IRS Scores Victory Over Alleged Tax Shelter

The Second Circuit Court of Appeals overturned the TIFD III-E Inc./Castle Harbour decision (see “Tax Matters,” JofA , June 05, page 93), a win for the IRS in its battle against tax shelters. The court ruled that the mere existence of a business purpose of a partnership does not preclude a conclusion that its primary purpose was tax avoidance. It also said Dutch banks with which TIFD III-E entered a partnership agreement had no meaningful stake in the partnership’s success and thus should not have been considered equity partners.

TIFD III-E was a wholly owned subsidiary of General Electric Capital Corp. (GECC), which in turn was a commercial-aircraft-leasing subsidiary of General Electric Co. To reduce its risks, GECC formed Castle Harbour, a limited liability company to which it contributed aircraft. Castle Harbour was owned by TIFD III-E and two other GE subsidiaries. TIFD III-E and the subsidiaries sold interests in Castle Harbour to Dutch banks. Under the arrangement, 98% of Castle Harbour’s operating income was allocated to the Dutch banks; consequently, the same percentage of net book income (operating income reduced by expenses including depreciation) was allocated to the banks, representing their actual income from the Castle Harbour investment.

All the aircraft in Castle Harbour, however, already had been fully depreciated for tax purposes. 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 such a large percentage of the income from fully tax-depreciated aircraft to the Dutch banks, GECC avoided an enormous tax burden while, at the same time, shifting very little book income.

The IRS reallocated Castle Harbour’s income to GECC, attributing $310 million of additional income to TIFD III-E that resulted in an additional tax liability of $62 million. TIFD III-E filed a complaint in U.S. District Court for Connecticut to recover $62 million it had deposited with the IRS to satisfy the tax liability. The district court found that the Castle Harbour transaction was “economically real,” undertaken, at least in part, for a nontax business purpose; it resulted in the creation of a true partnership with all participants holding valid partnership interests; and the income from the transaction was properly allocated among the partners under section 704(b) and regulations section 1.704-1. Thus, the court ordered the IRS to refund the $62 million plus interest. The IRS appealed to the Second Circuit.

Result. For the IRS. The Second Circuit judges determined the lower court failed to consider the appropriate tests of law. The test used by the Supreme Court in IRS v. Culbertson, 337 U.S. 733, 742, requires an examination of the nature of an interest based on a realistic appraisal of the totality of the circumstances. That test requires that “all of the facts—the agreement, the conduct of the parties in execution of its provision, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent” be used to determine the purpose of a partnership.

The Second Circuit also said the district court should have determined whether the purported partnership interest had the prevailing character of debt or equity as discussed in O’Hare v. Commissioner, 641 F.2d 83. The error here was that the district court accepted “at face value artificial constructs of the partnership agreement without examining all the circumstances to determine whether powers granted to the taxpayer effectively negated the apparent interests of the banks,” the Second Circuit said.

TIFD III-E Inc. v. U.S., 98 AFTR2d 2006-5616 (CA-2).

Prepared by Matt Stampfli, CPA, instructor of accounting, and Darlene Pulliam, CPA, Ph.D., professor of accounting, both of the College of Business, West Texas A&M University, Canyon.