Long Term Capital Holdings v. United States

FINDINGS AND OPINION

Table of Contents

I. Summary 127

II. Factual Background 128

A. Long Term Entities 128

*126 B. Babcock and Brown (“B & B”) and Onslow Trading and Commercial LLC (“OTC”) .131

C. CHIPS and TRIPS Transactions.132

1. CHIPS IVA and IVB .132

2. TRIPS I .135

3. Purported Tax Consequences of CHIPS IVA and IVB and TRIPS 1.135

D. OTC and Long Term.136

1. OTC/Long Term Transaction .136

2. Long Term/B & B/UBS Transaction.138

3. Long Term’s Tax Returns.139

4. B&B and OTC After CHIPS and TRIPS.139

5. The Origin of a Transaction for Long Term.142

6. Long Term and B&B.143

7. Long Term and Shearman & Sterling.145

8. Long Term and King & Spalding.147

a. Kuller’s Claimed Pre-Tax Expectation of Profit Analysis.149

b. Kuller’s Credibility .151

9. Long Term and OTC.153

a. Communication Among Long Term’s Principals.153

b. Unusual Nature of OTC’s Contributions.155

c. Long Term’s and OTC’s Intent Regarding the OTC Transaction.155

d. Scholes’ November 12,1996 Memorandum.157

10. The Turlington Problem.158

11. Petitioner’s Expert: Frank J. Fabozzi.160

12. Scholes’ Economic Analysis.161

13. Government’s Expert: Joseph Stiglitz.163

14. IRS Audit and Long Term’s Response .165

III. Discussion.165

A. Burden of Proof.165

1. Cooperation with Reasonable Requests.166

2. Net Worth.170

3. Conclusion on Burden of Proof.170

B. Lack of Economic Substance.171

1. Objective Economic Substance.172

2. The Scope of the Transaction for Purposes of Measuring Costs and Reasonable Expectation of Return.174

3. Reasonably Expected Return.175

4. Costs of the OTC Transaction.175

a. Legal Fees .176

b. “Consulting Arrangement” with B&B.177

c. The Turlington Payment.178

d. Scholes’ Allocation and Noe’s Bonus.180

e. Economic Structure of OTC Contributions.181

f. B & B’s Investment Through UBS.183

5. “Things Economic Happened” — Tr. [Doc. #207] at 3228:25-3229:1.185

6. Subjective Business Purpose.186

C. Step Transaction Doctrine .191

D. Penalties.196

1. Burden of Proof.196

2. Gross Valuation Misstatement.199

3. Substantial Understatement of Income Tax.200

a. Substantial Authority.201

b. Reasonable Belief.205

4. Reasonable Cause Exception.205

a. Receipt and Content of King & Spalding Advice.206

b. King & Spalding’s Written Opinion.208

c. Long Term’s Lack of Good Faith.211

IV. Conclusion.212

*127 Appendix — Timeline of OTC Transactional Events :.212

I. Summary

Petitioners Long-Term Capital Holdings (“Holdings”), Long-Term Capital Management L.P. (“LTCM”), Long-Term Capital Portfolio L.P. (“Portfolio”), Long-Term Capital Fund, 1 Eric Rosenfeld, and Richard Leahy filed petitions under 26 U.S.C. § 6226(a)(2) seeking (a) readjustment of the IRS denial of $106,058,228 in capital losses for petitioners’ 1997 tax year in connection with the sale by Portfolio on December 30, 1997 of preferred stock for $1,078,400 with a claimed basis of $107,136,628, and (b) a determination that the IRS imposition of penalties pursuant to 26 U.S.C. § 6662(a), (b)(l-3), (h) was erroneous. Jurisdiction is conferred by 28 U.S.C. § 1346(e). The Court’s findings of fact and conclusions of law set out in this opinion are based on the bench trial held June 23, 2003 — July 30, 2003.

Petitioners’ claim that Portfolio sold stock on December 30, 1997 with a tax basis one hundred times in excess of its fair market value arises from two separate sets of transactions. The first set is comprised of nine cross border lease-stripping transactions, five of which utilized a master lease or wrap lease structure and were termed “Computer Hardware Investment Portfolio” (“CHIPS”) and four of which utilized a sale/lease back structure and were termed “Trucking Investment Portfolios” (“TRIPS”).

In the CHIPS transactions, Onslow Trading and Commercial LLC (“OTC”), an entity incorporated under the laws of the Turks and Caicos Islands, purportedly leased from General Electric Capital Computer Leasing (“GECCL”) computer equipment already subject to existing leases to end-users and then immediately subleased its rights in the equipment to U.S. based partnerships. The new sublessees then pre-paid 92.5% of the rent due under the subleases. The prepayments, totaling tens of millions of dollars, were made with loans to the U.S.-based partnerships from Barclays Finance & Leasing B.V. (“Bar-clays”) and were guaranteed by GECCL. OTC, formed under foreign laws and resident in the United Kingdom, paid no U.S. taxes upon receipt of the, rent prepayments and deposited them into a Barclays branch bank account. OTC then exchanged the master leases, the subleases and the bank accounts with the prepayment deposits for preferred stock in certain U.S. corporations; OTC received approximately $1,000,000 in preferred stock for every $100,000,000 of prepayments and lease positions it gave up. OTC’s transfer was timed to be prior to accrual of rent under the subleases such that under UK law OTC paid no taxes on the prepayments. Pursuant to 26 U.S.C. §§ 351, 358, these exchanges were claimed to be tax free exchanges and OTC claimed an ad *128 justed basis in the preferred stock tranches it received of approximately $100,000,000.

In the TRIPS transactions, Wal-Mart sold fleets of trucks to NationsBanc and First American National Bank, the banks leased the trucks to OTC, and OTC subleased the trucks back to Wal-Mart. Wal-Mart guaranteed OTC’s obligations to the banks and prepaid a percentage of the rent due under the sublease. In TRIPS I, the prepayment was 92.5% of the rent due, approximately $27 million, which OTC deposited in a bank account. Again, before the sublease rent accrued, OTC exchanged its lease positions and bank deposits for preferred stock of American corporations. The ratio of exchange again approximated $1 of preferred stock received for every $100 of lease positions and prepayment deposits given up.

OTC, in a purported transaction under 26 U.S.C. § 721, contributed to Long Term the tranches of preferred stock it received from the TRIPS and CHIPS transactions, which had a fair market value of approximately $4 million and a claimed basis of $400 million, in exchange for a Long Term partnership interest. OTC subsequently sold its partnership interest to Long Term and withdrew from the partnership. Long Term then had Portfolio sell a portion of the contributed TRIPS and CHIPS stock to purportedly generate the claimed losses in dispute in this case and those losses were allocated to Long Term under the loss allocation rules of U.S. partnership tax law. 2

For the reasons set forth below, the Court finds that the transaction in which OTC and Long Term engaged lacked economic substance and therefore must be disregarded for tax purposes, and, in the alternative, must be recast under the step transaction doctrine as a sale of preferred stock by OTC to Long Term resulting in an adjustment in Long Term’s basis in the preferred stock to Long Term’s purchase price. With respect to penalties, the Court rejects Long Term’s contention that it satisfied the requirements of the reasonable cause defense to such penalties by obtaining legal opinions, and upholds the IRS application of 40% gross valuation misstatement and 20% substantial understatement penalties related to Long Term’s claim of basis in OTC’s contributed stock. Accordingly, the petitions are DENIED in all respects.

II. Factual Background

A. Long Term Entities

Long Term’s origins can be traced to late 1992 and January 1993, when founding principals John Meriwether, Eric Rosen-feld, 3 James McEntee, and Robert Merton 4 began discussing the prospect of creating a hedge fund 5 to execute strategies *129 using leveraged investments keyed to arbitrage opportunities in large bond markets. They used 1993 and early 1994 to raise money, find principals, locate office space, and hire employees. Ultimately, Long Term had twelve founding principals, including Meriwether, Rosenfeld, Merton, and Myron Scholes. 6 In March 1994, Long Term began to manage the investments it had raised. The principals themselves invested more than $100,000,000 in Long Term when the fund began its operations in 1994, and they sought to increase their individual investments throughout Long Term’s active operation, including through loans to LTCM, investment of LTCM’s working capital into Portfolio, and reinvestment of their individual investment profits into Portfolio. During 1994 and 1995, Scholes was giving explanatory presentations about the fund to prospective investors. He also worked closely with Long Term’s counsel in structuring Long Term’s private placement memoranda, which described the legal rights of investors, the objectives of an investment in the fund, and the risks involved with an investment. By 1996, Long Term had grown to 150 employees with twelve managing partners and offices in Greenwich, Connecticut, London, and Tokyo, and was managing five to six billion dollars of equity. Long-Term had a diverse group of investors, most of which were institutional investors, including a number of investment banking firms, but some of which were high net worth individuals. Two-thirds of its investors were located overseas.

Meriwether was the managing partner from March 1994 until at least 1996. As established and advanced by him, the twelve Long Term principals operated on a consensus management model, in which all twelve participated in managerial decisions, no votes were taken, and all had to agree or Long Term did not move forward with a proposed course of action. The principals participated in risk management meetings at least weekly. Meriwether would delegate particular issues or responsibilities to committees or principals who then bore the burden of explaining substantive issues and recommending courses of action. Scholes was the principal primarily in charge of the “OTC” transaction that figures centrally in this case. Larry Noe, hired in early 1996 as Long Term’s in-house tax counsel, worked closely with Scholes on the tax issues related to the OTC transaction. 7

Long Term operated with a three-tiered structure: LTCM was the top tier and *130 managed all of the affairs of Long Term generally; Portfolio, the hedge fund, was the bottom tier into which all investments flowed; and in the middle tier were various investment vehicles, including LTCP, a U.S. domestic limited partnership, which served as conduits to pool all investments in Portfolio. Multiple mid-tier investment vehicles were used in large part to avoid complexities arising from laws of different countries by pooling assets from investors from particular countries. Thus, generally, foreign investors did not invest in Portfolio via LTCP but through overseas investment vehicles only. LTCP was the only investment vehicle that was treated as a partnership under U.S. federal income tax laws.

Simpson Thacher Bartlett LLP was regular outside counsel for Portfolio during the 1994 to 1998 time frame, although LTCM utilized a number of different law firms depending on which one it considered best suited for particular problems as they arose. Prior to the OTC-related transactions at issue in this case, Long Term had not used the law firm of Shear-man & Sterling.

Long Term established general investing requirements, including minimum capital investment amounts and time periods, although the principals retained discretion to vary these terms for particular investors. The minimum investment required when Long Term began was $10 million but under certain circumstances Long Term accepted investments smaller than that amount. See e.g. infra note 9. Initially, Long Term required new investments to be committed for a three year period but allowed investors to remove their profits generated from the initial investment on a yearly basis. Early on, however, Long Term realized that the three year lock-in would result in a lumpy capital structure if investors elected to remove their capital at the expiration of the three year period, and it adjusted its investing requirements to permit investors to remove a third of invested capital annually. In addition, investors were required to obtain Long Term’s permission to pledge or assign their partnership interest. Taking on new investors was a fairly routine matter that did not typically require substantial outlay of expenses for legal advice or opinions.

LTCM charged fees on all equity capital invested in Portfolio: a two percent annual management fee calculated on a quarterly basis from the equity capital invested in Portfolio; and an incentive or performance fee of twenty-five percent of the gross return of Portfolio in excess of the two percent management fee. 8

In late 1995, Long Term was running out of investment strategies and “closed” Portfolio to new investors, prompted by concern that continued expansion of its equity capital base would compromise its ability to continue to earn the high returns obtained for investors in 1994 and 1995. “Closed,” however, did not mean that LTCM would not accept new investors under any circumstances. Rather, Portfolio remained open, in the discretion of the principals, to investors who provided strategic benefits or advantages to Long Term. 9 A strategic investor was one that *131 Long Term believed added value over and above the normal fees earned on any investment; procurement of fees alone did not constitute “strategic value.” 10

Long Term had an unrestricted right to redeem an investor’s interests. In late 1997, following investors declining voluntary dividends in early summer, Long Term decided to return approximately $2.7 billion in capital to its investors, 11 having concluded after extensive debate within the management committee that a reduction in capital was more in keeping with achieving a certain return relative to an agreed risk level. 12 After the capital return, Portfolio had a balance sheet of $5 billion, and its investment positions were virtually unchanged although supported by less equity. No capital was returned to LTCM so that its stake in Portfolio increased from 30 to 45 percent.

Long Term’s historical gross returns (without deduction of fees) were 28% for the ten months of its operation in 1994, 58.77% for 1995, 57.46% for 1996, and at least 21.55% in 1997. During only nine months in this 1994-1997 time period was its overall return negative although there was a decline in expected returns. Long Term examined its portfolio annually to adjust its expected return figure, making conservative estimates which only considered existing positions and did not account for new profit opportunities. When first marketing the fund, Long Term told investors it thought it could make a 30% to 40% overall return. In Summer 1997, concurrent with its request that investors take a voluntary dividend, Long Term advised investors that investing opportunities had decreased and percentage expected returns to them would be mid-teens (with expected gross returns in the low 20s). Internally, Long Term “thought [it was] going to make 30 to 40 percent gross returns in ’94, ... low 20s in ’97, and maybe mid-20s in 1996.... ” Tr. [Doc. #188] at 2271: 17-20.

B. Babcock and Brown (“B & B”) and Onslow Trading and Commercial LLC (“OTC”)

B & B is a San Francisco-based investment banking firm in the business of asset-based financing, including acquisition and sale or management of assets and advising *132 on the same. Richard Koffey, formerly a partner at the law firm of Morgan, Lewis, and Bockius, where he specialized in leveraged lease transactions, joined B & B in 1987. OTC was incorporated under the laws of the Turks and Caicos Islands on June 29, 1994, by three United Kingdom principals, Sir Geoffrey Leigh, Dominique Lubar, and Gregory Wills. Each principal capitalized OTC with a contribution of $2,500 and a personal loan commitment of $1.5 million.

C. CHIPS and TRIPS Transactions

Two types of cross-border leasing transactions, CHIPS and TRIPS, are claimed by petitioners to have produced the basis in the preferred stock which Portfolio sold in 1997 to generate claimed capital losses of over one hundred million dollars allocated to LTCM but disallowed by the IRS. Koffey was the principal designer and mastermind of both CHIPS and TRIPS, and Shearman & Sterling advised B & B on their structure, issuing legal opinions that the leases involved therein were true leases. OTC was formed specifically for the purpose of participating in the CHIPS and TRIPS leasing transactions because a U.K. entity was needed to create the purported tax benefits created by the transactions. 13 Five CHIPS transactions were completed and a sixth was unwound after it had begun. While the details of each CHIPS and TRIPS transaction differ slightly, each type shared a common structure. The Court focuses only on the transactions the parties have denominated CHIPS IVA and IVB and TRIPS I as those are the transactions that produced the lots of preferred stock sold by Portfolio in 1997 purportedly to generate the tax losses claimed by petitioners. Because the Court finds it unnecessary to address the economic substance of the CHIPS IVA and IVB and TRIPS I transactions, applicability of the step-transaction doctrine to them, or whether the purported 26 U.S.C. § 351 tax free exchange embedded in them in fact generated stock in the hands of OTC with the tax basis Long Term claims (three legal theories proposed by the Government), the Court will only set out background details on these transactions between OTC and Long Term necessary for understanding the Court’s conclusions. 14

1. CHIPS IVA and IVB

The CHIPS IVA transaction employed the following steps, all of which except the last took place on July 5,1995:

1. OTC entered into a Master Lease Agreement (“CHIPS IVA Master Lease”) with General Electric Capital Computer Leasing, Inc. (“GECCL”). The CHIPS IVA Master Lease was for a term of approximately 60 months and set out the terms for leasing computer hardware equipment (“CHIPS IVA Equipment”) to OTC, subject to existing leases to end users previously entered into by GECCL (“User Leases”). The User Leases had an average duration of 36 months, denominated the “Base Term” in the CHIPS IVA Master Lease. The period from the end of the Base Term to the end of the CHIPS IVA Master Lease was denominated the “Supplemental Term.”

2. OTC also entered into an Agreement of Sublease (“CHIPS IVA Sublease”) *133 with Britamer Computer Co., L.P. (“Bri-tamer”). Britamer was a partnership of B & B and a company called Cebera. 15 The CHIPS IVA Sublease provided for the sublease of the CHIPS IVA Equipment from OTC as sublessor to Britamer as sublessee, and was for a term of approximately 46 months. During the period of overlap between the CHIPS IVA Master Lease and the CHIPS IVA Sublease, Bri-tamer was entitled to receive rents generated by the User Leases, OTC was entitled to receive rents from Britamer, and GECCL was entitled to receive rents from OTC.

3. Britamer entered into a Loan Agreement with Barclays Financial & Leasing B.V. (“Barclays B.V.”) pursuant to which Britamer borrowed $46,133,860.27, or 91.5% of the present value of the rents due to Britamer under the User Leases.

4. Britamer prepaid to OTC $46,638,053, or 92.5% of the present value of the rents due to Britamer under the User Leases (the “Britamer Prepayment”).

5. OTC used the Britamer Prepayment to purchase a U.S. Treasury Bill in the amount of $46,633,446 (“CHIPS IVA Treasury Bill”).

6. GECCL and Barclays (PLC) Guaranty entered into a guaranty agreement (the “Barclays/GECCL Guaranty”) whereby Barclays (PLC) guaranteed payment of a portion of the rent due to GECCL under the CHIPS IVA Master Lease in an amount equal to the future value of the Britamer Prepayment.

7. OTC and Barclays (PLC) entered an agreement (“CHIPS IVA Onslow Agreement”) whereby OTC agreed (a) to reimburse Barclays (PLC) for any amount paid under the Barclays/GECCL Guaranty, (b) granted a security interest in the CHIPS IVA Treasury Bill to Barclays (PLC) as collateral to secure OTC’s obligations under the CHIPS IVA Onslow Agreement, and (c) agreed to provide substitute collateral in the future in the form of U.S. Treasury obligations or a deposit account at Barclays Finance Corporation of the Cayman Islands, Ltd. (“Barfinco”).

8. GECCL and Britamer entered into a Service and Remarketing Agreement providing that GECCL would, for a fee, perform the servicing of the leases and be responsible for remarketing any CHIPS IVA Equipment at the expiration or termination of the User Leases.

9. On August 4, 1995, OTC and Quest & Associates, Inc. (“Quest”) entered into an Exchange Agreement (the “Quest Exchange Agreement”). Quest was an existing subsidiary of the Interpublic Group of Companies, Inc. (“Interpublic”). Under the Quest Exchange Agreement, OTC transferred its purported interests in the CHIPS IVA Master Lease, the CHIPS IVA Sublease, the CHIPS IVA Treasury Bill and the CHIPS IVA Barfinco deposit account (the “Quest Exchange Property”) to Quest in return for 505 shares of Quest preferred stock (the “Quest Preferred Stock”). Also on August 4, 1995, Inter-public contributed $2,510,000 to Quest in exchange for 510 shares of Series A preferred stock.

The CHIPS IVB transaction employed the following steps, all of which except the last took place on July 5,1995:

*134 1. OTC entered into a Master Lease Agreement (“CHIPS IVB Master Lease”) with GECCL. The CHIPS IVB Master Lease was for a term of approximately 60 months, and set the terms for the leasing of computer hardware equipment (“CHIPS IVB Equipment”) to OTC subject to existing User Leases with an average duration of 36 months (the “Base Term” under the CHIPS IVB Master Lease). The period beginning with the end of the Base Term until the end of the CHIPS IVB Master Lease was denominated the “Supplemental Term.”

2. OTC entered into an Agreement of Sublease (“CHIPS IVB Sublease”) with Briternational Computer Co., L.P. (“Bri-ternational”), providing for the sublease of the CHIPS IVB Equipment from OTC as sublessor to Briternational as sublessee for a term of approximately 46 months. Similar to CHIPS IVA, during the period of overlap between the CHIPS IVB Master Lease and the CHIPS IVB Sublease, Bri-ternational was entitled to receive rents generated by the User Leases, OTC was entitled to receive rents from Britamer, and GECCL was entitled to receive rents from OTC.

3. Briternational entered into a Loan Agreement with Barclays B.V. pursuant to which Briternational borrowed 91.5% of the present value of the rents due to it under the User Leases.

4. Briternational prepaid to OTC $33,824,986.53 (92.5% of the present value of the rents due to Briternational under the User Leases (the “Briternational Prepayment”)).

5. OTC used the Briternational Prepayment to purchase a U.S. Treasury Bill in the amount of $33,816,182 (“CHIPS IVB Treasury Bill”).

6. GECCL and Barclays (PLC) Guaranty entered into a guaranty agreement (the “CHIPS IVB Barclays/GECCL Guaranty”) whereby Barclays (PLC) guaranteed payment of a portion of the rent due to GECCL under the CHIPS IVB Master Lease in an amount equal to the future value of the Briternational Prepayment.

7. OTC and Barclays (PLC) entered an agreement (“CHIPS IVB Onslow Agreement”) in which OTC agreed (a) to reimburse Barclays (PLC) for any amount paid under the Barclays/Guaranty, (b) granted a security interest in the CHIPS IVB Treasury Bill to Barclays (PLC) as collateral to secure OTC’s obligations under the CHIPS IVB Onslow Agreement, and (c) agreed to provide substitute collateral in the future in the form of U.S. Treasury obligations or a deposit account at Barfin-co.

8. GECCL and Briternational entered into a Service and Remarketing Agreement providing that GECCL would, for a fee, perform the servicing of the leases and be responsible for remarketing any CHIPS IVB Equipment at the expiration or termination of the User Leases.

9. On August 2, 1995, OTC and Rorer International Corporation (“Rorer”) entered into an Exchange Agreement (the “Rorer Exchange Agreement”). Rorer was an existing subsidiary of Rhone-Pou-lenc Rorer, Inc. (“RPR”). Under the Rorer Exchange Agreement, OTC transferred its purported interests in the CHIPS IVB Master Lease, the CHIPS IVB Sublease, the CHIPS IVB OTC/Barclays Guaranty, the CHIPS IVB Treasury Bill and the CHIPS IVB Barfínco deposit account, the TRAC Lease, the TRIPS Sublease and the TRIPS Deposit (the “Rorer Exchange Property”) 16 to Rorer in return for 6,600 *135 shares of Series B preferred stock issued by Rorer (the “Rorer Preferred Stock”). Also on August 2, 1995, another RPR subsidiary, Rorer Pharmaceutical Products Inc. (“RPPI”), contributed $10 million to Rorer in exchange for an amount of Rorer common stock equal to approximately 33.11% of the total issued and outstanding Rorer common stock.

2.TRIPS I

The TRIPS I transaction employed the following steps:

1. On June 30, 1995, OTC entered into a TRAC Lease agreement (the “TRAC Lease”) with NationsBanc Corporation of North Carolina (“NationsBanc”), which provided for the lease of long-haul truck tractors (“TRIPS Equipment”) to OTC. The TRAC Lease was for a term of 4.5 years.

2. On June 30, 1995, OTC entered into a Sublease agreement (the “TRIPS Sublease”) with Wal-Mart Stores, Inc. (“Wal-Mart”), which provided for the sublease of the TRIPS Equipment from OTC as sub-lessor to Wal-Mart as sublessee. The TRIPS Sublease was for a term of 4.5 years.

3. On July 5, 1995, Wal-Mart prepaid to OTC $26,773,985, or 92.5% of the present value of the rents due to OTC under the TRIPS Sublease (the “Wal-Mart Prepayment”).

4. OTC deposited with Sanwa Bank Ltd. (“Sanwa”) the Wal-Mart Prepayment of $26,687,000 (“TRIPS Deposit”).

5. OTC granted a security interest in the TRIPS Deposit as collateral security to secure its obligations under the TRAC Lease.

6. As described above, on August 2, 1995, OTC and Rorer International Corporation (“Rorer”) entered into an Exchange Agreement (the “Rorer Exchange Agreement”). Rorer was an existing subsidiary of Rhone-Poulenc Rorer, Inc. (“RPR”). Under the Rorer Exchange Agreement, OTC transferred its purported interests in the CHIPS IVB Master Lease, the CHIPS IVB Sublease, the CHIPS IVB OTC/Bar-clays Guaranty, the CHIPS IVB Treasury Bill and the CHIPS IVB Barfinco deposit account, the TRAC Lease, the TRIPS Sublease and the TRIPS Deposit (the “Rorer Exchange Property”) to Rorer in return for 6,600 shares of Series B preferred stock issued by Rorer (the “Rorer Preferred Stock”). Also on August 2, 1995, another RPR subsidiary, Rorer Pharmaceutical Products Inc. (“RPPI”), contributed $10 million to Rorer in exchange for an amount of Rorer common stock equal to approximately 33.11% of the total issued and outstanding Rorer common stock.

3.Purported Tax Consequences of CHIPS IVA and IVB and TRIPS I

The CHIPS and TRIPS transactions were designed to take advantage of OTC’s status as a foreign entity not subject to U.S. taxes, the United Kingdom’s tax laws under which prepayments of rent are not taxed until rent actually accrues, and U.S. tax law regarding non-recognition incorporation transactions. In theory, the prepayments OTC received were not taxable to it under U.S. tax law because of its foreign entity status, and were not taxable under U.K. law because, as “prepayments,” rents had not yet accrued under the subleases. Based on this theory, OTC’s business plan called for OTC to transfer its purported lease interests, treasury bills, and bank deposits associated with any particular CHIPS and TRIPS transaction as soon as it could identify an appropriate American corporation (Quest in CHIPS IVA and Rorer in CHIPS IVB and TRIPS I) to take them over. It was OTC’s expectation that the transfer could be accomplished in a couple of months and *136 thus would be effected prior to any accrual of rent. Each transfer was cast as a tax free incorporation under 26 U.S.C. § 351 pursuant to which the American corporation claimed no recognition of income from the prepayments it received from OTC (Quest and Rorer combined received approximately $100 million in prepayments in CHIPS IVA, CHIPS IVB, and TRIPS I), and OTC, although receiving in exchange preferred stock only valued at a small fraction of the prepayments it exchanged (approximately $1 million for CHIPS IVA, CHIPS IVB, and TRIPS I), was not required to adjust its carry over basis in stock under 26 U.S.C. § 358 from the purported tax basis it claimed to have had in the prepayments prior to the exchange. B & B required the American corporations to pay it several million dollars in fees per transaction. In this way, the income represented by prepayments of rent was never taxed but was claimed to have been stripped away from the corresponding deductions the American corporations claimed after making the rental payments required of them under the master leases with withdrawals from the bank accounts received from OTC. In sum, for every approximately $1 million in preferred stock and several million dollars in fees to Koffey and B & B with which the American corporations parted, they received in exchange guaranteed tax savings of $40 million (approximately $100 million in deductions multiplied by corporate tax rates).

B & B next endeavored to transfer the capital losses claimed to be inherent in OTC’s preferred stock (for CHIPS IVA, CHIPS IVB, and TRIPS I purportedly having a fair market value of $1 million but a carry over tax basis one hundred times that amount) to a U.S. tax paying entity.

D. OTC and Long Term

The following outline of the structure of both the transaction in which OTC and Long Term engaged as well as the transactions in which Long Term, B & B, and Union Bank of Switzerland (“UBS”) participated provides the background for the Court’s holdings that the transaction in which OTC and Long Term engaged lacked economic substance and therefore must be disregarded for tax purposes, and, in the alternative, must be recast under the step transaction doctrine as a sale of preferred stock by OTC to Long Term.

1. OTC/Long Term Transaction

On- August 1, 1996, OTC acquired a limited partnership interest in LTCP. Pursuant to a subscription agreement dated August 1, 1996, OTC contributed cash in the amount of $2,833,451 and preferred stock with a market value of $2,506,549 to LTCP in exchange for a partnership interest with an initial capital account of $5,340,000. The preferred stock contributed to LTCP by OTC on August 1, 1996 consisted of the Rorer Preferred Stock, as well as other preferred stock that OTC acquired in other CHIPS transactions. 17

On August 1, 1996, LTCM (UK), a United Kingdom limited partnership, 18 made a secured, recourse loan to OTC in the amount of $5,010,451. This loan bore in *137 terest at the market rate of 7% per annum and had a maturity date of November 21, 1997. From the proceeds of this loan, OTC used $2,833,451 to fund its cash contribution to LTCP, $2,116,000 to repay existing indebtedness that encumbered the contributed stock, and $61,000 to purchase two put options from LTCM. The loan was secured by OTC’s limited partnership interest in LTCP and the two put options.

The two put options sold by LTCM to OTC on August 1, 1996 were a “liquidity put” and a “downside put.” The liquidity put provided OTC with the option to sell its partnership interest in LTCP to LTCM during the period October 27, 1997 through October 31, 1997, at a strike price equal to the net asset value of its partnership interest as determined under the LTCP partnership agreement. OTC paid LTCM $1,000 for the liquidity put.

The downside put provided, OTC with the option to sell its partnership interest in LTCP to LTCM during the period October 27, 1997 through October 31, 1997, at a strike price equal to $5,340,000 (the value of OTC’s initial capital account with LTCP). OTC paid LTCM $60,000 for the downside put.

On August 1, 1996, the preferred stock and cash contributed to LTCP by OTC was contributed by LTCP to Portfolio. As a result, LTCP received an increase in its capital account in Portfolio of $5,340,000.

On November 1, 1996, OTC acquired an additional limited partnership interest in LTCP. Pursuant to a subscription agreement dated November 1, 1996, OTC contributed cash in the amount of $3,356,467 and preferred stock with a market value of $1,643,533 to LTCP in exchange for a partnership interest with an initial capital account in LTCP of $5,000,000. The preferred stock contributed to LTCP by OTC on November 1, 1996 consisted of the Quest Preferred Stock as well as other preferred stock that OTC acquired in other CHIPS transactions. 19

On November 1, 1996, LTCM (UK) made another secured, recourse loan to OTC in the amount of $4,316,842 with market rate interest again of 7% per annum and with a maturity date of November 21, 1997. From the proceeds of this loan, OTC used $3,356,467 to fund its cash contribution to LTCP, $900,375 to repay existing indebtedness that encumbered the contributed stock, and $60,000 to purchase two put options from LTCM. This loan, too, was secured by OTC’s limited partnership interest in LTCP and the two put options.

As previously, the two put options sold by LTCM to OTC on November 1, 1996 included a liquidity put and a downside put. The liquidity put provided OTC with the- option to sell its partnership interest in LTCP to LTCM during the identical period as before, October 27, 1997 through October 31, 1997, at a strike price equal to the net asset value of the partnership interest as determined under the LTCP partnership agreement. OTC paid LTCM $1,000 for the liquidity put.

The downside put provided OTC with the option to sell its partnership interest in LTCP to LTCM during the period October 27, 1997 through October 31, 1997, at a strike price equal to $5,000,000. OTC paid LTCM $59,000 for the downside put.

*138 On November 1, 1996, the preferred stock and cash contributed to LTCP by OTC was contributed by LTCP to Portfolio resulting in an increase in LTCP’s capital account in Portfolio of $5,000,000.

On October 28, 1997, OTC exercised its August 1, 1996 and November 1, 1996 liquidity put options and OTC sold its limited partnership interests in LTCP to LTCM as of October 31, 1997, for $12,614,188, an amount representing the aggregate fair market value of OTC’s capital account in LTCP on October 31, 1997. Based upon the total investment in LTCP by OTC in 1996 and 1997, LTCM earned management and incentive fees of $1,061,848.

Based upon bid estimates provided by Salomon, on December 30, 1997, Portfolio sold the Rorer Preferred Stock to an affiliate of Merrill Lynch & Co., Inc. (“Merrill”) for $613,800, which represented the fair market value of that preferred stock on December 30, 1997. On December 30, 1997, Portfolio sold the Quest Preferred Stock to an affiliate of Merrill for $464,600, which represented the fair market value of that preferred stock on December 30, 1997.

2. Long Term/B & B/UBS Transaction

Effective September 1, 1996, Carillon LLC (“Carillon”), a partnership whose partners included members of B & B, purchased a call option from UBS for a premium of $2,001,650, which provided that on August 31, 2001, Carillon could acquire from UBS an interest in LTCP representing the growth in a $30,000,000 capital account on September 1, 1996, for a strike price of $44,000,000. The call option had an expiration date of August 31, 2001.

Effective September 1, 1996, UBS invested $30,000,000 in Long-Term Capital, Ltd., a Cayman Islands company (“LTCL”) and purchased a put option from LTCM for a premium of $2,349,000, which provided that on August 31, 2001, UBS could sell to LTCM an interest in LTCL representing a $30,000,000 capital account on September 1, 1996, for a strike price of $44,000,000. The put option had an expiration date of August 31, 2001.

As of January 1, 1997, Carillon purchased another call option from UBS for a premium of $1,700,000, which provided that on December 31, 2001, Carillon could acquire from UBS an interest in LTCP representing a $20,000,000 capital account on January 1, 1997 for a strike price of $28,520,000. The call option had an expiration date of December 31, 2001.

Also effective January 1, 1997, UBS invested $20,000,000 in LTCL and purchased a put option from LTCM for a premium of $1,700,000, which provided that on December 31, 2001, UBS could sell to LTCM an interest in LTCL representing a $20,000,000 capital account on January 1, 1997, for a strike price of $28,520,000. The put option had an expiration date of December 31, 2001.

Through the end of 1997, LTCM earned management and incentive fees from the UBS investments made as part of the first UBS/B & B transaction of $3,597,504 and $1,580,387 from the second UBS/B & B transaction. The total fees earned by LTCM in 1996 and 1997 from both of these investments was $5,177,891.

As the structure and how UBS viewed the transaction makes apparent, these transactions were essentially a loan to Long Term from UBS at the LIBOR 20 rate plus fifty basis points. Ronald Ten- *139 nenbaum, head of global fund coverage at UBS during 1996 and UBS’ representative working with Scholes on the transaction, described the sale of call options to Carillon’ and UBS’ corresponding purchase of put options from Long Term: “[E]ssentially it works into a lending type of transaction .... But it looks more like a lending type transaction, or a use of balance sheet type transaction, where you are basically buying something today and selling it in 5 years time, so you need to earn interest over that period. Then the question becomes ‘okay, what rate of interest is appropriate given the risk,’ and that was deemed to have been 50 basis points over LIBOR on the first transaction and then, you know, we made a little bit more on the second transaction.” Govt. Ex. 436 at 9:14-23; see also id. at 49:21 (“I thought we were being paid for essentially lending money....”). Accordingly, UBS primarily focused on the strike price and exercise date of the options in negotiations with Scholes and Long Term and did not negotiate with B & B at all over the cost of the call options but left that matter to Long Term and B & B. UBS’ lending risk was the possibility that Long Term would not be able to perform if and when UBS put its options to Long Term at their respective strike prices. 21

3. Long Term’s Tax Returns

Rosenfeld was the tax matters partner for Long Term and responsible for ensuring the timely filing of accurate tax returns. He accomplished his task by delegating responsibility to Noe and outside accountants, including Price Waterhouse, expecting them to look at and raise important issues for his consideration. Long Term claimed losses of $106,058,228 resulting from the sale of Quest and Rorer preferred stock on its U.S. Return of Partnership Income (Form 1065) for its 1997 tax year. This claim was premised on Long Term’s claim that, after acquiring OTC’s partnership interest in Partners, it succeeded to OTC’s purported basis (approximately $100 million) in the Rorer and Quest preferred stock and the sale of the stock on December 31, 1997 for approximately $1,000,000 thus produced these capital losses. Long Term reported the losses as “Net Unrealized Gains” on line 6 of Schedule M-l. See e.g., Pets.’ Exs. 319, 332. An internally prepared draft copy of Portfolio’s return used the description “Net Capital Gains/Losses,” see Govt.’s Ex. 321, which was changed after input from Coopers & Lybrand and Price Waterhouse to its final form, “Net Unrealized Gains.” Pursuant to 26 U.S.C. § 704(c), Portfolio allocated the losses to LTCP, and LTCP allocated them to LTCM. The losses were then allocated by LTCM to LTCM’s partners and indirect partners under 26 U.S.C. § 704(b).

4. B & B and OTC After CHIPS and TRIPS

B & B expected to market for significant fees the preferred stock OTC obtained from the CHIPS and TRIPS transactions, including CHIPS LVA, CHIPS IVB, and TRIPS I. By fee agreements dated July 5, 1995 (the date of commence *140 ment of the CHIPS IVA and CHIPS IVB transactions but prior to the August 2 and 4, 1995 exchanges with Rorer and Quest), OTC and B & B agreed that B & B would be OTC’s exclusive agent for the sale of any non-cash consideration received in connection with the CHIPS IVA, CHIPS IVB, and TRIPS I transactions, see Pets.’ Exs. 159, 160, and 161, namely, the Rorer and Quest Preferred Stock. The exclusive agency was to last at least six months, and B & B was to earn a fee from the disposition of the stock, which was to be negotiated among the parties. Even after a termination of its exclusive agency, B & B retained the right to purchase the stock before OTC transferred it to another. This was a poison pill provision designed to assure that, if OTC and/or another tax product promoter attempted to cut B & B out of a deal involving the purportedly high basis stock, B & B could buy the stock and thereby destroy the claimed high basis. The exclusive agency and poison pill provisions in these fee agreements were, for all relevant purposes, identical to the ones in the fee agreements B & B and OTC had for all CHIPS transactions. See Tr. [Doc. # 163] at 314:24-315:7; Govt/s Ex. 120. 22 Regarding CHIPS II, Koffey estimated that the preferred stock OTC obtained from that transaction, because of its purportedly high tax basis and attendant “$100 million of deductions,” Tr. [Doc. # 163] at 327:2-3, could be transferred for a fee ranging from seven to nine million dollars as long as the structure of the transaction did not hurt those deductions, i.e., diminish the disparity between fair market value and purported tax basis, see id. at 324:9-327:6; Tr. [Doc. #164] at 456:18-23; Govt’s Ex. 172. 23

Initial marketing attempts had begun by early 1995. Koffey developed a structure *141 in which OTC would exchange its high basis preferred stock for preferred stock of another corporation. Koffey inquired of Shearman & Sterling on the viability of the structure, and Shearman & Sterling responded that the proposed exchange would not satisfy the requirements of 26 U.S.C. § 351. Simultaneously, Koffey asked Shearman & Sterling to render a legal opinion that OTC’s tax basis in the CHIPS and TRIPS preferred stock exceeded $90 million. 24 Koffey’s idea was to market the stock to a potential acquirer with a basis opinion from Shearman & Sterling and allow the acquirer to construct a transaction for transferring the high basis stock into its hands without diminishing the basis. Shearman & Sterling informed Koffey that it could render the requested basis opinion. The opinion Shearman & Sterling agreed to render was essentially the same opinion it ultimately delivered to Long Term in connection with OTC’s contributions of preferred stock to LTCP.

Part of Shearman & Sterling’s work on