Court Upholds Tax Ruling Against DiTech Founder

Monday, June 16, 2014

Page 1

Court Upholds Tax Ruling Against DiTech Founder

Ninth Circuit Rejects ‘Byzantine’ Shelter Devised by Accounting Firm KPMG

By a MetNews Staff Writer

The Internal Revenue Service and Tax Court were correct in disallowing more than $50 million in losses claimed by the founder of the DiTech mortgage companies, the Ninth U.S. Circuit Court of Appeals ruled Friday.

Judge Andrew Hurwitz said the Tax Court properly applied the “economic substance” doctrine in holding that the “byzantine” shelter developed by the accounting firm KPMG was designed primarily to generate tax losses and not profits.

John Paul Reddam, who founded DiTech in 1995 and sold it in 1999, was a longtime KPMG client, and had hired a KPMG partner as president of DiTech. The former partner, Scott Carnahan, had introduced Reddam to partner Carl Hastings, who advised him to invest in what the firm dubbed its “offshore portfolio investment strategy,” or OPIS.

The strategy was marketed as utilizing “100% leverage offshore” to allow investors “to avoid U.S. regulatory rules that limit the amount of financing permissible in securities transactions.”

Shell Corporations

After selling DiTech—then based in Orange County—in 1999, Reddam incurred a $48.5 million capital gain, which he sought to offset on his taxes with losses generated by OPIS. The strategy involved the use of shell corporations in the Cayman Islands, which would generate what the Tax Court found to be artificial losses by buying stock in foreign banks with funds borrowed from the same banks, permitting the investors to claim losses on stock they purported to purchase in the banks.

—AP

DiTech founder John Paul Reddam, who lost a major tax ruling Friday, is shown attending the Belmont Stakes in 2012.

The names of Reddam and his fellow participants became public in 2002 as a result of an IRS lawsuit against KPMG and others. The investors included members of the Simon family, including onetime U.S. Secretary of the Treasurer William E. Simon Sr. and 2002 California gubernatorial candidate William E. Simon Jr.; race car driver Dale Earnhart Jr., who had been killed the year before his involvement in OPIS became known; and New York Jets owner Robert Wood Johnson IV.

In 2003, the IRS offered the investors a settlement in which they would give up 80 percent of their asserted tax losses and remain liable for penalties. The government later said that 92 percent of those it identified as buying the shelter had accepted the offer.

Reddam—who after selling DiTech turned his interests toward horseracing, including ownership of 2012 Kentucky Derby and Preakness winner I’ll Have Another—declined the offer and was assessed an $8 million deficiency.

‘Practical Economic Effects’

The Tax Court judge, following a bench trial, said the transaction was properly characterized by the IRS because it lacked “practical economic effects” other than generating tax losses. He concluded that the “overriding purpose” of OPIS was tax avoidance, citing Reddam’s admission that he didn’t actually understand how the transaction worked, his “lack of due diligence,” and his reliance solely on advice from KPMG and not from independent investment or tax advisers.

Reddam, the judge said, “knew he was purchasing a tax loss rather than entering into a legitimate investment” and was willfully indifferent to any potential for profit.

Hurwitz, writing for the Ninth Circuit, said the Tax Court judge was correct.

He discounted Reddam’s testimony that he hoped to “make money” on OPIS, as well as expert testimony about the potential for profits. An economist opined that OPIS had as much as a 1-in-4 chance of being profitable.

Hurwitz wrote:

“[T]he small percentage chance that Reddam’s OPIS transaction could have created a sizeable economic gain in return for his multi-million dollar investment pales in comparison to the expectation that it would always create a tax loss of $42,000,000 to $50,000,000. No matter how the underlying Deutsche Bank stock performed, the OPIS transaction was designed inevitably to produce a tax loss: the $42,000,000 shift of basis from [offshore entity] Cormorant to Reddam would always (even under Reddam’s expert’s calculations) have overshadowed any possible gain.”

He elaborated in a footnote:

“It defies belief that an objective investor would risk $6,000,000 on a transaction that was designed to lose money at least seventy-five percent of the time, could make a nominal profit twenty percent of the time, but might, only five percent of the time, have generated profits in that range for any reason other than to garner the eight-figure tax loss the transaction was designed to generate.”

The opinion was joined by Senior Judge Jerome Farris and U.S. District Judge Paul Friedman of the District of Columbia, sitting by designation.

The case is Reddam v. Commissioner of Internal Revenue, 12-72135.