A winning tax shelter case.

In another loss for the IRS in its fight against tax shelters, a district court sustained allocations of income to a foreign partner that did not pay U.S. taxes, thereby allowing the partnership to avoid an enormous amount of U.S. income tax.

The General Electric Capital Corporation (GECC), a subsidiary of the General Electric Company (GE), was in the business of commercial aircraft leasing. To reduce its risks, GECC formed Castle Harbour, a limited liability company to which it contributed aircraft. Castle Harbour was owned by TIFD III-E Inc., a wholly owned subsidiary of GECC, and two other GE subsidiaries. TIFD III-E and the other subsidiaries sold interests in Castle Harbour to Dutch banks. Under the arrangement, 98% of Castle Harbour's operating income was allocated to the Dutch banks; consequently, the same percentage of net book income (operating income reduced by expenses including an allocable amount of depreciation) was allocated to the banks, representing their actual income from the Castle Harbour investment.

For tax purposes, the same allocation was made. All the aircraft in Castle Harbour, however, already had been fully depreciated for tax purposes. Consequently, although depreciation nominally is an expense for tax purposes, it did not actually reduce taxable income in this case. Accordingly, the taxable income allocated to the Dutch banks was greater than their book allocation by the amount of book depreciation for that year. The Dutch banks, however, did not pay U.S. income taxes. Thus, by allocating such a large percentage of the income from fully tax-depreciated aircraft to the Dutch banks, GECC avoided an enormous tax burden while, at the same time, shifting very little book income.

The IRS reallocated Castle Harbour's income to GECC, attributing $310 million of additional income to TIFD-III E that resulted in an additional tax liability of $62 million. TIFD-III E filed a complaint in the district court to recover $62 million it had deposited with the IRS in satisfaction of the tax liability.

Result. For the taxpayer. IRC section 6662 defines tax shelter as any partnership, entity, plan or arrangement that has as its significant purpose the avoidance or evasion of federal income tax. The government argued three alternative theories in its reallocation of Castle Harbour's income. First, Castle Harbour had been formed solely for tax purposes, making its formation a "sham" transaction. Second, even if the arrangement had a business purpose, the Dutch banks were, for tax purposes, only lenders to Castle Harbour, not partners, and, therefore, could not be allocated any partnership income. Third, even if Castle Harbour were treated as a partnership for tax purposes, the way it allocated income violated the "overall tax effect" rule of IRC section 704(b).

The district court, however, found the Castle Harbour transaction was "economically real," undertaken, at least in part, for a nontax business purpose; it resulted in the creation of a true partnership with all participants holding valid partnership interest; and the income from the transaction was properly allocated among the partners under section 704(b) and regulations section 1.704-1. Thus, the court ordered the IRS to refund the $62 million, plus interest.

The court pointed out there was no dispute that the Castle Harbour transaction had created significant tax savings for GECC. The critical question, however, was whether it also had economic substance. The court deems a transaction a "sham" if it has no business purpose or economic effect other than the creation of tax benefits. But in this case, the district court concluded the Castle Harbour transaction had a real, nontax economic effect.

* TIFD-III-E Inc. v. Commissioner, 94 AFTR. 2d 2004-6635 (DC Conn., 11/1/2004).

Prepared by Do-Jin Jung, PhD, CMA, CFM, assistant professor of accounting and Darlene Pulliam, CPA, PhD, professor of accounting, both of West Texas A&M University at Canyon.