Custom Adjustable Rate Debt Structure (CARDS)

What Are Custom Adjustable Rate Debt Structures (CARDS)?

Custom Adjustable Rate Debt Structures (CARDS) were a type of tax shelter used by high net-worth individuals (HNWIs) and corporations. As with all tax shelters, the purpose of CARDS was to reduce the investor’s overall tax liability. 

In the case of CARDS, this was achieved by lending a large sum of money into a foreign party, usually one related to the company brokering the transaction. After a series of derivative swap transactions, the party investing in the tax shelter receives a paper loss that is equivalent to the original value of the loan. This paper loss can then be used to offset real gains that the investor has earned elsewhere in their portfolio, reducing their taxes owing.

Today, CARDS are considered illegal by the Internal Revenue Service (IRS). As such, they cannot be used as part of a legitimate tax reduction strategy.

How CARDS Work

The fundamental idea behind CARDS is to generate a paper loss that can be used to offset legitimate gains earned elsewhere in the investor’s portfolio. To do so, the company providing the tax shelter first sets up a foreign shell company, to which the investor then lends a large sum of money. The loan is typically structured at a floating interest rate, providing the investor and the shell company to engage in a series of interest rate swaps that are designed to produce an unrealized loss for the investor. Importantly, although the losses appear real on paper, they are designed to never actually result in a monetary loss for the investor. In other words, they remain losses “on paper” only, despite the fact that those paper losses are used to offset the taxes otherwise owing on the investor’s broader portfolio. In this manner, the investor can reduce their overall tax liability simply by creating the appearance of losses through their swap transactions.

CARDS were widely used between 2000 and 2002, but their use sharply diminished following the IRS’s decision to deem them a form of illegal tax evasion. In making this case, the IRS argued that taxpayers should not be allowed to benefit from losses that were not actually realized. In several court cases, the court ruled in favor of the IRS, finding that CARDS lacked economic substance, the person entering a CARD agreement lacked a profit motive, and CARDS lacked a business purpose. According to the IRS, lowering taxes is not a legitimate business purpose unless the loss is a result of trying to make a profit or is the result of normal business.

Investors must be careful to ensure that they avoid using any tax shelters that may run afoul of current laws and regulations. Although certain tax reduction strategies, such as investing in an Individual Retirement Account (IRA), can produce legitimate and perfectly legal tax savings, other methods can be construed as illegal tax evasion. The penalties for tax evasion can be quite severe, potentially including significant fines and incarceration.

Real World Example of CARDS

CARDS and other questionable tax shelter products were so lucrative that some companies based their businesses on providing them. While CARDS were not issued after 2002, slightly different tax shelters pop up every year, usually with a nice acronym like CARDS, FLIP, DAD, COBRA, COINS – and the list goes on.

While the structure of each tax shelter varies, in order to be valid they all must pass the guidelines mentioned above or they face being struck down by the IRS. There must be a profit motive and an economic or business purpose for entering the transaction. Simply trying to create a tax deduction without the above motive or purposes could land the tax shelter in trouble. This is especially true if the taxpayer entering the transaction isn't actually realizing a material loss or isn't risking anything in the first place to realize the loss that will reduce their tax bill.