Chemtech Royalty Associates, L.P. v. United States
766 F.3d 453
| 5th Cir. | 2014Background
- From 1993–2006 Dow created two partnership transactions (Chemtech I and II) that contributed low‑basis high‑value assets (73 patents; a chemical plant) to Delaware limited partnerships largely controlled by Dow subsidiaries and involving five foreign banks as limited partners.
- Foreign banks invested roughly $200 million each cycle, were entitled to a fixed “priority return” (about 6.947% initially; later a reduced rate in Chemtech II), and received most taxable income allocations until the priority return was satisfied; Dow retained practical control and continued using the assets under license/lease agreements.
- Dow indemnified the banks for tax and liability risks, limited partnership assets to low‑risk items and Dow obligations, and structured liquidation rights and capital‑account protections that effectively guaranteed the banks’ principal and return.
- The IRS issued FPAAs for tax years 1993–2006 and asserted accuracy‑related penalties under I.R.C. § 6662 for 1997–2006; district court held after trial that the partnerships should be disregarded for tax purposes as shams, lacked economic substance, and that the banks’ interests were debt, not equity, and imposed 20% penalties (negligence and substantial understatement) but declined valuation‑misstatement penalties.
- On appeal the Fifth Circuit affirmed the sham‑partnership ruling (focusing on lack of intent to share profits and losses) but, in light of United States v. Woods, vacated and remanded the penalty determinations to consider valuation‑misstatement penalties.
Issues
| Issue | Dow's Argument | Government's Argument | Held |
|---|---|---|---|
| Whether Chemtech partnerships were shams under Culbertson/Tower | Transactions created equity interests; absence of creditor rights doesn’t preclude a valid partnership | Banks were not true partners: effectively guaranteed returns, bore no meaningful downside or management role | Affirmed: district court did not clearly err — Dow lacked intent to share profits and losses; partnership disregarded as a sham |
| Whether court must classify interests as debt/equity before sham inquiry | Classification as debt would compel finding of equity and thus a partnership; South Georgia Railway test controls | Classification unnecessary to sham inquiry; focus should be on intent to share profits/losses | Rejected Dow’s procedural rule; court need not classify debt/equity first and declined to reach debt holding (sham ruling dispositive) |
| Whether the transactions had economic substance | N/A on appeal (court affirmed sham so didn’t reach) | Government argued lack of substance; structured to achieve tax deductions with no genuine risk/reward sharing | Not reached (affirmance on sham grounds rendered economic‑substance ruling unnecessary) |
| Penalties under I.R.C. § 6662 (valuation‑misstatement applicability) | Conceded district court erred to foreclose gross‑valuation penalty if merits upheld | District court previously foreclosed valuation penalties based on Heasley | Vacated/remanded: Supreme Court’s Woods rejects Heasley; district court must reconsider whether substantial or gross valuation‑misstatement penalties apply and reconcile with imposed negligence/substantial‑understatement penalties |
Key Cases Cited
- United States v. Woods, 134 S. Ct. 557 (2013) (valuation‑misstatement penalty can apply even where transaction is disallowed on legal grounds)
- Southgate Master Fund, L.L.C. v. United States, 659 F.3d 466 (5th Cir. 2011) (apply Culbertson/Tower totality test to partnership‑sham inquiry)
- TIFD III–E, Inc. v. United States (Castle Harbour II), 459 F.3d 220 (2d Cir. 2006) (bank investors with guaranteed returns and no meaningful downside are not equity partners)
- Commissioner v. Tower, 327 U.S. 280 (1946) (partnership requires intent to join and community of interest in profits and losses)
- Commissioner v. Culbertson, 337 U.S. 733 (1949) (partners’ intent to be partners is factual inquiry for tax recognition)
- Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943) (form may be disregarded where it is a fiction)
- Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990) (pre‑Woods rule barring valuation penalties when entire deduction disallowed; superseded by Woods)
- South Georgia Ry. Co. v. Commissioner, 107 F.2d 3 (5th Cir. 1939) (historic test referenced for debt/equity classification)