Castle Harbour Decision: Legitimacy of Partnerships With...

Castle Harbour Decision: Legitimacy of Partnerships With Tax Benefits

Structuring the Entity to Withstand IRS Scrutiny andpresents Structuring the Entity to Withstand IRS Scrutiny and Maximize Tax Advantages

presents

A Live 90-Minute Teleconference/Webinar with Interactive Q&A

Today's panel features:Lawrence M. Hill, Partner, Dewey & LeBoeuf, New York

Todd Y. McArthur, Partner, Dewey & LeBoeuf, Washington, D.C.Abraham N.M. Shashy, Partner, Dewey & LeBoeuf, Washington, D.C.

Thursday, January 14, 2010

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Castle Harbour Decision: The Case and Implications

Strafford Webinar/TeleconferenceJanuary 14, 2010

Lawrence M. Hill, Dewey & LeBoeuf LLPT dd Y M A th D & L B f LLP

Dewey & LeBoeuf LLPdl.com

Todd Y. McArthur, Dewey & LeBoeuf LLPAbraham “Hap” N.M. Shashy, Jr., Dewey & LeBoeuf LLP

Castle Harbour Presentation - OverviewCastle Harbour Presentation Overview

F t● Facts● Issues Presented

– Sham transaction analysisy– “Partner” status– Partnership allocations

P lti d Oth T C t C id ti● Penalties and Other Tax Controversy Considerations● Potential Impact of Castle Habour● Lessons Learned● Addendum – Legislative History of the Ceiling Rule

Dewey & LeBoeuf LLP | 1

Castle Harbour FactsCastle Harbour – Facts


TIFD III-E Inc. v. United States (Castle Harbour)TIFD III E Inc. v. United States (Castle Harbour)

GE Tax objective: Shift of built-in gain with respect to appreciated assets through use of traditional method under I.R.C. § 704(c)

GECCof traditional method under I.R.C. § 704(c)

• 63 “Stage II” Aircraft

$1

M b

TIFD III-E TIFD III-MDutchBanks

MemberFMV = $300M AB = $0

• Cash = $296M

•TIFD VI Stock 2CH

Member Interest

Member Interest

$117.5M ($50M by purchase)

FMV = $0 AB = $0

2

Member InterestTIFD VI(CHLI)


Castle Harbour – Selected Terms of Banks’ InterestsCastle Harbour Selected Terms of Banks Interests

P i i l All ti t D t h B k● Principal Allocations to Dutch Banks– Operating Profits: 98% with no limit– Operating Losses

♦ 98% until Dutch banks receive $3.8M (less Disposition Losses under 90% tier)

♦ 1% of the next $547.97M of Operating Losses and Disposition Losses♦ 100% until Dutch banks’ capital accounts are zero

– Disposition Gains (including revaluation gains)♦ 90% until Dutch banks receive $2.8M♦ 1% of any excess

– Disposition Losses (including revaluation losses)♦ 90% until Dutch banks receive $2.8M (less Operating Losses under♦ 90% until Dutch banks receive $2.8M (less Operating Losses under

the 98% tier)♦ 1% of the next $547.97M of Operating Losses and Disposition Losses♦ 100% until Dutch banks’ capital accounts are zero


p

continued >


E hibit E Di t ib ti● Exhibit E Distributions– Annual cash distributions to Dutch banks scheduled to provide a

9.03587% IRR over 8 years– Rights to liquidate Castle Harbour, absent cash distributions

● Investment Accounts and Guaranteed Payment– Notional accounts = Dutch banks’ initial investment + annual return ofNotional accounts Dutch banks initial investment + annual return of

9.03587% (or 8.53587% in certain cases)– Upon Castle Harbour liquidation, the Dutch banks would be entitled to

a guaranteed payment equal to the excess if any of the adjustmentsa guaranteed payment equal to the excess, if any, of the adjustments to their investment accounts over their actual allocation of Operating Income and Disposition Gain♦ Represents a guarantee of a return on investment but not a return of♦ Represents a guarantee of a return on investment but not a return of

investment from available partnership assets

Dewey & LeBoeuf LLP | 5 continued >


GECC G t● GECC Guarantee– GECC guaranteed the performance and payment by the TIFD partners

and managers of all covenants, obligations, and indemnities.– TIFD partners were not obligated to make whole the Dutch banks for

any investment loss outside of their interests in Castle Harbour.

● Core Financial Assets Covenant– CHLI required to invest 110% of the current amounts in the Dutch

banks’ investment accounts in “core financial assets ” including cashbanks investment accounts in core financial assets, including cash and high-grade commercial paper


Castle Harbour – Selected Case HistoryCastle Harbour Selected Case History

TIFD III E I U it d St t 342 F S 2d 94 (D C 2004)● TIFD III-E Inc. v. United States, 342 F. Supp.2d 94 (D. Conn. 2004) (“Castle Harbour I”)

● TIFD III-E Inc. v. United States, 459 F.3d 220 (2d. Cir. 2006) (“Castle Harbour II”)

TIFD III E Inc v United States No 05 0064 2006 WL 4877892 (2d– TIFD III-E Inc. v. United States, No. 05-0064, 2006 WL 4877892 (2d Cir. Sept. 18, 2006) (denying petition for rehearing)

● TIFD III-E Inc. v. United States, Civil Action Nos. 3:01cv1839 (SRU), 3:01cv1840 (SRU), 2009 WL 3208650 (D. Conn. October 23, 2009) (“Castle Harbour III”)


Castle Harbour Issues PresentedCastle Harbour – Issues Presented


Castle Harbour – Issues PresentedCastle Harbour Issues Presented

W th f ti f C tl H b h t ti ?● Was the formation of Castle Harbour a sham transaction?– Subjective business purpose and/or non-tax economic effect at issue– Before trial, the government stipulated that Castle Harbour was classified as a

partnership under the Internal Revenue Code (“IRC”)partnership under the Internal Revenue Code ( IRC )

● Were the Dutch banks partners in Castle Harbour?– Culbertson debt-equity principles and IRC § 704(e)Culbertson, debt equity principles, and IRC § 704(e)

● Did the allocations of Castle Harbour’s profit and loss lack substantiality under the “overall tax effect” test?– Economic effect and other substantiality tests were not at issue

W C tl H b bj t t b t ti l d t t t d/● Was Castle Harbour subject to substantial understatement and/or negligence penalties?– Considered in the event of reversal


Castle Harbour –Sham Transaction Analysis


Castle Harbour – Sham Transaction AnalysisCastle Harbour Sham Transaction Analysis

C tl H b I● Castle Harbour I– Second Circuit decisions not “perfectly explicit” on the scope of the

sham transaction test but Castle Harbour had both substantial b i d bj i i ffbusiness purposes and objective economic effect

– Substantial business purposes achieved♦ Raised capital (without increasing GECC’s debt-equity ratio)♦ Monetized aircraft assets♦ Demonstrated to investors, rating agencies, and GECC senior

management that it could raise capital on its fleet of aging aircraft

● Castle Harbour II– Not addressed in this context

● Castle Harbour III● Castle Harbour III– Not addressed in this context


Castle Harbour – Non-tax Economic EffectCastle Harbour Non tax Economic Effect

C tl H b I● Castle Harbour I– $117M of minority interest financing was raised– Proceeds used to purchase aircraft and to retire GECC debt (for GAAP

purposes)– Dutch banks participated in upside potential – Rejected government’s argument that the combination of the Exhibit ERejected government s argument that the combination of the Exhibit E

payments, core financial asset covenant, investment accounts, and the guaranteed payment stripped the Dutch banks’ investment of any substance

● Castle Harbour II– Not addressed in this context

Castle Harbour III● Castle Harbour III– Not addressed in this context


Castle Harbour –“Partner” Status


Castle Harbour – “Partner” StatusCastle Harbour Partner Status

C tl H b I● Castle Harbour I

– IRC § 761 broadly defines “partnership” and “partner” ♦ The term “partnership” includes “a syndicate group pool joint venture or♦ The term partnership includes a syndicate, group, pool, joint venture, or

other unincorporated organization through or by means of which any business, financial operation, or venture is carried on.”

♦ A partner is “any member of a partnership ”♦ A partner is any member of a partnership.

– Economic reality of “partner” status is essentially the same as sham transaction analysis

– Nevertheless applied debt-equity test (Notice 94-47), concluding Dutch banks’ partnership interests were equity♦ Lack of risk and a “guaranteed return” did not prevent Dutch banks from♦ Lack of risk and a guaranteed return did not prevent Dutch banks from

participating in leasing business

♦ Dutch banks had upside tied to the performance of Castle Harbour’s business specifically 98% of all Operating Profits


business, specifically 98% of all Operating Profits

continued >


C tl H b II● Castle Harbour II

– District court erred as a matter of law by not applying the totality-of-the-circumstances test of Comm’r v. Culbertson, 337 U.S. 733 (1949), ( )♦ A partnership exists when, “considering all the facts—the agreement, the

conduct of the parties in execution of its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, their y p , p p ,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—the parties in good faith and acting with a business purpose intended to join together in the present conduct of thepurpose intended to join together in the present conduct of the enterprise.” Id. at 742 (emphasis added).

District court also erred by accepting at face value the partnership– District court also erred by accepting at face value the partnership agreement rather than assessing the underlying economic realities.



C tl H b II ( ti d)● Castle Harbour II (continued)– Debt-equity principles, largely developed in corporate cases, are

relevant in analyzing whether an interest in a partnership is a “bona fide equity participation” in the partnership.♦ See also Hambuechen v. Comm’r, 43 T.C. 90 (1964)

– Were the funds advanced with reasonable expectations of repayment regardless of the success of the venture or were the funds placed at the risk of the business?

– Declined to remand to the district court for new findings of fact



C tl H b II ( ti d)● Castle Harbour II (continued)– Influencing Factors

♦ GECC guarantee placed Dutch banks in a position that was senior in♦ GECC guarantee placed Dutch banks in a position that was senior in interest to the general creditors of Castle Harbour

♦ Scheduled payments to the Dutch banks were not dependent on partnership performance

♦ No meaningful sharing of the risks of the partnership business♦ Elaborate protection of the Dutch banks’ interests, including the

investment accounts, the related guaranteed payment, the Core Financial $Asset covenant, $300 million casualty-loss insurance

♦ Upside capped at preferred rate of return, plus $2,854,923, plus 1% residual gains According to the circuit court, the uncapped allocation of 98% of the Operating

Profits was severely limited as a practical matter (i.e., by transferring aircraft to CHLI, re-depreciating the aircraft, or by terminating Castle Harbour at any time).


Appeared willing to recognize partner status had the Dutch banks had a “sufficiently sizable share” of the profit potential

continued >


C tl H b II ( ti d)● Castle Harbour II (continued)– Holding and remand

♦ The Dutch banks’ interest was “in the nature of a secured loan, with an ,insignificant equity kicker.”

♦ The totality of the facts and circumstances “compel the conclusion that the Dutch banks’ interest, was, for tax purposes, not a bona find equity , , p p , q yparticipation.”

♦ Did not hold the interests were debt

♦ Remanded to the district court for “further proceedings consistent with this♦ Remanded to the district court for further proceedings consistent with this opinion.” Promising that any further appeal would be assigned to the same panel

N ti th t th t did t id th t ’ t d IRC § Noting that the court did not consider the taxpayer’s argument under IRC §704(e) and inviting the district court to consider the issue



C tl H b II ( ti d)● Castle Harbour II (continued)– Castle Harbour’s petition for rehearing was denied but not before

making several points. – Errors in the record

♦ GECC guarantee was a performance guarantee and not a payment guarantee. The Dutch banks’ interests were fully subordinated to the claims of Castle Harbour’s general creditors.

♦ The guaranteed payment related to investment accounts did not guarantee the repayment of the Dutch banks’ initial investment but just a

i i t th t i t t G t d t i t tminimum return on that investment. Guaranteed payments are consistent with partner status, as indicated by IRC § 707(c).

♦ Operating Profit could not realistically be reduced. F l C tl H b ’ b d i ft ld t b t f d t CHLI For example, Castle Harbour’s encumbered aircraft could not be transferred to CHLI

without the Dutch banks’ consent.

– Holding cannot be reconciled with established treatment of preferred equity issued routinely by corporations and partnerships.


equity issued routinely by corporations and partnerships.

continued >


C tl H b III Th IRC § 704( ) i● Castle Harbour III – The IRC § 704(e) issue– IRC § 704(e)(1)

♦ Notwithstanding the heading of “family partnerships,” IRC § 704(e)(1) clearly applies to all partnerships.

♦ A person shall be recognized as a partner for purposes of this subtitle if he owns a capital interest in a partnership in which capital is a material income producing factor whether or not such interest was derived byincome-producing factor, whether or not such interest was derived by purchase or gift from any person.

– Castle Harbour II’s holding does not preclude application of IRC §704(e)(1)704(e)(1).♦ Preferred stock is debt-like but is nevertheless treated as equity for tax

purposes. See, e.g, Jewel Tea Co. v. United States, 90 F.2d 451 (2d Cir. 1937); Comm’r v. O.P.P Holding Corp., 76 F.2d 11 (2d Cir. 1935)) g ( )

♦ Circuit court would not have expressly left the issue open for consideration had it held the Dutch banks’ interests were debt.



C tl H b III ( ti d)● Castle Harbour III (continued) – Application of IRC § 704(e)(1)

♦ Dutch banks were the real owners of their interests♦ Dutch banks were the real owners of their interests. Sham analysis required. A holder of a capital interest will not be recognized

as a partner unless the interest is acquired in “a bona fide transaction, not a mere sham for tax avoidance or evasion purposes, and the [holder] is the real p p , [ ]owner of such interest.” Treas. Reg. § 1.704-1(e)(1)(iii).

Whether an alleged partner is the real owner depends on all facts and circumstances, and the reality of ownership is determined in light of the transaction as a whole Treas Reg § 1 704 1(e)(2)(i)transaction as a whole. Treas. Reg. § 1.704-1(e)(2)(i).

Castle Harbour I finding of no sham transaction and review of partner rights



C tl H b III ( ti d)● Castle Harbour III (continued) ♦ Dutch banks’ interests were capital interests.

Right to share in assets of partnership upon partner retirement or partnership Right to share in assets of partnership upon partner retirement or partnership liquidation. Treas. Reg. § 1.704-1(e)(1)(v).

Hypothetical liquidation test

GECC performance guarantee did not guarantee repayment of investment GECC performance guarantee did not guarantee repayment of investment

Guaranteed payment upon liquidation also depended on partnership capital

♦ Capital was a material income-producing factor. Substantial portion of the gross income of the partnership must be attributable

to the employment of capital. Treas. Reg. § 1.704-1(e)(1)(iv).

Capital was the only income-producing factor in Castle Harbour.



C tl H b III ( ti d)● Castle Harbour III (continued) – Addressed relationship between Culbertson and IRC § 704(e)(1)

♦ Some courts have suggested that IRC § 704(e)(1) replaced the♦ Some courts have suggested that IRC § 704(e)(1) replaced the Culbertson test

♦ Other cases view IRC § 704(e)(1) as an alternative test

♦ Although the Dutch banks were not partners under Castle Harbour II’s Culbertson analysis, they were partners under IRC § 704(e)(1)

– Addressed penalties in an attempt to avoid another remand in the p pevent the Second Circuit reverses again

– Rebuttal to Castle Harbour II ♦ Footnote 2 in the opinion presents a spirited rebuttal to allegations that the

district court did not consider the “practical realities” of Castle Harbour and ignored Culbertson


♦ Notes the absence of any reference to “bona fide equity participation” in any federal case outside of Castle Harbour II

Castle Harbour –Partnership Allocations


Castle Harbour – Overview of Partnership AllocationsCastle Harbour Overview of Partnership Allocations

IRC § 704(b) id th t ll ti i t hi t● IRC § 704(b) provides that an allocation in a partnership agreement will be respected either if it has “substantial economic effect” or the allocation is consistent with “the partner’s interest in the partnership.”

● Substantial economic effect – Treas Reg § 1 704-1(b)(2)● Substantial economic effect Treas. Reg. § 1.704-1(b)(2)– Economic effect generally requires

♦ proper capital account maintenance♦ li id ti i d ith iti it l t b l♦ liquidation in accordance with positive capital account balances♦ partner obligations to restore any deficit capital account balances (or an

alternative economic effect test is met)♦ Economic effect was not at issue in Castle Harbour♦ Economic effect was not at issue in Castle Harbour.



S b t ti l i ff t T R § 1 704 1(b)(2)● Substantial economic effect – Treas. Reg. § 1.704-1(b)(2) (continued)

– An allocation generally will be “substantial” if there is a reasonable possibility that the allocation will affect substantially the amounts to be received by the partners, independent of tax consequences.y p p q

– There are several specific substantiality tests, including the overall tax-effect, or “one loser,” test, the shifting allocation test, and the transitoryeffect, or one loser, test, the shifting allocation test, and the transitory allocation test.

The shifting allocation test and the transitory allocation test were not at– The shifting allocation test and the transitory allocation test were not at issue in Castle Harbour.



S b t ti l i ff t T R § 1 704 1(b)(2)● Substantial economic effect – Treas. Reg. § 1.704-1(b)(2) (continued)– Overall tax-effect test - The economic effect of an allocation (or

allocations) will not be substantial if, at the time the allocation becomes part of the partnership agreement: ♦ The after-tax economic consequences of at least one partner may, in

fpresent value terms, be enhanced compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement, and

♦ There is a strong likelihood that the after tax economic consequences of♦ There is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement.” Treas. Reg. § 1.704-1(b)(2)(iii)(a).

– What is the baseline?



P t ’ i t t i th t hi● Partners’ interests in the partnership

– An allocation that does not have substantial economic effect still will be respected if the allocation is made in accordance with the partners’ interests in the partnership

– Facts and circumstances analysis, taking into account, among other factors:♦ relative partnership contributions♦ relative partnership contributions♦ interests in economic profits and losses♦ interests in cash flows and other non-liquidating distributions♦ rights to liquidating distributions♦ rights to liquidating distributions


Castle Harbour – SubstantialityCastle Harbour Substantiality

C tl H b I● Castle Harbour I

– Held that the allocation of 98% of the Operating Profit to the Dutch banks did not violate the overall tax-effect test and, therefore, should , ,be respected♦ If a partnership agreement includes bottom line profit and loss allocations

that define the economic sharing of the partners, without special g p , pallocations of partnership items based on specific tax characteristics of those items and the partners, then a partner’s interest in the partnership is determined by reference to the agreement.

♦ Allocation of 98% of the Operating Profit to the Dutch banks was consistent with the parties’ intent and economic agreement.

– Rejected government’s attempt to reallocate income in proportion toRejected government s attempt to reallocate income in proportion to capital contributions (i.e., 82% to TIFD entities and 18% to the Dutch banks)


Castle Harbour – SubstantialityCastle Harbour Substantiality

C tl H b II● Castle Harbour II– Not addressed

● Castle Harbour III– Not addressed

● Comments– The tax benefits at issue, that is the shift of taxable income to the Dutch banks

in excess of economic income, were not the result of the operative rules of IRC § 04(b)§ 704(b).

– The tax benefits derived from the ceiling rule limitation of IRC § 704(c).– Different allocation methods and an anti-abuse rule were added to IRC §

704( ) l ti Th l ti ff ti ft th C tl H b704(c) regulations. Those regulations were effective after the Castle Harbour transaction occurred, consistent with Congressional intent. See Addendum –Legislative History of the Ceiling Rule at the end of these materials.


Penalties and Other Tax Controversy Aspects of Castle Harbour


Defending Against Accuracy-Related PenaltiesUnder IRC § 6662Under IRC § 6662

S b t ti l d t t t lt d t l if th i● Substantial understatement penalty does not apply if there is substantial authority to support taxpayer’s tax treatment of an item or transaction unless the item or transaction is attributable to a tax shelter.

● What is substantial authority? Treas. Reg. § 1.6662-4(d)– Is an objective standard

– Requires analysis of law and application of law to relevant facts

I l t i t th lik l th t t d d– Is less stringent than more likely than not standard

– More stringent than reasonable basis standard

Can be demonstrated even if the position is ultimately held– Can be demonstrated even if the position is ultimately held to be wrong



Wh t i t h lt ? T R § 1 6662 4( )● What is a tax shelter? Treas. Reg. § 1.6662-4(g)– Principal purpose of entity, plan or arrangement, based on objective

evidence, is to avoid or evade federal income tax,

– Principal purpose is not to avoid or evade federal income tax if the taxpayer has the purpose of claiming tax benefits in a manner consistent with the statute and Congressional purposeconsistent with the statute and Congressional purpose

● Negligence penalty applies where the taxpayer has failed to make a reasonable attempt to comply with the provisions of the internal p p y prevenue laws or to exercise ordinary and reasonable care in the preparation of a tax return.

A ret rn position that has a reasonable basis is not attrib table to● A return position that has a reasonable basis is not attributable to negligence. Treas. Reg. § 1.6662-3(b).– Reasonable basis standard is less stringent than the substantial


gauthority standard

continued >

Defending Against Accuracy-Related Penalties Under IRC § 6662Under IRC § 6662

Th t i C tl H b l d f t it l● The taxpayer in Castle Harbour only used fact witnesses – several company executives – to defend against the IRC § 6662 substantial understatement penalty.

● Taxpayer did not introduce (and claimed privilege with respect to) the legal advice provided by counsel on the merits of the transactiontransaction.

● Nevertheless, the district court found the IRC § 6662 substantial understatement penalty did not apply because there was p y pp ysubstantial authority and the transaction was not a tax shelter.



Di t i t t d t i d th b t ti l th it ti● District court determined there was substantial authority supporting treating the Dutch banks as partners.– Government failed to cite any court decision holding that an entity that

purchased an interest in a purported partnership for substantial consideration did not qualify as a partner under IRC § 704(e)(1)

– Second Circuit’s ruling did not compel a contrary conclusion; prior to ruling, there was substantial authority

● District court determined Castle Harbour was not a tax shelter.– Second Circuit did not disturb District Court’s findings in CastleSecond Circuit did not disturb District Court s findings in Castle

Harbour I that the partnership had bona fide purposes and had some economic effect

– There was not a factual finding or legal conclusion in either Castleg gHarbour I or II that tax savings were the principal purpose of the Castle Harbour transaction

– Court was also persuaded by the testimony of taxpayer’s executives


that “demonstrating liquidity” and “monetizing” the aircraft were important motivations for forming Castle Harbour

continued >

Defending Against Accuracy-Related Penalties Under IRC § 6662Under IRC § 6662

Si th di t i t t f d th b t ti l th it it● Since the district court found there was substantial authority, it summarily rejected application of negligence penalty.

● Practical ways to defend against the IRC § 6662 substantial● Practical ways to defend against the IRC § 6662 substantial understatement penalty if, as in Castle Harbour III, the legal advice provided by counsel is not turned over to the government– Provide in-house counsel with a binder of all the legal authorities relied

upon in the opinion and have him/her separately review it and form his/her own opinion

– Prepare two opinions – a privileged one and one that will be turned over to the government♦ Latter opinion is not intended to be a confidential communication i e a♦ Latter opinion is not intended to be a confidential communication, i.e., a

privileged communication, and so there arguably can be no subject matter waiver of the attorney-client privilege


Standard of Review in Economic Substance CasesStandard of Review in Economic Substance Cases

It i i ll k l d d th t l l li i d● It is universally acknowledged that pure legal rulings are reviewed de novo while purely factual findings are scrutinized for clear error.

● Applying the correct standard of review in economic substance cases is important – sets tone and framework for appellate court’s consideration of the ultimate issue.

● Circuit courts are split on correct standard of review of the so-called mixed question arising from applying the economic substance test –a legal test – to the facts.g



Cl t d d i ll li d b th S d Thi d● Clear error standard is generally applied by the Second, Third, Fourth, and Seventh Circuits.– See, e.g., Nicole Rose Corp. v. Commissioner, 320 F.3d 282, 284 (2dSee, e.g., Nicole Rose Corp. v. Commissioner, 320 F.3d 282, 284 (2d

cir. 2002).

– Under clear error standard, appellate court defers to the overall assessment of the case as well as the specific fact finding by the trialassessment of the case, as well as the specific fact-finding, by the trial court.

● De novo standard is generally applied by the Sixth, Tenth, and Federal Circuits.– Under de novo review, the appellate court carefully examines the

ultimate determination and freely substitutes is own judgment for that of the trial court



C tl H b II t d d f i ?● Castle Harbour II standard of review?– On brief, taxpayer asserted clear error standard

O b i f t t d d t d d– On brief, government asserted de novo standard

● Appears Second Circuit employed a de novo standard● Appears Second Circuit employed a de novo standard

Wh t h ld b th t d d f i if th i● What should be the proper standard of review if there is Castle Harbour IV?


Bench Trial vs. Jury Trial to LitigateHighly-Complex TransactionsHighly Complex Transactions

T h tit ti l i ht d th S th● Taxpayers have no constitutional right under the Seventh Amendment to a jury trial in a tax case.

● By statute any tax refund action in federal district court generally● By statute, any tax refund action in federal district court generally will, at either party’s request, be tried by a court with a jury. (28 U.S.C. § 2402; FRCP 38(b))

● Tax Court and Court of Federal Claims are courts of limited jurisdiction so taxpayers are not entitled to a jury trial.

● Can juries comprehend complex legal and factual issues?● Can juries comprehend complex legal and factual issues?– Federal judges have denied jury trials in cases that were too

complicated for a jury to decide – See, e.g., Bernstein v. Universal Pictures, Inc., 79 F.R.D. 59 (S.D.N.Y. 1978).


Bench Trial vs. Jury Trial to LitigateHighly-Complex TransactionsHighly Complex Transactions

N t t liti ti t t t d d j t i l?● New government tax litigation strategy to demand a jury trial?– AIG, Inc. v. United States, docketed in Southern District of New York

(FTC Generator case)– Sovereign Bancorp, Inc. v. United States, docketed in District Court of

Massachusetts (FTC Generator case)– Altria Group Inc v United States jury verdict with no explanation orAltria Group, Inc. v. United States, jury verdict with no explanation or

analysis rendered in July 2009 in favor of government in Southern District of New York (SILO case)Fifth Third Bancorp v United States jury verdict rendered with no– Fifth Third Bancorp v. United States, jury verdict rendered with no explanation or analysis in April 2008 in favor of government in Southern District of Ohio (LILO case)♦ Commonality most of the taxpayers are financial services institutions♦ Commonality – most of the taxpayers are financial services institutions♦ Government trying to use current economic crisis as a tactical advantage?♦ Government trying to steer taxpayers to Tax Court and Court of Federal

Claims which are courts of national jurisdiction and where government


Claims, which are courts of national jurisdiction and where government views the judges as more predictable and government-friendly?

Forum Selection Choices to Litigate Highly-Complex Transactions Challenged on Economic Substance GroundsChallenged on Economic Substance Grounds

R l t Ch t i ti f C t f F d l Cl i● Relevant Characteristics of Court of Federal Claims– Thorough economic substance analysis – Consolidated Edison Co. v.

United States (LILO case)– Court of Federal Claims has national jurisdiction– Non-availability of a jury trial

● Relevant Characteristics of the Tax Court● Relevant Characteristics of the Tax Court– As a general matter, the Tax Court has not adopted its own economic

substance standard; it generally employs the standard of the Court of Appeals for the circuit to which a particular case would be appealedAppeals for the circuit to which a particular case would be appealed

– Non-availability of a jury trial

● Relevant Characteristics of District Courts– Less government-friendly and knowledgeable about tax– Availability of a jury trial– District court may also be bound by an unfavorable economic standard


y yadopted by its Court of Appeals

Potential Impact of Castle HarbourPotential Impact of Castle Harbour



C tl H b III i lik l t b l d d t b th fi l● Castle Harbour III is likely to be appealed and may not be the final word. – Affirmation or reversal of IRC § 704(e) decisionAffirmation or reversal of IRC § 704(e) decision

– Revisit the debt-equity issue

– Address sham and partnership allocation issues not addressed in p pCastle Harbour II

● Potential impact on traditional debt-equity analysis– Maybe little impact? Castle Harbour II did not classify the Dutch

banks’ interests as debt, and its holding appears to be based on a misunderstanding of the facts.

– On the other hand, the focus on limited upside potential and downside protection is troubling in the context of numerous examples of preferred stock and partnership interests that have little or no upside


p p p ppotential and substantial downside protection.

continued >


E l f f d i t t t d it– Examples of preferred interests respected as equity♦ Partnerships used to create the economic equivalent of a variable-rate,

tax-exempt bond. See Rev. Proc. 2003-84, 2003-2 C.B. 1159. Variable-rate interest entitled to preferred variable return on capital Inverse interest entitled to all remaining interest Notice 2008-80, 2008-40, I.R.B. 820 would require not less than 5% of gain

from sale of tax exempt bonds to be allocated to variable rate interestsfrom sale of tax-exempt bonds to be allocated to variable-rate interests

♦ Limited partnership interests entitled to guaranteed payments Rev. Rul. 66-95, 1966-1 C.B. 169 – no share of losses and a guaranteed,

i i l 4% t lth h l titl d t id f 25% f t fitminimum annual 4% return, although also entitled to upside of 25% of net profits Treas. Reg. § 1.707-1(c) Example (2)

♦ Mandatory redeemable preferred stock Redeemable in 10 years at par with a 10% annual return; callable in advance

at a premium – Treas. Reg. § 1.305-5(d) Example (5) Redeemable after 5 years, subject to asset maintenance, no new debt, and

regular course of business covenants – Rev Rul 78-142 1978-1 C B 112


regular course of business covenants Rev. Rul. 78 142, 1978 1 C.B. 112

continued >


E l f f d i t t t d it ( ti d)– Examples of preferred interests respected as equity (continued)♦ Adjustable rate preferred stock – Rev. Rul. 90-27, 1990-1 C.B. 50

“an investment alternative to commercial paper or other short-term debt”p p

Non-voting, no return other than based on an external interest-rate index, which is reset to ensure sale at par, no loss

♦ Nonqualified preferred stock – IRC § 351(g)♦ Nonqualified preferred stock IRC § 351(g) “limited and preferred as to dividends and does not participate in corporate

growth to any significant extent”

Callable redeemable and/or has a dividend rate determined by reference to Callable, redeemable, and/or has a dividend rate determined by reference to an external index

See also IRC § 1504(a)(4) stock



P t ti l i t t hi t ti● Potential impact on partnership taxation– Castle Harbour II raises the possibility of an interest that is not a

partnership interest but is not debt– This “twilight zone” violates the broad statutory definition of

“partnership” in IRC §§ 761 and 7701. See Plaintiff’s Brief on Remand Regarding IRC § 704(e). g g § ( )♦ enacted in 1932 in response to the tax treatment of income from non-

entity partnerships♦ Investors were not including their shares of income on individual returns♦ Investors were not including their shares of income on individual returns

based on a view they were not “partners.” See Plaintiff’s Brief on Remand (citing H.R. Rep. No. 72-708, at 53 (1932).

– General non-recognition treatment is available only for contributions ofGeneral non recognition treatment is available only for contributions of property in exchange for partnership interests.

– Would sales of such interests be subject to provisions in Subchapter K that prevent conversion of ordinary income into capital gain or loss


that prevent conversion of ordinary income into capital gain or loss duplication? See, e.g., IRC §§ 751(a), 743(d).

continued >


C id t ti t t d d bt t hi● Consider protective terms to reduce debt or non-partnership equity treatment– Minimum of 5% residual profit participation? Cf. Notice 2008-80.Minimum of 5% residual profit participation? Cf. Notice 2008 80.

– Management rights

– No payment guaranteesp y g


Lessons Learned from Castle HarbourLessons Learned from Castle Harbour



E i b t l i li d i th t t f t hi● Economic substance analysis applied in the context of partnership transactions– Castle Harbour ICastle Harbour I

♦ Demonstrates that tax planning in the context of a purposeful business transaction is sustainable I t t t t d t i t ll l t d t th Investment structure and tax consequences were integrally related to the

business objective of raising minority capital

Dutch banks provided $117.5 million of capital, the proceeds of which were actually used to help retire GECC commercial paper and purchase aircrafty p p p p

Dutch banks’ interests, although preferred, were subject to the risks of an aircraft leasing business consisting of 63 stage 2 aircraft leased to various airlines

♦ The tax benefit resulted from a fundamental provision in Subchapter K, the ceiling rule, that functioned as contemplated. See Addendum -Legislative History of the Ceiling Rule at the end of these materials.



C tl H b I ( ti d)– Castle Harbour I (continued)♦ Appears willing to disregard a partnership (or partner) if a partnership

undertakes a legitimate business or otherwise has economic effect but only if there is no non tax reason for parties to join together as partnersonly if there is no non-tax reason for parties to join together as partners (discussing ASA Investerings and Boca Investerings)

– Contingent payment installment note sale transactions – ASA Investerings Partnership Boca Investerings Partnership and SabaInvesterings Partnership, Boca Investerings Partnership, and Saba Partnership (D.C. Circuit)♦ Basic facts – Taxpayer and foreign bank formed a partnership in

exchange for substantial cash contributions that were invested in a preexchange for substantial cash contributions that were invested in a pre-packaged manner. The partnership purchased private placement notes (“PPNs”) that were sold shortly thereafter for cash and contingent payment installment notes and cash.

♦ Purported business purpose – interest rate investment strategy, pre-tax profit

♦ Anticipated tax benefit – Large capital gain allocated to tax indifferent


foreign bank and large built-in capital loss in the contingent payment installment notes made available to the taxpayer

continued >


C ti t t i t ll t t l t ti ASA– Contingent payment installment note sale transactions – ASA Investerings Partnership, Boca Investorings Partnership, and Saba Partnership (D.C. Circuit) (continued)♦ ASA Investerings♦ ASA Investerings

Partnership was a sham. The parties lacked intent to form a “real partnership” and the foreign “partner” was in fact a lender only looking for a specific return

“absence of a non-tax business purpose is fatal” “Business activity” for purposes of Moline Properties, Inc. does not include

“activity whose sole purpose is tax avoidance.” Relied on Culbertson’s good faith-business purpose test to sham the partnership

♦ Boca Investerings (taxpayer victory reversed on appeal)♦ Boca Investerings (taxpayer victory reversed on appeal) Partnership did not serve a non-tax business purpose and is a sham. A partnership will be respected where there is “a non-tax business purpose need

for the partnership in order to accomplish the goals of the partners.” “[W]h t ’ l b t t hi ’ ith titi t d l l f “[W]here taxpayers use an ’elaborate partnership’ with entities created solely for

the purpose of the questioned transaction, ’the absence of a non-tax business purpose’ is fatal to the recognition of the entity for the tax purposes.”

District court relied on IRC § 704(e) to sustain partnership.


♦ Saba Partnership Reliance on ASA Investerings

continued >


C ti t t i t ll t t l t ti ASA– Contingent payment installment note sale transactions – ASA Investerings Partnership, Boca Investorings Partnership, and Saba Partnership (D.C. Circuit) (continued)♦ Distinguishing factors

Marketed by investment bank to multiple taxpayers

Pre-packaged transaction with no material arms-length negotiationsp g g g

Partnership not needed to accomplish interest rate strategy; interest rate strategy could have been achieved without a partnership and with substantially less transaction costs

Finding of no legitimate non-tax business purpose

Partnership and transactions not related to business or ordinary investment activity of the taxpayer



A d t h L L C C ’ 83 T C M (CCH) 1476 ff’d i t d– Andantech L.L.C. v. Comm’r, 83 T.C.M. (CCH) 1476, aff’d in part and remanded in part, 331 F.3d 972 (D.C. Cir. 2003)♦ Lease strip case in which accelerated rent was allocated to two, short-

term, tax indifferent “partners” before those partners transferred their interest to a corporate subsidiary of the taxpayer

♦ Partnership was a sham because the parties did not intend to join together as partners in a business enterprise and there was no evidence of “a non-tax need to form the partnership.”

♦ Tax Court, in alternative, applied the step transaction doctrine to disregard the partner status of the short-term partners

♦ Factors No evidence of arms’-length negotiation of computer transactionsg g p

Modest $200,000 investment in context of $122 million transaction, and was withdrawn within three months

No non-tax business purpose or reasonable possibility of profit


p p p y p

Partnership unnecessary to underlying transaction

continued >


S l f t t id● Some general factors to consider– Identification of intended non-tax objective(s)

Wh th t bj ti ( ) ld h b d ith t t– Whether non-tax objective(s) would have been pursued without tax benefit

– Actual non-tax effect or consequences, e.g., non-tax regulatory changes or changes in economic rights and obligations

– Implementation consistent with non-tax objectives

P i l f fi h l– Potential for pre-tax profit, where relevant

– Existence of pre-determined outcome



S l f t t id ( ti d)● Some general factors to consider (continued)– Nature and magnitude of third-party investment

O i i d f f th t ti– Origin and frequency of the transaction

– Absence or presence of arms’-length negotiations

Transitory parties or assets– Transitory parties or assets

– Existence of side agreements, actions, or internal documentation that undercut intended characterization

– Whether parties conducted due diligence and otherwise acted in a business-like manner


Addendum —Legislative History of the Ceiling Rule


Legislative History of the Ceiling RuleLegislative History of the Ceiling Rule

C ili R l● Ceiling Rule– Tax follows book.

H th t t l i l d i ti ith t t– However, the total gain, loss, or depreciation with respect to contributed property allocated to partners cannot differ from the amount of partnership gain, loss, or depreciation with respect to the contributed property [1] (endnotes below)contributed property.[1] (endnotes below)

● Prior to 1954, there was considerable doubt as the partners’ distributive shares of depreciation on contributed property and gain p p p y gand loss from a partnership’s sale of contributed property.[2]



1954 A t● 1954 Act – The House of Representatives adopted an entity approach “in the

interest of simplification of the partnership provisions.”[3] Under the p p p p [ ]entity approach, depreciation, gain, and loss related to contributed property would be calculated without regard to which partner contributed the property. Each partner would share in such depreciation, gain, or loss in accordance with its distributive share of such items (as determined for IRC § 704(b) purposes). The House of Representatives recognized that the noncontributing partners could be d l ( iti l ) i t d b t it t d th t th t ti ladversely (or positively) impacted, but it noted that the potential

detriment or gain was largely a timing difference that would reverse upon the sale or other disposition of partnership interests of noncontributing partnersnoncontributing partners.

– The Senate accepted the entity approach as the general rule but proposed an elective version of IRC § 704(c), which was enacted in 1954 and remained elective for three decades The ceiling rule was a


1954 and remained elective for three decades. The ceiling rule was a core component of the Senate’s proposal.[4]

continued >


Th l ti t f IRC § 704( ) d t t C ’● The elective nature of IRC § 704(c) demonstrates Congress’ decision in 1954 to promote simplicity over “getting it right” while providing partnerships an election to limit distortions attributed to contributed property in return for accepting additional complexity.

● By 1984, Congress clearly recognized the potential to shift income or loss among partners attributable to variations between the basisor loss among partners attributable to variations between the basis and fair market value of contributed property.[5]

● The elective nature of IRC § 704(c) was repealed. In addition, the § ( ) plegislative history foreshadowed the advent of curative allocations by anticipating regulations that would permit partnerships to agree to a more rapid elimination of differences in the fair market value pand basis of contributed property by substituting items not described in IRC § 704(c) for items described in IRC § 704(c) and vice versa provided there is no tax avoidance potential [6]


vice versa, provided there is no tax avoidance potential.[6]

continued >


Th St ff f th J i t C itt T ti li it i● The Staff of the Joint Committee on Taxation was more explicit in expressing its concern about the tax avoidance potential relating to contributed property:– [Congress] also believed that special rules were needed to prevent the

artificial shifting of tax consequences between partners with respect to pre-contribution gain or loss. This is particularly important since the p g p y pvarious partners may have different tax positions. For example, a partner to whom gain could have been shifted in the absence of the Act’s provisions could be tax-exempt, could have lower marginal rates than the contributing partner, or could have an expiring net operating loss carryover.[7]



C id d l t th it t dif i ifi tl th● Congress provided regulatory authority to modify significantly the IRC § 704(c) regulations in effect before 1984, but it expected that any such modifications would apply on a prospective basis only. Until such modifications were proposed, Congress intended that partnerships could continue to rely on the pre-1984 IRC § 704(c) regulations.[8] Future regulations could have taken into account situations not in the pre-1984 regulations, including, among examples identified, property when there are disproportionate profit and loss sharing arrangements contained in the partnership g g p pagreement.[9]



E d● Endnotes[1] E.g., Treas. Reg. § 1.704-3(b)(1); see also S. Rep. No. 83-1635,

at 381 (1954).[2] S. Rep. No. 83-1635, at 90.[3] H.R. Rep. No. 83-1337, at A223 (154); see also id. at 66 (preferring the

“extreme simplicity contrasted with any other alternative” and reasoning that the entity approach conformed to the usual expectations of partnersthat the entity approach conformed to the usual expectations of partners.

[4] S. Rep. No. 83-1635, at 381 (providing several examples of the application of IRC § 704(c)).

[5] See H.R. Rep. No. 98-432, pt. 2, at 1208 (1984) (observing that, although any shift was a timing difference, the benefit could be preserved as long as the partnership remained in existence); see also S. Prt. No. 98-169, vol. 1, at 213-15 (1984); H.R. Conf. Rep. No. 98-861, at 857-58 (1984).

[6] See e g H R Rep No 98-432 pt 2 at 1209[6] See, e.g., H.R. Rep. No. 98 432, pt. 2, at 1209.[7] Staff of the Joint Committee on Taxation, General Explanation of the

Revenue Provisions of the Tax Reform Act of 1984, at 213 (JCS-41-84, Comm. Prt. 1984) (the “1984 Blue Book”).

[8] S 1984 Bl B k t 213 3


[8] See 1984 Blue Book, at 213 n.3.[9] See id. at 214.

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