In TIFD III-E Inc. v. United States, the Second Circuit Court of Appeals reversed a judgment of the District Court and granted the Government’s motion to impose a 20-percent accuracy-related penalty against plaintiff TIFD III-E, a subsidiary of General Electric Capital Corporation, under Section 6662.33 Section 6662 imposes a 20-percent penalty on any portion of an underpayment of tax that is attributable to, in part, “[n]egligence or disregard of rules or regulations.”34 Taxpayer argued that it should not be subject to the negligence penalty because it had a “reasonable basis” for treating the Dutch banks’ interest in a partnership as equity rather than debt.

This case, often referred to as “Castle Harbour,” has a long and winding history, lasting more than a decade and had already been appealed twice to the Second Circuit.35 The underlying tax issue was whether a pair of Dutch banks who joined with TIFD’s parent company, General Electric Capital Corporation, to form an aircraft leasing company, should be considered partners in the leasing company. The Circuit Court previously rejected TIFD’s claim that the two Dutch banks were equity partners and had a meaningful stake in the success of the partnership.36 In addition, the Second Circuit held that the IRS could impose a 20% accuracy penalty under Section 6662 against TIFD for substantial understatement of its income taxes in 1997 and 1998. However, the Second Circuit’s decision did not end the dispute. The government later realized that the substantial understatement penalty could not be assessed because the 10% substantial understatement threshold had not been satisfied. As a result, the Service sought to impose the 20% accuracy penalty attributable to negligence.

The District Court denied the government’s motion, finding that TIFD had a “reasonable basis” for treating the Dutch banks’ stake in Castle Harbor as an equity interest rather than debt. According to the District Court, it was entirely reasonable for TIFD to rely upon a “mountain of authority” that classified preferred stock as equity, even if the holders were guaranteed a result and their profits did not depend on corporate growth.37 The District Court described the government’s position as defying common sense and “mind boggling,” noting that the government declined to respond to TIFD’s many supportive authorities.38

The Circuit Court reversed and found that the District Court erred in finding that TIFD’s underpayment was not attributable to negligence. The Circuit Court stated that TIFD did not create an equity interest. “The Dutch banks’ interests were designed to have a superficial appearance of equity participation,” and the taxpayer failed to undertake a proper investigation of the correctness of its tax position. Accordingly, TIFD failed to satisfy its burden of establishing the absence of negligence. 39

As to reasonable cause, the Circuit Court found that TIFD had pointed to no authorities to treat the interests of the Dutch banks’ as equity. The preferred-stock authorities relied on by TIFD provided no support for its treatment of the Dutch banks’ interest as equity, according to the Court.