Castle Harbour: Old Concepts, New Facts and an Adverse Result for a Taxpayer

October 1, 2012
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The family partnership rules are an old tax law concept and were designed to prevent the assignment of income to family members in lower income tax brackets.  The Culbertson case, decided in 1949, focused on the intent of the parties to form and operate a joint enterprise for profit. The facts were relatively simple as the parents tried to allocate income to their children, some of whom were serving overseas in the military and others lived out-of-state. The aforementioned children did not work at the ranch or contribute any capital to the partnership. As you might suspect, the taxpayers lost. Then, in 1951, Internal Revenue Code §704(e) was adopted, codifying the family partnership rules of Culbertson and addressing other issues.  §704(e) was designed to accommodate legitimate partnerships such as those investing in financial assets and real estate. Where capital is a material factor, one need only show that the party owns his or her capital account to satisfy the statutory test for a legitimate partnership. We fast forward to the General Electric 2011 Annual Report which contained the following disclosure in footnote 14 on page 108.  It reads:

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.