Source: https://appellatetax.com/category/partnerships/
Timestamp: 2019-04-25 04:25:22+00:00

Document:
In Eaton Corp. v. Commissioner, 152 T.C. No. 2 (2019), a divided Tax Court decided (by a 10-2 margin) that the CFC partners in a U.S. partnership must increase earnings and profits (E&P) for the partnership’s subpart F inclusions. Members in the taxpayer’s group owned several CFCs (the “CFC partners”) that were partners in a U.S. partnership. That partnership in turn owned several lower-tier CFCs (the “lower-tier CFCs”) that generated subpart F income. There was no dispute that the U.S. partnership had to include the subpart F income of the lower-tier CFCs. The question before the Tax Court on motions for summary judgment was whether the CFC partners were required to increase their E&P in the amount of the U.S. partnership’s income inclusions (which ultimately determined whether the U.S. parent must include income from a section 956 investment in U.S. property by the CFC partners).
In an opinion by Judge Kerrigan, the majority held that the law required the CFC partners to increase E&P for the U.S. partnership’s income inclusions. Although the opinion does not expressly state so, it appears to adopt the IRS’s arguments for increasing the CFC partners’ E&P.
The court began with the language of section 964(a), which provides that “[e]xcept as provided in section 312(k)(4), for purposes of this subpart the earnings and profits of any foreign corporation…for any taxable year shall be determined according to rules substantially similar to those applicable to domestic corporations, under regulations prescribed by the Secretary….” (emphasis added). The court then held that because the rules “applicable to domestic corporations” are those in section 312 and its accompanying regulations, the computation of foreign corporation E&P under 964(a) should be made under the “elaborate, technical rules” of section 312 and its regulations.
The court observed that under Treas. Reg. § 1.312-6(b), the computation of E&P includes “all items includible in gross income under section 61….” Although there “is no explicit rule in section 312, section 964, or their accompanying regulations specifying how a CFC’s distributive share of partnership income…should be treated for purposes of computing its E&P,” the court looked to “the general rules set forth in subpart F and section 312.” Under those general rules, the court reasoned that the CFC partners should compute gross income “as if they were domestic corporations,” which meant including their distributive share of partnership income under section 702. And since the U.S. partnership’s gross income “includes subpart F income and section 956(a) inclusions from the lower-tier CFCs,” the court concluded that the CFC partners must increase their E&P by the subpart F amounts that are included in their gross income.
The court rejected that reading of Treas. Reg. § 1.964-1(a)(1) on the grounds that the three enumerated steps in that regulation are insufficient for computing E&P. To compute E&P at all, it is necessary to know how corporate transactions and events—like property distributions, stock distributions, redemptions, discharge of indebtedness income, and depreciation—affect E&P. And since the regulations under section 964 address none of these transactions or events, the court held that they cannot alone determine foreign corporation E&P. Rather, recourse to section 312 and its regulations is necessary. The court also observed that the section 964 regulations specifically provide that the depreciation rules in section 312(k) do not apply in computing foreign corporation E&P. And the court inferred that this meant that section 312 and its regulations must apply in computing foreign corporation E&P, otherwise there would be no need to explicitly bar the application of the section 312(k) depreciation rules.
The court also addressed the taxpayer’s other argument that the CFC partners’ subpart F inclusions “do not increase the dividend[-]paying capacity of the upper[-]tier CFC partners.” The court observed that “[t]here are many instances in which E&P are increased when amounts are included in income but no cash is received,” citing original issue discount and income accrual as examples.
Most of the rest of the Tax Court joined Judge Kerrigan’s opinion, with Judge Pugh abstaining and Judge Morrison writing a brief concurrence (in which he clarifies his opinion that it is the language in Treas. Reg. § 1.964-1(a)(1)—and not, as the majority stated, the language in section 964(a)—that imports section 312 and its regulations into the computation of foreign corporation E&P). Judge Foley, however, wrote a dissent in which Judge Gustafson joined.
Given that it involves a purely legal issue and a divided Tax Court, the case seems destined for appeal, so stay tuned for further updates.
The Fifth Circuit has finally issued its opinion in NPR (as reflected in our prior coverage, this case was argued almost two years ago), a case involving a Son-of-BOSS tax shelter in which the district court absolved the taxpayers of penalties. The taxpayers were not as fortunate on appeal, as the Fifth Circuit handed the government a complete victory.
The court’s consideration of the two issues before the court of broadest applicability were overtaken by events — specifically, the Supreme Court’s December 2013 decision in United States v. Woods. See our report here. In line with that decision, the NPR court held that the penalty issue could be determined at the partnership level and that the 40% penalty was applicable because the economic substance holding meant that the basis in the partnership was overstated. This latter holding reversed the district court, which had relied on the Fifth Circuit precedents that were rejected in Woods.
The other issues resolved by the Court were mostly of lesser precedential value. First, the court affirmed the district court’s conclusion that a second FPAA issued by the IRS was valid because NPR had made a “misrepresentation of a material fact” on its partnership return.
Second, the court rejected the district court’s holding that the taxpayers could avoid penalties on the ground that there was “substantial authority” for their position. It criticized the district court for basing its “substantial authority” finding in part on the existence of a favorable tax opinion from a law firm (authored by R.J. Ruble who eventually went to prison as a result of his activities in promoting tax shelters). The court explained that a legal opinion cannot provide “substantial authority”; that can be found only in the legal authorities cited in the opinion. Here, the legal opinion had relied on the “Helmer line of cases,” which establish that contingent obligations generally do not effect a change in a partner’s basis. The court of appeals held that Helmer did not constitute substantial authority in a situation in which the transactions lack economic substance and in which the partnership lacked a profit motive. The court also observed that the IRS was correct in arguing that its Notice 2000-44 should be considered as adverse “authority” for purposes of the “substantial authority” analysis — albeit entitled to less weight than a statute or regulation.
Finally, the court overturned the district court’s finding that the taxpayers had demonstrated “reasonable cause” for the underpayment of tax. With respect to the partnership, the court stated flatly that “the evidence is conclusive that NPR did not have reasonable cause.” With respect to the individual partners, the court left a glimmer of hope, ruling that an individual partner’s reasonable cause can be determined only in a partner-level proceeding. Thus, the court merely vacated the district court’s finding of reasonable cause and left the individual partners the option of raising their own individual reasonable cause defenses (whatever those might be) in a partner-level proceeding.
The Court this morning granted the government’s petition for certiorari in United States v. Woods, No. 12-562. As we recently reported, the issue presented in the petition concerns the applicability of the valuation overstatement penalty — specifically, whether tax underpayments are “attributable to” overstatements of basis when the inflated basis claim has been disallowed based on a finding that the underlying transactions lacked economic substance.
The Court also added a second question for the parties to brief — “Whether the district court had jurisdiction in this case under 26 U.S.C. section 6226 to consider the substantial valuation misstatement penalty.” This issue involves the general question under TEFRA of which issues are to be resolved in a partner-level proceeding and which should be resolved at the partnership level. See Petaluma FX Partners, LLC v. Commissioner, 591 F.3d 649, 655-56 (D.C. Cir. 2010).
The government’s opening brief is due May 9. Oral argument will likely be scheduled for late 2013, with a decision expected by June 2014.
We have previously reported extensively (see previous reports here) on the Third Circuit’s decision in Historic Boardwalk denying a claim for historic rehabilitation tax credits by the private partner in a public/private partnership that rehabilitated a historic property on the Atlantic City boardwalk. Although the Third Circuit declined to rehear the case, the taxpayer has now filed a petition for certiorari seeking Supreme Court review (docketed as No. 12-901).
The petition elaborates by proffering three reasons why the case should be viewed as presenting tax law issues of exceptional national importance. First, the Third Circuit’s ruling that the taxpayer was not a bona fide partner is asserted to squarely conflict with Commissioner v. Culbertson, 337 U.S. 733 (1949). Second, the petition criticizes the court of appeals’ holding that the allocation of tax credits “should be considered a ‘sale’ or ‘repayment’ of ‘property’” as “utterly baseless” and at odds with Supreme Court precedent. Third, the petition criticizes the Third Circuit for considering the credits themselves as a component of the substance over form analysis.
The petition urges the Court to hear the case because of its importance, stating that it undermines Congress’s intent “to encourage private investment in the restoration of historic properties” and that the issues “bear broadly on . . . thousands of [historic rehabilitation tax credit] partnership investment transactions across the nation involving billions of dollars.” The breadth of the impact of a decision is an important factor in the Court’s consideration of whether to grant review, but the petition still faces an uphill battle, as the Court rarely grants certiorari in technical tax cases in the absence of a circuit conflict – unless the government urges it to do so. Here, there is every reason to expect that the government will oppose the petition.
The government’s brief in response is currently due, after one 30-day extension, on March 25.
The Third Circuit yesterday denied the taxpayer’s petition for rehearing en banc in Historic Boardwalk in what seems like record time (the petition was filed on October 10). The taxpayer’s last hope is to seek Supreme Court review, though the case does not look like one that could pique the Court’s interest. A petition for certiorari would be due on January 22.
The taxpayer has filed a petition for rehearing and rehearing en banc in Historic Boardwalk, asking the Third Circuit to reconsider its decision denying the taxpayer’s claim for historic rehabilitation credits. Among other points, the petition criticizes the panel’s decision for analogizing this case to the Second Circuit’s Castle Harbour decision, TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006), which found that the partner there had no downside risk that it would not recover its capital contribution. The taxpayer argues that there was a risk here that the partner would not recover its capital contribution from the partnership, and the court erred in finding that there was no risk by taking the tax credits into account. Specifically, the petition argues, “the Opinion wrongfully treats the allocation of the historic rehabilitation tax credits to [the investor] by operation of law (i.e., under the Code) as a repayment of capital to” the investor by the partnership.
There is no due date for a response by the government. Under Rules 35 and 40 of the Federal Rules of Appellate Procedure, a party is prohibited from responding to a petition for rehearing unless it is directed to do so by the court.
In a detailed 85-page opinion, the Third Circuit has reversed the Tax Court’s opinion that upheld a claim for historic rehabilitation tax credits by the private partner in a public/private partnership that rehabilitated a historic property on the Atlantic City boardwalk. See our earlier report here. The government had argued both that the transaction lacked economic substance and that the private partner, Pitney Bowes, was not a bona fide partner in the enterprise. The Third Circuit agreed with the government’s second argument and therefore found it unnecessary to decide whether there was economic substance. Given that approach, the court stated that it would “not opine on the parties’ dispute” on whether the Ninth Circuit was correct in Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995), in stating that the policy of providing a rehabilitation credit as a tax incentive is relevant “in evaluating whether a transaction has economic substance.” Slip op. 54 n.50. The court did make some general observations on economic substance, however, noting its agreement with amicus that the government’s position had inappropriately blurred the line between economic substance and the substance-over-form doctrine, which are “distinct” doctrines. Slip op. 52 n.50. Citing Southgate Master Fund, L.L.C. v. United States, 659 F.3d 466, 484 (5th Cir. 2011), the court added that “even if a transaction has economic substance, the tax treatment of those engaged in the transaction is still subject to a substance-over-form inquiry to determine whether a party was a bona fide partner in the business engaged in the transaction.” Slip op. 53 n.50.
Turning to the issue that it found dispositive, the court concluded that Pitney Bowes was not a bona fide partner because it “lacked a meaningful stake in either the success or failure of [the partnership].” Slip op. 85. In reaching that conclusion, the court relied heavily on two recent court of appeals’ decisions, the Second Circuit’s analysis of bona fide equity partnership participation in TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006) (“Castle Harbour”) and the Fourth Circuit’s analysis of “disguised sales” in Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011). Although the taxpayer had objected that the latter case was irrelevant because no disguised sale issue was present, the court agreed with the government’s argument in its reply brief that “the disguised-sale analysis in that case ‘touches on the same risk-reward analysis that lies at the heart of the bona fide-partner determination.’” Slip op. 67 n.54 (quoting U.S. Reply Br. 9). See our previous report here. The court elaborated on this point as follows: “Although we are not suggesting that a disguised-sale determination and a bona fide-partner inquiry are interchangeable, the analysis pertinent to each look to whether the putative partner is subject to meaningful risks of partnership operations before that partner receives the benefits which may flow from that enterprise.” Id. at 69 n.54.
The taxpayer had relied heavily on the Tax Court’s findings regarding the essentially factbound question of bona fide partnership, but the Third Circuit found that the deferential standard of review of factual findings was not an obstacle to reversal. The court first stated that “the record belies” the Tax Court’s conclusion that Pitney Bowes faced a risk that the rehabilitation would not be completed. Id. at 73. To deal with the standard of review, the court of appeals drew a hair-splitting distinction between the factual issue of “the existence of a risk” and what the court believed to be a “purely . . . legal question of how the parties agreed to divide that risk,” which “depends on the . . . documents and hence is a question of law.” Id. at 73 n.57. The court of appeals directly rejected other Tax Court findings regarding risk as “clearly erroneous.” Id. at 76.
The court did not dwell on the policy implications of its decision. It stated that it was “mindful of Congress’s goal of encouraging rehabilitation of historic buildings” and had not ignored the concerns expressed by the amici that a ruling for the government could “jeopardize the viability of future historic rehabilitation projects.” Id. at 84. But the court brushed aside those concerns, taking comfort in the response of the government’s reply brief that “[i]t is the prohibited sale of tax credits, not the tax credit provision itself, that the IRS has challenged.” Id. at 85. Be that as it may, decisions like this are likely to diminish the practical effectiveness of the credit as an incentive and thus to frustrate to some extent Congress’s desire to encourage historic rehabilitation projects.
A petition for rehearing would be due on October 11.
The Second Circuit has announced a May 16 oral argument date in TIFD III-E, Inc. v. United States, which is the second go-round for the case better known as Castle Harbour after the district court ruled again for the taxpayer on remand from the Second Circuit’s previous reversal. (See our prior reports and the briefs here, here, and here.) The identity of the three-judge panel will not be revealed until a later date.

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