Family Partnership Rules Applied in TIFD III-E Remand

In a case reversed and remanded by the Second Circuit, the U.S. District Court in Connecticut again held that a General Electric subsidiary could treat Dutch banks’ interests as partnership equity rather than debt. In so doing, the district court in the long-running TIFD III-E case again sided with the taxpayer in its transaction with two foreign banks that the Second Circuit had labeled a tax avoidance “fiction.” For earlier “Tax Matters” coverage, see “IRS Scores Victory Over Alleged Tax Shelter,” April 07, page 78, and “A Winning Tax Shelter Case,” June 05, page 93.

General Electric Capital Corp. (GECC) purchased and then leased commercial airplanes to airline companies. When the commercial airlines encountered financial difficulties in the early 1990s, GECC began searching for ways to reduce its risks. Accordingly, three subsidiaries of GECC (TIFD III-E Inc., TIFD III-M Inc., and General Electric Capital AG) formed Castle Harbour-I LLC in 1993. Later, the GECC subsidiaries sold $50 million worth of their interests to two Dutch banks, ING and Rabo Merchant Bank, which then contributed an additional $67.5 million in cash to Castle Harbour. The GECC subsidiaries contributed cash, receivables and leased airplanes. The bank’s partnership interests were self-liquidating; that is, they would be bought out in eight years in a complex system of allocating income, gains and losses. In 2001, the IRS reclassified the banks as creditors rather than equity partners, increasing the tax liability of TIFD III-E Inc., Castle Harbour’s tax matters partner, by $62.2 million for tax years 1993 through 1998. TIFD III-E paid the amount and sued for a refund.

The district court ruled (342 F. Supp. 2d 94 (11/10/2004)) that tax avoidance may have been a principal but not sole consideration, that the transaction was undertaken to at least some extent for a nontax business purpose, and that it created a true partnership with valid partnership interests. Furthermore, it did not, as the IRS argued, violate partnership allocation rules of IRC § 704(b), the court said. The IRS appealed.

The Second Circuit reversed and remanded (459 F.3d 220 (8/3/2006)), holding that the Dutch banks were not bona fide equity partners in Castle Harbour under the test of U.S. v. Culbertson (337 U.S. 733 (1949)), that courts should determine by facts and circumstances the true nature of a purported business interest irrespective of its label. In a footnote, the Second Circuit left for consideration by the district court what it said was the taxpayer’s argument that the arrangement constituted a family partnership under section 704(e).

On remand, the district court found in that footnote a rationale to reassert its original holding. It cited Evans v. Commissioner (54 TC 40, aff’d, 477 F.2d 547 (7th Cir., 1971)) and Carriage Square Inc. v. Commissioner (69 TC 119) as holding that the language of section 704(e) is sufficiently broad to apply to non-family partnerships. Section 704(e)(1) provides that a purchaser or donee of a partnership interest is recognized as a partner where that person owns and exercises dominion and control over a capital interest in a partnership in which capital is a material income-producing factor. The banks could exercise dominion and control because they had the right to force liquidation of the partnership, the court said. The court also applied tests of Treas. Regs. §§ 1.704-1(e)(2)(iv) through (vi): The banks participated in the management of the partnership and received distributions, and the partnership conducted its business consistent with the understanding that the banks owned their interests.

In determining that the Dutch banks were capital interest holders, the district court looked at the outcome of hypothetically liquidating their interests as well as their actual liquidation. The court stated, “Because, upon liquidation, the Dutch Banks were paid out of their capital accounts, which reflected their stake in Castle Harbour’s capital, and were not instead limited to sharing in the profits and losses of the partnership, the Banks’ interests in Castle Harbour were capital interests.” Although it was not the case, the court noted that under this arrangement the capital accounts of the Dutch banks could have been negative upon dissolution.

Finally, the Service contended that the Dutch banks’ capital contributions were not income-producing because of the additional constraints set forth on the use of cash after the contributions. However, the district court rejected this argument and emphasized that consideration should focus on whether a substantial portion of gross income was produced by the capital of the business, which it said had occurred in this case, rather than focusing on a particular partner’s capital contribution.

  TIFD III-E Inc. v. U.S., docket nos. 3:01cv1839 and 3:01cv1840 (Conn. 10/23/2009)

By Wei-Chih Chiang, DBA, assistant professor of accounting, Texas A&M International University, Laredo, Texas.