Effective Date: July 26, 2005

Coordinated Issue Paper, All Industries, "Notice 2003-81" Tax Shelter, UIL 9300.31-00

INTRODUCTION

On December 4, 2003, the Service issued Notice 2003-81, 2003-2 C.B. 1223,
announcing that it will challenge transactions involving the assignment of offsetting
foreign currency options to a charity in order to claim substantial artificial net losses and identifying these transactions as listed transactions for purposes of I.R.C. §§ 6011, 6111, and 6112. The transaction is designed to create an overall net loss (either ordinary or capital) when a taxpayer transfers two foreign currency contracts to a charity where only one such contract is subject to the mark-to-market rules contained in I.R.C. § 1256.

ISSUES

1. Whether the tax law permits premium income received on a taxpayer’s written “minor” foreign currency option contracts to go untaxed where the taxpayer retains the premium but transfers the obligation associated with the written option to a charity.
2. Whether a taxpayer participating in this shelter strategy obtained a timing benefit by being able to recognize a loss on a purchased foreign currency option in advance of gain recognition on the premium received for writing a foreign currency option.
3. Whether a taxpayer's purported loss is a bona fide loss allowable under I.R.C. § 165.
4. Whether the at-risk provisions of I.R.C. § 465 limit the taxpayer's claimed loss.
5. Whether the transaction as a whole lacks economic substance and business purpose apart from tax savings.
6. Whether the provisions of I.R.C. § 988 limit a taxpayer’s claimed foreign currency losses.
7. Whether the Service should assert the appropriate I.R.C. § 6662 accuracy-related penalty against a taxpayer who entered into the transaction.
8. Whether the Service should examine the role of the charity in this transaction.

SUMMARY OF CONCLUSIONS

1. A taxpayer remains obligated to take into income the premium received for writing a “minor” foreign currency option contract even if it transfers the obligation associated with that written option to a charity.
2. A taxpayer did not obtain a timing benefit because I.R.C. § 1092 does not permit a taxpayer to recognize loss in advance of gain on offsetting foreign currency contracts.
3. The taxpayer's loss is not a bona fide loss allowable under I.R.C. § 165.
4. The taxpayer's loss is limited by the I.R.C. § 465 at-risk provisions.
5. The taxpayer's loss is disallowed because the transaction as a whole lacks economic substance and business purpose apart from tax savings.
6. The taxpayer is not entitled to an ordinary loss under I.R.C. § 988.
7. The 20-percent accuracy-related penalty under I.R.C. § 6662 should be asserted against a taxpayer entering into this transaction unless the taxpayer is able to establish reasonable cause and good faith under I.R.C. § 6664(c)(1) and the applicable regulations.
8. The agent examining the taxable entity should forward all information gathered about the involvement of the charity to the Exempt Organizations Division of TEGE through the process established by the Notice 2003-81 Issue Management Team.

FACTS

A. Background

Taxpayers deployed Notice 2003-81 transactions in order to offset substantial taxable
income (either capital or ordinary) . Taxpayers initiated the transactions by entering into an investment management agreement and opening a trading account managed by the promoter, who is also a registered investment advisor. Generally, the initial capital
investment is determined by the anticipated loss needed. The required investment
amount is equal to either (1) 15% of the desired ordinary loss or (2) 10% of the desired capital loss. The taxpayer agrees to leave the funds in the account for a five-year period, although funds can be withdrawn at any time subject to significant monetary penalties. A small portion, approximately 1.75%, of the initial capital investment is used to establish a foreign currency trading account that is used to purchase foreign currency option contracts. The remaining balance is invested in a hedge fund of funds that in turn invests in a variety of investment vehicles including other hedge funds, stock funds, commodity funds and currency funds.

B. Foreign Currency "Investment" Strategy

The foreign currency "investment" strategy involves the purchase and sale of a series of
foreign currency option contracts denominated in both a foreign currency in which
positions are traded through regulated futures contracts and a foreign currency that is
not traded through regulated futures contracts. The values of the two currencies
underlying the options (i) historically have demonstrated a very high positive correlation with one another, or (ii) officially have been linked to one another, such as through the European Exchange Rate Mechanism ("ERM II").¹ In one version, the taxpayer buys two 180-day European-style digital currency options, pegged to fluctuations in the exchange rate between the U.S. dollar and the euro. These positions are in a foreign currency traded through regulated futures contracts, and thus the taxpayer takes the position that such positions are I.R.C. § 1256(g)(2)(A) foreign currency contracts. In the promotional materials, these contracts are referred to as the “major options.” At the same time, the taxpayer sells two 180-day European-style digital currency options, pegged to fluctuations in the exchange rate between the U.S. dollar and a stated European currency. The European currency is one in which positions are not traded on a qualified board or exchange and are not I.R.C. § 1256(g)(2)(A) foreign currency contracts. In the promotional materials, these contracts are referred to as the “minor options.” The counterparty is the same for all four currency contracts. Therefore, the initial cash outlay to enter into the foreign currency positions is limited to the net premium among the offsetting contracts.

In a more complex variation of the transaction, the taxpayer enters into a series of 180-day European-style digital options on the same day. Usually, the taxpayer buys two put options and sells two call options pegged to fluctuations in the exchange rate between the U.S. dollar and the euro. This group of options comprises the “major options.” The taxpayer also buys two call options and sells two put options, pegged to fluctuations in the exchange rate between the U.S. dollar and a stated European currency. This group of options comprises the “minor options .” Again, the counterparty is the same for all eight currency contracts and the initial cash outlay is relatively small in reference to the stated notional amounts of the contracts. In some deals, the taxpayer will enter into a second series of 180-day European-style options on the following day.

The values of the respective currencies underlying the foreign currency transactions
historically have demonstrated a very high positive correlation with one another.
Therefore, the major options will move inversely to the minor options such that any gain in a major foreign currency position will be largely offset by a corresponding, though not always identical, loss in a minor foreign currency position. The bank, which serves as counterparty for these deals, generally makes representations to the taxpayer and trader concerning the statistical probabilities of the potential rate of return from the option positions indicating a profit is possible but unlikely. In fact, according to the
analysis provided by the bank, there is usually a better than 50% chance that the
taxpayer will lose its entire investment.

C. Assignment of Major and Minor Contract to Charity

Prior to the exercise date, that taxpayer assigns two of its open foreign currency
contracts to a charity. The first contract is a major currency option contract that is in a
loss position at the time of assignment. The taxpayer also assigns the obligation that is
associated with a minor currency option contract that is in a gain position at the time of
assignment of the obligation. The taxpayer takes the position that (1) the assignment of
the major contract (i.e., I.R.C. § 1256 contract) is treated as a termination of the contract requiring recognition of the inherent gain or loss in such contract; and (2) the
assignment of the minor contract obligation does not trigger the recognition of income
because that contract is not covered by the mark-to-market provisions contained in
I.R.C. § 1256.

D. Reporting of Transaction for Federal Income Tax Purposes

In some cases, the taxpayer will report the listed transaction on Form 4797, Part II,
Ordinary Gains and Losses as an I.R.C § 988 foreign currency transaction. The loss
claimed is a direct result from the disparate reporting of the donated major and minor
contracts. The major contract in a loss position and the remaining option contracts that are not assigned to the charity are accounted for on Form 4797. The remaining option contract positions when closed effectively offset one another. The reporting exclusion of the gain from the donated minor contract, which closely mirrors the loss reported from the donated major contract, creates the artificial loss claimed by the taxpayer. In other cases, the taxpayer will report the listed transaction on Schedule D, Capital Gains & Losses. In these instances, the taxpayer makes an election pursuant to I. R.C. § 988(a)(1)(B) and Treas. Reg. § 1.988-3(b)(4) to treat its foreign currency contracts as capital assets in order to claim a capital loss. The taxpayer is required to attach a verification statement to its filed return for a valid capital treatment election.

DISCUSSION

1.  A taxpayer remains obligated to take into income the premium that it received when it writes a “minor” foreign currency option contract and later transfers the obligation associated with that written option to a charity.

Gain and loss on options is accounted for on an open transaction basis. As explained
in Notice 2003-81, the justification for open transaction treatment is that the gain or loss on an option cannot be finally accounted for until such time as the option is terminated.  Thus, premium income is not recognized until an option is sold or terminated. Rev. Rul. 58-234, 1958-1 C.B. 279, Accord Rev. Rul. 78-182, 1978-1 C.B. 265; Koch v.Commissioner, 67 T.C. 71 (1976), acq. 1980-2 C.B. 1. Rev. Rul. 58-234 explains that this is the treatment for the option writer because the option writer assumes a burdensome and continuing obligation, and the transaction therefore stays open without any ascertainable income or gain until the writer's obligation is finally terminated. When the option writer's obligation terminates, the transaction closes, and the option writer must recognize any income or gain attributable to the prior receipt of the option premium.

Though each taxpayer’s transaction should be evaluated independently, the assignment
documents reviewed to date have been three-party arrangements (involving the option
writer, holder and charity) that seem to give rise to a novation of the option contracts.
Where there is a novation, the option writer's obligation under the minor option contract terminates on the charity's assumption of the written option obligation. However, in other cases where a novation does not occur, the writer of the minor foreign currency option writer may well have a continuing obligation because the writer may be called upon to perform if the charity fails to perform or to reimburse the charity for any losses or expenses it may incur if called upon to perform.

If an assumption of the liability by the charity causes the option writer's obligation under the option contract to terminate, then the option writer must recognize gain upon
assignment, when the option obligation is assumed. Notice 2003-81. If the assumption
does not terminate the option writer's obligation under the option contract, the option
writer must recognize the premium when the option writer's obligation under the option
contract terminates (other than through an exercise of the option against, and
performance by, the option writer). Notice 2003-81. It is generally understood that
charities that received these options may have terminated them either
contemporaneous with or shortly after the assignments.

Even if a novation did not occur to cause premium income to be recognized, there is still no support for the apparent contention that responsibility for recognizing premium
income shifts to the charity as a result of the assignment of the obligation on the written
option. At least some of the tax promotional materials associated with this shelter
transaction suggest that the gain or premium income received by the taxpayer on the
written option must be recognized by the charity (but goes untaxed because of its taxexempt status). However, there is no support for this “too good to be true” result.
Rather, the taxpayers and their advisors seem to simply assume that a taxpayer can
receive premium income, pass off the obligation associated with having received that
premium and not be taxed on the premium. No discussion was found in the materials ,
including an undated draft shelter memorandum (“Shelter Memorandum”), that explains why the premium received by the taxpayer is not a taxable accession to wealth of the taxpayer. Nor is there any explanation as to how a charity could be taxed on this premium that the charity does not receive.

There is some hint in the promotional materials that the promoters may have been
seeking to pass off the transfer of the obligation on the written minor option as a
“donation.” Generally, taxpayers do not recognize gain upon transfer of appreciated
property to a qualified charity. See Rev. Rul. 55-138, 1955-1 C.B. 223, modified on
other grounds by Rev. Rul. 68-69, 1968-1 C.B. 80. In these challenged transactions,
however, property rights were not transferred – only the obligation associated with the
out-of-the money (losing) purchased option was transferred. The assumption of an
obligation is not a donation of property to which I.R.C. § 170 applies. Rather it is a
disposition event governed by I.R.C. § 1001. Crane v. Commissioner, 331 U.S. 1
(1947). If the assumption of the obligation by the charity also involves the donation of
associated property, I.R.C. § 1001(b) applies and the transaction is treated as a bargain sale.² Treas. Reg. § 1.1011-2(a)(3); Ebben v. Commissioner, 783 F.2d 906 (9th Cir. 1986). Thus, to the extent there was a transfer of property along with an associated obligation, the taxpayers were, in general, properly advised in this scheme that their charitable deduction for the donated purchased option rights would be reduced by the amount of liability relief provided by the charity that assumed the obligation on the written minor option.

In short, contrary to the advice apparently received by the taxpayers, there is no factual or legal basis for the contention that taxpayers in these shelters shifted the responsibility for recognizing the premium income or gain on the written minor option position to a charity. Rather, the taxpayers only transferred an obligation and must be taxed on the premium that they retain.³

2.  A taxpayer did not obtain a timing benefit because section 1092 does not permit a taxpayer to recognize loss in advance of gain on the offsetting foreign currency contracts.

For several reasons, this foreign currency shelter transaction did not provide a timing
benefit to participating taxpayers.

As explained in issue 1, the open transaction doctrine deferred a taxpayer’s recognition of premium income only until it became possible to finally account for the option transaction. As also indicated, a taxpayer will be required to pick up premium income on the minor option at the same time as loss is allowed on the major option under I.R.C. § 1256(c) if there was a novation of the minor option. However, even if a novation did not occur, a taxpayer was still required to recognize income when that taxpayer’s secondary obligation under the written minor option contract terminated. That may have occurred in the same tax year as the assignment because the options were short term and are understood to have been closed out by the charities either contemporaneous with or shortly after assignment.

However, even if a charity kept open the written option obligation beyond the year of
assignment, a taxpayer still would not have obtained an overall timing advantage. As
indicated in Notice 2003-81, the purchased major foreign currency option and the
written minor foreign currency option are substantially offsetting positions.
Consequently, such positions were parts of a straddle subject to I.R.C. § 1092. Thus,
under I.R.C. § 1092, any mark-to-market loss on the contributed major foreign currency option would have been appropriately deferred to the extent of the taxpayer’s unrecognized gain on the written minor foreign currency option.

3.  The taxpayer's loss is not a bona fide loss allowable under I.R.C. § 165.

I.R.C. § 165(a) provides that there shall be allowed as a deduction any loss sustained
during the taxable year and not compensated for by insurance or otherwise. Treas.
Reg. § 1.165-1(b) provides that to be allowable as a deduction under I.R.C. § 165(a), a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and, except as otherwise provided in I.R.C. § 165(h) and Treas. Reg. § 1.165-11 (relating to disaster losses), actually sustained during the taxable year. Under I.R.C. § 165(b), the amount of the loss from the sale or other disposition of property is the adjusted basis provided in I.R.C. § 1011. Treas. Reg. § 1.165-1(b) further states that only a bona fide loss is allowable and that substance and not mere form shall govern in determining a deductible loss. See also ACM Partnership v. Commissioner, 157 F.3d 231, 252 (3d Cir. 1998), cert. denied, 526 U.S. 1017 (1999) [“Tax losses . . . which do not correspond to any actual economic losses, do not constitute the type of ‘bona fide’ losses that are deductible under the Internal Revenue Code and regulations”]. Section 165(c) provides that, in the case of an individual, the deduction under § 165(a) is limited to losses incurred in a trade or business, losses incurred in a transaction entered into for profit, and certain casualty or theft losses.

In this case, the taxpayer has suffered no real economic loss because the acquisition
and disposition of the offsetting option contracts constitute an economically
inconsequential investment, with the taxpayer effectively in the same economic position
as prior to the purported investment strategy less fees paid to the promoter. See ACM Partnership v. Commissioner, 157 F.3d at 251-252. Accordingly, the loss is not allowable under I.R.C. § 165.

I.R.C. § 165(c) also disallows the loss for an individual taxpayer. The “loss” in this
transaction is not incurred in a trade or business or from a casualty or theft, within the
meaning of I.R.C. § 165(c)(1) and (3). Therefore, a loss in this transaction is only
allowable for an individual if it is incurred in a transaction undertaken for profit. I.R.C.
§ 165(c)(2); Fox v. Commissioner, 82 T.C. 1001 (1984); Smith v. Commissioner, 78 T.C. 350 (1982). For the loss to be allowable, a profit motive must be the taxpayer’s primary motive for engaging in the transaction. Fox v. Commissioner, 82 T.C. at 1020-21 [citing Helvering v. National Grocery Co., 304 U.S. 282, 289 n.5 (1938)].

The taxpayer’s potential profit from this transaction, apart from tax savings, is
statistically improbable. Moreover, any profit generated would likely be derived from the capital that was invested in the hedge fund of funds rather than the small amount of
capital used to acquire the major and minor contracts. In fact, the tax materials
distinguish the two investment components by opining that the “possible profits” from
the tax-driven currency option trading and the “expected profits” from investing in the
hedge funds create sufficient “economic substance”. Therefore, it is unlikely that a
taxpayer can demonstrate a reasonable expectation to earn more than minimal profit
solely from the foreign currency investment strategy described above, apart from tax
savings. See Knetsch v. United States, 348 F.2d 932, 938 (Ct. Cl. 1965) [The statutory definition of profit under I.R.C. § 165(c)(2) “cannot embrace profit seeking activity in which the only economic gain derived therefrom results from a tax reduction.”].
Therefore, the loss is disallowed under I.R.C. § 165(c)(2).

4.  The taxpayer's loss is limited by the I.R.C. § 465 at-risk provisions.

I.R.C. § 465 generally limits deductions for losses in certain activities to the amount for
which the taxpayer is at-risk. In the case of an individual taxpayer, I.R.C. § 465 limits
the taxpayer’s losses to the amount for which the taxpayer is at risk in the activity.
I.R.C. § 465(a)(1). I.R.C. § 465 applies to all activities engaged in by the taxpayer in
carrying on a trade or business or for the production of income. I.R.C. § 465(c)(3)(A).  Under those sections, losses incurred in an activity engaged in by a taxpayer carrying on a trade or business or for the production of income is defined broadly to include “excess of the allowable deductions allocable to the activity over the income received or accrued by the taxpayer during the taxable year from the activity.” Lansburgh v. Commissioner, 92 T.C. 448, 454-55 (1989). This interpretation is supported by the legislative history of I.R.C. § 465 that provides the at risk limitation applies to losses “regardless of the kind of deductible expenses which contributed to the loss.” S. Rept. 94-938, at 48 (1976), 1976-3 C.B. (Vol.3) 86. In this case, I.R.C. § 465 applies to the loss stemming from taxpayer's purchase of the foreign currency option contracts.

The amount at-risk includes the amount of money and the adjusted basis of any
property contributed by the taxpayer to the activity, and any amounts borrowed with
respect to the activity to the extent that the taxpayer is personally liable to repay the
amount, and to the extent of the fair market value of the taxpayer’s interest in property, not used in the activity, pledged as security for the borrowed amount. I.R.C. § 465(b)(1) and (2). Amounts protected against loss by nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements, however, are not at-risk. I.R.C. § 465(b)(4). The Senate report promulgated in connection with I.R.C. § 465 states in pertinent part that "a taxpayer's capital is not ‘at risk’ in the business, even as to the equity capital which he has contributed to the extent he is protected against economic loss of all or part of such capital by reason of an agreement or arrangement for compensation or reimbursement to him of any loss which he may suffer." S. Rept. No. 94-938, Pt. I at 49, 94th Cong., 2d Sess. (1976).

The at-risk rules in I.R.C. § 465 are most commonly applied to cases involving
nonrecourse liabilities; however, neither the statutory language nor the legislative
history interprets the at-risk rules that narrowly. The legislative history notes that the
overall purpose of the at-risk rules is to "prevent a situation where the taxpayer may
deduct a loss in excess of his econo mic investment in certain types of activities." S.
Rept. No. 938, Pt. I at 48, 94th Cong., 2d Sess. (1976). The legislative history also
provides that in evaluating the amount at-risk, it should be assumed that a loss-protection guarantee, repurchase agreement or other loss limiting mechanism will
be fully paid to the taxpayer. S. Rep. No. 938, 94th Cong., 2d Sess. 50 n.6 (1976), C.B. 1976-3 at 88. Although the foregoing assumption regarding loss-limiting arrangements does not explicitly claim to interpret I.R.C. § 465(b)(4), more than one circuit has found such an interpretation to be reasonable. See e.g., Moser v. Commissioner, 914 F.2d 1040, 1048 (8th Cir. 1990); American Principals Leasing Corp. v. Commissioner, 904 F.2d 477, 482 (9th Cir. 1990) [assuming in both cases that the reference to loss-limiting arrangements in I.R.C. § 465 legislative history refers to I.R.C.§ 465(b)(4)]. I.R.C. § 465(b)(4) limits losses to amounts at risk where a transaction is structured, by whatever method, to remove any realistic possibility that the taxpayer will suffer an economic loss.  A theoretical possibility of economic loss is insufficient to avoid the suspension of losses. See Levien v.Commissioner, 103 T.C. 120, 125 (1994).

The case law, however, is not in complete accord on this issue. In Emershaw v.
Commissioner, 949 F.2d 841, 845 (6th Cir. 1991), the court adopted a worst-case
scenario approach and determined that the issue of whether a taxpayer is “at risk" for
purposes of I.R.C. § 465(b)(4) “must be resolved on the basis of who realistically will be the payor of last resort if the transaction goes sour and the secured property associated with the transaction is not adequate to pay off the debt.” quoting Levy v. Commissioner, 91 T.C. 838, 869 (1988). In contrast, the Second, Eighth, Ninth, and Eleventh Circuits look to the underlying economic substance of the arrangements under I.R.C. § 465(b)(4). Waters v. Commissioner, 978 F.2d 1310, 1316 (2d Cir. 1992) (citing American Principals Leasing Corp v. United States, 904 F.2d 477, 483 (9th Cir. 1990); Young v. Commissioner, 926 F.2d 1083, 1089 (11th Cir. 1991); Moser v. Commissioner, 914 F.2d at 1048-49. The view, as adopted by these circuits, is that, in determining who has the ultimate liability for an obligation, the economic substance and the commercial realities of the transaction control. See Waters v. Commissioner, 978 F.2d at 1316; Levien v. Commissioner, 103 T.C. 120; Thornock v. Commissioner, 94 T.C. 439, 448 (1990); Bussing v. Commissioner, 89 T.C. 1050, 1057 (1987). To determine whether a taxpayer is protected from ultimate liability, a transaction should be examined to see if it
“is structured - by whatever method - to remove any realistic possibility that the taxpayer will suffer an economic loss if the transaction turns out to be unprofitable.” American Principals Leasing Corp. v. United States, 904 F.2d at 483; See Young v. Commissioner, 926 F.2d at 1088; Thornock v. Commissioner, 94 T.C. at 448-49; Owens v. United States, 818 F.Supp. 1089, 1097 (E.D. Tenn. 1993); Bussing v. Commissioner, 89 T.C. at 1057-58. “[A] binding contract is not necessary for [I.R.C. § 465(b)(4)] to apply.” American Principals Leasing Corp. v United States, 904 F.2d at 482-83. In addition, “the substance and commercial realities of the financing arrangements presented . . . by each transaction” should be taken into account under I.R.C. § 465(b)(4). Thornock v. Commissioner, 94 T.C. at 449. To avoid the application of I.R.C. § 465(b)(4), there must be more than “a theoretical possibility that the taxpayer will suffer economic loss.” American Principals Leasing Corp. v United States, 904 F.2d at 483.

In the typical “Notice 2003-81” deal, the counterparty to all the foreign currency
contracts is the same. Due to the fact that the currency movements between the euro
and European currency used in the minor contracts closely parallel each other, the
taxpayer’s cash investment is relatively small. The transaction is carefully structured so
that any gain in one option position is largely offset by a loss in another contract.
Therefore, the taxpayer’s true at-risk amount equals the net out of pocket premium paid to acquire the aggregate offsetting foreign currency positions.

5.  The taxpayer's loss is disallowed because the transaction as a whole lacks economic substance and business purpose apart from tax savings.

In addition to the statutory provisions discussed herein, the taxpayer’s purported loss
may be disallowed under the economic substance doctrine. This approach would deny
the tax benefits arising because the transaction does not result in a meaningful change
to the taxpayer’s economic position other than the manufactured loss that results in the
purported reduction in tax. See Knestch v. United States, 364 U.S. 361 (1960). The Tax Court has stated that tax law “requires that the intended transactions have economic substance separate and distinct from economic benefit achieved solely by tax reduction.” ACM Partnership v. Commissioner, T.C. Memo. 1997-115, aff'd in part and rev'd in part, 157 F.3d 231 (3rd Cir. 1998). Accordingly, this doctrine is applicable to the typical Notice 2003-81 transaction where the purported tax benefits are unintended by Congress and accomplished by a prearranged deal that serves no economic purpose apart from tax savings.

In determining whether a transaction is to be respected for tax purposes, both the
objective economic substance of the transaction and the subjective business motivation
are considered. ACM Partnership v. Commissioner, 157 F.3d 231, 247 (3d Cir. 1998); Horn v. Commissioner, 968 F.2d 1229, 1237 (D.C. Cir. 1992); Casebeer v. Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990). Some courts apply a conjunctive analysis that requires a taxpayer to establish the presence of both economic substance (i.e., objective test) and business purpose (i.e., subjective test to determine whether the taxpayer intended the transaction to serve some useful non-tax purpose). See Pasternak v. Commissioner, 990 F.2d 893, 898 (6th Cir. 1993). Other courts apply a less stringent test that either a subjective business purpose or actual economic substance is sufficient. Rice’s Toyota World v. Commissioner, 752 F.2d 89, 91-92 (4th Cir. 1985). An alternative analysis views economic substance and business purpose as “simply more precise factors to consider” in determining whether a transaction has any practical economic effects other than the tax benefits created. ACM Partnership v. Commissioner, 157 F.3d at 247. See also Casebeer v. Commissioner, 909 F.2d at 1363; Sacks v. Commissioner, 69 F.3d 982, 985 (9th Cir. 1995); James v. Commissioner, 899 F.2d 905, 908 (10th Cir. 1995). In addition, several courts have applied the economic substance doctrine where a taxpayer was exposed to limited risk and the transaction had a theoretical potential for profit but the profit potential was nominal and insignificant when compared to the tax benefit derived. Gregory v. Helvering, 293 U.S. 465 (1935) [Transaction that is entered into for the primary purposes of creating a loss is subject to special scrutiny to determine whether such loss was bona fide]; Knetsch v. United States, 364 U.S. 361 (1960) [Leveraged acquisition of Treasury bills and accompanying prepaid interest deduction lacked economic substance]; Goldstein v. Commissioner, 364 F.2d 734 739-40 (2d Cir. 1966)[Deduction disallowed even though taxpayer has a possibility of small gain or loss from ownership of Treasury bills]; Sheldon v. Commissioner, 94 T.C. 738, 768 (1990)[Loss disallowed
from prearranged substantially offsetting transaction where profit potential “infinitesimally nominal and vastly insignificant” in comparison to loss claimed]; Rice’s
Toyota World v. Commissioner, 752 F.2d at 94; [Economic substance inquiry requires an objective determination of whether reasonable possibility of profit existed apart from tax benefits]. See also Compaq Computer Corp v. Commissioner, 277 F.3d at 781; IES Industries v. United States, 253 F.3d at 354 [Applying same objective economic substance test discussed in Rice’s Toyota World].

The doctrine of economic substance should be raised in cases where the facts show
that the transaction at issue was primarily designed to generate the tax losses, with little
if any possibility for profit, and that such was the expectation of all the parties to the
transaction. The wide variety of facts required to support its application should be
developed at examination. The administrative record should include documents
obtained from the taxpayer, the promoter and other third parties; interviews with the
same; and expert analysis of financial data and industry practices. Summonses should
be promptly issued whenever necessary to obtain the requisite transactional
documents.

In addition to evidence that shows a lack of pre-tax profit potential, facts should be
developed demonstrating that the taxpayer and the promoter primarily planned the
transaction for tax purposes. Such evidence should include the following: (1)
documents or other evidence that the foreign currency option contracts were sold as tax shelters with limited consideration of the underlying economics of the transaction; and (2) evidence that a prudent investor would not have invested in the strategy but for the tax savings. A primary source of such evidence is correspondence between the
promoter and the taxpayer, including, but not limited to, offering memos, letters
identifying tax goals, e -mails and in-house communications at the offices of the
promoter and any other third party involved in the strategy. Written corres