## Facts

- A GE Capital subsidiary formed Castle Harbour LLC to hold aging commercial aircraft and lease rights that had largely exhausted depreciation benefits.
- The taxpayer contributed aircraft, lease rights, and cash; GE-related affiliates held “Class A” interests and controlled the venture.
- Two Dutch banks contributed cash (about 20% of capital) for “Class B” interests that were allocated 98% of the partnership’s “Operating Income” for tax purposes.
- The operating agreement targeted a fixed pre-tax internal rate of return (about 9–10%) for the banks and scheduled repayment of their capital.
- The banks’ principal and targeted return were heavily protected through deal terms tied to partnership assets and GE-related undertakings, making loss or a materially different return highly unlikely.
- Although the documents described limited upside and downside exposure for the banks, projections showed a remote chance of meaningful gain beyond the fixed return or meaningful loss.
- The taxpayer treated the banks as equity partners and allocated to them most taxable operating income; because the banks were foreign, this reduced U.S. tax on the GE-related participants.
- The IRS recharacterized the banks’ interests as debt-like (secured lending) and reallocated income to the U.S. partners, producing roughly $62 million in additional tax.
- After a bench trial, the district court held for the taxpayer; the government appealed.

## Issues

1. Whether the Dutch banks’ “Class B” interests were bona fide equity interests in a partnership for federal income tax purposes.
2. Whether, based on economic reality, the IRS could recharacterize the banks’ interests as secured loans and reallocate partnership income away from the banks.

## Decision

- The Second Circuit reversed the district court.
- The court held the banks’ interests were not bona fide equity participation but were overwhelmingly in the nature of secured lenders’ interests.
- The court upheld the IRS’s reallocation of partnership income from the banks to the GE-related partners.
- The case was remanded for proceedings consistent with that holding.

## Legal Principles

- Federal tax classification turns on economic reality; the IRS may disregard formal labels when an interest matches its stated classification only in illusory or insignificant respects.
- A partner-level equity interest requires meaningful exposure to entrepreneurial upside and a meaningful risk of loss; a fixed, effectively protected return indicates debt-like character.
- Debt–equity analysis considers the overall arrangement (including fixed return, security/guarantees, and practical likelihood of gain or loss), not nominal contractual terms alone.
- Tax allocations that place most taxable income on parties who do not bear the corresponding economic benefits and risks may be disregarded when inconsistent with the transaction’s substance.

## Conclusion

The court treated the Dutch banks as secured lenders rather than equity partners because their expected return was fixed and effectively protected and their upside and downside exposure was remote; therefore, the IRS properly reallocated Castle Harbour’s income to the U.S. participants.


TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006)