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Supreme Court won’t hear case finding foreign banks did not have capital interest in partnership

TIFD III-E Inc. v. U.S., (CA 2 1/24/2012), 109 AFTR 2d 2012-632109 AFTR 2d 2012-632, cert denied 1/11/2016

The Supreme Court has declined to review the decision of the Court of Appeals for the Second Circuit, which, reversing the district court on remand for the second time, held that an interest overwhelmingly in the nature of debt couldn’t qualify as a partnership interest under Code Sec. 704(e)(1). The Second Circuit held that a bank’s risks were minimal and more in the nature of the appearance of risk, and not real risk.

Background. Under Code Sec. 704(e), any person who owns a capital interest in a partnership in which capital is a material income-producing factor must be recognized as a partner whether the interest was derived by purchase or by gift. Under Reg. § 1.704-1(e)(1)(iii) , a donee or purchaser of a capital interest in a partnership is not recognized as a partner under the principles of Code Sec. 704(e)(1) unless the interest is acquired in a bona fide transaction, not a mere sham for tax avoidance or evasion purposes, and the donee or purchaser is the real owner of such interest. To be recognized, a transfer must vest dominion and control of the partnership interest in the transferee.

For partnership tax years beginning after Dec. 31, 2015, Code Sec. 704(e) and Code Sec. 761(b) (which defines who is a partner) were amended by Sec. 1102 of the Bipartisan Budget Act of 2015 (P.L. 114-74, 11/2/2015) to clarify that the so called “family partnership rules” of Code Sec. 704(e) were not intended to provide an alternative test for whether a person is a partner in a partnership. The determination of whether the owner of a capital interest is a partner is to be made under the generally applicable rules defining a partnership and a partner. (Section-by-Section Summary of the Budget Act)

RIA observation: Although the Budget Act doesn’t explicitly refer to the TIFD III-E Inc. case (also known as the Castle Harbour decision, see below), it is generally thought that the law change was to some extent prompted by it and similar cases. And so, while less than a simple codification of the Second Circuit’s Castle Harbour holding, Code Sec. 704(e) and Code Sec. 761(b), as amended, would seem to require that the rules generally applicable in defining a partnership and a partner—such as the existence of a bona fide partnership—cannot be ignored.

Facts. TIFD III-E Inc. (TIFD III-E), a wholly owned subsidiary of the General Electric Capital Corporation (GECC), a subsidiary of the General Electric Company (GE), sued the government to recover approximately $62 million that it deposited with IRS in satisfaction of a tax liability that IRS said it owed from incorrectly reporting the amount of income TIFD III-E earned as a partner in Castle Harbour-I Limited-Liability Company (Castle Harbour). GECC was in the business of commercial aircraft leasing. To reduce its risks, GECC formed Castle Harbour and sold interests in it to Dutch banks.

Castle Harbour was a self-liquidating partnership. Through two entities, GECC contributed to Castle Harbour a net $246 million in cash and about $294 million worth of leased aircraft. The Dutch banks contributed approximately $117.5 million in cash. Each partner received an allocation of the net income of the partnership. Over eight years, the Dutch banks’ ownership interest was to be almost entirely bought out with the income of the partnership.

Under the arrangement, 98% of Castle Harbour’s operating income was allocated to the Dutch banks. Operating income was reduced by expenses, including asset depreciation, which in most years equaled close to 70% of gross rental income. For tax purposes, the same allocation was made; operating income was allocated 98% to the Dutch banks. Again, operating income was reduced by expenses, including depreciation, but all the aircraft in Castle Harbour had already been fully depreciated for tax purposes. So although depreciation was nominally an expense for tax purposes, it did not actually reduce taxable income. Accordingly, the taxable income allocated to the Dutch banks was greater than their book allocation by the amount of book depreciation for that year. The Dutch banks, however, did not pay U.S. income taxes. Thus, by allocating 98% of the income from fully tax-depreciated aircraft to the Dutch banks, GECC avoided an enormous tax burden, while shifting very little book income.

The bottom line was that the Dutch banks were allocated much more taxable income than book income. Specifically, the Dutch banks were allocated approximately $310 million in taxable income. Had this income been allocated to GECC, then GECC would have been required to pay approximately $62 million in taxes on that income.

First district court decision. In its initial decision, the district court found that the Castle Harbour transaction was an economically real transaction, undertaken, at least in part, for a non-tax business purpose (a desire on the part of GECC to raise capital and a desire to demonstrate its ability to do so). The transaction resulted in the creation of a true partnership with all participants holding valid partnership interests; and the income was properly allocated among the partners under Code Sec. 704(b) and Reg. § 1.704-1 . Thus, it ordered IRS to refund the $62 million. (TIFD III-E INC. v. U.S., (DC CT 11/1/2004) 94 AFTR 2d 2004-663594 AFTR 2d 2004-6635, see Weekly Alert ¶  10  11/11/2004)

Second Circuit reversed district court. In 2006, the Second Circuit said that the district court should not have rejected IRS’s contention that the Dutch banks’ interest was not a bona fide equity partnership participation without examining the question under the all-facts-and-circumstances test of Com. v. Culbertson, W. Sr., (1949, S Ct) 37 AFTR 139137 AFTR 1391, 337 US 733. After considering the totality of the circumstances, the Second Circuit on its own concluded that, for tax purposes, the banks were not bona fide equity partners in Castle Harbour. Accordingly, it did not remand the case for new findings on this issue. It did remand to the district court, however, to consider the taxpayer’s argument that the partnership qualified under Code Sec. 704(e). (TIFD III-E, Inc v. U.S., (CA 2 2006) 98 AFTR 2d 2006-561698 AFTR 2d 2006-5616, see Weekly Alert ¶  8  08/01/2006)

Second district court decision. On remand, the district court determined that the Dutch banks were owners of a capital interest in a partnership (Castle Harbour) in which capital was a material income-producing factor under Code Sec. 704(e) and thus that allocations to them were proper. The district court determined that the Dutch banks’ interest was a capital interest because the banks incurred “real risk” that their capital accounts would be negative upon dissolution, requiring them to restore the deficit. It attributed this “real risk” to the possibility of partnership losses sufficiently large to trigger the allocation of 1% of those losses to the banks, or even so large as to trigger the allocation of 100% of those losses to the banks. (TIFD III-E Inc. v. U.S., (DC CT 2009) 104 AFTR 2d 2009-6746104 AFTR 2d 2009-6746, see Weekly Alert ¶  12  10/15/2009)

Reg. § 1.704-1(e)(1)(v) defines a “capital interest” as an interest in the assets of the partnership, which is distributable to the owner of the capital interest upon his withdrawal from the partnership or upon liquidation of the partnership. Because the payout to the Dutch banks upon liquidation of the partnership was linked, in some degree, to the value of the banks’ capital accounts, and because the value of those accounts was in turn linked, in some degree, to the value of Castle Harbour’s assets, the district court reasoned that the payout to the banks upon liquidation was “tied to the availability of partnership capital.” The court concluded that the Dutch banks’ interest was therefore an “interest in the assets of the partnership” distributable to them upon liquidation.

Second Circuit reverses again. The Second Circuit again reversed the district court. It said that the district court’s analysis was thorough and thoughtful, but it found that the Dutch banks’ interest was not a capital interest within the meaning of Code Sec. 704(e)(1) for essentially the same reasons as supported its earlier conclusion that the banks’ interest was not bona fide equity participation. The Second Circuit concluded that the same evidence which, on its last review, compelled the conclusion that the Dutch banks’ interest was so markedly in the nature of debt that it did not qualify as bona fide equity participation also compelled the conclusion that the banks’ interest was not a capital interest under Code Sec. 704(e)(1). The Second Circuit said that the “risks” in question were in the nature of appearance of risk, rather than real risk. The risks did not justify treating the Dutch banks’ interest as a capital, or equity, interest. Accordingly, the Second Circuit held that the banks’ interest was not a capital interest within the meaning of Reg. § 1.704-1(e)(1)(v). (TIFD III-E, Inc v. U.S., (CA 2 2012) 109 AFTR 2d 2012-632109 AFTR 2d 2012-632, see Weekly Alert ¶  19  02/02/2012)

No further review . On January 11, the Supreme Court refused to review the Second Circuit’s decision in TIFD III-E Inc. Thus, that decision is now final.

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