June 28, 2010
As many if not most tax practitioners are aware, Castle Harbour is the nickname of a partnership taxation case that has been the subject of a great deal of attention in recent years. See TIFD III-E Inc. v. United States, 342 F. Supp. 2d 94 (D.Conn. 2004), rev’d, 459 F.3d 220 (2d Cir. 2006). The case involved a partnership arrangement that allocated 98% of the taxable income derived from fully depreciated aircraft leases to two foreign banks, even though the banks received only a relatively meager debt-like return on their partnership interests. The IRS attacked the structure on two basic grounds: (1) that the overall arrangement was a sham, and (2) that the foreign banks were not bona fide equity partners, but rather held interests economically in the nature of secured loans.
The district court decided the case in the taxpayer’s favor, holding that the partnership arrangement was not a sham because there were legitimate business purposes for the deal, and the arrangement did have appreciable economic effects, even though the partners had tax avoidance motives in entering into the deal. The Second Circuit reversed the district court on the IRS’ second argument, namely that the banks were not bona fide partners because they had no meaningful stake in the entrepreneurial success or failure of the venture. The court’s holding was based on an application of the Supreme Court’s facts and circumstances test for bona fide partner status set forth in Commissioner v. Culbertson, 337 U.S. 733 (1949). The Second Circuit remanded the case for further consideration of an alternative argument by the taxpayer—that the partnership was a “family partnership” under I.R.C. section 704(e).
In a somewhat surprising turn, the district court held that the banks were partners in a partnership under section 704(e), irrespective of the Second Circuit’s ruling applying Culbertson. The government, of course, has appealed to the Second CIrcuit, No. 10-70. The government’s brief is linked below. The taxapayer’s brief is due September 14, 2010.