Dow SLIPs in Court
The U.S. District Court for the Middle District of Louisiana disallowed deductions generated by two Special Limited Investment Partnerships (SLIPs) transactions because the transactions lacked economic substance and did not have a nontax business purpose. In addition, the court found that the two partnerships at the heart of the transactions were sham partnerships because they lacked a true business purpose. The court also ruled that some of the purported partners were not true equity partners because they received guaranteed returns similar to those of a creditor. Transactions that lack economic reality may be disregarded for tax purposes under the economic substance doctrine (as applied in the Fifth Circuit, which Louisiana is in, under the test from Klamath Strategic Investment Fund, 568 F.3d 537 (5th Cir. 2009)) if the taxpayer fails to establish that the transaction had a reasonable possibility of profit and was entered into for a legitimate nontax business purpose. A partnership will also be disregarded for tax purposes if its partners do not intend "to join together for the purpose of carrying on the business and sharing in the profits and losses or both" (Culbertson, 337 U.S. 733 (1949)). Despite engaging in a transaction with economic substance, a partnership will be disregarded for tax purposes if there is no legitimate business reason for the entity to operate as a partnership. In 1993, two subsidiaries of Dow Chemical joined with five foreign banks to form Chemtech I, a SLIPs entity SLIPs was a complex marketed tax shelter involving circular cash flows and the allocation of taxable income to a tax-exempt foreign investor and tax deductions to a U.S. taxpayer. In 1993, Dow Chemical contributed low- or zero-basis patents to Chemtech I, which leased them back to Dow. From 1993 to 1997, Dow made royalty payments to Chemtech I approximating $526 million. During those years, Chemtech I loaned Dow about $543 million and made annual interest-like payments of $13.9 million to the foreign banks. Dow deducted the $526 million royalty payments on its 1993-97 tax returns, while Chemtech I allocated about $383 million and $143 million of its reported taxable income to the foreign banks and Dow, respectively. At the end of 1997, Chemtech I was terminated due to new Treasury regulations effective at the beginning of 1998, prompting Dow to create Chemtech II, another SLIPs entity The new transaction also involved the transfer of an appreciated asset (a chemical plant) by Dow to the partnership, circular cash flows, and rental deductions to Dow. …