Tifd III-E Inc. v. United States
| Decision Date | 28 March 2014 |
| Docket Number | Nos. 01cv1839 SRU lead,01cv1840 SRU.,s. 01cv1839 SRU lead |
| Court | U.S. District Court — District of Connecticut |
| Parties | TIFD III–E INC., The Tax Matters Partner of Castle Harbour–I Limited–Liability Company, Plaintiff, v. UNITED STATES of America, Defendant. |
Ann H. Rubin, Carmody & Torrance, Waterbury, CT, Anthony M. Fitzgerald, David S. Hardy, Carmody & Torrance, New Haven, CT, David J. Curtin, Michael J. Desmond, William S. McKee, William F. Nelson, Bingham McCutchen, John A. Galotto, McKee & Nelson, Washington, DC, Suzanne C. Feese, King & Spalding, Atlanta, GA, for Plaintiff.
Christine Grant Michaelis, Lara E. Ewens, Robert J. Higgins, Barry E. Reiferson, U.S. Department of Justice, Washington, DC, John B. Hughes, U.S. Attorney's Office, New Haven, CT, for Defendant.
RULING ON MOTION FOR IMPOSITION OF THE NEGLIGENCE PENALTY
Defendant, the United States, moves for an order imposing a negligence penalty on plaintiff TIFD III–E Inc. (“TIFD”) for tax years 1997 and 1998. During the 1990s, TIFD's parent company, General Electric Capital Corporation (“GECC”), joined with a pair of Dutch banks (“the Dutch Banks” or “the Banks”) to form an aircraft leasing company. TIFD considered the Dutch Banks to be its partners in the venture, and did not report any income allocated to the Banks on its own tax returns. During the course of this litigation, I twice found that decision to be more than reasonable; indeed, I found that the company correctly deemed the Banks to be equity stakeholders rather than lenders. TIFD III–E v. United States, 342 F.Supp.2d 94 (D.Conn.2004) (“Castle Harbour I ”); TIFD III–E v. United States, 660 F.Supp.2d 367 (D.Conn.2009) (“Castle Harbour III ”). The Second Circuit twice disagreed. TIFD III–E v. United States, 459 F.3d 220 (2d Cir.2006) (“Castle Harbour II ”); TIFD III–E v. United States, 666 F.3d 836 (2d Cir.2012) (“Castle Harbour IV ”). So, after more than a decade of litigation, TIFD ultimately lost this case. In addition, the Second Circuit held that the IRS could impose a 20% accuracy penalty against TIFD for substantial understatement of its income taxes in 1997 and 1998.
Ordinarily, that would have ended the matter. The government, however, later realized that the substantial understatement penalty could not be assessed because the 10% substantial understatement threshold had not been satisfied (presumably because the payments to the Dutch Banks that the Second Circuit held were interest payments thereby became deductible to the taxpayer, thus reducing its tax liability).See I.R.C. § 6662(d). As a result, the government now seeks to impose the 20% accuracy penalty for different reasons, arguing that TIFD's underpayment was attributable to negligence. For the reasons set forth below, I find that TIFD's tax position had a reasonable basis and therefore conclude that the negligence penalty is not applicable.
I assume the parties' familiarity with the facts underlying this case. See Castle Harbour I, 342 F.Supp.2d at 95–108. For the purposes of this opinion, however, it is useful to recall GECC's intent when it went into business with the Dutch Banks, and the basic structure of Castle Harbour's financing. All facts are taken from my previous decisions.
GECC entered the aircraft leasing business to reap tax benefits, but it later sold a stake in its airplanes for a different reason entirely—to mitigate risk in a shaky aircraft-leasing market. Commercial aircraft lose substantial value over time. Companies with sizable income like GECC purchase airplanes and then lease them so that they can take advantage of large, predictable depreciation deductions. But in the early 1990s, GECC started to question the wisdom of its investment; several airlines had fallen into bankruptcy, and GECC worried about the risk of owning airplanes that it did not use and could not rent to others.
To reduce its exposure, it initiated what it called a “sell-down” effort—it sought a partner that would buy a stake in the airplanes, leaving GECC with cash up front and less risk down the line. In other words, as I explained in my previous opinion, “rather than simply awaiting return in the form of the now-less-certain-rental income, GECC wanted to lower its risk by raising immediate cash against the future stream of income.” Castle Harbour–I, 342 F.Supp.2d at 96. But GECC could not pursue traditional strategies for raising cash. The market for aging commercial aircraft was weak, so it could not sell off the planes. Nor could it use them as collateral for a secured loan. In order to maintain its AAA credit rating, GECC had agreed to limit its leverage, and in 1993 GECC's debt-to-common-equity ratio hovered just below that threshold. In addition, a number of GECC's medium-term and long-term debt instruments contained a “negative pledge”—a covenant prohibiting GECC from using its assets to secure debt other than purchase money debt.
With those circumstances in mind, GECC solicited proposals that would allow it to raise cash without incurring any debt. Seven major investment banks responded, but after careful review, GECC rejected each of those bids as inadequate to achieve its purpose. After some back and forth, the investment bank Babcock & Brown submitted a plan acceptable to GECC. Pursuant to the plan, GECC would create a separate entity to which it would contribute aircraft and would then solicit investors to purchase ownership shares in the new entity. The proposal had an additional lucrative upside—the investors would be foreign tax-neutral entities, and any income allocated to those partners would not be subject to U.S. income tax.
Had the Dutch Banks simply bought a stake in the business, the parties would have been spared more than ten years of litigation. But the deal was more complex; as the Second Circuit described it, “[a]n extraordinarily complex maze of partnership provisions dictate[d] how the revenues, losses, and assets of the partnership would be allocated over the eight-year duration of the partnership.” Castle Harbour II, 459 F.3d at 226. The details of that labyrinth can be found in my previous decisions, but they resulted in a partnership arrangement that in some ways resembled preferred stock, but in other ways resembled the relationship between a debtor and a creditor: GECC retained the ability to buy the Dutch Banks out of their stake at any time. If GECC did not exercise that option, the entity would slowly buy the Dutch Banks' stake over the course of eight years, and the Banks would reap a guaranteed return of at least 8.5 % on their initial investment. But even though the Dutch Banks were insulated from any loss, they could still benefit from what I called the “upside potential”—the chance that the business would perform well and they would earn more than the guaranteed return (indeed, the Banks actually realized an approximately 9.1 % gain). Castle Harbour–I, 342 F.Supp.2d at 110. I have always seen this possibility as a meaningful opportunity, whereas the Second Circuit viewed it as “narrowly circumscribed.” Castle Harbour II, 459 F.3d at 234. My finding that the transaction had economic substance and a valid business purpose, however, was not overturned on appeal. See id. at 231–32.1
Despite the extensive litigation, no court has had occasion to squarely address the question whether TIFD acted negligently when it treated the Dutch Banks as equity partners for tax purposes. The government sought two alternative accuracy-related penalties in this case: one for substantial understatement of income tax and one for negligence.2 After remand in Castle Harbour II, I held that the government could not collect a substantial understatement penalty, because TIFD had a sound basis for believing it had given its partners an equity stake in the Castle Harbour venture. Castle Harbour III, 660 F.Supp.2d at 399 ). Because I held that TIFD had cleared the higher standard of substantial authority, I necessarily concluded that TIFD had a reasonable basis to treat the Banks as equity partners. Id. The Second Circuit reversed the first holding; therefore, it was unnecessary for it to decide whether the negligence penalty applied. After realizing that the substantial understatement penalty would not yield a penalty payment, however, the government revived its fallback theory. It now argues that TIFD had no reasonable basis for believing that the Banks were anything but lenders, and that it should be penalized for its negligence.
As a threshold matter, the government asserts that I lack the authority to decide whether the negligence penalty applies, because the Second Circuit's decision in Castle Harbour IV automatically became an order of this court, pursuant to Local Rule 77.1(e). That argument is flawed, because the parties jointly moved to alter the judgment (doc. # 145), and I granted that motion (doc. # 146). It was not until a dispute over the substance of the proposed alterations arose that the government opposed modification of the judgment on the grounds that the Second Circuit reversed without remand. Def.'s Proposal Re Entry of Judgment (doc. # 155).3 Yet, it is the government, not TIFD, which seeks to amend the judgment to include a negligence penalty. See Mot. Hr'g Tr. 2:18–25, Apr. 25, 2013 (doc. # 183); Proposed Judgment (doc. # 160). Because the parties properly moved to alter the judgment, I have the authority to decide whether to impose the negligence penalty despite the Second Circuit's reversal without remand.
Substantively, the government's position is that Castle Harbour IV vacated my decision in Castle Harbour III in its entirety and left intact the FPAA determination made by the IRS before this suit began. Def.'s Mem. Supp....
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