Legal Alert: A Trend Emerging? District Court Disallows $1 Billion of Deductions

Earlier this year, the United States District Court for the Middle District of Louisiana upheld the Internal Revenue Service’s disallowance of $1 billion of deductions claimed by Dow Chemical in relation to two transactions that the court ruled lacked economic substance and involved sham partnerships. Chemtech Royalty Associates, L.P. v. United States , 05 - cv - 00944. While much of the court’s analysis focused on the common law tests of economic substance and sham partnership, the court also included a debt - equity analysis of the partnership interests, a trend that has started to emerge over the last year in tax litigation throughout federal courts.

The transactions, called Chemtech I and Chemtech II, were special limited investment partnership (SLIPS) transactions, a type of lease - strip transaction developed by Gold man Sachs. The transactions involved the creation of foreign limited partnerships to which Dow contributed physical assets and patents with a near - zero basis, which were the n leased or licensed back to Dow. Because of the nature of the property contributed, the partnerships could not earn income from third parties, and the partnerships’ income was limited to the payments from Dow. Dow’s use of the property did not change. The general partner was a Dow foreign subsidiary. The limited partners were foreign banks. The limited partnership interests carried the right to a fixed payment of 6% to 7%. Limited partnership distributions were funded with approximately 10% of the royalty and rental payments made by Dow, and all remaining cash in the partnerships was loaned back to Dow. These transactions were similar to the transaction involved in Castle Harbour , which involved a partnership owning fully depreciated aircraft. See T IFD III - E, Inc. v. United States , 459 F.3d 220 (2d Cir. 2006).

For tax purposes, the partnerships allocated approximately 80% of the rental or royalty income to the foreign banks even though they received only 10% of the income as cash distributions. The remaining 20% of the rental or royalty income was allocated to Dow. The effect of the transactions was that Dow deducted the full royalty and rental payments, received the bulk of the payments back in the form of nontaxable loans, and reported income only in the amount of its 20% partnership allocation. The court viewed the circular nature of the cash flows and the mismatch between the cash flows and the tax effects very unfavorably.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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