## Facts

- Colgate had significant long-term capital gains and sought capital losses to offset them.
- Merrill Lynch proposed a structured investment partnership designed to generate capital losses while providing Colgate financing.
- ACM Partnership was formed in Curaçao; its partners were subsidiaries of Colgate, ABN (a foreign bank), and a Merrill Lynch affiliate.
- ACM engaged in transactions involving short-term notes/securities and a disposition for cash plus a multi-year contingent-payment right tied to LIBOR.
- The structure allocated substantial early gains primarily to ABN (not subject to U.S. tax on that income) and later losses primarily to Colgate.
- ABN’s interest was redeemed using cash proceeds, after which Colgate’s partnership interest increased to roughly 97%, positioning it to receive most later losses.
- Colgate effectively bore most transaction costs (about $3 million).
- The IRS issued an FPAA disallowing claimed losses on the ground that the transactions lacked economic substance.
- The Tax Court largely sustained the IRS, finding the transactions were primarily tax-motivated and lacked economic substance; ACM appealed and the Commissioner cross-appealed.

## Issues

1. Whether the partnership transactions should be disregarded for federal tax purposes because they lacked economic substance and a non-tax business purpose.
2. Whether ACM properly computed and characterized gains and losses, including basis and gain/loss treatment for contingent-payment rights.
3. Whether, if any parts of the transactions were respected, various technical partnership tax and timing/valuation determinations were correct.

## Decision

- The Third Circuit affirmed in part and reversed in part the Tax Court, dismissed the Commissioner’s cross-appeal, and remanded.
- The court agreed that the core loss-generating transactions were shaped primarily by tax considerations, lacked meaningful profit potential, and were properly disregarded to that extent.
- The court upheld disallowance/reallocation approaches that prevented artificial losses generated by basis allocations to contingent-payment components inconsistent with economic reality.
- The court did not disregard every element of the overall arrangement and remanded for further proceedings consistent with its partial reversals on secondary matters.

## Legal Principles

- Transactions complying with the literal terms of the Internal Revenue Code may be disregarded if they lack economic substance or a legitimate non-tax business purpose.
- Economic substance analysis considers whether the transaction had practical economic effects beyond tax benefits, including real risk and a reasonable possibility of pre-tax profit.
- In assessing substance, courts may consider the deal’s design features, including prearranged steps, circular cash flows, allocations engineered to exploit different tax profiles, and timing designed to accelerate gains and defer losses.
- Where a purported investment’s tax results depend on basis allocations or valuation assumptions detached from economic reality (including contingent-payment components), courts may disallow or adjust those results to prevent artificial loss creation.

## Conclusion

The Third Circuit treated ACM’s partnership structure as ineffective for producing the claimed capital losses because the key steps were principally tax-driven and lacked meaningful non-tax profit potential, while allowing that not every aspect of the broader arrangement had to be ignored and remanding for recalculation on remaining issues.


ACM P'ship v. Comm'r, 157 F.3d 231 (3d Cir. 1998)