Tax Law | Expert Legal Commentary
March 21, 2012
TIFD III-E, Inc. v. United States: Second Circuit Rejects Debt Holder as Partner, Enforces § 6662 Penalties
TIFD III-E, Inc. v. United States
H. Jacob Lager of Zuber Lawler & Del Duca
The Second Circuit recently found that partners whose interests are bound by overwhelmingly debt-like features are not partners for tax purposes. In TIFD III-E, Inc. v. United States, 666 F.3d 836 (2d. Cir. 2012), the Second Circuit rejected taxpayer’s argument that I.R.C. § 704(e)(1) broadened existing law to include debt holders as partners. On the factual issue of whether the partners were equity or debt holders, the Court examined the partnership terms and found overwhelming evidence of debt-like features, while finding that the terms were written with only an “appearance of risk.” Thus, the Court held against the U.S. taxpayer, thus imposing tax liability and I.R.C. § 6662 penalties.
An aircraft leasing concern affiliated with GE Capital created a partnership in the early 1990s for tax planning purposes. This partnership, named Castle Harbour LLC, included two Dutch banks – ING Bank N.V. and Rabo Merchant Bank N.V. As foreign entities, both banks were not subject to U.S. taxation and thus could capture the tax-free benefit of such an arrangement. The partnership also included TIFD III-E as the tax-matters partner and is the taxpayer in the litigation below. The partnership’s $590 million in assets included a fleet of fully tax-depreciated aircraft under lease to airlines. Id. at 838.
The terms of the Dutch banks’ participation in the partnership were structured with many elements of debt – the banks’ initial investment of $117.5 million was virtually guaranteed an annual rate of return of between 8.53% and 9.03%, absent the occurrence of unlikely risk factors. For tax purposes, the Dutch banks received much of the operating income of the partnership, thus escaping U.S. taxation. Id.
The United States challenged the Dutch banks’ classification as partners, alleging that the banks were actually lenders for purposes of taxation. If the banks were found to be lenders, the partnership’s profits would be allocated instead to TIFD III-E, which is within U.S. tax jurisdiction and would thus incur a U.S. tax liability. Id. at 839.
The U.S. District Court of Connecticut ruled that the banks were properly characterized as partners for tax purposes. Id. at 840. On appeal, the Second Circuit held that the district court erred and under the totality-of-the-circumstances test of Culbertson, the banks’ participation was not “bona fide equity participation,” but rather “overwhelmingly in the nature of a secured lender’s interest.” Id. at 840.
The Court remanded on a separate issue – whether the banks qualified as partners under I.R.C. § 704(e)(1), which provides that, “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 by purchase or gift from any other person.” Id. at 841-42. The district court held that the banks were partners under the code. Id. at 841. Alternatively the court held that even if the banks were not partners and TIFD III-E was liable for tax, the government could not assess a penalty for substantial underpayment under I.R.C. § 6662 because the substantial authority threshold had been met. Id. The United States appealed. Id.
I.R.C. § 704(e)(1) Did not Broaden Existing Law to include Debt Holders
The central issue before the Court was whether § 704(e)(1) changed the law so that holding a debt (in contrast with a holding of equity) qualified as a partnership interest. Id. at 842. The Court examined the definition of “capital interest” (a requirement of § 704(e)(1)), which is defined under regulations as “an interest in the assets of the partnership, which is distributable to the owner of the capital interest upon his withdrawal from the partnership or upon liquidation of the partnership.” Id. (quoting Treas. Reg. § 1.704-1(e)(1)(v)).
After examining both the statute and the regulation for plain meaning and finding a slight favor to the United States’ position that debt would not qualify as an interest in a partnership, the Court examined the legislative history, which “made clear that the provision did not intend to broaden the character of interests in partnerships that qualify for treatment as a partnership interest to include debt.” Id. at 844.
In fact, the Court noted that the statute’s original purpose was centered on the second clause of the statute regarding the issue of method of transfer – specifically, a partnership would be found notwithstanding whether the partnership interest was transferred as a gift. Id. The Court cited a number of cases litigated under § 704(e)(1) which all dealt with the relevance of a gift transfer in identifying the owner (and thus taxpayer) of a partnership interest. Id. Thus, the Court found that § 704(e)(1) did not address the issue of debt holders as partners, and thus did not change the law to include debt holders as partners. Id.
Court Rejects Low Bar for Finding Equity Interests in Partnerships
The Court then reviewed whether the Dutch banks’ partnership interest was based in equity or debt. The Court cited terms of the partnership that showed the banks would receive a guaranteed rate of return, except in the cases where 1% of partnership’s losses exceeding $7 million would be allocated to the banks, as well as 100% of losses exceeding $541 million. Id. at 845. While the district court labeled this as “real risk,” the Court called these terms an “appearance of risk” and found the risk associated with the $7 million term to be minimal, and the $541 figure to be “not relevant because it was so unlikely to materialize.” Id. at 846. The Court was unconvinced that these risk allocation terms changed the reality of the banks participation from debt to equity.
Thus, because the Court categorized the Dutch banks’ interest “for all practical purposes a fixed obligation, requiring reimbursement of their investment as a set rate of return in all but the most unlikely of scenarios,” the Court found that the Dutch banks’ interest was a liability of the partnership, not a “capital interest” under § 704(e)(1). Id. at 847. In doing so, the partnership’s tax liability was now shifted to TIFD III-E.
Court Finds No Substantial Authority to Prevent I.R.C. § 6662 Penalties
Because the Court’s holding resulted in tax liability for TIFD III-E, the Court examined whether the United States could impose penalties for substantial understatement of taxes under I.R.C. § 6662. Under § 6662, a taxpayer can avoid penalty by showing substantial authority for the taxpayer’s treatment which resulted in the understatement. Id. at 848. Substantial authority exists “if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.” Id.
The Court contrasted the instant case with Jewel Tea, in which preferred shares were treated as equity and the shareholders could not demand their money at any time and return was based on company performance. Id. Instead, the Court found the instant case similar to O.P.P., where a purported debenture was treated properly as debt because the holder’s interest consisted of a fixed entitlement due at a specific time. Id. at 849.
The Court also rejected the district court’s contention that cases such as Dyer and Slifka stood for the rule that if a partnership has a valid business purpose, interests held by partners should be treated as equity, regardless of how pervasive the features of debt are. Id.
Thus, the Court found that TIFD III-E did not point to substantial authority supporting its treatment of the banks as partners, and thus the Court allowed the assessment of a penalty. Id. at 850.
TIFD E-III settles the question of whether I.R.C. § 704(e)(1) broadened the law to include debt holders as partners for the purposes of taxation. The clear answer being “no,” the Court also showed its willingness to examine the terms of partnership interests for debt-like features, such as fixed returns and exceedingly low risk. Partnerships facing tax planning issues should contact experienced tax counsel to see how TIFD E-III may affect your partnership’s structure and tax issues.
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