A Connecticut district judge ruled against the Internal Revenue Service and ordered the agency to refund more than $62 million to a General Electric subsidiary stemming from a transaction that the IRS said was a sham.
TIFD III-E Inc., a wholly owned subsidiary of the General Electric Capital Corp., won its lawsuit to recover some $62 million that it had deposited with the IRS to satisfy an alleged tax liability that arose from an IRS determination that the company had incorrectly calculated and reported the amount of income that it earned from 1993 to 1998 as a partner in Castle Harbour-I LLC, a commercial aircraft-leasing partnership created by GE to reduce GECC's risk in the aircraft leasing business.
In 2001, the IRS issued two notices of final partnership administrative adjustments concerning Castle Harbour that attributed approximately $310 million of additional income to TIFD-III E, resulting in an additional tax liability over $62 million.
The government argued that Castle Harbour was formed with no non-tax purpose, making its formation a "sham" transaction, and that even if the arrangement had a business purpose, the Dutch banks that bought stakes in the partnership were, for tax purposes, only lenders to Castle Harbour, not partners, and therefore couldn't be allocated any partnership income. In addition, the IRS contended that even if Castle Harbour should be treated as a partnership for tax purposes, the way it allocated income violated an "overall tax effect" rule of the Internal Revenue Code.
However, U.S. District Judge Stefan R. Underhill ruled that Castle Harbour properly allocated income among its partners, and that the FPAAs issued by the IRS were in error.
While Judge Underhill said that "it appears likely that one of GECC's principal motivations in entering into this transaction - though certainly not its only motivation - was to avoid that substantial tax burden," he ruled that the Castle Harbour transaction was "an economically real transaction, undertaken, at least in part, for a non-tax business purpose; the transaction resulted in the creation of a true partnership with all participants holding valid partnership interests; and the income was allocated among the partners in accordance with the Internal Revenue Code and Treasury regulations."
"The transaction, though it sheltered a great deal of income from taxes, was legally permissible. Under such circumstances, the IRS should address its concerns to those who write the tax laws," Underhill wrote.
The ruling is the third defeat in two months for the IRS, which lost two decisions concerning tax-related transactions that it regarded as being invalid for deductions involving Black & Decker and Coltec Industries.
