Tax Court denies capital loss generated by a partnership formed with an unrelated foreign bank.

The Tax Court held, in ASA Investerings Partnership, AlliedSignal, Inc., TC Memo 1998-305, that a partnership formed by AlliedSignal (Allied) with a foreign commercial bank (ABN) was not a valid partnership for U.S. tax purposes. The proposed transaction was designed to create a capital loss that would offset anticipated capital gain from an unrelated transaction. The Tax Court concluded that the parties had actually entered into a debtor-creditor relationship, based on the fact that they had "divergent, rather than common, interests." As a result, the court disregarded the attempted allocation of gains and losses between the parties.

The facts of the case are complicated. Allied was expecting to generate more than $446 million in capital gain on the sale of its interest in a company. Seeking ways to generate capital losses to offset the anticipated capital gain, Allied formed a partnership with the Netherlands Antilles subsidiaries of ABN, a Dutch bank not subject to U.S. tax. The partnership was capitalized with cash contributions, mainly from ABN. As part of the transaction, it purchased high-grade, floating-rate private placement notes (PPNs) and sold them for consideration consisting of 80% cash and 20% London Interbank Offering Rate-indexed installment notes (LIBOR notes). The partnership reported the sale of the PPNs on the installment basis, with the gain allocated according to the partnership interests. The partnership then purchased high-grade financial instruments and allocated income earned according to the partnership interests. Allied purchased a portion of ABN's partnership interest, becoming the majority partner. The partnership distributed the LIBOR notes to Allied and the cash to ABN. Allied then sold the LIBOR notes for a loss and the partnership liquidated within 12 to 24 months of formation.

Although the partnership agreement contained provisions outlining the allocation of income and losses, Allied and ABN had entered into various other agreements at a meeting in Bermuda prior to the formation of the partnership. This initial agreement included a provision providing a specified return that ABN expected on its investment in the partnership.

The Tax Court concluded that no valid partnership was formed by the subsidiaries of Allied and ABN, because to form a valid partnership, the parties must intend to join together to conduct an enterprise. The court rejected Allied's assertion that the partnership was formed as an investment vehicle; rather, the court held that Allied entered into the partnership to generate losses to shelter anticipated gains, while ABN entered into the partnership to receive a specified return on investment.

The court further held that the partner's allocation of profits and losses was improper; the conduct of Allied and ABN demonstrated that the Bermuda agreement, which provided for a guaranteed return on investment for ABN, was the substance behind the formula provided by the partnership agreement. Moreover, while the partnership agreement provided that the parties would share losses on a pro rata basis, internal documentation indicated that ABN had no intention of absorbing any portion of the losses. Finally, although Allied and ABN knew their intentions would jeopardize the status of the partnership, it was clear from internal documentation that the parties intended that the LIBOR notes would be distributed to Allied prior to the start of the partnership agreement.

As a result, the court held that the parties had entered into a lending transaction. This was evident in Allied's behavior, including its debtor-like tracking of the income allocation to ABN with the return on investment that ABN was guaranteed under the Bermuda agreement. Similarly, ABN behaved more like a creditor than a partner, by requesting approval from its credit committees and submitting a loan application to such committees in seeking internal approval for the transaction.

By concluding that the transaction was in substance a loan, the court held that ABN's subsidiaries were not considered to be partners. As a result, the gains relating to the sale of the PPNs and the loss generated on the sale of the LIBOR notes were allocated entirely to the Allied affiliated group.

In ACM Partnership, TC Memo 1997-115, the Tax Court addressed a similar transaction. However, the court did not focus on the validity of the `partnership, but examined the economics of the contingent installment sale transaction in determining that the transaction lacked substance. In light of Allied and ACM, taxpayers should more critically examine the substance of transactions involving partnerships, to ensure they will be respected.

FROM MICHAEL LAYDEN, CPA, JAMES M. GANNON, CPA, AND GLENN E. DANCE, CPA, WASHINGTON, D.C.