In 2001, TIFD III-E Inc. (“TIFD III-E”) sued the United States of America to recover approximately $62 million that TIFD III-E deposited with the Internal Revenue Service (“I.R.S.”) in satisfaction of an alleged tax liability. That tax liability arose from the I.R.S.’s determination that TIFD III-E had incorrectly calculated and reported the amount of income TIFD III-E earned as a partner in Castle Harbour-I Limited Liability Company (“Castle Harbour”). After an eightday bench trial, I ruled that: (1) Castle Harbour’s formation was not a sham transaction; (2) ING Bank N.V. and Rabo Merchant Bank N.V. (collectively, the “Dutch Banks” or the “Banks”), two foreign tax-neutral entities, were partners rather than lenders both in economic reality and for tax purposes, see Commissioner v. Culbertson, 337 U.S. 733 (1949); and (3) the entities’ allocation of Castle Harbour’s income did not violate the “overall tax effect” rule of section 704(b) of the Internal Revenue Code. Accordingly, I held that Castle Harbour properly allocated income among its partners and that the final partnership administrative adjustments (“FPAAs”) issued by the I.R.S. were in error, and I ordered the I.R.S. to refund to TIFD III-E the total amount of TIFD III-E's jurisdictional deposit, plus any interest called for by 26 U.S.C. §§ 6226 and 6611. TIFD III-E Inc. v. United States, 342 F. Supp. 2d 94 (D. Conn. 2004) (“Castle Harbour I”).
On appeal, the Second Circuit held that the Dutch Banks were not bona fide equity participants in the Castle Harbour partnership. TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006) (“Castle Harbour II”). The Castle Harbour II panel reversed my decision and remanded this matter for further proceedings, including consideration of “the taxpayer’s argument that the partnership was a family partnership under the provisions of I.R.C. § 704(e).” Castle Harbour II, 459 F.3d at 241 n.19. This opinion addresses that question. ...
For the reasons discussed above, the Banks were owners of a capital interest in Capital Harbour, a partnership in which capital was a material income-producing factor. Accordingly, the Dutch Banks were partners in Castle Harbour, and their interests in that partnership should be treated as such under section 704(e).
Even if the Dutch Banks are later held not to have been partners in Castle Harbour, the partnership’s tax position treating the Banks as partners was supported by substantial authority and a reasonable basis. Accordingly, penalties against the taxpayer are unwarranted.
Castle Harbour properly allocated income among its partners and the final partnership administrative adjustments issued by the I.R.S. were in error. The I.R.S. is hereby ordered to refund to TIFD III-E the total amount of TIFD III-E’s jurisdictional deposit, plus any interest called for by 26 U.S.C. §§ 6226 and 6611.