend primarily on context and
underlying policy.

Here, Congress' phrase "attributable to" is

5

The district court only had jurisdiction over "the
applicability of any penalty . . . which relates to an adjustment
to a partnership item," 26 U.S.C. § 6226(f), and Egan's personal
liability will be assessed in a separate, partner-level proceeding,
but the IRS must issue a notice to the partnership before making
assessments against individual partners. Id. § 6225(a). Courts
seem willing to assume that a partnership adjustment is likely to
produce an underpayment at the partner level. See, e.g., Am. Boat
Co. v. United States, 583 F.3d 471, 473 (7th Cir. 2009).
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easily read to cover the role of the misstatements in lowering
Egan's taxes and that reading serves the underlying policy.
To repeat, the heavy penalty for gross misstatements of
value or basis reflects their resulting harm and difficulty in
detection.

See note 4, above.

The misstatements were the vehicle

for generating the spurious Fidelity losses carried over to Egan's
return to shield his income.

That (in this case) alternative

grounds with lower or no penalties existed for disallowing the same
claimed losses hardly detracts from the need to penalize and
discourage the gross value misstatements.
Indeed, one might think that it would be perverse to
allow the taxpayer to avoid a penalty otherwise applicable to his
conduct on the ground that the taxpayer had also engaged in
additional

violations

claimed losses.

that

would

support

disallowance

of

the

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

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

Most circuit courts

that have confronted variations on Fidelity's argument in the lack
of economic substance context have rejected it.6
The

only

unimpaired

circuit

precedents

Fidelity's position are from the Fifth Circuit.

6

favoring

In Todd v.

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

862

F.2d

540

Page: 16

(5th

Date Filed: 10/21/2011

Cir.

1988),

later

Entry ID: 5589974

summarily

followed by Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990),
the court accepted the position that an overvaluation underpinning
claimed tax benefits should go unpenalized because other grounds
also existed for imputing the same higher income to the taxpayer.
We think Todd rests on a misunderstanding of the sources relied on.
The court reached its result not by considering how the
"attributable to" language should be read in light of its purpose
(in fact, it admitted that its reading "ascribe[s] an intent to
Congress which might, at first blush, seem inequitable," Todd, 862
F.2d at 545) but rather because it glossed that requirement by
reading language in a congressional tax document generated to
explain the predecessor penalty to section 6662 passed in 1981.
This document's key language reads as follows:
The portion of a tax underpayment that is
attributable to a valuation overstatement will
be determined after taking into account any
other proper adjustments to tax liability.
Thus, the underpayment resulting from a
valuation overstatement will be determined by
comparing the taxpayer's (1) actual tax
liability (i.e., the tax liability that
results from a proper valuation and which
takes
into
account
any
other
proper
adjustments) with (2) actual tax liability as
reduced by taking into account the valuation
overstatement. The difference between these
two amounts will be the underpayment that is
attributable to the valuation overstatement.

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Todd, 862 F.2d at 542-43 (quoting Staff of the Joint Committee on
Taxation, General Explanation of the Economic Recovery Tax Act of
1981, at 333 (Comm. Print 1981)).
In

our

view,

that

language

is

designed

to

avoid

attributing to a basis or value misstatement an upward adjustment
of taxes that is unrelated to the overstatement but due solely to
some other tax reporting error (for example, if Egan had also
falsely claimed a charitable contribution on his return).
surely what

the

quoted

language

means

in

excluding

This is
from the

overstatement penalty increased taxes due to "any other proper
adjustments."

This

is

quite

different

from

excusing

an

overstatement because it is one of two independent, rather than the
sole, cause of the same under-reporting error.
Although the Ninth Circuit followed Todd's misreading in
Gainer v. Commissioner, 893 F.2d 225 (9th Cir. 1990), a later
decision of

the

court

conceded

that

Gainer

was

a

vulnerable

precedent in conflict with other circuits; but the panel felt
compelled to follow prior circuit precedent.
1061.

Keller, 556 F.3d at

We follow without hesitation the dominant view of the

circuits that have addressed this issue.
The Supposedly Conflicting Penalty Provisions. Fidelity
finally points to Congress' recent provision adding transactions
lacking economic substance to the list of tax underpayments to
which accuracy-related penalties apply.

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26 U.S.C.A. § 6662(b)(6)

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(West 2011).

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Entry ID: 5589974

This new provision, applying only to transactions

entered into after March 31, 2010, Health Care and Education
Reconciliation Act of 2010, Pub. L. No. 111-152, § 1409(e)(2), 124
Stat. 1029, 1070 (2010), applies a 40 percent penalty to those
transactions which are not disclosed and reduces it to 20 percent
for those that are, 26 U.S.C.A. § 6662(i) (West 2011).
Here, the individual Fidelity transactions at issue were,
in one sense at least, disclosed.

On this premise, Fidelity

alleges a potential conflict created by reading the gross valuation
misstatement penalty to cover a disclosed transaction that lacks
economic substance: the incentive to disclose created by the new
provision

is

greatly

reduced

because

the

government

could

presumably seek the 40 percent penalty under the gross valuation
misstatement provision for a fully disclosed transaction that
lacked economic substance.
The new statute was enacted after the transactions that
are in issue in this case, and
governs those transactions.

Fidelity does not claim that it

So this is not even a case in which

one can argue that two provisions apply simultaneously to the same
transaction

and

that

one

provision's

language

reinterpreted to avoid an unreasonable result.

should

be

Fidelity is in

effect arguing that the language in the earlier statute should be
re-read because of other changes by a later Congress.

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Document: 00116280030

Page: 19

Date Filed: 10/21/2011

Entry ID: 5589974

Anyway, the new provision is not limited solely to
misstatements of basis or value, which Congress earlier singled out
in imposing the higher penalty without regard to disclosure.

And

the new penalty is a strict liability provision, while the gross
valuation misstatement penalty allows taxpayers to raise reasonable
cause and good faith defenses.

26 U.S.C. § 6664(c)(1)-(2) (West

2011).

The two penalty provisions are designed differently but

create

no

such

conflict

as

would

lead

us

to

tamper

with

straightforward language of the 40 percent penalty provision.
Affirmed.

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