The U.S. District Court for the Middle District of Louisiana disallowed deductions generated by two Special Limited Investment Partnerships (SLIPs) transactions because the transactions lacked economic substance and did not have a nontax business purpose. In addition, the court found that the two partnerships at the heart of the transactions were sham partnerships because they lacked a true business purpose. The court also ruled that some of the purported partners were not true equity partners because they received guaranteed returns similar to those of a creditor.
Transactions that lack economic reality may be disregarded for tax purposes under the economic substance doctrine (as applied in the Fifth Circuit, which Louisiana is in, under the test from Klamath Strategic Investment Fund, 568 F.3d 537 (5th Cir. 2009)) if the taxpayer fails to establish that the transaction had a reasonable possibility of profit and was entered into for a legitimate nontax business purpose. A partnership will also be disregarded for tax purposes if its partners do not intend “to join together for the purpose of carrying on the business and sharing in the profits and losses or both” (Culbertson, 337 U.S. 733 (1949)). Despite engaging in a transaction with economic substance, a partnership will be disregarded for tax purposes if there is no legitimate business reason for the entity to operate as a partnership.
In 1993, two subsidiaries of Dow Chemical joined with five foreign banks to form Chemtech I, a SLIPs entity. SLIPs was a complex marketed tax shelter involving circular cash flows and the allocation of taxable income to a tax-exempt foreign investor and tax deductions to a U.S. taxpayer. In 1993, Dow Chemical contributed low- or zero-basis patents to Chemtech I, which leased them back to Dow. From 1993 to 1997, Dow made royalty payments to Chemtech I approximating $526 million. During those years, Chemtech I loaned Dow about $543 million and made annual interest-like payments of $13.9 million to the foreign banks. Dow deducted the $526 million royalty payments on its 1993–97 tax returns, while Chemtech I allocated about $383 million and $143 million of its reported taxable income to the foreign banks and Dow, respectively.
At the end of 1997, Chemtech I was terminated due to new Treasury regulations effective at the beginning of 1998, prompting Dow to create Chemtech II, another SLIPs entity. The new transaction also involved the transfer of an appreciated asset (a chemical plant) by Dow to the partnership, circular cash flows, and rental deductions to Dow. A Sec. 754 election at Chemtech II’s inception allowed it to increase the basis of the chemical plant, and virtually all of the resulting depreciation deductions flowed back to Dow on its 1999 to 2003 tax returns. Also, from 1999 to 2003, some of Chemtech II’s income flowed back to Dow, while a foreign bank involved in the partnership received an interest-like payment.
The IRS issued a final partnership administrative adjustment to Chemtech I in 2006 and Chemtech II in 2007. The tax matters partner of each partnership petitioned the district court for a readjustment, and the cases were consolidated for tax years 1993 to 2003.
The court held that the Chemtech transactions were sham transactions that lacked economic substance, since the circular flow of money did not change Dow’s financial position. According to the court, the Chemtech transactions had no business purpose other than tax avoidance, despite Dow’s argument that the purpose was to increase its credit rating and maintain its debt-to-capital ratio by providing off-balance-sheet financing. The court held that there were cheaper and less complex ways of achieving that goal and that a prudent business owner would not have used the SLIPs without their inherent tax benefits.
The court also held that Dow’s SLIPs transactions created sham partnerships since “Dow and the foreign banks did not ‘in good faith and acting with a business purpose’ join together in the present conduct of an enterprise” (slip op. at 55–56, quoting Culbertson, 337 U.S. at 742). According to the court, there was no intent to raise additional revenue from the transferred patents, the cash flows were circular, and one of the partners received a specified guaranteed return. Also, the court held that the foreign banks were not actual partners, since their interests resembled debt rather than equity due to their guaranteed return.
The court also upheld the IRS’s assessment of a 20% penalty on the underpayments of tax from both transactions because the underpayments were due to negligence and a substantial understatement of income tax. However, it rejected the IRS’s claim that a 40% penalty for an underpayment due to a gross valuation misstatement should apply to the Chemtech II transaction.
Chemtech Royalty Associates, L.P., Nos. 05-944-BAJ-DLD, 06-258-BAJ-DLD, and 07-405-BAJ-DLD (M.D. La. 2/26/13)
By Charles J. Reichert, CPA, instructor of
accounting, University of Minnesota–Duluth.