For the second time in six years, the U.S. Court of Appeals for the Second Circuit (the “Second Circuit”) rejected a GE Capital Corporation (“GECC”) transaction involving allocation of aircraft lease income to two Dutch banks. On January 24, 2012, the Second Circuit unanimously held that the IRS properly assessed additional tax and a substantial understatement penalty against a GECC subsidiary for its 1997 and 1998 tax years.

The case involved a 1993 transaction in which the GECC subsidiary (TIFD III-E, Inc.) created an LLC (Castle Harbour) that was treated as a partnership for federal income tax purposes with two Dutch banks as partners. GE contributed cash, fully tax depreciated airplanes and rents due on the airplanes. The Dutch partners contributed $67.5 million to Castle Harbour and purchased $50 million of GE’s interest in Castle Harbour, bringing the total Dutch contribution to $117.5 million, representing 18% of Castle Harbour’s capital. The partnership agreement allocated 98% of Castle Harbour’s operating income to the Dutch partners and provided that over eight years, the Dutch banks’ interest would be almost entirely bought out by partnership income, giving the Dutch partners a 9% return on their investment. Since the aircraft were fully depreciated for tax purposes, the taxable income allocated to the Dutch banks was greater than their book allocation by the amount of book depreciation. (The Dutch partners were insensitive to this book/tax difference since they paid no U.S. taxes.) The IRS challenged this transaction on three grounds. First, the IRS argued that the transaction should be disregarded as a sham. Second, the IRS argued that the Dutch banks were not really partners for tax purposes and should not be allocated any partnership income. Finally, the IRS argued that the partnership allocations violated the “overall tax effect” rule of Code Section 704(b).

In 2004, the Federal District Court in Connecticut found that the banks were valid partners and rejected each of these arguments. In particular, the court found that the transaction had both a non-tax economic effect (since the Dutch partners had a direct stake in the partnership’s fortunes and participated in economic upside) as well as a non-tax business purpose (including GE’s need to raise capital).

The Second Circuit reversed and remanded the District Court’s ruling for the first time in 2006. The Second Circuit considered the transaction a sham and held that the Dutch banks were not partners under common law partnership tax principles. The Second Circuit, however, remanded the case to the District Court for consideration in the first instance of the taxpayer’s argument that the banks qualified as partners under Section 704(e)(1).

In 2009, on remand, the IRS argued to the District Court that the Second Circuit’s holding that the banks’ interest was not a bona fide equity participation precluded the court from finding, on the same factual record, that the banks qualified as partners. The District Court rejected this argument and found that the banks met the requirements of the “family partnership” rules4 in Section 704(e)(1) because (i) they, as opposed to some other entity, truly owned their interest in Castle Harbour; (ii) their interest was a capital interest; and (iii) capital, in the form of aircraft, was a material income-producing factor for Castle Harbour. Lastly, the District Court also concluded that, even if its ruling that the banks qualified as partners under Section 704(e) was ultimately overturned, the government could not impose a penalty pursuant to Section 6662(d) on the taxpayer for substantial understatement of income or negligent underpayment of tax in the years 1997 and 1998, because “substantial authority” supported the treatment of the banks’ interest as equity for tax purposes.

In reversing the District Court again in January of this year, the Second Circuit held that the Dutch banks were not partners under Section 704(e)(1) and that a substantial understatement penalty could be imposed. The Second Circuit found that the banks’ interest was not a capital interest under Section 704(e) (1). The court concluded that holding a debt, the nature of the banks’ interest, does not result in ownership of a capital interest in a partnership to qualify that person as a partner under Section 704(e) (1). Thus, the Second Circuit rejected the District Court’s finding that Section 704(e) (1) changed the law to allow debt to be considered a partnership interest after the Supreme Court’s decision in Commissioner v. Culbertson. The Second Circuit also disagreed with the District Court that there was substantial authority for treatment of the banks as partners, finding that no substantial authority was provided for the tax treatment and that the IRS properly assessed a penalty for substantial understatement of income.