Attorney-at-Law

WOODSHEDDING YOUR EXPERT – REDIVIVUS

In Uncategorized on 08/06/2013 at 08:09

No, not Stobie Creek, but John Hancock Life Insurance Company (U.S.A.), as Successor in Interest to John Hancock Life Insurance Company (f.k.a. John Hancock Mutual Life Insurance Company) and Subsidiaries, et al., is up a different creek, leading off 141 T.C. in 141 T. C. 1, filed 8/5/13.

And the reason this blogpost is a day late (but hopefully not a dollar short) is that I wanted to reflect on the 244 pages of Judge Haines’ prose before leaping onto the internet.

Remember the “synthetic leases” of the 1980s? No? Take a look at FAS 13, the accounting guide to leveraged leases and off-balance-sheet finagling. The idea was to put up 20% of the deal, borrow 80% nonrecourse, lease and lease back (later buy and lease back, when IRS blew up the lease and lease back deals (called LILOs) under Section 467) from a tax-indifferent, take heavy depreciation and interest deductions, when in fact all the cash you were going to owe was put in secure accounts, so that all payments were made out of those accounts. Your transaction costs were the broker’s commission and the tax-indifferent’s vigorish for doing the deal.

And the nonrecourse debt was off-balance-sheet per FAS 13.

I remember a CLE program given at that time, run by a now-defunct abstract company, where these were extolled. I denounced them publicly as a fraud. As usual, nobody listened.

The American Jobs Creation Act of 2004 put paid to the whole game, but prospectively only; those deals then in place, to the extent compliant with pre-existing law, were unaffected.

John Hancock, needing to offset investment gains, found itself besieged by various brokers peddling this dodge. So it did deals with the Austrian State Railways, the Belgian State Railways, the City of Dortmund in Germany, and some Austrian and German public utilities.

IRS first claims that these aren’t leases at all but financing arrangements, so John Hancock’s depreciation and loan interest deductions are out, but they do get some other interest income and minor deductions. None of the other deductions IRS gives John Hancock comes close to the roughly $560 million in deficiencies, not counting interest and penalties (which Judge Haines doesn’t discuss, but which will surely surface after the Section 155 beancount he orders).

So we have the trial. “The Court held a five-week special trial session in Boston, Massachusetts. The record in these cases includes the testimony of 53 witnesses, over 3,600 exhibits, over 4,000 pages of trial transcripts, and over 1,000 pages of briefing.” 141 T. C. 1, at p. 76.

Bottom line is that IRS wins. If international wheeling-dealing  sings your song, you can read all about it.

But the point I want to make here is why IRS wins. IRS’ initial attack is substance over form: John Hancock never had benefits and burdens of a net lessor or of an owner. It only had cash at risk in two deals, and even those were financing deals, not leases. For the rest, it was a roundy-round with the cash, with John Hancock getting the write-offs, and, though it wasn’t 100% certain that the indifferents would buy out of the leases at the bail-out date, it was probable enough to satisfy Judge Haines that John Hancock would not be buying electric power in Austria or running high-speed expresses from Brussels to Paris. And that’s what carries the day.

Now IRS got cute at the pre-trial memorandum stage. IRS wild-carded in an economic substance argument, that they hadn’t raised in the SNODs or in their answer.

John Hancock moved to preclude any evidence IRS might offer on that score from the 53 witnesses or the 3600 exhibits, but Judge Haines let it all in. However, IRS had the burden of proof, and the Health Care Reform Act codification plays no part.

IRS relies on its expert, Dr. Thomas Lys, who, Judge Haines notes, “has previously testified for the Government in other Federal leasing cases.” 141 T. C. 1, at p. 82. Professional witness, maybe?

But the Prof lets the IRS down, and IRS loses on economic substance, because IRS can’t carry the burden of proof.

“Having found that a net present value analysis may be useful in these cases, we turn to respondent’s argument that the ABC reports do not provide reliable pretax economic returns and thus that Dr. Lys’ net present value calculations should control. We disagree. If, as Dr. Lys opined, the proper test of profitability requires an investor to accumulate a return on an investment and discount the return back at the same rate and over the same period, any investment with transaction costs would always produce a pretax loss. In fact, Dr. Lys stated at trial that the actual pretax cashflows from the test transactions were ‘irrelevant’.

“At trial petitioners presented Dr. Lys with a simple example to illustrate this point.

“Q:            So my simple example is: Assume that you walk into your stockbroker and you have $101,000 in your pocket.

“A:            Uh-huh.

“Q:            And you buy a $100,000 bond – –

“A:            101 or –

“Q:            A $100,000 bond, because there are going to be some transaction costs.

“A:            Okay.

“Q:            The broker is going to charge you $1,000 for that transaction.

“A:            That’s correct.

“Q:            Using your methodology, assume my bond is 4 percent – – you would calculate the present value today of that bond at maturity, you would take the $100,000 and accumulate it forward at 4 percent, and then you would discount it back at 4 percent. Am I right?

“A:            Correct.

“Q:            So on a present-value basis, the value of my investment is [$]100,000.

“A:            That’s correct.

“Q:            But I have [$]101,000 invested.

“A:            That’s correct.

“Q:            Is that a value-destroying investment?

“A:            Yeah. But may I specify, Your Honor? But I get a service. What the broker did is – – I had a problem. I had $100,000 today, and I didn’t want to have $100,000 today, I wanted to have $100,000 tomorrow, or whenever that period is. The $1,000 transaction fee is something that I voluntarily paid for getting $100,000 tomorrow.” 141 T. C.1, at pp. 136-137.

Judge Haines isn’t buying. “Neither Dr. Lys nor respondent [IRS] has provided a logical explanation to support a real world application of his method and calculations. As a result, the record does not include a credible net present value calculation.” 141 T. C. 1, at p. 139.

There’s more, enough to knock Dr. Lys completely out of the box, but this is enough.

Let’s go back to my blogpost “Woodshedding Your Experts – Stobie Creek Part Deux”, 1/10/11, wherein I said “(T)he takeaway for counsel? As with currency trades, every litigated case has a ‘sweet spot’, the one disputed point your side must prove to win.  Before choosing experts, ask what you want your experts to establish to hit the ‘sweet spot’. Work with them. Learn their craft, so far as possible. And sweat them good, both in preparation of their reports and in preparation for depositions. And if they can’t properly opine, it’s time for a major heart-to-heart with the taxpayer-client.”

I would add that if, after the time has run for you to amend your pleadings, you have a bright idea, make sure your expert is on board.

And that what your expert tells you and the judge bears some relation to reality, not just to what you want to hear.

 

 

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