Academic journal article Journal of Accountancy

IRS Scores Victory over Alleged Tax Shelter

Academic journal article Journal of Accountancy

IRS Scores Victory over Alleged Tax Shelter

Article excerpt

The Second Circuit Court of Appeals overturned the TIFD III-E Inc./Castle Harbour decision (see "Tax Matters," JofA, June05, page 93), a win for the IRS in its battle against tax shelters. The court ruled that the mere existence of a business purpose of a partnership does not preclude a conclusion that its primary purpose was tax avoidance. It also said Dutch banks with which TIFD III-E entered a partnership agreement had no meaningful stake in the partnership's success and thus should not have been considered equity partners.

TIFD III-E was a wholly owned subsidiary of General Electric Capital Corp. (GECC), which in turn was a commercial-aircraft-leasing subsidiary of General Electric Co. 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 and two other GE subsidiaries. TIFD III-E and the 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 depreciation) was allocated to the banks, representing their actual income from the Castle Harbour investment.

All the aircraft in Castle Harbour, however, already had been fully depreciated for tax purposes. 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 U.S. District Court for Connecticut to recover $62 million it had deposited with the IRS to satisfy the tax liability. …

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