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19th AnnualReal Estate Tax Forum

Volume Two

Co-ChairsLeslie H. Loffman

Sanford C. PresantBlake D. Rubin

© Practising Law Institute

33

Partnership Disguised Sales of Property: G-I Holdings Misses the Mark

Blake D. Rubin Andrea Macintosh Whiteway

EY

Jon G. Finkelstein

KPMG LLP

March 15, 2010

Copyright 2010 Blake D. Rubin, Andrea Macintosh Whiteway and Jon G. Finkelstein. All rights reserved.

Reprinted from the PLI Course Handbook, 18th Annual Real Estate Tax Forum (Order #144587)

If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.


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INTRODUCTION

In United States v. G-I Holdings Inc.,1 the District Court analyzed a complex partnership transaction under Code Sec. 707(a)(2)(B) to determine whether a contributing partner engaged in a disguised sale of property to the partnership. In a discussion that extends for more than 45 pages, the District Court recharacterized a loan that in form was to a partner as in substance a loan to the partnership, and then, based on that recharacterization, concluded that a disguised sale had occurred. After that extensive discussion, the District Court held that the government’s claim must be dismissed because the statute of limitations with respect to the claim had expired.

Since its enactment in 1984, no court has applied Code Sec. 707(a)(2)(B) to find a disguised sale of property to a partnership, and G-I Holdings is therefore of great potential interest to partnership tax practitioners. This column summarizes the transaction at issue in G-I Holdings and discusses the District Court’s analysis of the disguised sale issue. As discussed below, the District Court’s analysis in the case is seriously flawed in several respects. Moreover, because of its conclusion that the government’s claim was time-barred, the District Court’s analysis of the application of Code Sec. 707(a)(2)(B) was not necessary to the ultimate disposition of the case and is, therefore, entirely dicta.2 In addition, the G-I Holdings opinion was issued as an “unpublished opinion” that will not appear in an official case reporter service. Unpublished opinions are generally accorded limited or no precedential weight.3 As a result, notwithstanding its great potential interest to partnership tax practitioners, we expect that the case will have little impact on the future development of the disguised sale rules.

1. Bankr. Case Nos. 01-30135 (RG) and 01-38790 (RG) (D.N.J. 2009) (December 14, 2009).

2. Seminole Tribe of Florida v. Florida, 517 U.S. 44, 67 (1996) (the holding of a case is “not only the result but also those portions of the opinion necessary to that result”). The District Court’s disguised sale analysis in this case was not necessary to its result.

3. Any appeal in G-I Holdings will lie in the Third Circuit, which recently stated, “We remind the District Court that unpublished district court opinions are not a source of law.” Pinho v. Gonzales, 432 F.3d 193, 213 n.26 (3d Cir. 2005). See generally 21 C.J.S. Courts § 234 (2009) (“An opinion not designated for publication is written primarily for the parties . . . [and] does not establish a precedent as to any legal issue decided”).


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RELEVANT FACTS OF G-I HOLDINGS

On February 12, 1990, GAF Chemicals Corporation and Alkaril Chemicals (together with G-I Holdings, Inc. and ACI Inc., successors in interest to GAF Chemicals Corporation and Alkaril Chemicals, respectively, “GAF”) and a subsidiary of Citibank (“Citibank”) formed a limited partnership (the “Partnership”) with Rhone Poulenc (“RP”). GAF, through two grantor trusts (the “GAF Trusts”) contributed the assets of its surfactants chemicals business with a value of $480 million to the Partnership. Citibank contributed approximately $10 million in cash to the Partnership. The GAF Trusts received a 49% limited partner interest and an initial capital account valued at $480 million. Citibank received a 1% limited partner interest and a capital account valued at approximately $10 million. RP contributed assets related to certain of its chemicals businesses and cash with a value of approximately $490 million to the Partnership in exchange for a 49% limited partner interest and a 1% general partner interest.4

The GAF Trusts, along with Citibank, assigned their limited partner interests to CHC Capital Trust (“CHC”), which was also apparently a grantor trust. The GAF Trusts owned a 98% interest in CHC and Citibank owned a 2% interest in CHC. On February 12, 1990, CHC borrowed approximately $460 million on a nonrecourse basis from Credit Suisse and pledged its 50% limited partner interest as collateral for the loan. On February 12, 1990, CHC distributed approximately $450 million of the proceeds of the Credit Suisse loan to the GAF Trusts and approximately $10 million of the proceeds of the Credit Suisse loan to Citibank. The GAF Trusts immediately distributed the approximately $450 million of cash to GAF. The Credit Suisse loan called for monthly interest payments at a rate of LIBOR plus 0.375%. However, CHC entered into a swap agreement with Citibank with respect to the interest payments due on the Credit Suisse loan, pursuant to which CHC’s interest payments were fixed at 9.141%. Citibank acted as security agent with respect to the Credit Suisse loan and the Citibank swap. GAF used the approximately $450 million of loan proceeds to repay debt incurred in an earlier leveraged buyout transaction.5

Under the terms of the Partnership agreement, CHC was entitled to a 9.125% per annum cumulative preferred return on its initial capital of

4. Final Pretrial Order at 40. 5. G-I Holdings at 6.

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approximately $490 million, distributed monthly and compounding to the extent not distributed. The proceeds of the preferred return were to be used to pay any interest due on the Credit Suisse loan, with any surplus distributed to the GAF Trusts and Citibank. CHC received a priority al-location of gross income to match its preferred return. After the gross income allocation on account of CHC’s preferred return, profits were allocated to offset any cumulative losses previously allocated. Thereafter, profits were to be allocated 99% to RP and 1% to CHC until RP received a 14.875% cumulative compounding return on its approx-imately $490 million of contributed capital plus any additional capital contributions made by RP. Any additional profits were to be allocated as follows: (1) the next $100 million of profits were to be allocated 80% to RP and 20% to CHC, (2) the next $50 million of profits were to be allo-cated 90% to RP and 10% to CHC, (3) the next $50 million of profits were to be allocated 95% to RP and 5% to CHC, and (4) the balance of any profits were allocated 99% to RP and 1% to CHC.6 Each tier of distributions other than the CHC preferred return were to be matched with an allocation of net profits (in contrast to the gross profit allocation to match CHC’s preferred return, as noted above).

Under the Partnership agreement, losses were first allocated to eliminate allocations of net income (but not to eliminate the allocations of gross income on account of CHC’s preferred return). After offsetting previous allocations of net income, losses were to be allocated as follows (1) the next $425 million of losses were to be allocated 95% to RP and 5% to CHC, (2) the next $555 million of losses were to be allocated 99% to RP and 1% to CHC, and (3) the balance of losses were to be allocated 100% to RP. Thus, under the terms of the Partnership agreement, CHC could be allocated only $26.8 million of losses in excess of its allocation of net profits.7

The Partnership was required to make monthly cash distributions to CHC equal to its preferred return (approximately $3.7 million per month). RP was obligated to maintain a $10 million working capital reserve for the Partnership, which was required to be replenished by RP to the extent the funds were used. The working capital reserve was permitted to be used to satisfy CHC’s preferred return. In the event that at any time, the Partnership’s aggregate liabilities exceeded the fair market value of its assets, RP was required to contribute sufficient capital

6. Final Pretrial Order at 43-45. 7. Final Pretrial Order at 46-47.


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to eliminate such excess. In addition, RP was obligated to restore any deficit in its capital account in connection with a liquidation of its interest in the Partnership or if CHC’s interest in the Partnership were liquidated. RP also entered into guarantee agreements in favor of GAF and Citibank with respect to the Partnership’s and RP’s financial obligations, including the obligation to make the preferred distributions to CHC, the maintenance of the working capital reserve and RP’s deficit capital account makeup obligation.8 In the event of a default on the Partnership’s obligation to pay the preferred return or maintain the working capital reserve, GAF and Citibank had the right to cause the liquidation of the partnership, which would result in liquidating distributions to the partners equal to their capital account balances. As an alternative to liquidating the Partnership, RP had the right to cause the Partnership to redeem GAF’s and Citibank’s interests in the Partnership for an amount equal to their capital account balances.9 In addition, in the event of a default under the Credit Suisse loan, Citibank, as security agent for the loan, had the right to put CHC’s Partnership interest to RP for an amount equal to the value of CHC’s capital account.10

The United States argued that GAF’s contribution to the Partnership and the Credit Suisse loan should be viewed together as a sale or exchange of property under Code Sec. 707(a)(2)(B)(iii). GAF argued that its contribution to the Partnership should be respected as a nonrecognition transaction under Code Sec. 721(a), and that the Credit Suisse loan was simply a non-taxable nonrecourse loan to CHC.

DISTRICT COURT’S ANALYSIS UNDER CODE SEC. 707(a)(2)(B)

As noted above, the District Court concluded that the United States’ claim was time barred by the three-year statute of limitations under Code Sec. 6501(a) because the United States failed to prove that the gross income reported on GAF’s return was understated by more than 25%.11 Nevertheless, prior to reaching this conclusion, the District Court engaged in an analysis extending more than 45 pages regarding whether the transaction constituted a disguised sale of GAF’s assets. The District

8. Final Pretrial Order at 52-54. 9. Final Pretrial Order at 57-59. 10. Final Pretrial Order at 69. 11. G-I Holdings at 82.

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Court concluded that Code Sec. 707(a)(2)(B) applies to the contribution of assets by CHC to the partnership. Code Sec. 707(a)(2)(B) provides:

(a) Partner Not Acting in Capacity as Partner.

(2) Treatment of Payments to Partners for Property or Services. – Under regulations prescribed by the Secretary –

(B) Treatment of Certain Property Transfers. – If –

(i) there is a direct or indirect transfer of money or other property by a partner to a partnership,

(ii) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and

(iii) the transfers described in clauses (i) and (ii), when viewed together, are properly characterized as a opsale or exchange of property,

such transfers shall be treated either as a transaction described in paragraph (1) or as a transaction between 2 or more partners acting other than in their capacity as members of the partnership.

The court stated that “GAF’s case is greatly weakened by its failure to come to grips with the reality of the disguised sale statute. The disguised sale statute allows a transfer to be recharacterized based on a larger picture which includes other transfers.”12 Clearly, the form of the transaction in G-I Holdings involved a transfer of property by GAF to the Partnership. Consistent with that form, the requirement of Code Sec. 707(a)(2)(B)(i) that there be “a direct or indirect transfer of money or other property by a partner to a partnership” was met. In form, however, the requirement of Code Sec. 707(a)(2)(B)(ii) that there be “a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner)” was not met. In form, no such transfer took place, because the Credit Suisse loan was, in form, a borrowing by CHC from an unrelated third party (Credit Suisse) and did not involve a transfer of money or other property from the Partnership or RP to GAF or CHC. Thus, as an essential prerequisite to its conclusion that Code Sec. 707(a)(2)(B) applied, the court had to recharacterize the Credit Suisse loan as a direct or indirect transfer of money from the Partnership or RP to GAF or CHC.

12. G-I Holdings at 24. The court noted that, in its opening post-trial briefs GAF presented no rebuttal case on this point, asserting simply that the disguised sale statute was “irrelevant.” G-I Holdings at footnote 15.


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The court dealt with this obstacle as follows: This Court concludes that responsibility for repayment of the loan rested indirectly with the partnership or the other partners. On the surface, CHC Capital Trust paid the interest on the loan. The economic reality, however, is that, while the transactions were carefully structured to create the appearance that CHC repaid the loan, all repayment came from the partnership or other partners.

First and foremost, the loan was nonrecourse and, in the event of default, Credit Suisse’s only recourse was to the collateral that had been pledged. (Stip. No. 229.) The $450 million in loan proceeds that GAF received could not, under any circumstances, be reached by Credit Suisse.13

The court then focused on the fact that the proceeds of CHC’s pre-ferred return were to be used to pay interest on the Credit Suisse loan. The court concluded that, because these proceeds were to be used to pay interest on the Credit Suisse loan, the Partnership or RP should be viewed as having responsibility to indirectly make these payments. In addition, the court focused on the requirement that the Partnership or RP liquidate or purchase GAF’s Partnership interest for the value of GAF’s capital account. As noted above, the Partnership agreement limited the losses allocable to CHC to $26.8 million in excess of allocated net prof-its, thereby ensuring that CHC’s capital account would always equal at least the principal balance of the Credit Suisse loan. Further, the court focused on RP’s guaranty of the Partnership’s obligation to liquidate CHC’s Partnership interest and RP’s obligation to restore its negative capital account as further support for the court’s conclusion that the Cre-dit Suisse loan should not be viewed as an obligation of CHC. Rather, the court concluded that these provisions essentially shifted the burden of repayment of the Credit Suisse loan to the Partnership and RP. The court stated that “although [the Partnership] was not in name the borrower un-der the Credit Suisse loan, as a matter of economic substance, Credit Suisse loaned the $450 million to [the Partnership] to fund the payment transfer [to GAF].”14 As a result, under the court’s recharacterization of the transaction, the contribution of assets by GAF into the Partnership, followed by the deemed distribution of the loan proceeds to GAF from the Partnership constituted a disguised sale of the assets under Code Sec. 707(a)(2)(B).

13. G-I Holdings at 29. 14. Id. at 40.

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PLANTATION PATTERNS INC. v. COMMISSIONER

As discussed above, the court’s application of Code Sec. 707(a)(2)(B) relies on a recharacterization of the Credit Suisse loan as a borrowing by the Partnership. Absent this recharacterization, there would not be a distribution by the Partnership to which Code Sec. 707(a)(2)(B) could apply.

The seminal case involving the determination of the true debtor for Federal income tax purposes is Plantation Patterns Inc. v. Commisioner.15 Bizarrely, the G-I Holdings opinion does not even cite the case, and it certainly does not apply the analytical framework developed in Plantation Patterns and its progeny in determining whether CHC or the Partnership should be treated as the true borrower under the Credit Suisse loan.

In Plantation Patterns, an individual formed a corporation with nominal capitalization to acquire all of the stock of the taxpayer, Plantation Patterns. To pay for the stock, the acquiring corporation issued to the selling stockholders 55 notes with a 5.5% interest rate and an aggregate principal amount of $609,878, in addition to a $100,000 cash payment. The notes had fixed maturity dates over a ten-year period and were guaranteed by the individual who formed the acquiring corporation and by his investment banking firm. The guarantees were necessary because of the low down payment and because the debt had to be unsecured to enable the new corporation to obtain financing for its operations.

In determining the tax consequences of the purported indebtedness, the Tax Court looked to the substance of the transaction in which the newly-formed corporation acquired the business of Plantation Patterns. In holding that the interest on the guaranteed debt was not deductible by the corporation and that payments of interest and principal on such debt were dividends to the guarantor, the court stated that the advances made in the form of guaranteed debt were capital contributions by the individual to his newly-formed corporation. As a result, the court disallowed the deductions for interest payments claimed by the new corporation and held that such payments constituted nondeductible dividends paid by the corporation to the shareholder.

In reaching this conclusion, the Tax Court first noted that “this court has recognized that the fact that advances are made in the form of

15. Plantation Patterns, T.C. Memo 1970-182, aff’d, 462 F.2d 712.


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guaranteed debt, rather than direct loans, does not negate their treatment as capital contributions.”16 The court found that, at the time the advances were made, the assets of the newly-formed company were inadequate to sustain the purported debt, and that no unrelated party would have advanced a comparable sum without the absolute guaranty of the shareholder. The court determined that the subordination of the notes, in effect, subjected the advances to the same risks as an equity interest of the guarantor.

Affirming the Tax Court, the Fifth Circuit stated: The guarantee enabled [the individual] to put a minimum amount of cash into [the new corporation] immediately, and to avoid any further cash investment in the corporation unless and until it should fall on hard times. At the same time he exercised total control over its management. Adding together the personal guarantee of [the individual] to the guarantee of [his investment banking firm], which was wholly owned by him and [the individual’s] control of [the new corporation], we think that the result is that [the individual’s] guarantee simply amounted to a covert way of putting his money “at the risk of the business.” Stated differently, the guarantee enabled [the individual] to create borrowing power for the corporation which normally would have existed only through the presence of more adequate capitalization.17

The courts have applied Plantation Patterns to similar situations. For example, in In re Lane, the Eleventh Circuit treated funds guaranteed by the primary shareholder as a loan to the guarantor followed by the guarantor’s contributions to the capital of three S corporations, where the corporations were thinly capitalized and continually operated at a loss.18 In addition to guaranteeing the third-party debt, the shareholder also had made certain advances to the three S corporations that lacked a fixed maturity date. The shareholder testified that he did not expect to receive any interest and that he would not demand repayment of the advances until it was good for the corporation’s business. In addition, the shareholder did not take the steps that a lender usually takes to assure repayment in the event that the business failed. These factors contributed to the court’s conclusion that the advances were equity and that in addition, by making the guarantees on the third-party debt, the shareholder was putting his money at risk of the business.

16. Plantation Patterns, T.C. Memo 1970-182 (citing Santa Anita Consol. Inc., 50 T.C. at 550).

17. Plantation Patterns, 462 F.2d at 722-723. 18. 742 F.2d 1311 (1984).

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In Stoneking v. Commissioner,19 the Tax Court treated guaranteed debt as a borrowing by the guarantor followed by a capital contribution by the guarantor to a closely-held, thinly-capitalized corporation that could not obtain outside financing. Similarly, the Internal Revenue Service (the “Service”) applied the principles of Plantation Patterns in Revenue Ruling 79-4,20 concluding that a loan to a corporation was properly characterized as a loan to the individual sole-shareholder/ guarantor followed by guarantor’s capital contribution to the corporation, where the corporation was inadequately capitalized. In Selfe v. United States,21 the Eleventh Circuit remanded the case for the district court to apply Plantation Patterns and determine whether the loan to the corporation was in reality a loan to the shareholder because the bank primarily looked to the shareholder for repayment.22 The fact that the corporation was thinly capitalized and that it was “highly unlikely” that a bank would have advanced the funds to the corporation without the shareholder guaranty contributed to the Eleventh Circuit’s decision to reverse the lower court’s finding that the corporation was the true borrower.

The courts have not applied Plantation Patterns to treat the shareholder guarantor as the debtor for U.S. Federal tax purposes unless, at the time of the purported loans to the corporation, the corporation was thinly capitalized without the ability to repay the borrowing from operations. In the following cases, the courts considered the reasoning in Plantation Patterns, but ultimately decided not to recharacterize the guaranteed loans as loans to the guarantor.

In each of Murphy Logging v. United States23 and Santa Anita Consolidated Inc. v. Commissioner,24 the court relied on the fact that the borrower was not thinly capitalized to reject the Service’s attempt to characterize a loan to the borrower as a loan to the guarantor. In Murphy Logging, the borrower’s capital was found adequate despite “thin” appearance on the books because, in addition to tangible assets, the borrower owned valuable intangible property. In Santa Anita, the capital was not nominal and repayments were scaled to debtor’s cash flow. In

19. T.C. Memo 1985-532. 20. 1979-1 C.B. 150. 21. 778 F.2d 769. 22. There is no published district court opinion on rehearing after the Eleventh

Circuit’s remand. 23. 378 F.2d 222 (9th Cir. 1967). 24. 50 T.C. 536 (1968).


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addition, the bank required extensive financial data from the primary debtor. The court did not treat the shareholder-guarantor as the true borrower despite the fact that the lender did not require security and the loan proceeds were used to purchase capital assets.

In Smyers v. Commissioner,25 the Tax Court held that the fact that a bank loan would not have been made without the guaranty of the shareholder does not, per se, cause the loan to be treated as equity if the corporation is not otherwise thinly capitalized. The court found that the guaranteed bank loans were debt because there was an unconditional obligation to pay a fixed sum on a fixed maturity date, an obligation to pay interest, the debt was unsubordinated, and the lender looked first to the primary borrower for repayment of the loan.

In Integraph Corp. v. Commissioner,26 the Tax Court found that where the subsidiary was the borrower in form, the substance followed the form, and the court respected the borrower as the true borrower. Supporting this conclusion were the facts that the shareholder-guarantor did not reflect a foreign currency exposure with respect to the loan on its balance sheet, and the corporation, rather than the shareholder-guarantor, made the loan repayments.

APPLYING THE PLANTATION PATTERNS ANALYSIS TO G-I HOLDINGS

In Plantation Patterns, the nominal borrower was a thinly capitalized corporation and the shareholder and his investment banking firm guaranteed the loan. The court determined that the shareholder was the true borrower for tax purposes, emphasizing that, at the time the advances were made, the assets of the newly-formed company were inadequate to sustain the purported debt, and that no unrelated party would have advanced a comparable sum without the absolute guaranty of the shareholder.

In G-I Holdings, the nominal borrower was CHC, and the question is whether the Partnership or RP should be treated as the true borrower of the Credit Suisse loan for tax purposes. Applying the Plantation Patterns analysis, the Partnership or RP should only be treated as the true borrower of the Credit Suisse loan if the Partnership or RP guaranteed the loan, the assets of GAF were insufficient to sustain the debt, and no

25. 57 T.C. 189 (1971). 26. 106 T.C. 312 (1996) , aff’d, 121 F.3d 723 (11th Cir. 1997).

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unrelated party would have advanced a comparable sum without the guaranty of the Partnership or RP. We can accept for the sake of argument that the terms of the Partnership agreement, working capital reserve, put right and other arrangements were tantamount to a guarantee of the Credit Suisse loan by the Partnership and RP. Were the assets of GAF insufficient to sustain the debt, and would an unrelated party have advanced a comparable sum without the “guaranty” of the Partnership or RP?

The court made no factual finding along these lines, and its failure to do so is a serious defect in its analysis. The fact that GAF used the proceeds of the Credit Suisse loan to repay other debt suggests that an unrelated party would have advanced a comparable sum without the “guaranty” of the Partnership or RP (the lender under the debt that was repaid had already done so). Experience suggests that, absent the special terms of the Partnership agreement, working capital reserve, put right and other arrangements, GAF might have obtained less favorable loan terms, perhaps including a requirement of recourse liability, higher interest rate and the like. Nevertheless, the Plantation Patterns analysis requires a finding that absent the “guaranty,” an unrelated third party would not have advanced a comparable sum of money. The court made no such factual finding, and absent such a finding, recharacterization is inappropriate.

OTHER FACTORS RELATING TO RECHARACTERIZATION OF THE CREDIT SUISSE LOAN

We believe the correct approach in G-I Holdings would be to apply Plantation Patterns to determine whether the CHC or the Partnership (or RP) should be treated as the true borrower on the Credit Suisse loan. Nevertheless, in recharacterizing the Credit Suisse loan as an obligation of the Partnership, the District Court cited a variety of other factors not mentioned in Plantation Patterns, and some comment on those factors is appropriate.

In stating the reasons for its conclusion that the Credit Suisse loan should be viewed as an obligation of the Partnership, the court stated “[f] irst and foremost, the loan was nonrecourse and, in the event of default, Credit Suisse’s only recourse was to the collateral that had been pledged.” The court seems to argue that because a debtor’s assets are not all at risk with respect to a nonrecourse loan, the loan must be recharacterized as a sale of assets. The court’s reliance on this factor is


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misplaced. It is well established that merely incurring nonrecourse indebtedness in excess of the tax basis of the property collateralizing the loan does not result in gain recognition, notwithstanding that the transaction effectively insulates the taxpayer from loss from a decline in value of the property below the amount of the loan.27 Nor does the fact that the nonrecourse loan is secured by an interest in an entity suggest that the entity, rather than the owner of the interest in the entity, is the true obligor on the loan.

CHC continued to have an incentive to ensure that the Credit Suisse loan was not in default so it could retain its Partnership interest. As discussed below, CHC could potentially benefit from its preferred return to the extent the Credit Suisse loan could be refinanced or repaid without disposing of CHC’s interest in the Partnership. Further, although the terms of the Partnership agreement limited the allocation of losses to CHC, the allocation of profits to CHC was not so limited. The profit allocation waterfall provided that CHC was entitled to $27.5 million of the first $200 million of profits in excess of RP’s preferred return and a 1% interest in all additional profit of the partnership. Accordingly, contrary to the court’s assertion, CHC enjoyed the benefits of a retained Partnership interest and should not be viewed as having sold its assets.

Moreover, the rights and obligations of the parties in G-I Holdings are very different than the they would have been if the loan were an obligation of the Partnership. In the event of a default, Credit Suisse would have had the right to foreclose on CHC’s Partnership interest and enforce its rights under the Partnership agreement. However, Credit Suisse would not have a right to foreclose directly upon any of the Partnership’s assets. Credit Suisse might “step into the shoes” of CHC as a partner, but those rights are significantly different from the rights that a direct creditor of the Partnership would have. Like the rights of any mezzanine lender whose loan is secured by an interest in a partnership, Credit Suisse’s claim against the Partnership in the event of a foreclosure on CHC’s Partnership interest would be structurally subordinate to the rights of the Partnership’s other creditors.

The District Court focused on the fact that the proceeds of CHC’s preferred return would be used to pay the interest due on the Credit Suisse loan as evidence that the Partnership should be viewed as the

27. See Woodsam Associates v. Commissioner, 198 F.2d 357 (2nd Cir. 1952); see also Crane v. Commissioner, 331 U.S. 1 (1947); Mayerson v. Commissioner, 47 T.C. 340 (1966).

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obligor on the loan. As noted above, the Partnership had no direct obligation to Credit Suisse to pay CHC’s preferred return. In addition, the obligation of the Partnership to pay CHC’s preferred return was not dependent on the existence of the Credit Suisse loan. If CHC refinanced or repaid the Credit Suisse loan, the Partnership would still be obligated to pay CHC its preferred return. Thus, if CHC were able to refinance the Credit Suisse loan at a lower interest rate, CHC and not the Partnership would benefit. In contrast, if the Credit Suisse loan were a Partnership obligation, CHC would not be entitled to a preferred return and would not have the ability to improve its financial position by repaying or refinancing the Credit Suisse loan.

DEBT-FINANCED TRANSFER EXCEPTION TO DISGUISED SALE TREATMENT

Even assuming for the sake of argument that the Credit Suisse loan was properly viewed as an obligation of the Partnership for Federal income tax purposes, that would not establish that disguised sale treatment is appropriate. The provisions of Code Sec. 707(a)(2)(B)(i) and (ii) (set forth above) would be met, but Code Sec. 707(a)(2)(B)(iii) contains a third requirement, namely that “the transfers described in clauses (i) and (ii), when viewed together, are properly characterized as a sale or exchange of property.” In that regard, the Conference Report relating to the disguised sale legislation in 1984 states:

The conferees wish to note that when a partner of a partnership contributes property to the partnership and that property is borrowed against, pledged as collateral for a loan, or otherwise refinanced, and the proceeds of the loan are distributed to the contributing partner, there will be no disguised sale under the provision to the extent the contributing partner, in substance, retains liability for repayment of the borrowed amounts (i.e., to the extent the other partners have no direct or indirect risk of loss with respect to such amounts) since, in effect, the partner has simply borrowed through the partnership. However, to the extent the other partners directly or indirectly bear the risk of loss with respect to the borrowed amounts, this may constitute a payment to the contributing partner.28

Under the District Court’s recharacterization, the Credit Suisse loan was borrowed by the Partnership and the proceeds distributed to CHC. Under that view of the substance of the transaction, the legislative history above potentially exempts at least some of the debt proceeds from

28. H.R. Rep. H.R. Rep. No. 98-861, at 862 (1984).


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disguised sale treatment. Thus, in order to conclude that a disguised sale had occurred under its recharacterization of the facts, the District Court should have analyzed whether the above legislative history might exempt any of the proceeds from disguised sale treatment. Its failure to do so is yet another flaw in its analysis.

DISTRICT COURT’S ANALYSIS UNDER THE PARTNERSHIP DISGUISED SALE REGULATIONS

In addition to analyzing the transaction under the Code, the court also engaged in an analysis of the transaction under the final regulations under Code Sec. 707(a)(2)(B). These regulations were not promulgated until 1992 and therefore do not apply to the transaction at issue. The inapplicability of the regulations was noted by the court, but it nevertheless engaged in the analysis under the regulations, stating that “they are informative and useful as an indication of how an expert in tax law – the Treasury Department – interpreted the disguised sale statute.”29

Reg. § 1.707-3(b) provides that A transfer of property (excluding money or an obligation to contribute money) by a partner to a partnership and a transfer of money or other consideration (including the assumption of or the taking subject to a liability) by the partnership to the partner constitute a sale of property, in whole or in part, by the partner to the partnership only if based on all the facts and circumstances –

(i) The transfer of money or other consideration would not have been made but for the transfer of property; and

(ii) In cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations.

The regulations contain a nonexclusive list of ten factors that may be considered in connection with the determination as to whether a transfer of consideration to a partner would not have been made but for the transfer of property to the partnership, and, in the case of a non-simultaneous transfer, whether the transfer of consideration to a partner is not dependent on the entrepreneurial risks of partnership operations. The court concluded that the factors set forth in the regulations support the characterization of the transaction as a disguised sale of assets by GAF. In particular, the court noted (1) that GAF’s transfer to the Partnership and the distribution of the loan proceeds to GAF occurred at

29. G-I Holdings at 38.

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the same time and GAF’s receipt of payment was “absolutely secure and certain,” (2) the transactions were structured to ensure that RP was legally obligated to make contributions to the Partnership to permit the transfer of money or other consideration, (3) although the Partnership was not the borrower on the Credit Suisse loan, it was the borrower “as a matter of economic substance,” (4) as a matter of substance the Partnership incurred debt to fund the payment transfer to GAF, (5) after the property transfer, GAF retained no operational control over the transferred property, (6) the $450 million payment to GAF had no connection to partnership profits, and (7) GAF had no obligation to return or repay the $450 million to the Partnership.30

Like Code Sec. 707(a)(2)(B), the regulations require a transfer of consideration by a partnership to a partner in order for a disguised sale of assets to the partnership to occur. As noted above, in our view the court’s conclusion that the Credit Suisse loan was a loan to the Partnership was incorrect and, accordingly, the $450 million of loan proceeds could not be characterized as a distribution of consideration by the Partnership. Once again, even assuming for the sake of argument that the Credit Suisse loan was properly characterized as a loan to the Partnership for Federal income tax purposes, the court’s analysis under the disguised sale regulations is incomplete. In particular, the legislative history quoted above relating to debt-financed transfers has been implemented in the regulations. Specifically, Reg. § 1.707-5(b)(2) provides –

For purposes of §1.707-3, if a partner transfers property to a partnership, and the partnership incurs a liability and all or a portion of the proceeds of that liability are allocable under §1.163-8T to a transfer of money or other consideration to the partner made within 90 days of incurring the liability, the transfer of money or other consideration to the partner is taken into account only to the extent that the amount of money or the fair market value of the other consideration transferred exceeds that partner's allocable share of the partnership liability.

The court simply concluded that the Credit Suisse loan should be characterized as a loan to the Partnership, but did not undertake the additional analysis required under the disguised sale regulations as to the extent to which the purported distribution exceeded CHC’s allocable share of the Credit Suisse loan. This analysis requires a determination of whether the Credit Suisse loan should be treated as recourse or nonrecourse loan under the Code Sec. 752 regulations and the allocation of such recourse or nonrecourse loan. See Reg. § 1.707-5(a)(2). Without

30. G-I Holdings at 40-41.


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undertaking this analysis, the court could not properly reach a determination under the regulations as to whether GAF had engaged in a disguised sale of assets to the Partnership.

CONCLUSION

As noted above, G-I Holdings is the first case to find a disguised sale of property to a partnership under Code Sec. 707(a)(2)(B) since its enactment in 1984. Unfortunately, the court’s recharacterization of the Credit Suisse loan as an obligation of the Partnership completely ignores and does not even cite the key line of cases, beginning with Plantation Patterns, that deal with the circumstances under which it is appropriate to recharacterize a loan to one taxpayer as in substance made to another. Moreover, the free-form analysis that the court engaged in on this issue is inconsistent with those cases. Furthermore, even assuming for the sake of the argument that the court’s recharacterization of the Credit Suisse loan as an obligation of the Partnership was appropriate, it failed to analyze the applicability of the exception to disguised sale treatment for debt-financed transfers contained in the legislative history and regulations. Fortunately, the court’s disguised sale analysis is entirely dicta and the opinion is unpublished, so it should be accorded limited or no precedential weight.

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NOTES


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