## Facts

- GE Capital Corp. subsidiaries formed Castle Harbour LLC (a partnership) with two Dutch banks, ING Bank N.V. and Rabo Merchant Bank N.V., in 1993.
- GE subsidiaries contributed commercial aircraft and an aircraft leasing business; the banks contributed cash.
- The partnership agreement allocated roughly 98% of “operating income” to the Dutch banks (not subject to U.S. tax) and about 2% to the GE entities, while GE retained substantial depreciation deductions.
- The IRS issued Final Partnership Administrative Adjustments reallocating income from the banks back to the GE affiliate serving as tax-matters partner, concluding the banks’ interests were not equity but resembled secured loans.
- In prior appellate proceedings, the Second Circuit held the evidence compelled the conclusion that the banks’ interests were “overwhelmingly in the nature of a secured lender’s interest,” and remanded.
- On remand, the district court held the banks nevertheless qualified as partners under I.R.C. § 704(e)(1) as holders of a “capital interest,” and rejected an accuracy-related penalty under I.R.C. § 6662 for the years at issue (1997 and 1998).

## Issues

1. Whether the Dutch banks owned a “capital interest” in a capital-intensive partnership and therefore must be recognized as partners under I.R.C. § 704(e)(1) despite the debt-like economic substance of their interests.
2. If the banks were not partners for tax purposes, whether the government was entitled to impose an accuracy-related penalty for substantial understatement under I.R.C. § 6662.

## Decision

- The Second Circuit reversed the district court.
- The court held the banks did not qualify as partners under I.R.C. § 704(e)(1) because their interests, in economic substance, were secured loans rather than bona fide equity capital at risk.
- The court sustained the IRS’s reallocation of the partnership’s taxable income away from the banks and back to the taxpayer.
- The court held the government was entitled to impose the I.R.C. § 6662 accuracy-related penalty for substantial understatement.

## Legal Principles

- Partner recognition and income allocation depend on economic substance; labels in a partnership agreement do not control when an interest is functionally a secured lending arrangement.
- I.R.C. § 704(e)(1) recognizes as partners those who own genuine equity “capital interests” in partnerships where capital materially produces income; it does not convert substantively debt-like positions with fixed or protected returns into equity.
- A prior appellate determination that an interest is “overwhelmingly” lender-like constrains later characterization of the same interest as a capital interest under § 704(e)(1).
- Where a taxpayer allocates nearly all taxable income to foreign or tax-indifferent parties lacking meaningful equity risk, the IRS may reallocate income and impose a § 6662 penalty when the resulting tax position produces a substantial understatement and lacks sufficient support.

## Conclusion

The Second Circuit held that § 704(e)(1) did not require recognition of the Dutch banks as partners because their arrangement was, in substance, a secured lending transaction rather than bona fide equity participation, and it reinstated both the IRS income reallocation and the § 6662 accuracy-related penalty for substantial understatement.


TIFD III-E, Inc. v. United States, 666 F.3d 836 (2d Cir. 2012)