News & Articles


09 / 07 / 2009

One of the most hotly contested partnership tax cases ever to be litigated is now in the post-trial stages, after 12 years of litigation. 
The Government's View of the Evidence Presented at Trial:
It was a Disguised Sale Under Section 707, Not a 721 Contribution; Alternatively, GAF not a valid partner
In the case, the United States is claiming that on February 12, 1990, GAF sold its surfactants business to Rhone Poulenc, but attempted to disguise the sale as a Section 721 non-taxable capital contribution to a partnership.  The United States claims that GAF was doing this to avoid having to recognize nearly $400 million of taxable gain, or an income tax liability of roughly $120 million.  Essentially, the United States believes that the transaction falls squarely under 26 U.S.C. Sec. 707, as a transaction that Congress intended to strike down when it sought to overrule Otey v. IRS, 70 T.C. 312 (1978), aff'd, 634 F.3d 1046 (6th Cir. 1980).  The United States views the transaction as one that was "dazzingly complex" but the substance of which is one in which GAF immediately received $450 million in cash (by and through a Credit Suisse loan that was nonrecourse to GAF, and essentially guaranteed, by and through a put agreement), plus $30 million in additional consideration.*  Notably, the United States claims that as a result of the transfers to and from GAF in 1990, GAF ceded to RP all of the benefits and burdens of owning its surfactants assets, placing these in RP's control. 
* As to this $30 million of additional consideration, the United States claims that even if this were to be viewed by the Court as "equity component," there was still a $450 million sale that went down.
Alternatively, even if the transaction was not a Section 707 disguised sale, the United States claims that GAF was not a bona fide partner in a partnership, because it essentially took back an interest that involved no meaningful risk.  Any proclaimed "maximum loss" of $26.3 million was, as it put it, de minimis when compared to the size of the transaction and the amount of long-terms tax deferral being pursued.  As the United States summarized, GAF was not liable for repayment of the Credit Suisse loan, it was ensured a return of at least $453.7 million, and did not bear the risks of the venture, nor have any reasonable prospect of profitting from the partnership's operations.  See U.S. Proposed Findings of Fac and Conclusions of Law, Doc. #397 (Case No. 2:02-cv-03082)(8/14/2009).
Taxpayer's View:
Government's Factual Allegations Were Thoroughly Discredited at Trial! Government's Entire Case is One of Overreaching!! (RP, and not GAF, initiated and only then, did parties pursue Partnership and Did So for Non-Tax Business Reasons, with no side agreement).
In taking starkingly different views of the evidence presented to the court, the taxpayer debtor (G-I Holdings, Inc.) proclaims in its post-trial filings that the United States is relying on "novel legal theories."
GAF again looks to Judge Learned Hand, and notes how "any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a partriotic duty to increase one's taxes."  Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff'd, 293 U.S. 465, 469 (1935).  Warning that the Government's legal theories would move the Court into unchartered territory, the taxpayer suggests that onece there is a valid contribution of capital, and as long as the partnership is genuine, the exchange is tax-free, and the tax laws therefore cannot penalize secured borrowings.  The taxpayer points out that hybrid instruments, like preferred interests, must be viewed as partnership interests even if they don't look like common, vanilla interests.  Debtors' Post-Trial Brief, Doc #399, at 6-9 (8/14/2009).
As the taxpayer puts it, in 1989, RP offered to purchase GAF's surfactants business for $465 million OR consider entering into a joint venture (valuing GAF's business at $435 million), and after negotiation, the parties executed an asset sale agreement, at a price of $480 million.  But, then, it claims that when RP became concerned about taking on additional on-balance sheet debt to finance the purchase, it looked to its advisor, Citibank, and started to explore a partnership structure that would enable RP to record GAF's interest as minority equity.  Debtor's Post-Trial Brief, at 6.  As stated, GAF was willing to accommodate RP's partnership proposal, as long as the economics of the deal made sense and RP could not back out.  As the testimony revealed, "Project SAL" showed how GAF had been exploring possible joint venture structurings.  Noting that the negotiations were "intense," at times had broke down, and how GAF put RP on notice that if the partnership agreement did not close by early 1990, GAF would insist on enforcing the asset sale agreement.  GAF's "paramount objective" accordingly was to "close a deal" and NOT simply secure tax benefits associated with any particular structure.  Post Trial, at 8.  The Partnership structure allowed for GAF to reduce interest costs by $70 million that had put a "choke hold" around the company, and essentially convert its highly illiquid common interest and convert it into an independently valued 49% preferred equity interest in a world class billion-dollar surfactants joint venture, with an attractive priority return, highly stable and financeable.  As to any questions about its interactions with McKee and Nelson of King & Spalding, it suggested that it worked with them at the same time that it evaluated these business considerations, but took a conversative approach to the transaction, beleiving that a priority return alone would qualify any interest as a partnership interest, but to be safe, they also negotiated for a more meaningful share of profits beyond that priority return.  Essentially, as to whether or not GAF was a valid partner, the taxpayer argued that it need only satisfy either a subjective test or an objective test, under the United States Supreme Court's standardson set forth in IRS v. Culbertson, 337 U.S. 733, 742 (1949).  It claims that at trial, it was demonstrated that GAF and RP had strong business reasons for entering into the partnership, and that GAF received a bona fide, capital interest in the partnership.
The taxpayer noted that the Government is relying on Castle Harbour (TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006), suggesting somehow that when there, as purportedly held by tax-indifferent foreign persons, a purported equity ownership was illusory, negligible and insignificant, because it did not have meaningful downside risk, not expected to participate in any profits beyond a fixed return, in G-I Holdings, GAF bore a share of first-tier partnership losses, was entitled to 20% of the first tranche of profits beyond the priority returns, and contributed assets of equal value to RPs.  The taxpayer points out that the partnership there was attacked because it was used to shelter income (transferring otherwise taxable business income from a US taxpayer to non-US investors), but here, the government is trying to create taxable incoem that would not otherwise exist.  Post-Trial Brief, at 28. 
The taxpayer believes that under the United States Supreme Court's decision in Frank Lyon, involving a sale-leaseback, with a lease and a loan where the lease payments would cover the interest payments on a loan, the United States may not disregard the form of the transaction and treat GAF's nonrecourse borrowing as a borrowing by RP or the partnership.  The taxpayer claims that the fact that GAF's partnership interest served as collateral and that the priority return covered the interest payments does not change the fact that GAF, and not RP, was the borrower.  As the taxpayer claims, the United States is trying to improperly bifurcate the transaction, and any interest, into two pieces, one worth $450 milllion and the other worth $30 million, whereby GAF essentially exchanged part of its assets for an equity interest, and sold part in exchange for debt.  Interestingly enough, the taxpayer then looked at how Congress back in 1989 took a look at how to bifurcation might work with regard to corporate debt instrments.  And, the taxpayer took issue with the government's effort to rely on Farley Realty Corp. v. IRS, 279 F.2d 701, 704 (1960), where the court disallowed a deduction taken by the owner of real estate who sought to treat an equity appreciation payment to a co-investor as deductible interest, whereby an individual investor occupied dual status of stockholder and creditor.  But, the taxpayer claims that the interest held by GAF, is a single, indivisible interest, whereas in Farley, there were two distinct instruments, a debt instrument with a fixed maturity date and an equity appreciation right having no fixed maturity date.  Put another way, the taxpayer contends "As every relevant case decided in the last fifty years makes clear, when courts confront a single indivisible financial instrument that has some elements resembling debt and some resembling equity, they must decide whether the interest is debt or equity.  The courts (it says) do not split the instrument in two."  at 34.  As the taxpayer puts it, characterizing GAF's equity partnership interest as debt, or economically equivalent to debt without ruling on what it actually is would create a host of thorny issues for the Court to work through, as it claims has occurred in Castle Harbour, which it says has been bogged down in remand proceedings, for years, because the government there, it says, can't decide if foreign banks did not hold equity, then what did they hold. at 35.  As a matter of policy, the concern might be that tax planners might have a new, and valuable tool, if bifurcation is permitted, because interest payments on debt are deductible, and so, the full consequences of the government's novel theories are difficult to anticipate.  at 36-38.
The taxapery further claims that even if the United States wins on the merits, its challenge must fail under the 6-year statute of limitations period, because the amount of gross income omitted from GAF's 1990 tax return under its theory of the case is $259,697,883, which is only 22.37% of the gross income on the 1990 GAF return (i.e., less than the 25% required to extend the statute of limitations).  It disputes the Government's effort to claim that a portion of the reported income in 1990 represents an allocated portion of partnership income and therefore, if GAF is not a true partner, then it shouldn't be allocated this income (i.e., that GAF held debt and not equity).  Instead, it claims that so long as GAF is a partner, then the portion of income allocated to it on the partnership return is the relevant number (i.e., what was actually reported, not what should have been reported).  at 39. 
As to any penalties, the taxpayer claims that GAF reasonably relied on the advice of tax counsel, and after having heard from Mr. Nelson at trial, and seen how diligently and carefully he approached the task of structuring the GAF transaction, the Court ought to appreciate just how far the government has overreached when it sought to exclude his testimony as biased and unreliable.  A pre-trial effort to deny Mr. Nelson from testifying was rejected, because "the fact that you have put your reputation on the line is an added protection for you to have, in act, given a valid, reliable opinion."  As the taxpayer puts it, the trial evidence confirmed that GAF and its lawyers did everything possible to comply with the letter and spirit of the law.  at 41-42.
PreTrial Briefing
In a June 5, 2009 filing of the parties' Final Pretrial Order submitted to the Honorable Stanley R. Chesler, the parties stipulated that the first issue for trial relates to the federal income tax consequences of a 1990 transaction involving a purported contribution of assets by the GAF Corp. to a newly formed limited partnership (RPSSLP), simultaneously with the purported contribution of cash by a subsidiary of the French Government.  The United States Government contends that the 1990 transaction is a taxable one, either because it is a "disguised sale" under Section 707(a)(2)(B) or because RPSSLP is not a valid partnership for Federal income tax purposes, or even if it was, then the so-called debtors were not "partners" in any such partnership.  A second issue for trial deals with whether the debtors are subject to penalties.  A third issue for trial is whether the United States is correct in claiming that a six-year statute of limitations period applies, based on an allegedly omitted amount of gross income of more than 25% of the gross income stated on the debtors' tax return.  A fourth issue for trial is whether the debtors are subject to penalties as a result of positions taken on their 1999 tax return.  
While the transaction at issue developed in 1989-1990, it is noteworthy that the case is in the bankruptcy court, where the IRS has filed proof of claims against two subsidiaries of the GAF Corp., one in the amount of $400,698,443.89 (relating to unpaid federal income tax liabilities for 1986-1988, 1990-1992, 1995-1996, and 1998-1999), and the other, against the other subsidiary, in the amount of $530,612,540.13 (relating to unpaid federal income tax liabilities for same years).  Later, amended proofs of claim of $512,032,187.02 and $540,424,081.66 were filed, respectively.  A closer inspection of these claims reveals that the IRS is claiming that taxes of $78,690,851 are due from each subsidiary pertaining to the 1990 transaction, with over $100 million of interest, and that $112,112,661 of tax is due from each pertaining to the 1999 transaction, with between $10 and $17 million of interest due.
In 2006, the Court found that the 1990 transaction was not adequately disclosed on the debtors' 1990 tax return, but the Court did not decide whether the United States' claims are time barred because the income allegedly omitted from the debtors' 1990 tax return was not in excess of 25% of the gross income stated on the return. 
The 1990 transaction evolved from a 1989 Asset Sale Agreement, whereby a nonbinding offer of $400 million is alleged to have been presented to GAF by a subsidiary of the French government.  As counsel for GAF, William F. Nelson, an attorney then with King & Spalding, published an article titled "Use of Partnerships in Taxable Corporate Acquisitions," 293 PLT/Tax 603 (9/1/89), describing a hypothetical partnership transaction that closely resembles the 1990 transaction.  The purchase price appearing in the 1989 Asset Sale Agreement was $480 million.  In October, 1989, the French Government subsidiary, Rhone Poulanc approached Citibank for help in financing its purchase, and this led the parties to eventually go to William McKee and William Nelson, two of the most prominent experts on partnership tax in the country.  The restructured transaction resulted in transfers being implemented in early 1990.
From there, two significantly different views of the transactions have emerged, setting the stage for one of the most significant partnership tax cases to ever go into a trial, and at the center of the transactional planning are two of the most highly regarded partnership tax experts, McKee and Nelson.  The United States intends on proving that it was McKee and Nelson who presented Citibank officials, then advising the French Government subsidiary, Rhone Poulanc, with the idea that the September 19, 1989 asset sale agreement could be "restructured" into a partnership transaction consummated in 1990.  The United States further intends on showing at trial that the newly formed limited partnership was formed because of GAF's desire to achieve tax benefits or tax savings, but that Rhone Poulenc viewed the 1990 transaction as nothing more than an acquisition of GAF-SSC, and furthermore, as an alternative means of financing the acquistion.  The United States further contends that a contemplated exit strategy was being structured, involving a contemplated receipt of 30-year Treasury bonds, coupled with a long-ter repo transaction.  The 1990 transaction it is said, by the United States, to have been structured to permit GAF the right to defer tax for another 30 years, and to the United States, this is "indistinguishable from outright tax avoidance."  Pretrial Order, at 147.  The United States further notes that in the summer of 1992, GAF learned that the Congress was contemplating adding Section 737 to the Code, and if so, this could potentially cause GAF to recognize taxable gain if the Rhone Poulenc elected to retire 98% of its investment in the partnership in February 1993, as the parties had originally contemplated.  However, GAF understood that it would avoid incurring any taxable gain under Section 737 if no portion of GAF's investment in the limited partnership were retired until February, 1995.  Thus, GAF believed that if the French Government subsidiary, Rhone Poulenc, exercised the buy-out option in 1993, GAF would incur a $120 million federal income tax liability.  See Rhone-Poulenc, 1993 WL 125512 at *2; at 147.  Negotiations ensued, and when these reached an impasse in December, 1992, GAF threatened to file a lawsuit against Rhone Poulenc for breach of fiduciary duty if it exercised its right to retire 98% of GAF's investment in the limited partnership in 1993, and sought $120 million of damges, corresponding to the income tax liability GAF expected it would incur upon retirement of its investment in the limited partnership.  In January 1993, Rhone Poulenc filed a complaint in Delaware, seeking a declaratory jdugment that its effort to retire GAF's 98% investment would NOT be a breach and that GAF could not recover any damages.   The court did not make any findings, acccording to the United States. Then, in April, 1993, GAF intitiated litigation in Texas, stating that it "had affirmatively structured the 1990 transaction to avoid incurring this $120 million tax liability.  GAF filed for a temporary injunction, and in August, 1993, the state court granted the injunction, thereby, according to the United States, achieving GAF's objective of preserving its tax strategy at all costs.  at 150-151.  As the United States claims, the public disclosures made at the time by Rhone Poulenc in a removal action, by Solomon Warhaftig, reveal the tax strategy, by pointing out what the IRS would claim and further that GAF was not sufficiently subject to entrepreneurial risks of the partnership's busienss to be considered a bona fide partner, because only a very limited amount of income and gains could be allocated to it.  at 152.  As the United States then claims, "RP's public disclosures ...contradict the sanitized account of the 1990 Transaction and related subsequent events that GAF presses upon the Court in the present litigation."  The United States further believes that GAF improperly dictated settlement terms to RP, by demanding that RP indemnify GAF against adverse income tax consequences, and thereafter entered into a Tax Matters Agreement whereby RP agreed to adhere to GAF's characterization of the 1990 transaction as a nontaxable partnership formation, rather than a taxable sale.