Taxpayers’ fortunes in litigating tax shelter cases improved a bit over the last couple of months. For years now, the tax community has been following a case popularly known as “Castle Harbor” involving a subsidiary of the General Electric Capital Corporation (“GECC”). GECC owned aircraft that it leased to users which were fully depreciated for tax purposes. In order to effectively depreciate the aircraft a second time, it contributed them to a partnership the other partners of which were foreign banks, which contributed cash. The partnership agreement allocated a very high percentage of the partnership’s operating income to the banks. However, for financial accounting purposes, the aircraft were depreciated based on their fair market value so very little accounting net income resulted. Because there was no tax depreciation left, the banks were also allocated very substantial amounts of taxable income. Since the banks were not US taxpayers, they did not have to pay US income taxes on this income. From GECC’s point of view, allocating taxable income to the banks rather than to GECC was as good as having depreciation deductions to offset its own taxable income.

The IRS challenged these partnership allocations and initially GECC prevailed at trial in the United States District Court. However, in 2006 the United States Court of Appeals for the Second Circuit reversed the decision after finding that the foreign banks should not be treated as partners because the economic arrangement between them and GECC was more akin to that of a lender. The Court of Appeals remanded the case to the District Court for further consideration of certain issues.

Upon remand, in October 2009 the district court once again held in favor of GECC. This time the court found that a section of the Internal Revenue Code captioned “Family Partnerships” was applicable. The court acknowledged that this was not a family partnership but only the caption to the section referred to family partnerships. The actual code section (Section 704(e)) provides that if a person owns a capital interest in a partnership where capital is a material income producing factor, then that person must be recognized as a partner. The court held that the foreign banks fell within this provision and must be recognized as partners.

The government will no doubt appeal once again to the Second Circuit. Of course, if the Second Circuit feels that the banks’ cash contribution was economically more like a loan, it could easily say they do not hold a capital interest and reverse the case again.

The second case was decided by the Court of Federal Claims, also in October 2009. It involved a complicated leasing transaction entered into by the Consolidated Edison Company of New York, Inc. We will not go into the details of the complex transaction but they were designed to produce tax deferral for the party engaging in the transaction. What is significant is that the main way the IRS attacks these transactions is to say they have no “economic substance;” that is they do nothing but produce tax benefits for taxpayers engaging in the transaction. A transaction generally is found to lack economic substance where the taxpayer is protected against economic losses but at the same time has little or no opportunity to realize an economic profit from the transaction. Economic substance has become such a hot button issue that Congress has repeatedly entertained the notion of adopting a statutory economic substance requirement and imposing new penalties on transactions that do not comply. In fact, such a provision is contained in the version of the healthcare legislation that has been passed by the House of Representatives.

In the Consolidated Edison case, the court found that the transactions engaged in by the taxpayer did have economic substance. Although the transactions were clearly structured to minimize any economic risk to the taxpayer, the court found the taxpayer still had several different ways in which the transaction could generate an economic profit. While this case will likely also be appealed, it is nevertheless a meaningful victory in light of the possible codification of an economic substance requirement.