In addition to providing analysis and updates on pending tax appeals, this blog is intended to serve as a resource where readers can easily access the briefs and relevant opinions in those cases. Because of the press of business and other reasons, the posting of a couple of the opinions in cases we have discussed has slipped through the cracks. So we are providing links to those opinions here, even though the opinions are long past the point of “breaking news”:
The Second Circuit’s decision in TIFD (“Castle Harbour”), once again reversing the district court and holding that the banks did not qualify as partners under § 704(e)(1), and that the government could impose a penalty on the taxpayer for substantial understatement of income.
The Eleventh Circuit’s decision in Calloway, affirming the Tax Court and holding that the transaction in question was properly treated as a sale, not a loan, and upholding the penalties. The decision approves the multi-factor approach employed by the Tax Court majority, and notes infirmities in the alternative analytical approaches suggested by Judges Halpern and Holmes in their respective concurring opinions.
The Supreme Court’s decision upholding the Affordable Care Act (linked below). The opinion was eventually entitled NFIB v. Sebelius, although we had covered it using the caption of one of the companion cases, HHS v. Florida. The discussion of the Anti-Injunction Act, the issue that was covered in the blog, is found at pages 11-15 of the Court’s slip opinion. Our prior coverage (linked here only so that I can show off my against-the-mainstream prediction that the legislation would survive) can be found here and here. The majority’s key holding that the individual mandate could be upheld as an exercise of the Taxing Power is found at pp. 33-44.
The taxpayer has filed a petition for rehearing and rehearing en banc in Historic Boardwalk, asking the Third Circuit to reconsider its decision denying the taxpayer’s claim for historic rehabilitation credits. Among other points, the petition criticizes the panel’s decision for analogizing this case to the Second Circuit’s Castle Harbour decision, TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006), which found that the partner there had no downside risk that it would not recover its capital contribution. The taxpayer argues that there was a risk here that the partner would not recover its capital contribution from the partnership, and the court erred in finding that there was no risk by taking the tax credits into account. Specifically, the petition argues, “the Opinion wrongfully treats the allocation of the historic rehabilitation tax credits to [the investor] by operation of law (i.e., under the Code) as a repayment of capital to” the investor by the partnership.
There is no due date for a response by the government. Under Rules 35 and 40 of the Federal Rules of Appellate Procedure, a party is prohibited from responding to a petition for rehearing unless it is directed to do so by the court.
[Note: Miller & Chevalier filed a brief in this case on behalf of National Trust for Historic Preservation]
In a detailed 85-page opinion, the Third Circuit has reversed the Tax Court’s opinion that upheld a claim for historic rehabilitation tax credits by the private partner in a public/private partnership that rehabilitated a historic property on the Atlantic City boardwalk. See our earlier report here. The government had argued both that the transaction lacked economic substance and that the private partner, Pitney Bowes, was not a bona fide partner in the enterprise. The Third Circuit agreed with the government’s second argument and therefore found it unnecessary to decide whether there was economic substance. Given that approach, the court stated that it would “not opine on the parties’ dispute” on whether the Ninth Circuit was correct in Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995), in stating that the policy of providing a rehabilitation credit as a tax incentive is relevant “in evaluating whether a transaction has economic substance.” Slip op. 54 n.50. The court did make some general observations on economic substance, however, noting its agreement with amicus that the government’s position had inappropriately blurred the line between economic substance and the substance-over-form doctrine, which are “distinct” doctrines. Slip op. 52 n.50. Citing Southgate Master Fund, L.L.C. v. United States, 659 F.3d 466, 484 (5th Cir. 2011), the court added that “even if a transaction has economic substance, the tax treatment of those engaged in the transaction is still subject to a substance-over-form inquiry to determine whether a party was a bona fide partner in the business engaged in the transaction.” Slip op. 53 n.50.
Turning to the issue that it found dispositive, the court concluded that Pitney Bowes was not a bona fide partner because it “lacked a meaningful stake in either the success or failure of [the partnership].” Slip op. 85. In reaching that conclusion, the court relied heavily on two recent court of appeals’ decisions, the Second Circuit’s analysis of bona fide equity partnership participation in TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006) (“Castle Harbour”) and the Fourth Circuit’s analysis of “disguised sales” in Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011). Although the taxpayer had objected that the latter case was irrelevant because no disguised sale issue was present, the court agreed with the government’s argument in its reply brief that “the disguised-sale analysis in that case ‘touches on the same risk-reward analysis that lies at the heart of the bona fide-partner determination.’” Slip op. 67 n.54 (quoting U.S. Reply Br. 9). See our previous report here. The court elaborated on this point as follows: “Although we are not suggesting that a disguised-sale determination and a bona fide-partner inquiry are interchangeable, the analysis pertinent to each look to whether the putative partner is subject to meaningful risks of partnership operations before that partner receives the benefits which may flow from that enterprise.” Id. at 69 n.54.
The taxpayer had relied heavily on the Tax Court’s findings regarding the essentially factbound question of bona fide partnership, but the Third Circuit found that the deferential standard of review of factual findings was not an obstacle to reversal. The court first stated that “the record belies” the Tax Court’s conclusion that Pitney Bowes faced a risk that the rehabilitation would not be completed. Id. at 73. To deal with the standard of review, the court of appeals drew a hair-splitting distinction between the factual issue of “the existence of a risk” and what the court believed to be a “purely . . . legal question of how the parties agreed to divide that risk,” which “depends on the . . . documents and hence is a question of law.” Id. at 73 n.57. The court of appeals directly rejected other Tax Court findings regarding risk as “clearly erroneous.” Id. at 76.
The court did not dwell on the policy implications of its decision. It stated that it was “mindful of Congress’s goal of encouraging rehabilitation of historic buildings” and had not ignored the concerns expressed by the amici that a ruling for the government could “jeopardize the viability of future historic rehabilitation projects.” Id. at 84. But the court brushed aside those concerns, taking comfort in the response of the government’s reply brief that “[i]t is the prohibited sale of tax credits, not the tax credit provision itself, that the IRS has challenged.” Id. at 85. Be that as it may, decisions like this are likely to diminish the practical effectiveness of the credit as an incentive and thus to frustrate to some extent Congress’s desire to encourage historic rehabilitation projects.
A petition for rehearing would be due on October 11.
[Note: Miller and Chevalier represents amicus National Trust for Historic Preservation in this case]
We present here a guest post by our colleague David Blair who has considerable experience in this area and authored the amicus brief in this case on behalf of the National Trust for Historic Preservation.
The government has appealed to the Third Circuit its loss before the Tax Court in Historic Boardwalk Hall, LLC v. Comm’r, which involves a public/private partnership that earned historic rehabilitation tax credits under Code section 47. The partnership rehabilitated East Hall, which is located on the boardwalk in Atlantic City. East Hall was completed in 1929, hosted the Miss America Pageant for many years, and is listed on the National Register of Historic Places. The IRS sought to prevent the private partner, Pitney Bowes, from claiming the historic rehabilitation tax credits, but the Tax Court upheld the taxpayer’s position after a four-day trial.
In its opening brief, the government advances the same three arguments in support of its disallowance that it made in the Tax Court. First, it asserts that Pitney Bowes was not in substance a partner because it did not have a meaningful stake in the partnership under the Culbertson-Tower line of cases. Second, it argues that the partnership was a sham for tax purposes under sham partnership and economic substance cases. Third, it argues that the partnership did not own the historic building for tax purposes and thus was not eligible for the section 47 credits for rehabilitating the building. In making the first two arguments, the government relies heavily on its recent victory in Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, where the Fourth Circuit overturned the Tax Court and found a disguised sale of state tax credits. (See our previous reports on that case here.) Similarly, the government’s brief places heavy reliance on its first-round victory before the Second Circuit in TIFD III-E, Inc. v. Comm’r (Castle Harbor), which is now back up on appeal. (See our previous reports on that case here.) In support of its sham partnership theory, the government cites provisions in the partnership agreement that protect investors from unnecessary risks, including environmental risks. On the third argument, the government asserts that the partnership never owned the building for tax purposes because the benefits and burdens of ownership never transferred.
Having won at trial, the taxpayer’s brief emphasizes the Tax Court’s factual findings in its favor. It also emphasizes the historic character of the building and the Congressional policy of using the tax laws to encourage private investment to preserve this type of historic structure. The taxpayer argues that the partnership was bona fide because the partners joined together with a business purpose of rehabilitating East Hall and earning profits going forward. The taxpayer also argues that the partnership has economic substance. In this regard, the taxpayer argues that the Ninth Circuit’s decision in Sacks v. Comm’r, 69 F.3d 982 (9th Cir. 1995), requires a modification of the normal economic substance analysis where Congress has offered tax credits to change taxpayers’ incentives. The taxpayer also argues that the partnership owned East Hall for tax purposes and therefore was eligible for the section 47 credits.
The National Trust for Historic Preservation filed an amicus brief in support of the taxpayer. That brief sets out the longstanding Congressional policy of offering the section 47 credit to encourage taxpayers to invest in historic rehabilitation projects that would not otherwise make economic sense. It further explains that historic rehabilitation projects typically involve partnerships between developers and investors that are motivated in part by the availability of the credit. It also is typical for these partnership agreements to protect the investors from unnecessarily taking on business risks. The amicus brief argues that, in applying the economic substance doctrine, courts should not override the narrowly focused Congressional policy of encouraging rehabilitation projects through the section 47 credit. Thus, courts should not simply review the non-tax business purpose and pre-tax profitability of investments in historic rehabilitation projects, but should acknowledge that the taxpayer can properly take into account the credits that Congress provides for historic rehabilitation projects. To do otherwise, as the Ninth Circuit observed in Sacks, “takes away with the executive hand what [the government] gives with the legislative.” The amicus argues that, at any rate, the transaction met the economic substance doctrine under Third Circuit precedent and that the partnership and Pitney Bowes interests were bona fide. It also points out that the Virginia Historic case is inapplicable because it involved a disguised sale, which the government has not alleged in this case. Similarly, the Castle Harbor case is distinguished on its facts due to the differences in the partnership agreements in the two cases.
The Real Estate Roundtable also filed an amicus brief, which highlights to the court that the recent codification of the economic substance doctrine in Code section 7701(o) places significant pressure on the distinction between, on the one hand, the economic substance doctrine, and on the other hand, substance-over-form and other “soft doctrine” attacks on transactions. This is due to the strict liability penalty that can apply to transactions that violate the economic substance doctrine. As the IRS has recognized in recent guidance under section 7701(o), it is necessary for the IRS and courts to carefully distinguish between cases where the economic substance doctrine is “relevant” and those where other judicial doctrines apply. The Real Estate Round Table then argues that the transaction at issue had economic substance.
The government’s reply brief is due January 31.
The Second Circuit has announced a May 16 oral argument date in TIFD III-E, Inc. v. United States, which is the second go-round for the case better known as Castle Harbour after the district court ruled again for the taxpayer on remand from the Second Circuit’s previous reversal. (See our prior reports and the briefs here, here, and here.) The identity of the three-judge panel will not be revealed until a later date.
On September 14, 2010, the tax matters partner (“TMP”) for Castle Harbour LLC filed its response brief in TIFD III-E Inc. v. United States, No. 10-70 (2nd Cir.) (brief linked below). For our prior coverage of this case, see here. As many readers are no doubt aware, this is the second time this case is before the Second Circuit.
In the response brief , the TMP frames the issues as: (1) whether the district court, upon remand, correctly determined the investment banks were partners under I.R.C. section 704(e)(1), (2) whether the IRS can reallocate income under I.R.C. section 704(b) despite the section 704(c) “ceiling rule,” and (3) whether the district court correctly decided that I.R.C. section 6662 accuracy-related penalties were not applicable.
First, the TMP argues that section 704(e)(1) creates an independent, objective alternative to the Culbertson test, with the critical issue being whether the purported partner holds a “capital interest.” The TMP contends that, because the banks’ interests were economically and legally equivalent to preferred stock, and because preferred stock is treated as equity for tax purposes even though it possesses many characteristics of debt, the banks held “capital interests” under section 704(e)(1). Accordingly, the TMP argues that the banks were bona fide partners in Castle Harbour, the Second Circuit’s application of Culbertson notwithstanding.
Second, the TMP contests the IRS’s ability to reallocate income under I.R.C. section 704(b) in spite of application of the section 704(c) ceiling rule (assuming the banks were bona fide partners). The regulations under section 704(c) were amended to allow such a reallocation for property contributions occurring after December 20, 1993, which is after the contributions at issue in the case. Accordingly, the TMP takes the position that the IRS is attempting an end-run around the effective date of the amended regulations.
Finally, the TMP also argues that victory at trial, based on the careful findings of fact by the district court, demonstrates that the transactions were primarily business-motivated, and furthermore, that substantial authority existed for the TMP’s return position. Accordingly, the TMP contends that accuracy-related penalties should not apply, even if the IRS’s adjustment is ultimately upheld.
Based our recent post on the Sala decision here, we have had several comments inquiring about the varied application of penalties in the “tax shelter” cases. This is the first in a planned series of responses to those comments that will try to explain, iron out, or at least flag, some of the irregularities.
When looking at the application of penalties to “shelter” cases generally, procedural posture matters. A good example of this is Sala. Why did the 10th Circuit discussion in Sala omit penalties? Because it was a refund case in which the taxpayer appears to have filed a qualified amended return (“QAR”) prior to being “caught” by the IRS. See generally 26 C.F.R. § 1.6664-2(c)(2). There is a discussion of whether Sala’s amended return was qualified in the district court opinion and that ruling apparently was not a subject of the appeal. Sala v. United States, 552 F. Supp. 2d 1167, 1204 (D. Colo. 2008). Thus, in a refund suit posture, there may be procedural reasons why penalties are inapplicable.
The refund claim situation is contrasted for penalty purposes with either deficiency proceedings or TEFRA proceedings. In either of the latter, penalties cannot be abated by a QAR (at least as to the matter at issue) because the taxpayer must have a deficiency or adjustment (to income) in order to bring either action. See generally sections 6212 and 6225-6. Thus, in cases such as Gouveia v. Commissioner, T.C. Memo 2004-25 (2004), the Tax Court addressed (and imposed) penalties in a deficiency context. And, in Castle Harbor, the courts addressed (but did not impose) penalties in the context of a TEFRA proceeding. TIFD III-E Inc. v. United States, 2009 U.S. Dist. LEXIS 93853 (D. Conn 2009). (We previously discussed the pending appeal in Castle Harbour here.)
While there is nothing mysterious about the foregoing, the different routes tax cases take can often cause an illusion that there is inconsistency in the application of penalties when, in fact, the cases are just procedurally different. One other area in which this confusion is particularly common (and an area in which there is a bit of a dispute as to the correct application of the law) concerns whose behavior “counts” for purposes of the sections 6662 (reasonable basis) and 6664 (reasonable cause and good faith) defenses in the context of a TEFRA proceeding. We will address that issue in our next post on penalties.
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.