CHEMTECH ROYALTY ASSOCIATES, L.P., As Tax Matters Partner Real Party in Interest Dow Europe, S.A., Plaintiff-Appellant Cross-Appellee,
UNITED STATES OF AMERICA, Defendant-Appellee Cross-Appellant. CHEMTECH ROYALTY ASSOCIATES, L.P., by Dow Europe, S.A. as Tax Matters Partner, Plaintiff-Appellant Cross-Appellee,
UNITED STATES OF AMERICA, Defendant-Appellee Cross-Appellant. CHEMTECH II, L.P., Plaintiff-Appellant Cross-Appellee,
UNITED STATES OF AMERICA, Defendant-Appellee Cross-Appellant. CHEMTECH II, L.P. BY IFCO, INCORPORATED, as Tax Matters Partner, Plaintiff-Appellant Cross-Appellee,
UNITED STATES OF AMERICA, Defendant-Appellee Cross-Appellant
Appeals from the United States District Court for the Middle District of Louisiana.
For Chemtech Royalty Associates, L.P., as Tax Matters Partner Real Party in Interest Dow Europe, S.A., Chemtech Ii, L.P., Chemtech Royalty Associates, L.P., by Dow Europe, S.A. as Tax Matters Partner, CHEMTECH II, L.P. BY IFCO, INCORPORATED, as Tax Matters Partner, Plaintiffs - Appellants Cross-Appellees: Christopher Landau, Jason Michael Wilcox, Kirkland & Ellis, L.L.P., Washington, DC; John B. Magee, Hartman Evans Blanchard Jr., Esq., James David Bridgeman, Robert Andrew Leonard, Christopher Patrick Murphy, Esq., Counsel, Bingham McCutchen, L.L.P., Washington, DC; Preston J. Castille Jr., Trial Attorney, Taylor, Porter, Brooks & Phillips, L.L.P., Baton Rouge, LA.
For United States of America, Defendant - Appellee Cross-Appellant: Francesca Ugolini, Tamara W. Ashford, Esq., Deputy Assistant Attorney General, Richard Bradshaw Farber, Esq., Supervisory Attorney, Thomas James Sawyer, U.S. Department of Justice, Tax Division, Appellate Section, Washington, DC; Gilbert Steven Rothenberg, Esq., Deputy Assistant Attorney General, U.S. Department of Justice, Washington, DC; John Joseph Gaupp, Esq., Assistant U.S. Attorney, James Patrick Thompson, Assistant U.S. Attorney, U.S. Attorney's Office, Middle District of Louisiana, Baton Rouge, LA.
Before DAVIS, SMITH, and CLEMENT, Circuit Judges.
JERRY E. SMITH, Circuit Judge:
This appeal concerns the tax consequences of two transactions undertaken by Dow Chemical Company (" Dow" ) and a number of foreign banks from 1993 through 2006. During those years, Dow and the foreign banks purported to operate two partnerships that generated over one billion dollars in tax deductions for Dow. After a five-day trial, the district court disregarded the partnerships for tax purposes on three grounds: (1) The partnerships were shams; (2) the transactions lacked economic substance; and (3) the banks' interests in Chemtech Royalty Associates, L.P. (" Chemtech" ), were debt, not equity. The court also imposed substantial understatement and negligence penalties but refused to impose substantial-valuation or gross-valuation misstatement penalties. Because, under these specific facts, the court did not clearly err in holding that Dow lacked the intent to share the profits and losses with the foreign banks, we affirm its sham-partnership holding. In light of United States v. Woods, 134 S.Ct. 557, 187 L.Ed.2d 472 (2013), however, we vacate and remand as to the penalty award.
In the early 1990s, Goldman Sachs developed a financial product called Special Limited Investment Partnerships (" SLIPs" ), which it promoted as a tax shelter. A series of steps typically had to be executed to create this type of product. First, the American corporation had to identify a valuable group of assets with a
tax basis at or near zero. Second, the corporation needed to create or designate subsidiaries through which it would participate in the transaction. Those subsidiaries would then contribute the assets to the partnership. Third, the corporation had to entice foreign entities to participate in the transaction. The tax benefits generated by the partnership could be attained only if the partnership's income could be assigned to a tax-indifferent party. Fourth, the parties would need to enter into various agreements that would govern the transaction. In 1992, Dow decided to pursue this transaction, endeavoring to create an asset-backed equity financing vehicle.
Following these steps, Dow selected 73 patents to contribute to the partnership. The district court found that Dow did not select " patents that would be attractive to a third party." Instead, it contributed those patents that (1) " had the highest value (in order to reduce the total number of patents)," (2) had a zero or near zero tax basis, and (3) were actively used by one of Dow's businesses. For most patents, Dow " did not contribute all technology that would have been necessary for third party licensees," requiring a potential third-party licensee to obtain licenses from both the partnership and Dow. In line with these findings, Dow selected patents valued at roughly $867 million, with 71 of the 73 patents having zero tax basis.
Next, Dow created two domestic subsidiaries--Diamond Technology Partnership Co. (" DTPC" ) and Ifco, Inc. (" Ifco" )--and used a wholly-owned foreign subsidiary--Dow Europe, S.A. (" DESA" )--to carry out this transaction. Through these subsidiaries, Dow formed Chemtech as a Delaware limited partnership with its principal place of business in Switzerland. Again through these subsidiaries, Dow contributed to Chemtech I the identified 73 patents, $110 million, and all of the stock of Chemtech Portfolio, Inc. (" CPI" ), a pre-existing shell corporation owned by Dow.
Five foreign banks decided to participate as limited partners in Chemtech, investing a total of $200 million in the partnership. The entry of the foreign banks forced Ifco's partnership share to be retired. By October 1993, Chemtech was owned 1% by DESA (the general partner), 81% by DTPC, and 18% by the foreign banks.
Finally, Dow and the foreign banks entered into various agreements to govern the transaction, including a patent license agreement, a partnership agreement, and various indemnity agreements. The patent license agreement allowed Dow to continue
to use the patents contributed to Chemtech. Under that agreement, Dow bore responsibility for all costs related to the patents and paid a royalty to Chemtech, regardless of Dow's use of the patents. Chemtech did not change Dow's use of its patents. The partnership agreement, in relevant part, (1) required the maintenance of capital accounts for each partner, (2) governed the allocation of profits and losses among the partners, (3) limited the types of assets the partnership could hold, (4) included the conditions that triggered the right to liquidate the partnership, and (5) provided the manner in which assets would be allocated on liquidation. Finally, because the foreign banks conditioned their willingness to participate in Chemtech on being indemnified against any liability arising from the assets or any tax liability, Dow indemnified them against those risks.
Chemtech I operated from April 1993 through June 1998, during which time Dow's royalty payments served as Chemtech's primary source of income, totaling $646 million. Because Chemtech claimed $476.1 million of book depreciation on the patents contributed to it, it reported book profits of only $61.7 million, out of which it paid (1) the 6.947% priority return to the foreign banks, (2) a 1% distribution to DESA, and (3) a relatively small distribution to each partner to pay its Swiss tax obligation. Chemtech then contributed the remaining cash to CPI, which loaned the bulk of the cash to Dow. Chemtech allocated the overwhelming majority of its
income to the foreign banks and only a fraction of its income to Dow. As the district court observed, " [w]hile Dow claimed royalty expense deductions for the money flowing to Chemtech, it did not take into account the ...