Castle Harbour: Old Concepts, New Facts and an Adverse Result for a Taxpayer
October 1, 2012
In January 2012, the United States Court of Appeals for the Second Circuit reversed the District Court decision which allowed General Electric’s $62Million refund claim regarding taxation of Castle Harbour aircraft leasing partnership from 1993 to 1998.The facts of the case are straight forward. A GE subsidiary contributed fully depreciated aircraft and two Dutch banks contributed cash to an offshore partnership in exchange for partnership interests. GE subsidiaries continued to lease and service the aircraft. The Dutch banks were allocated 98% of the income; however, the banks did not report this income in the Netherlands because the Dutch territorial system of taxation did not tax income earned outside its home country. Offshore financing structures are not unknown around the world. Instead, the banks received cash distributions on their investment account which was the sum of capital invested, plus a preferred return (8% or so), less cash distributions. Note the absence of any reference to a capital account proved fatal. The IRS successfully sought to disregard the existence of the partnership and to force the GE subsidiary to report all of the income. Tax doctrines, such as “family partnership rules,” but are applied more broadly than the name implies. Certainly no one would consider GE and the banks as a family. In hindsight, could this financing structure be redesigned? The Internet makes it easier to establish a business off-shore, share information and operate the enterprise. Perhaps the Banks could perform treasury and other functions. The downside of the Castle Harbour structure was that the Banks had no appreciable upside just a fixed return. The question is whether the next version of a Castle Harbour structure will give the bank an upside, eliminate the use of an investment account and rely upon a capital account as one would in a true partnership.