Reinvoicing & Transfer Pricing Arrangements

[Riser Adkisson LLP]

Reinvoicing & Transfer Pricing Arrangements

We get a lot of calls from folks who say "Hey, I'd like your help in forming an offshore corporation which will receive income I am receiving from some source, keep most of the income, and then will pay me a small portion of what is left so that I don't have to pay income taxes on the full amount."

This is the businessman's dream -- to be able to keep from paying income tax, while allowing money to grow tax-free in some sunny Caribbean haven.

But as shown this can amount to tax evasion.

How It Works

A businessman (whom we will call "Client") creates an International Business Company (IBC) in a tax-free haven to which profit is diverted. The intermediary marks-up the price during the transfer (hence "transfer pricing") and then "reinvoices" the Client's domestic corporation at the higher price.

Before Implementation

Assume the Client owns a Business which purchases a product for $1. The Client's Business is able to sell the product to the public for $10, thus generating a taxable profit to the Client of $9.

After Implementation

The Client creates an International Business Company (IBC), but does not report the creation of the IBC to the Internal Revenue Service. The IBC purchases the product at $1, but marks-up and reinvoices the Client's Business for the same product at $9. The Client's Business still sells the product to consumers at $10, but the Client only reports $1 in taxable profit to the Internal Revenue Service. The other $8 remains in the IBC and grows-tax free. This is blatant tax-evasion.

Tax Evasion

While these schemes sound very attractive to businessmen, they have been around long enough for a body of law to develop which gives the Internal Revenue Service some of its strongest powers to combat abuses in this area. Now, the IRS essentially has the power to simply disregard the intermediary IBC and tax the Client as if there had been no intermediary, and also assessing severe penalties and interest for the non-payment of tax on this money.

Additionally (claims of sleazy tax practitioners aside) the intermediary IBC is a controlled-foreign corporation, and to not report profits made by it and then made in investments is simply tax evasion.

Offshore corporation providers often promote these schemes, and claim that because of offshore secrecy and confidentiality laws they can never be discovered. However, they are frequently discovered, and in this author's opinion and experience only a scant few succeed. Why? Because it really isn't that difficult for the IRS to figure out these schemes.

IRS Red Flag: Unexplained High Purchase Price -- Let's say Sanyo sells CD players for $15, but you are purchasing the same CD players from a Nevis company for $65. Not too hard to figure out what is going on.

IRS Red Flag: Unnecessary Foreign Transaction -- You are purchasing a product made in Florida and selling it in California. But you are purchasing it from a Panamanian corporation. Not too hard to figure out what is going on.

IRS Red Flag: Brass Plate Company -- The company from whom you are purchasing property doesn't have any real offices, employees, or warehouses. Not too hard to figure out what is going on.

IRS Red Flag: Declining Profits -- Last year you made $10 per unit, but this year only $1 per unit. However, the industry-wide price hasn't changed. Not too hard to figure out what is going on.

IRS Red Flag: Public Complaint -- Now you've divorced and your ex-spouse wants his or her half of the money overseas, in addition to everything else. And so a roadmap of what has happened is provided to the IRS.

These are just a few easy examples known to us. The IRS has dedicated manpower, and has developed a variety of techniques to discover and bust these scams. You're just crazy if you think you can create one of these structures and get away with it for very long.

These schemes are known by a variety of names, in the U.S. they are called "transfer pricing schemes" and offshore they are called "reinvoicing structures". Sometimes they are called "Margolis schemes" because of the late California tax attorney Harry Margolis who created hundreds of these schemes (nearly all of which failed) in the 1980s. See, for example:

Erhard v. Commissioner of Internal Revenue

Schulman v. United States

Goldberg v. United States

[Note: Your author's first federal court trial experience, and first "offshore" experience, was in 1988 as a law clerk assisting a litigation firm in the trial against the estate of the late Mr. Margolis, who had set up one of these schemes using a series of Panamanian corporations.]

Legal Transfer-Pricing Schemes

It is actually possible to create 100% legal transfer pricing schemes, although these schemes benefit from so-called Double Tax Treaties (DTAs), and the goal is the substantial reduction of taxes by taking advantage of different tax rates in different jurisdictions which have tax treaties with the United States. Indeed, there are whole cadres of international tax attorneys who sit around looking for ways to take advantage of DTAs. Even with these, however, we recommend that you get an opinion letter from one of the major accounting firms to protect yourself.

Another method to implement a transfer pricing scheme is to add some value to the product to justify differing the profit abroad. This whole area, however, can be very tricky, and you sure don't want to attempt one of these schemes without a "Transfer Pricing Study" by one of the major accounting firms (and even these studies, which are very expensive, may not protect you).

[Riser Adkisson LLP]

Werner H. Erhard v. Commissioner Internal Revenue Service,
No. 93-70357 (9th.Cir. 02/08/1995)

United States Court of Appeals for the Ninth Circuit

WERNER H. ERHARD,

Petitioner-Appellant,

v.

COMMISSIONER INTERNAL REVENUE SERVICE,

Respondent-Appellee.

Docket No. 93-70357

Date of Decision: February 8, 1995

Judge: O'Scannlain, Diarmuid F.

Tax Analysts Citation: 95 TNT 31-14

Parallel Citations: 95-1 USTC Para. 50,074, 75 AFTR2d Par. 95-502

Principal Code Reference: Section 163

Tax Ct. No. 39473-85

Tax Ct. No. 46712-86

No. 93-70360

Tax Ct. No. 39532-87

OPINION APPEAL FROM A DECISION OF THE UNITED STATES TAX COURT Argued and Submitted November 17, 1994 -- San Francisco, California

Filed February 8, 1995

Before: Donald P. Lay, /*/ Harry Pregerson, and Diarmuid F. O'Scannlain, Circuit Judges.

Opinionby: Judge O'Scannlain

COUNSEL: Michael I. Saltzman, Baker & McKenzie, New York, New York, for the petitioner-appellant.

William J. Patton, Tax Division, United States Department of Justice, Washington, D.C., for the respondent-appellee.

OPINION

O'SCANNLAIN, CIRCUIT JUDGE:

We are invited to follow the winding paths of circular money movements to determine whether they lead to transactions of economic substance for federal income tax purposes.

I

Werner Erhard has offered a variety of seminars, workshops, and other programs in personal effectiveness since 1971. At that time, Erhard hired tax attorney Harry Margolis to be his personal financial and legal advisor. Margolis arranged the formation and financing of Erhard Seminars Training, Inc.
In 1975, Margolis created a new corporation, "est, a.e.c.," to assume the activities of Erhard Seminars Training, Inc. The stock of est, a.e.c. was seemingly owned by a complex web of offshore entities created by Margolis. /1/ Erhard purported to be just an employee of est, a.e.c., without any legal ownership interest.

Integral to both est, a.e.c. and its predecessor, Erhard Seminars Training, Inc., was the Harry Margolis "system." The system was composed of offshore and domestic corporations, trusts, banks, partnerships, and other entities that were used to implement Margolis' tax planning. Such so-called "system entities" were controlled either directly or indirectly by Margolis. The est, a.e.c., organizational structure devised by Margolis was a maze of intertwined organizations with numerous agreements among the entities involved. After Margolis created est, a.e.c., he created a variety of system entities which dealt only with est, a.e.c. As Erhard's counsel explained, the main purpose of such an organization was "to try to get money paid offshore in a deductible fashion, and then the money would find its way onshore in a non-income fashion." Reporter's Transcript, volume 22 at 102.

In implementing this tax planning, Margolis devised orchestrated money movements that were structured by contractual arrangements. In a typical circular money movement, funds would pass from one system entity to a taxpayer, and then from the taxpayer to a second system entity for some ostensible business purpose of the taxpayer. Thus, the taxpayer would appear to have incurred a substantial expenditure, whereas he in reality had merely taken money from, and then returned it to, the system. Consequently, Margolis' transactions have been described as "financial gymnastics, devoid of economic substance." Goldberg v. United States, 789 F.2d 1341, 1343-44 (9th Cir. 1986).

Margolis maintained so-called "system accounting" for his clients which consisted of a chronological list of the client's transactions within the system and which kept track of the client's balance, either positive or negative, vis a vis the system. All funds that went into the system from a client or a nonsystem entity were entered as a credit to the client while all funds that went out of the system to a client or a nonsystem entity were entered as a debit to the client. A client earned interest on positive balances in the system accounting and was charged interest on negative balances. Transactions between system entities were not recorded because the funds stayed in the system. Though Erhard purportedly had no ownership interest in est, a.e.c., Margolis maintained only one combined system accounting for Erhard and est, a.e.c.

The tax court found that Margolis' representation of clients generally consisted of three phases. During the initial phase, the client's goals were defined and documents were drafted to realize the goals. Then, followed an implementation stage during which the required relationships were established. Finally, there was a clean- up phase when the client wished to terminate the contractual relationships. Where required, money movements would be made in order to complete the clean-up phase. Erhard v. Commissioner, 62 T.C.M. (CCH) 1, 3 (1991). In a memorandum of May 1980, Margolis stated that at the time est, a.e.c. was formed in 1975, it was contemplated that the corporation would not exist for more than three years. Id. at 4.

In 1976, Margolis was indicted on criminal tax charges. He was acquitted of all charges in 1977, but after the indictment, Erhard allegedly became concerned about negative publicity surrounding Margolis' involvement in est, a.e.c. Further, the Margolis system was so complex that Erhard could not assess his own financial condition or that of est, a.e.c. Thus, in January 1980, Erhard announced the initiation of a project to "create est anew." To that end, Erhard formed a task force composed of est, a.e.c. executives, staff members, and outside legal advisors. In May 1980, Erhard issued a memorandum advising his staff that Erhard, Margolis, and the task force had jointly determined to replace Margolis as the general and tax counsel of est, a.e.c.

The task force recommended that Erhard convert the operation into a sole proprietorship. Accordingly, Werner Erhard and Associates ("WEA") was established as a sole proprietorship in February 1981. At this point, WEA needed to acquire the assets of est a.e.c. WEA also needed funds for the acquisition. As for the funds, Margolis indicated that, "[t]he truth is that there is no source other than the accumulated values of the past decade." Id. at 12.

The asset acquisition was accomplished in four phases. In the first phase, which occurred in June and July 1981, Erhard borrowed $2,200,000 from Terla, B.V., a system entity and $5,000,000 from Barclays Bank of San Francisco. Barclays Bank was not a system entity, but the loan was a back-to-back loan secured by Parallax Corp., a system entity. /2/ Thus, the money lent to WEA originated with the system. WEA immediately transferred $4,950,677 back to various system entities, allegedly in payment for assets. However, out of the aggregate loan proceeds of $7,200,000, Erhard retained $2,249,323 for operating expenses.
Phase two occurred on or about August 27, 1981 and was financed through three separate loans to WEA from Terla, a system entity, in the aggregate amount of $6,580,000. WEA retained $850,854 and transferred the rest back into the system through a number of system entities. Thus, in phases one and two, Erhard retained a total of approximately $3 million while the rest of the money cycled out of, and back into, the system.

Phase three took place on September 15, 1981. At this point, WEA owed approximately $13,800,000 in short-term debt to Terla and Barclays Bank. Erhard desired to replace his short-term debt with a long-term loan. Accordingly, Erhard called Wolfgang Somary, co- founder of Intercultural Cooperation Foundation ("ICF"), seeking to borrow money for WEA. ICF had no money to lend; however, shortly thereafter, Margolis called Somary and arranged for ICF to accept funds from a Margolis system entity and then to lend those funds to WEA. Margolis also contacted Fernando Flores, co-founder of the St. John Fundacion, who likewise agreed to act as a conduit for the loan so long as the funds were made available to him. As nonsystem entities, ICF and St. John were enlisted to participate because Erhard's outside lawyers regarded a fully disclosable source of the loan as essential to an acceptable asset acquisition plan.

The ultimate source of the $14 million eventually loaned to Erhard during phase three was Island Bank, a system entity. On September 15, 1981, Island Bank transferred $96 million to Sineuri, S.A., another system entity. From this amount, Sineuri transferred $15 million to Brown Education Corp. ("BEC"). BEC had been formed just prior to this transaction as part of Margolis' tax planning. BEC then purported to loan $14 million to ICF. BEC transferred the money to an account in the name of Everd van Walsum, a Margolis associate who was acting on behalf of ICF. /3/ BEC was ostensibly loaning this money to ICF, yet ICF never provided BEC financial statements. The agreement that ICF and BEC did execute had been drafted with significant help from Margolis. Moreover, ICF agreed to receive funds from BEC only on condition that ICF would not be liable to BEC if WEA defaulted on the loan.

ICF then loaned the $14 million to St. John Fundacion, transferring the money to Paul Mason, a Margolis associate who was acting on behalf of St. John. Margolis also had a hand in drafting the documents executed between ICF and St. John. St. John then made a loan of $14 million to Erhard and WEA. St. John did nothing to ensure that the loan would be repaid by Erhard. Indeed, Flores immediately endorsed the instrument to ICF. BEC also assigned to Island Bank all right, title, and interest in the promissory note from ICF.

On the same day that Erhard received the money (which was the same day that all the above transactions occurred), Erhard transferred it all back to Island Bank, a system entity. Island Bank then transferred $8,976,284.95 to Terla B.V. as payment for the loans Erhard obtained during phases one and two. Island Bank also transferred $5,023,500 to Barclays Bank in payment for the loan Erhard obtained during phase one. Payment of the Barclays loan released the collateral deposit back to Parallax, the System entity that had secured the loan.

Phase four took place in December 1981, ostensibly because Erhard needed more money to complete the asset acquisition. This phase was financed with a $1 million demand loan again from ICF through St. John. The source of the funds was Antigua Banking, Ltd., and ABC Trust Company, both system entities. Over a four-month period, Antigua and ABC funneled the funds to the Harry E. Wright, Jr. Charitable Trust, a Margolis client. On August 27, 1981, the Trust transferred $750,000 to Island Bank. On December 17, 1981, the Trust transferred $250,000 to Island Bank. On December 18, 1981, Island Bank transferred $1 million to ICF. ICF then transferred $1 million to St. John, which on the same day transferred the funds to WEA. WEA then transferred the $1 million, plus an additional $547,645 to est, a.e.c.

Thus, at the close of the four phases, WEA had acquired all of est, a.e.c,'s operating assets. /4/ It had replaced its short-term loans and owed a total of $15 million, consisting of a $1 million demand loan and a $14 million long-term loan. Both loans were owed to ICF.

WEA paid interest to ICF on both the demand loan and the long- term loan. WEA properly withheld ICF's federal income tax from its payments to ICF and transmitted these amounts to the IRS. In early 1985, WEA paid $1 million, purportedly in repayment of the $1 million demand loan. However, Erhard transferred $550,000 directly to Island Bank rather than to ICF. Island Bank informed ICF that it would not release the $550,000 unless ICF initiated legal action in California to uphold the validity of the $14 million note in Erhard's then- active matrimonial action. Thus, of the $450,000 ICF did receive, it spent approximately $400,000 to defend the $14 million note.

On their returns for the tax years of 1981, 1982, and 1983, Erhard and WEA claimed depreciation and interest deductions based on the transactions described above. The IRS disallowed all the deductions and asserted additions to tax under sections 6653(a)(1), 6653(a)(2), and 6661, as well as increased interest under section 6621(c). Erhard petitioned the tax court for a redetermination of the asserted deficiencies, and the cases were assigned to Special Trial Judge Gussis for hearing. Erhard objected to the assignment on the ground that Judge Gussis was biased against Erhard because he presided over two prior cases involving est, a.e.c. The tax court denied Erhard's motion, and this court denied his petition for mandamus. After a six-week trial, the cases were assigned to Tax Court Judge Scott, who adopted Judge Gussis' opinion. The opinion held that Erhard was not entitled to interest or depreciation deductions because the transactions through which they were generated lacked economic substance, and it sustained the determination and imposition of increased interest under section 6621(c).

On September 3, 1991, Erhard filed a motion for reconsideration. The tax court reaffirmed its conclusions with regard to the disallowance of interest deductions and the determination and imposition of increased interest. The court determined, however, that Erhard was entitled to some depreciation deductions. The court then stated that decisions will be entered under Rule 155." Erhard v. Commissioner, 64 T.C.M. (CCH) 10, 15 (1992). Erhard and the Commissioner disagreed about the appropriate computations under Tax Rule 155 and this appeal followed.

Erhard raises three issues on appeal: (1) the disallowance of interest deductions; (2) the imposition of increased interest; and (3) the tax court's computations of Erhard's deficiency.

II

Erhard first argues that this court should remand the case to the tax court, asserting that Judge Scott improperly allowed the special trial judge to make the decision of the tax court.

The chief judge of the tax court may assign a case to be heard by a special trial judge, IRC section 7443A(b)(4); however, the special trial judge has no authority to decide the case. IRC section 7443A(c). Rather, the special trial judge submits a report to the assigned tax court judge, who must "review the work of the special trial judge." Freytag v. Commissioner, 111 S. Ct. 2631, 2635 n.2 (1991). The litigants do not automatically receive a copy of the report and, therefore, are not routinely allowed to file objections to it.

Once the tax court judge has reviewed the report, she may adopt the Special Trial Judge's report, or may modify it or may reject it in whole or in part, or may direct the filing of additional briefs or may receive further evidence or may direct oral argument, or may recommit the report with instructions.

Tax Court Rule 183(c). Whichever course the tax court judge takes, she must presume that the special trial judge's findings of fact are correct, and she must give "[d]ue regard" to the fact "that the Special Trial Judge had the opportunity to evaluate the credibility of witnesses." Id. Here, Judge Scott adopted Special Trial Judge Gussis' report. Erhard was not permitted to file objections to the report prior to Judge Scott's action.

Erhard first argues that because the parties are not provided an opportunity to object to the special trial judge's report, it is likely that the special trial judge will end up deciding the case. /5/ Indeed, permitting the litigants to file objections to the special judge's report might well decrease the danger that the tax court judge will simply endorse the report without review, see Linda J. Silberman, Masters and Magistrates Part II: The American Analogue, 50 N.Y.U. L. Rev. 1297, 1344 n.268 (1975). Yet, absent such a procedure, the tax court judge will not necessarily abdicate her judicial responsibility. The Supreme Court has cautioned specifically that "'rubber stamp' activity" on the part of the tax court judge is not to be assumed. Freytag, 111 S. Ct. at 2653 n.2.

Second, Erhard maintains that Judge Scott, in fact, did not adequately review the case. Erhard makes much of several quotes from Judge Scott where she admits that she relied on Special Judge Gussis' findings and did not examine every exhibit nor read the entire transcript. However, these admissions do not lead to the conclusion that Judge Scott's review was inadequate. First of all, Tax Court Rule 183 requires Judge Scott to give "due regard" to Judge Gussis' report on findings of fact and credibility. Further, the record in this case is so voluminous /6/ that it was perfectly reasonable for Judge Scott not to read every word. Judge Scott made clear that while she did rely on Judge Gussis' findings, she did not "take them carte blanche."

Finally, Erhard maintains that Judge Scott's comments during the reconsideration hearing showed that she misunderstood important facts. Erhard points out that Judge Scott mistakenly believed that ICF and the Harry E. Wright, Jr. Charitable Trust were system entities, and that Erhard owned stock in est, a.e.c. Erhard contends that these mistakes show that Judge Scott did not adequately review the record.

After carefully examining the record and Judge Scott's comments, we are convinced that Judge Scott's review of the case was adequate. Erhard points to isolated mistakes; however, Judge Scott's other comments indicate a satisfactory understanding of the case. Further, we believe that the few errors Judge Scott did make were understandable in light of the case's enormous complexity. Although the Wright Trust was not a system entity, it was a Margolis client, and the Commissioner has claimed that it was effectively controlled by Margolis. Similarly, ICF, though not a system entity, clearly took part in the transactions at Margolis' request and with his direction. Finally, Judge Scott's confusion about Erhard's ownership of est, a.e.c. also is understandable given that everyone seemed to acknowledge that Erhard was the "owner" of the business, and given est, a.e.c's purposefully complicated organization structure. Accordingly, we see no reason to remand.

III

Erhard next challenges the tax court's finding of sham. The tax court's determination that a transaction is lacking in economic substance is a factual determination that this court reviews for clear error. Karme v. Commissioner, 673 F.2d 1062, 1065 (9th Cir. 1980). /7/

At issue here are interest deductions that Erhard claimed for the ICF loans and the Terla B.V. loans. Section 163(a) of the Internal Revenue Code provides for an income tax deduction for "interest paid or accrued within the taxable year on indebtedness." In order to be deductible, however, interest must be paid on genuine indebtedness, an indebtedness in substance and not merely in form. Knetsch v. United States, 364 U.S. 361 (1960). The burden is on the taxpayer to show that the borrowing scheme was a bona fide arrangement entered into for economic purposes, rather than merely a tax avoidance scheme. Valley Title Co. v. Commissioner, 559 F.2d 1139, 1141 (9th Cir. 1977).

The tax court found that the transactions at issue here were without economic substance; that they were merely circular money movements that "began and ended with system entities, with no change in the economic position of the system viewed as a whole." 62 T.C.M. (CCH) 1, 26 (1991).

After conducting a detailed examination of each of the phases, the court concluded the following: In phases one and two, most of the borrowed money simply circled out of the system, through WEA, and back into the system. However, WEA retained approximately $3 million purportedly to use for operating expenses. In phase three, the entire $14 million loan circled through the system in one day. Id. After recounting the convoluted series of transactions involved in phase three, the court concluded that the "loans which had originated from system funds (directly or indirectly) in phases one and two were repaid with system funds in phase three, and the total amount of such repayments were returned, directly or indirectly, to the system." Id.

The court found that the $1 million loan in phase four followed a similar pattern. "Again, the funds originated in a money movement from the Margolis system through the Harry E. Wright, Jr., Charitable Trust, to Island Bank, Ltd., to Intercultural Cooperation Foundation to St. John Foundation to WEA and from WEA to est, a.e.c." Id. Consequently, the tax court concluded that "the $14,000,000 and $1,000,000 loans purportedly obtained by petitioner to finance the acquisitions were sham transactions completely lacking in economic substance." Id. at 27.

The court's findings of sham are based on its conclusion that the complex est, a.e.c. organizational structure was simply a means of shielding "the true ownership of assets that in reality belonged to the Werner Erhard operation." Id. at 28. The court concluded that the entire series of transactions "merely represented the so-called 'clean-up' phase in which the structure created by Margolis for Werner Erhard in 1975 was shed as a prelude to a new structure." Id. at 27. The court, noting that no "effort was made in the system accounting to differentiate between Werner Erhard and the entities (Erhard Seminars Training, Inc., and est, a.e.c.) which were used to conduct the Erhard business over the years," found that the system accounting simply served to reflect a client's cash position within the system. Id. Thus, when est, a.e.c. was to be dismantled in favor of a new structure, Erhard needed to balance accounts with the system and to remove the assets which, in reality were his, but which had been acquired in the name of various system entities.

This was accomplished in the transactions which took place for the most part in phases one through four in 1981. Werner Erhard or (WEA) obtained all the business assets needed to continue his operations. Personal loans owed by Werner Erhard in substantial amounts were paid. He also acquired possession of art work valued at some $765,038 which had been held in the name of a system entity, the auxiliary sloop Sirona valued at $225,000 which had also been held in the name of a system entity and certain motor vehicles. It also appears that some $3,000,000 remained with Erhard (or WEA) as a result of the circular money movements in phases one and two.

Id.

Thus, the court concluded: "We believe that est, a.e.c. was in effect terminated as originally contemplated in 1975, a financial accounting was rendered for Werner Erhard covering some 10 years of close involvement with the system and its entities, and the assets transferred to Werner Erhard in an artificial series of transactions that produced . . . interest expense deductions." Id. at 28.

Although Erhard valiantly attempts to discredit these findings, we are more than satisfied that the tax court committed no clear error in finding that the transactions lacked economic substance.
Erhard first points out that est, a.e.c. was a multi-million dollar business before the asset purchase, as was WEA after the purchase. This, however, is beside the point. The tax court found the asset acquisition to be a sham, not because est, a.e.c. itself was a sham, but because Erhard never really bought est, a.e.c.

Second, Erhard maintains that the court's conclusions about circular money movements are contradicted by the court's own finding that WEA retained a portion of the borrowed funds. However, the court was fully aware that not all the money circulated. Indeed, the court found that the funds that Erhard retained constituted est, a.e.c.'s excess cash balances that needed to be transferred to Erhard in order to square the accounts. This conclusion is supported by the evidence. In a May 20, 1981 memorandum, Margolis indicated that when all the contemplated transactions were concluded, the cash position of est, a.e.c. would be reduced by $2,950,000 while the cash holdings of WEA would increase by that amount. /8/

Third, Erhard maintains that he had a clear business purpose for engaging in the transactions because he desired to terminate his relationship with Margolis. /9/ However, even if Erhard had a legitimate business purpose for terminating his relationship with Margolis, that did not give him a business purpose for engaging in the specific transactions at issue here. The fact that he may have had a good business reason for separating from Margolis does not necessarily justify resorting to circular money movements (that just happened to create tax benefits) to effectuate that separation.

Finally, Erhard points out that even though the $l4 million loan in phase three and the $1 million loan in phase four came from system entities and were immediately returned to system entities, Erhard nonetheless paid over $2 million in interest on the loans over the next several years. He also repaid the $1 million demand loan in 1985. These payments, according to Erhard, are evidence that he was genuinely indebted; after all, he would not have made any payments if the loans had been shams.

We agree that such payments would ordinarily indicate genuine indebtedness; however, the facts of this case immediately dispel such a suggestion. The evidence shows the following: Margolis created the amazingly complicated est, a.e.c. organizational structure, with its numerous offshore entities, in order that money could be "paid offshore in a deductible fashion, and then the money would find its way onshore in a non-income fashion." Reporter's Transcript, volume 22 at 102. Though nominally just an employee of est, a.e.c., Erhard was understood to be its owner. So, when Erhard decided to transform est, a.e.c. into a sole proprietorship, the assets that were ostensibly the property of est, a.e.c. were transferred to Erhard in exchange for payments that were really just circular money movements. Thus, during phases one and two, even though it appeared as though Erhard transferred millions of dollars to est, a.e.c. in exchange for assets, the system was the source not only for the purchase money but also for the additional $3 million that represented est, a.e.c.'s cash reserves.

Further, the convoluted, circular path of the two ICF loans in phases three and four simply makes it hard to believe that these loans were bona fide. The funds began with the system, went through two nonsystem entities in order to provide the transaction with legitimacy, and then went back to the system. Margolis was intimately involved in all these transfers. He arranged for the loans between BEC, ICF, and St. John, and he helped prepare the agreements between the parties. None of these parties knew each other before the transactions, nor did they conduct any of the investigations that are customary in an arms-length transaction. Given this evidence, the fact that Erhard made some subsequent payments to ICF does not lead to the conclusion that the tax court committed clear error in its finding of sham. Indeed, these payments to ICF can be explained in any number of ways /10/ that are wholly in keeping with the tax court's conclusion that the transactions lacked economic substance.

IV

Erhard next contends that the tax court erred in imposing increased interest. This court reviews the tax court's imposition of increased interest pursuant to section 6621 for clear error. Wolf v. Commissioner, 4 F.3d 709, 715 (9th Cir. 1993).

Before its repeal, IRC section 6621(c) imposed increased interest on an understatement of tax to the extent that the understatement was a "substantial underpayment attributable to tax motivated transactions." Prior to l986, the section defined "tax motivated transactions" as including only four specific types of transactions. /11/ The Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2750, amended section 6621(c) to add "any sham or fraudulent transaction" to the list of tax motivated transactions. The Commissioner imposed increased interest on Erhard on the basis of this last category.

Erhard maintains that the legislative history indicates that a transaction does not come within the "sham or fraudulent transaction" category unless the transaction is a fraudulent version of one of the specific types of transactions that were originally defined to be tax motivated transactions. /12/ However, Erhard's argument is not supported by language of the section or by precedent. See Hildebrand v. Commissioner, 967 F.2d 350, 353 (9th Cir. 1992). See also Estate of Carberry, 933 F.2d 1124, 1129-30 (2d Cir. 1991). The section, on its face, applies to ANY sham or fraudulent transaction. Thus, we reject the limitation Erhard urges as not plausible in light of the statute's clear language.

V

Finally, Erhard challenges the tax court's computations under Tax Court Rule 155. Computations under Rule 155 are reviewed for an abuse of discretion. Kelly v. Commissioner, 877 F.2d 756, 760 (9th Cir. 1989). Erhard alleges that the tax court abused its discretion (1) by refusing to accept his computations as to the useful lives of the depreciable assets, and (2) by refusing to credit him for amounts that he withheld from his payments to ICF.

A

Upon reconsideration, the tax court held that Erhard was entitled to depreciation deductions for certain assets that WEA acquired from est, a.e.c. The court directed that decisions, would be entered under Tax Court Rule 155. The parties could not agree on the useful lines of those assets; therefore, each party submitted its own computation under Rule 155.

The Commissioner computed the useful lives of the assets by using the class life guidelines contained in the tables in Rev. Proc. 77-10, 1977-1 C.B. 548. Under this method, the Commissioner allowed Erhard to depreciate the assets from the date that est, a.e.c. transferred the assets to WEA. Erhard maintains, by contrast, that the useful lives of the assets should be computed from the earlier date the assets were acquired by est, a.e.c. in the amount identified from the est, a.e.c. tax returns that had been admitted into evidence.

A computation under Rule 155 must be made solely from the evidence in the record and the opinion of the tax court; it cannot be used to reopen the evidence or raise a new issue. Tax Court Rule 155(c). See also Paccar, Inc. v. Commissioner, 849 F.2d 393, 399-400 (9th Cir. 1988). Here, the tax court found that Erhard's computation was an accounting opinion that raised a new issue of fact. Erhard disagrees, contending that, because the record already included est, a.e.c. tax returns, the remaining useful lives could be calculated "by simple mathematical computations from those returns."

The tax court did not abuse its discretion in refusing to accept Erhard's calculations. The record does not disclose the useful life of each of the assets which remained at the time of the asset acquisition. Rather, Erhard's computations are based on information from est, a.e.c. tax returns. Though the returns are in the record, they were not stipulated to for accuracy or truth, and the Commissioner had no opportunity to contest the accuracy of particular items on the returns. Thus, we agree with the district court that determining the accuracy of Erhard's computations would require reopening the record to permit opinion testimony from both Erhard's accountant and the Commissioner's expert.

B

WEA withheld amounts from its purported interest payments to ICF and properly remitted the withheld amounts to the IRS on ICF's behalf. Erhard now claims that since the Commissioner has determined that he never really had an obligation to pay interest to ICF, then he was not a bona fide withholding agent and thus must have made the payments to the IRS for his own account.

We are not persuaded by Erhard's argument. The amounts Erhard remitted to the IRS were withheld from payments to ICF and thus were in payment of ICF's tax, not Erhard's tax. Section 1464 provides that a refund or credit of an overpayment of tax which has actually been withheld at the source shall be made to the taxpayer from whose income the amount of such tax was in fact withheld. I.R.C. section 1464; Treas. Reg. section 1.1464-1(a); Bank of America v. Anglin, 138 F.2d 7, 8 (9th Cir. 1943). Thus, the IRS may refund any overpaid amount only to ICF, the taxpayer from whose income the tax was withheld. That the IRS deemed the loans shams does not transform payments made on behalf of ICF into payments made on behalf of Erhard. Erhard withheld that money on ICF's behalf regardless of the underlying purpose of the payments.

Affirmed.

FOOTNOTES

/*/ The Honorable Donald P. Lay, Senior United States Circuit Judge for the Eighth Circuit, sitting by designation.

/1/ The ownership of est, a.e.c. was so complex that when Erhard decided to alter the organizational structure in 1981, it apparently took his legal and financial advisors months to sort through the complicated legal and financial structures that Margolis had used in his planning.

/2/ A back-to-back loan occurs when a bank loan is collateralized with a cash deposit from a third party. When the loan principal is repaid, then the compensating deposit is released. In the Margolis' system accounting, a system entity's deposit securing a back-to-back loan was treated as a charge against the client receiving the loan from the bank. The client's account was credited when the loan was repaid and the deposit released back to the system entity.

/3/ BEC also transferred $1 million back to Island Bank.

/4/ WEA had also acquired some artwork, an auxiliary sloop, and various recreational vehicles.

/5/ Erhard analogizes special trial judges in the tax court to special masters and magistrates in the district court, pointing out that litigants in the district court are permitted to file objections to the special master's report before the district judge acts on it.

/6/ The transcript comprised 27 volumes.

/7/ Contrary to Erhard's contention, Casebeer v. Commissioner, 909 F.2d 1360, 1362 (9th Cir. 1990) does not set forth a de novo standard for review of sham transactions.

/8/ Erhard also argues that the tax court erred as a matter of law by admitting inaccurate IRS charts as evidence of circular money movements. Erhard's claim is meritless, however. Erhard is correct that the charts do not include certain transactions, but it is clear from the court's opinion that the court was aware of and considered these transactions in making its determination.

/9/ Erhard also claims that the court applied the wrong test for business purpose. Erhard claims that because the court rejected his asserted business purpose argument on the ground that it was not "convincing," the court erroneously applied an objective test rather than a subjective test. 62 T.C.M. (CCH) 1, 28 (1991). However, Erhard seems to be arguing that unless the court blindly accepts Erhard's assertions, then it is applying an objective test. The text of the opinion shows that the court was not substituting its opinion for Erhard's. Rather, the court was merely stating that, based on the evidence, it did not believe Erhard's assertions.

/10/ For example, the payments could very well have been rendered as a part of the final accounting between Erhard and the system. That is, the transactions that occurred during the four phases may have been calculated to take account of Erhard's subsequent payments to ICF.

/11/ They were (1) any valuation overstatement; (2) any loss disallowed under the at-risk investment credit provisions; (3) any straddle transaction; or (4) any use of an accounting method that created distortion.

/12/ Erhard argues that Congress added the "sham" category in order to reverse a line of tax court cases that refused to impose increased interest to a fraudulent straddle because fraudulent straddles are not really straddles.

END OF FOOTNOTES

[Riser Adkisson LLP]

United States of America v. Gerald L. Schulman,
No. 86-5251 (9th.Cir. 05/20/1987)

Schulman, Gerald L., U.S. v.

United States Court of Appeals for the Ninth Circuit

UNITED STATES OF AMERICA,

Plaintiff-Appellant

v.

GERALD L. SCHULMAN,

Defendant-Appellee.

Docket No. 86-5251

Date of Decision: May 20, 1987

Judge: Tang, opinion

Tax Analysts Citation: 87 TNT 103-19

Parallel Citations: 87-1 USTC Para. 9334, 76 AFTR2d Par. 95-5759

Principal Code Reference: Section 7206

D.C. No. CR-86-253-MRP

Argued and Submitted

March 2, 1987 -- Pasadena, California

Filed May 20, 1987

Before: J. Clifford Wallace. Thomas Tang and

Arthur L. Alarcon, Circuit Judges.

Opinion by Judge Tang

Appeal from the United States District Court

for the Central District of California

Mariana R. Pfaelzer, District Judge, Presiding

COUNSEL

Donald Searles, Washington, D.C., for the plaintiff-appellant.

Bruce Hochman, Beverly Hills, California, for the defendant- appellee.

OPINION

TANG, CIRCUIT JUDGE:

The government appeals the district court's dismissal of 23 counts of a 25-count indictment charging Schulman with conspiracy, tax fraud and perjury. The charges arose from the promotion, sale and administration of a tax shelter scheme Schulman developed, in which 91 limited partnerships purchased buildings leased to the United States Postal Service, public utilities and state governmental units, and claimed interest deductions equal to each limited partner's total capital contribution. The district court dismissed the conspiracy and tax fraud charges on the ground that the government could not prove the element of willfulness essential to convictions under 26 U.S.C. section 7206(1) (making or subscribing a false tax return) and 26 U.S.C. section 7206(2) (aiding in preparation and presentation of a false tax return) because the government could not show that the type of tax shelter promoted by Schulman was clearly illegal in 1978 and 1979. We reverse.

BACKGROUND

Schulman is an accountant who has done tax planning for clients since the early 1970's. He was a client of tax attorney Harry Margolis for several years beginning in 1974 and received advice about real estate tax shelters based on deductions generated by circular financing. See e.g., Goldberg v. United States, 789 F.2d 1341 (9th Cir. 1986). In 1978 and 1979 Schulman created 91 real estate limited partnerships for the purpose of acquiring various public buildings to be purchased through long-term purchase money mortgages, requiring no down payment and bearing interest at below market rates Schulman promoted the sale of the partnership interests by representing that all money invested would be deductible on 1979 tax returns as an interest expense. Schulman was the general partner in each limited partnership.

The promised tax objective was realized through a series of financing and loan transactions between the partnerships and two foreign corporations. Hexagram, a Netherlands Antilles corporation, and Parallax, a Panamanian corporation. The corporations and the limited partnerships all had bank accounts at Banco de Iberoamerica, in Panama, and at Barclays Bank in Holland. The partnerships each secured a short-term loan from Hexagram and executed promissory notes to Hexagram bearing interest at 10%. Each partnership delivered the funds borrowed from Hexagram to Parallax under a financing agreement in which the partnership agreed not to charge any interest as consideration for Parallax's agreement to obtain favorable long-term financing for the purchase of the real estate. Parallax deposited the money in the Panamanian Bank with instructions to loan it to Hexagram. These loans and transfers thus were effected through the use of circular financing, with the same transaction being repeated 91 times in two days on October 31 and December 5, 1978; the result was that $252 million was "loaned" to the Schulman partnerships. Some twelve to fourteen months later, on December 27, 1979, the principal amount ($220 million) was repaid to Hexagram by reversing the circle using the accounts at Barclays Bank. When Parallax returned the money to each partnership, it in turn repaid Hexagram the loan plus interest The interest payment equaled the initial capital contribution of the partners (approximately $28 million).

There is no dispute that the limited partners made capital contributions, or that the partnerships did purchase and do own real buildings in the United States, or that some of the partnership transactions had economic substance apart from their tax consequences. The government does not argue that Schulman, the partners, or the partnerships had any ownership interest in the two foreign companies or that the companies were not duly organized under the laws of the Netherlands Antilles or Panama.

The government alleges that the loan and financing transactions between the Schulman partnerships and Hexagram and Parallax had no economic substance. There was not $252 million in cash to be loaned. Rather, there was a collected fund available for cash withdrawal of as little as one thousand dollars. The thousand dollars was circulated through the accounts until a total of $252 million was reached. Thus these transactions were mere "check swaps" which cannot be characterized as loans. Since there were no loans, the December 1979 cash payments to Hexagram, the government contends, cannot be characterized as interest payments.

The IRS began a civil audit in 1982 of the 1979 partnerships and in August 1983 reached a Settlement Plan Agreement in which the lRS agreed to permit 70% of the interest deductions to be taken in the first year of investment and the balance to be deducted over the term of the purchase money notes executed by the partnerships to acquire the leased properties. Mr. Schulman agreed to restructure future transactions so that no foreign entities would be involved. The Service, however, abandoned the agreement in 1984 and instituted a summons enforcement proceeding in which it took Schulman's deposition.

Count I of the indictment -- the conspiracy count -- alleges that Schulman organized and promoted the Schulman partnerships, orchestrated the financing transactions which generated the false loans and falsely reported the payments as interest on federal tax filings. The substantive tax counts arise from the tax plan and charge that Schulman aided and assisted in preparation of false and fraudulent returns filed by the limited partnerships (Counts II -- XIII) and individual partners (Counts XIV -- XIX) in violation of 26 U.S.C. section 7206(2) and by Schulman himself (Count XX) in violation of 26 U.S.C section 7206(1) Counts XXI -- XXV charge that Schulman perjured himself while giving deposition testimony in violation of 18 U.S.C. section 1623.

Schulman moved to dismiss the indictment and for a bill of particulars. The district court granted Schulman's motion to dismiss the tax fraud and conspiracy counts on the ground that the due process defense was legally sufficient because in 1978 and 1979 this type of circular financing was not clearly illegal. The district court dismissed two of the perjury counts (Counts XXII and XXIII) because the questioning had been too ambiguous. The government agreed to dismissal of Count XXV as multiplicitous.

ANALYSIS

I. Dismissal of Tax Shelter Counts

A. Standard of Review

We review the sufficiency of an indictment de novo United States v. Buckley 689 F.2d 893, 897 n.4 (9th Cir. 1982), cert. denied, 460 U.S. 1086 (1983).

A Rule 12(b)(1) motion to dismiss is appropriately granted when it is based on questions of law rather than fact. United States v. Shortt Accountancy Corp., 785 F.2d 1448, 1452 (9th Cir.), cert. denied, 106 S. Ct. 3301 (1986). Here Schulman argued that he lacked notice of the criminality of his conduct, and that this constitutional deficiency provided a complete due process defense to the charges, and that the legal defense was capable of determination without trial. The district court agreed. The court assumed all facts alleged and found them insufficient to create a triable issue of fact with regard to the due process defense. The district court relied on United States v. Dahlstrom, 713 F.2d, 1423, 1428 (9th Cir. 1983), cert. denied, 466 U.S. 980 (1984) in deciding that the law in 1978 and 1979 was not sufficiently clear as to the legality of the tax shelter program Schulman promoted to find Schulman had the requisite intent to violate the law. Because the district court ruled as a matter of law, we review the holding de novo. United States v. Russell, 804 F.2d 571, 574 (9th Cir. 1986).

B. Is Willfulness a Factual Question?

The government first argues that the district court erred in dismissing the indictment as a matter of law because the question of Schulman's willfulness is a factual question of his subjective intent, not a legal question of the objective certainty in the law. The government argues that willfulness is a question of subjective intent because when a defendant knows he is committing a wrongful act it does not matter that "there is no litigated fact pattern precisely in point." United States v. Ingredient Technology Corp., 698 F.2d 88, 96 (2d Cir.) (quoting United States v. Brown, 555 F.2d 336, 339-40 (2d Cir. 1977)), cert. denied, 462 U.S. 1131 (1983). The government thus insists that if a defendant has the willful intent to commit a wrongful act, but the act is not illegal as a matter of law, the indictment should be dismissed not for the failure to establish intent but because another essential element of the charged offense is missing. We need not decide the issue because even if the government is correct, we still must review the district court's determination that the tax shelter scheme Schulman promoted was not clearly illegal in 1978 and 1979.

C. Legality of Schulman's Tax Shelter

The district court dismissed the indictment because it believed Dahlstrom, 713 F.2d at 1428, stands for the proposition that when the legality of a tax shelter is unsettled by clearly relevant precedent an indictment must be dismissed because the requisite intent is lacking. Dahlstrom is more properly read as a case barring the "[p]rosecution for advocacy of a tax shelter program in the absence of any evidence of a specific intent to violate the law" because such prosecution "is offensive to the first and fifth amendments." Id. at 1429 (emphasis added); see also Russell, 804 F.2d at 576 (Ferguson, J., concurring) (Dahlstrom "was primarily a First Amendment case involving pure advocacy"). In this case, Schulman did not merely advocate the tax shelter in question, he was involved in "orchestrating the generation of the questionable tax deduction." United States v. Crooks 804 F.2d 1441, 1449 (9th Cir. 1986) (distinguishing Dahlstrom in a factually similar case).

Of course even in a case involving more than mere advocacy, the inquiry must be whether the law clearly prohibited the conduct alleged in the indictment. There is no dispute in this case that the law is well settled that sham transactions are illegal. Commissioner v. Court Holding Co., 324 U.S. 331 (1945); Knetsch v. United States, 364 U.S. 361 (1960); United States v. Clardy, 612 F.2d 1139, 1151-53 (9th Cir. 1980). In Court Holding the Supreme Court established the fundamental doctrine that the true nature of a transaction may not "be disguised by mere formalisms, which exist solely to alter tax liabilities." 324 U.S. at 334. The Supreme Court has also clearly held that for an interest payment to be deductible, the interest must be paid on genuine indebtedness. Knetsch, 364 U.S. at 365-66. When there is no genuine indebtedness underlying the interest payment, the transaction is a sham. Id. Relying on Knetsch we upheld a conviction for false return information in a case of claimed deductions for interest payments because our analysis revealed "that there was no substance behind the forms employed." Clardy, 612 F.2d at 1152.

In this case the district court found that the transactions were not a sham because "real money" was expended, and that the transactions were not devoid of economic substance because the partnerships each acquired a real building. We believe the financing arrangement has to be evaluated separately on its own merits and cannot be found to have substance merely because the partnerships acquired real property or invested "real" money. The only question is whether there were real interest payments on genuine indebtedness. The indictment sufficiently alleges a lack of substance behind the check cycle to sustain the charges against a motion to dismiss.

The transactions in this case are similar to those we held to be a sham in Crooks, 804 F.2d 1441. In Crooks the defendant devised a tax shelter in which investors purchased interests in limited partnerships which owned coal leases and claimed deductions three times the amount of their investment for payments denominated advance mineral royalty payments. Id. at 1443. Because the partnerships lacked the assets to make the royalty payments they created a "check cyclone" with simultaneous, same bank transfers of checks in a circular transaction which we characterized "as borrowing money, paying oneself a royalty payment, and paying back the lender, leaving each party in the same position it was in before the transaction." Id. at 1443, 1449. In Crook's we upheld a conviction for conspiracy and filing false returns on facts similar to those alleged in the Schulman indictment. We are persuaded the allegations in this case are sufficient to withstand dismissal.

We agree with the government that the Schulman financing transactions were a sham that lacked substance because there was no economic risk associated with the purported loans. See Goldberg v. United States 789 F.2d 1341, 1343 (9th Cir. 1986) (indebtedness a sham when taxpayers do not incur "any actual economic liabilities of any substance"). Schulman does not dispute that there were no actual loans of real money in the amount of $252 million; further the government contends that the promissory notes in this case are wholly unenforceable. Assuming that contention is true, there is no risk of any sort in the underlying financing transactions and the $28 million was improperly characterized as a deductible interest expense. Such a sham transaction was clearly prohibited by law in 1978 and 1979, and thus dismissal of the indictment was improper since an intent to violate the law cannot be ruled out as a matter of law. /1/

II. Dismissal of Perjury Counts

A. Standard of Review

The legal sufficiency of a perjury indictment is reviewed de novo United States v. DeCoito, 764 F.2d 690 (9th Cir. 1985).

B. Dismissal of Counts XXII and XXIII

Count XXII charged that Schulman lied when he stated "all . . . the complete sets" of books and records for the partnerships had been turned over to the IRS because in truth he "well knew and believed, the complete sets of books for each partnership had not been turned over." The district court held that the truth paragraph did not specify what records and statements were not provided by the defendant, and thus the count failed to meet the standard of United States v. Cowley, 720 F.2d 1037, 1042 (9th Cir. 1983), cert. denied, 465 U.S. 1029 (1984). Cowley indicates an indictment must set out the "allegedly perjurious statements and the objective truth in stark contrast so that the claim of falsity is clear to all who read the charge." Id. (quoting United States v. Tonelli, 577 F.2d 194, 195 (3d Cir. 1978)). Schulman's statement was volunteered and nonresponsive to any question. In the context of his discourse on the mechanics of the partnership transactions with Parallax and Hexagram, Schulman stated that each partnership had its own set of books and that the complete sets had been turned over to the IRS. What Schulman may have meant is unclear when viewed in context, since he may have been talking only about the records called for in the subpoena or only about the partnerships that dealt with Parallax and Hexagram. It was incumbent on the government attorney "to bring the witness back to the mark, to flush out the whole truth with the tools of adversary examination." Bronston v. United States, 409 U.S. 352, 358-59 (1973). Here the attorney failed "to pin the witness down to the specific object of the questioner's inquiry." Id. at 360. Because the meaning of Schulman's answer is ambiguous we agree with the district court that the truth paragraph did not stand out in stark contrast to the allegedly perjurious statement.

Count XXIII charged that Schulman lied when he denied he knew what Parallax did with the money received from the partnerships and when he said he had no first-hand knowledge concerning Parallax's depositing of the money because Schulman himself deposited the checks into the Parallax account. The government attorney asked Schulman if he knew whether Parallax deposited the money from the partnerships. Schulman said he did not know. The government says that in truth Schulman acted for Parallax by initialing and depositing the deposit tickets and checks into the Parallax account. The government contends this contrast between the answer and the truth is sufficient for a charge of perjury. We agree with the district court that there is not a stark contrast between the statements because the government attorney did not ask questions specific enough to pin down precisely what Schulman's role had been. Bronston 409 U.S. at 360.

CONCLUSION

We conclude that, assuming the truth of the allegations in the indictment, the defendant was engaged in promoting a tax scheme, the illegality of which he had fair notice. The district court erred in granting defendant's motion for dismissal of 20 counts. The court did not err in dismissing the two perjury counts.

AFFIRMED in part, REVERSED in part and REMANDED.

FOOTNOTE

/1/ The district court's other reasons for dismissing the indictment are unsound. The court thought that the 1975 prosecution of Harry Margolis for tax fraud involving a theory of sham circle transfers, which resulted in Margolis's acquittal would have served to make Schulman believe his activities were permissible. The government is correct in saying Schulman's knowledge and understanding of the implications of the Margolis trial is a factual question for the jury. The disposition of the Margolis case offers little guidance on the law at the time since the government of course could not appeal from the acquittal. The district court cited two other attorney designed tax plans approved by this court as a reason for dismissal of the Schulman indictment. The cases are inapposite because they are not sham transaction cases. See Stern v. Commissioner, 747 F.2d 555 (9th Cir. 1984); Roberts v. Commissioner, 643 F.2d 654(9th Cir. 1981). The district court also thought the government's proposed Settlement Plan entered into with Schulman constituted evidence of the legality of the tax shelters. Aside from the fact that subsequent opinions are irrelevant to an inquiry into the objective state of the law at a prior time, as the government notes, it did not have proof of the sham nature of the transactions when it entered into the agreement. Once the government obtained that evidence it cancelled the agreement.

[Riser Adkisson LLP]

Jerome Goldberg and Marjorie Goldberg
v. United States of America,
No. 86-5632 (9th.Cir. 05/14/1986)

United States Court of Appeals for the Ninth Circuit

JEROME GOLDBERG AND MARJORIE GOLDBERG,

Plaintiffs-Appellants,

v.

UNITED STATES OF AMERICA,

Defendant-Appellee.

Docket No. 85-5632

Date of Decision: May 14, 1986

Judge: Schroeder, opinion

Tax Analysts Citation: 86 TNT 100-63

Parallel Citations: 86-1 USTC Para. 9413, 789 F2d 1341, Tax Ct. No. 1615-85

Principal Code Reference: Section 163

D.C. # CV 82-3040-CHH

OPINION

Appeal from the United States District Court for the Central District of California Cynthia Holcomb Hall, District Judge, Presiding Argued and submitted April 7, 1986 Pasadena, California

Before: Schroeder and Fletcher, Circuit Judges, and Wilkins,* District Judge.

SCHROEDER, CIRCUIT JUDGE.

The Goldbergs appeal from the judgment of the district court in favor of the government and disallowing them a refund based upon their claim of a $14,667 interest deduction. The interest was alleged to have been paid on an indebtedness to Anglo Dutch Capital Corporation (Anglo Dutch), now defunct. The district court concluded that neither the "indebtedness" to Anglo Dutch nor the claimed interest payment had any substantial economic purpose or effect. It held that they were shams undertaken for the purpose of tax reduction. See Kneetsch v. United States, 364 U.S. 361, 365-66 (1960); Thompson v. Commissioner, 631 F.2d 642, 646 (9th Cir. 1980), cert. denied, 452 U.S. 961 (1981). We affirm.

The "transactions" in this case begin where the transactions in Thompson v. Commissioner left off. In Thompson, a series of transactions resulting in the issuance of $6,800,000 in promissory notes assumed by Del Cerro Associates, a limited partnership, was held to constitute a tax avoidance scam lacking in economic substance. In 1967, Del Cerro agreed with World Minerals, the holder of the notes, to cancel the interest obligation. In succeeding years, the guiding hand of Harry Margolis arranged agreements whereby the Del Cerro partners were to pay off the indebtedness. In a manner not explained in this record, the indebtedness was reduced from $6.8 million to slightly less than one million dollars. The Goldbergs were to pay off their share of that indebtedness, $88,988.45, corresponding to their negative capital account balance in the partnership. Pursuant to an agreement with Margolis which was not reduced to writing, the loan, originally interest-free, was extended with a ten percent interest rate. In August 1976, Margolis arranged for that loan to be paid off by another loan in the amount of $103,600 from the Goldberg family's foreign trust, which had been organized by Margolis under Bahamian Law with an initial corpus of $500.

On August 23, 1976, Antigua Banking Limited, an enterprise owned by Margolis, received a "cable advice" that $103,600 had been transferred to the Goldbergs, care of Antigua Banking Ltd., from Daoheng Bank, Ltd., Hong Kong. On the same day a Margolis employee prepared and signed a check drawn on the Goldbergs' Barclays bank account in the amount of $103,655 and payable to Anglo Dutch. Anglo Dutch deposited the funds in its account in Barclays Bank. Appellants claim $14,667 as an interest deduction.

The district court concluded that because Margolis was "so inextricably entwined in this transaction," his practices were relevant to the determination of whether the transactions involved in this case were shams. The court stated that

Margolis transactions are characterized by convoluted transfers of overvalued property rights, circular money movements among foreign trusts, delayed drafting, signing and backdating of documents, and client oblivion to the financial realities of their investments. Obfuscation of the facts behind offshore trusts is Margolis' primary shield from taxation. The contrived nature of his schemes has been succinctly described as a "labyrinthian design of tax avoidance . . . and a concomitant hopelessness from the beginning of any economic benefit or effect, other than tax reduction . . ." (citations omitted).

The court went on to state that

Margolis transactions constitute financial gymnastics, devoid of economic substance. Margolis clients typically purchase highly inflated investments and tax shelters, oblivious of the economics of the investment. Indeed, proclaimed ignorance of the facts is a hallmark of Margolis clients. Even so, their ignorance is explained by the fact that there is no economic risk, since the transactions often are not legally binding, but shams. (citations omitted).

The district court pointed out that the transactions in this case were based upon the same "indebtedness" which had been held to have been a sham from its very inception. Thompson v. Commissioner, 66 T.C. 1024, 1050 (1976), aff'd, 631 F.2d 642 (9th Cir. 1980), cert. denied, 452 U.S. 961 (1981). Also persuasive to the district court was the plaintiffs' lack of knowledge of the transactions at issue here and their blind reliance upon Margolis, to the extent of having one of his employees sign a check drawn from their bank account in the amount $103,655.

Appellants first contend that the district court's conclusion that the claimed indebtedness and interest payment lacked economic substance is unsupported by the evidence. This contention is utterly without merit. In a case such as this one, in which the Commissioner has made a deficiency determination, the taxpayer has "the burden of producing enough evidence to rebut the deficiency determination and the burden of persuasion in substantiating a claimed deduction." Valley-Title, Co. v. Commissioner, 559 F.2d 1139, 1141 (9th Cir. 1977); See Meridian Wood Products Co. v. United States, 725 F.2d 1183, 1189 (9th Cir. 1984); Rocwell v. Commissioner, 512 F.2d 882, 885-87 (9th Cir.), cert. denied, 423 U.S. 1015 (1975). Because the genuineness of an indebtedness is at issue here, the court must focus on the substance of the transaction, rather than its form. Knetsch v. United States, 364 U.S. at 365-66; Foster v. Commissioner, 756 F.2d 1430, 1436 (9th Cir. 1985), cert. denied, 106 S. Ct. 793 (1986); Beck v. Commissioner, 678 F.2d 818, 821 (9th Cir. 1982). The burden is therefore on the taxpayer to show that the form of the transactions reflect their substance.

The underlying indebtedness in this case is the same as that shown to have been a sham in Thompson v. Commissioner. The district court properly discredited the appellants' own testimony concerning these transactions in view of their total lack of knowledge and their reliance upon Margolis. The transactions were wholly lacking in the indicia of arms length transactions, and the record is devoid of any indication that the taxpayers incurred any actual economic liabilities of any substance. The plaintiffs have not met their burden.

Appellants next contend that revenue agent Karis presented inadmissible expert testimony. Karis, an experienced revenue agent, was testifying concerning summaries of voluminous tax records, as expressly permitted by Fed. R. Evid. 1006. See United States v. Johnson, 594 F.2d 1253, 1255 (9th Cir.), cert. denied, 444 U.S. 964 (1979). The district court considered the taxpayers' objection to his testimony as being that of an expert, but found that that no expert opinions or conclusions were offered. Our review of the transcript reveals that there was no abuse of discretion in permitting the testimony.

The appellants object to the court's receipt of the government's memorandum of law on the applicability of the Thompson decision. The memorandum was filed approximately one week before trial. The memorandum was neither a pleading, governed by Local Rule 3 and Fed. R. Civ. P. 12, nor a pretrial memorandum prepared for purposes of a pretrial conference as contemplated by Local Rule 9.5. Its submission thus violated no rules. Appellants have not shown that they lacked opportunity to respond to the memorandum or that they were prejudiced in any way. Its relevance was manifest given the relationship between the transactions in this case and those in the Thompson case.

The Goldbergs objected to admission of numerous exhibits consisting of the Del Cerro partnership tax returns, and documents reflecting the Goldbergs' capital account at Del Cerro for the years 1966 through 1972, and that account as reduced by the Goldbergs' pro rata share of the transactions held to be a sham in Thompson. The trial court properly ruled that these exhibits were relevant to the issue of whether the deductions claimed in this case were bona fide.

Finally, the Goldbergs argue that the district court abused its discretion in admitting the deposition testimony of Florence Valkenberg. Mrs. Valkenberg's testimony was relevant. She was intimately familiar with the tax avoidance activities of Margolis, themselves relevant in a case like this in which a client claims a deduction based on a transaction he structured. See Karme v. Commissioner, 673 F.2d 1062, 1064 (9th Cir. 1982). Because Valkenberg lived outside the subpoena power of the court and indicated an unwillingness to appear voluntarily, the district court did not abuse its discretion in finding that the unavailability requirement for admitting deposition testimony had been met.

Affirmed.

FOOTNOTE

* Honorable Philip C. Wilkins, Senior United States District Judge for the Eastern District of California, sitting by designation.