Free Trial Memo - District Court of Connecticut - Connecticut

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IN THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF CONNECTICUT TIFD III-E INC.,THE TAX MATTERS PARTNER OF CASTLE HARBOUR-I LIMITED-LIABILITY COMPANY, Plaintiff, v. UNITED STATES OF AMERICA, Defendant. ) ) ) ) ) ) ) ) ) ) )

CASE NOS. 3:01CV01839(SRU) 3.01CV01840(SRU)

UNITED STATES' TRIAL BRIEF STATEMENT A. Introduction This is a TEFRA proceeding1 in which the Tax Matters Partner, TIFD-III E, Inc. contests, on behalf of Castle Harbour-I, LLC, a limited liability company which elected to be taxed as a partnership, adjustments to its federal income tax returns for its taxable years 1993 through 1998, determined by the IRS in Notices of Final Partnership Administrative Adjustment on June 29, 2001. The IRS proposed adjustments to the Castle Harbour partnership tax return, which will flow through to the partners and increase the tax liability of the partners which are United States taxpayers (TIFD III-E, A "TEFRA Proceeding" is one commenced pursuant to §§ 6221 through 6234 of the Internal Revenue Code (IRC), enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, 96 Stat.324, 648. Under TEFRA, the parties in a partnership may file an action to resolve various tax issues associated with the partnership. IRC § 6226(a). These issues, known as "partnership items," include the total amount of taxable income earned by the partnership, and the fraction of the partnership's taxable income that should be included in each partner's taxable income. Treas. Reg. § 301.6231(a)(3)-1. -11

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Inc., and TIFD III-M, Inc., wholly owned subsidiaries of the General Electric Capital Corporation (GECC), and referred to here as the "GE entities").2 GECC is a subsidiary of the General Electric Company. 3 The IRS also determined that any underpayments of tax for these years resulting from the determined adjustments are subject to either the 20% penalty for negligence or disregard of rules or regulations (IRC § 6662(b)(1)), or the 20% penalty for a substantial understatement of income tax (IRC § 6662(b)(2)). 4 The government defends this action on several alternative theories. The government first will demonstrate at trial that no valid partnership existed for tax purposes among the participants in Castle Harbour, as the GE entities and two Dutch banks, ING Bank, N.V. and Rabo Merchant Bank, N.V., did not join together with a

To satisfy the jurisdictional requirements of IRC § 6226(e)(1), the plaintiff deposited $62,212,010 with the IRS. This amount closely corresponds to the increased income tax liability of GE resulting from the IRS' proposed adjustments, exclusive of interest and penalties. GECC went through a reorganization and name change in 2001 but was known as GECC during the years at issue here. Pursuant to IRC § 6226(f), as amended effective for partnership tax years ending after August 5, 1997, the applicability of penalties that relate to partnership items are within the scope of a court's jurisdiction in a partnership-level proceeding under § 6226(a) or (b). Accordingly, with respect to the years 1997 and 1998, this Court has jurisdiction to decide what penalties are applicable with respect to any adjustments to partnership items. (In subsequent refund litigation, a partner could raise partner-level defenses to the applicability of the penalties, but could not challenge partnership-level judicial determinations with respect to partnership items or the applicability of penalties.) With respect to the years 1993-1996, the applicability of penalties that relate to adjustments to the partnership items at issue in this case must be determined in separate partner-level proceedings. This Court's factual findings, however, will be binding on all partners who are treated as parties to this litigation pursuant to § 6226(c) and (d).
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non-tax business purpose, i.e., the intent to join together for the conduct of a business enterprise. ASA Investerings Partnership v. Commissioner, 201 F.3d 505, 511 (2000), cert. denied, 581 U.S. 871 (2000). "[E]scaping taxation is not a `business' in the

ordinary meaning." National Investors Corp. v. Hoey, 144 F.2d 466, 468 (2d Cir. 1944) (Hand, J.). An arrangement, be it a transaction or the formation of an entity, which lacks a non-tax business purpose is "sham" and is disregarded for tax purposes. ASA Investerings Partnership, 201 F.3d at 512. A transaction is a sham, and therefore without effect for Federal income tax purposes, "if it is fictitious or if it has no business purpose or economic effect other than the creation of tax deductions." Nicole Rose v. Commissioner, 320 F.3d 282 (2d Cir. 2003), citing DeMartino v. Commissioner, 862 F.2d 400, 406 (2d Cir. 1988). Second, in addition to demonstrating that the arrangement between the GE entities and the Dutch banks was a sham, the government also will demonstrate at trial that even if Castle Harbour had a non-tax business purpose, the Dutch banks' participation was, in substance, in the nature of a lender rather than a partner. Castle Harbour, therefore, could not allocate any of its income to the Dutch banks, and all the income is properly allocated to the GE entities which, in substance, were the only equity investors in Castle Harbour. Third, the government will demonstrate at trial that even if the partnership is not disregarded as a sham, and even if the Dutch banks' participation was that of an equity investor and not merely a lender, the "special allocation" by Castle Harbour of 98% of Castle Harbour's taxable income to the Dutch banks violates IRC § 704(b)(2) as lacking "substantial economic effect," as defined by Treas. Reg. § 1.704-1(b)(2), and should be -3-

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disregarded. As a result, without the 98% allocation of income to the Dutch banks, the allocation of income would reflect the ownership interests of the banks during the 1993 through 1998 period which declined from 8.57% at the end of 1993 to 2.45% prior to a buyout in December 1998. Absent this "special allocation" the tax liability of the GE entities increases by approximately $56 million. B. The Castle Harbour Arrangement 1. GECC created Castle Harbour

In July 1993, GECC contributed all of the original assets to Castle Harbour through its subsidiaries. These subsidiaries were TIFD III-E, Inc., TIFD III-M, Inc., and General Electric Capital AG. These assets consisted of beneficial interests in 63 aircraft with a claimed fair market value of $550 million, subject to leveraged leases with $251 million of non-recourse debt, and $296 million in cash, for total net asset value of $595 million.5

A leveraged lease is a way of making sure that the depreciation deductions from an asset are enjoyed by a taxpayer who can use the deduction. Suppose that L is a company that requires the use of an asset, but that L is unprofitable, and so it does not have taxable income it can reduce with a depreciation deduction. A profitable company, P, buys the asset and leases the asset to L. P borrows money to come up with the purchase price. P is thus required to make interest payments to the lender. These interest payments are roughly equal to the rental payments that L is required to pay P. Over time, P takes the depreciation deductions. See Marvin A. Ehirelstein, Federal Income Taxation, 142-45 (1988). Here, GECC appears to have used leverage leases to acquire the rights to use the depreciation deductions associated with aircraft. If one commentator is right, then most aircraft in the country are subject to leveraged leases. Here, we are not challenging GECC's use of a leveraged lease to acquire depreciation deductions. What is at issue here is GECC's attempt to eliminate the tax it should pay on the rents it received from the users of the aircraft. Lee A. Shepard, Goodbye Mr. Chips: Lease Stripping on Trial Again, With Add-Ons, 100 Tax Notes 453 (July 28, 2003). -4-

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The cash investment was later reduced to $240 million.6 When contributed to Castle Harbour, the aircraft were leased primarily to United States registered airlines of relative strength, and all the leases were performing. The 63 aircraft were fully depreciated on the books of GECC. That is, all 63 aircraft had a tax basis of zero at the time of their contribution to Castle Harbour. They remained under long-term leases and, therefore, would continue to generate significant lease income for the remainder of their leases. 7 2. Tax Indifferent Foreign Banks Shortly after the formation of Castle Harbour in July, 1993, an effort began to solicit participation by a foreign bank (which would be indifferent to the tax consequences of allocating to it 98% of the taxable income). Personnel from GECC and its investment firm, Babcock & Brown, traveled to Europe to obtain foreign participants. Babcock & Brown authored an "investment memorandum" to provide potential participants. The memorandum described the transaction and the existing operating agreement, and the expected range of return for the banks. The plaintiff does not contend that domestic participants were considered seriously.

At trial the government will demonstrate the cash contribution was contributed to a subsidiary (Castle Harbour Leasing, Inc. (CHLI)) and used to purchase commercial paper, principally that of GECC, effecting a circular flow of the cash contribution. The aircraft were depreciated for tax purposes under the allowable accelerated depreciation methods. Consequently, depreciation deductions were allowable in excess of actual depreciation in value and the aircraft had remaining useful lives long after they were fully depreciated for tax purposes. In general, during the years when the accelerated depreciation deductions were allowable, the depreciation deductions would exceed the lease income and could actually shelter other income from tax. Conversely, however, once fully depreciated for tax purposes, the continuing lease income would be fully taxable if it remained on the books of GE. -57

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ING and Rabo were separately solicited and expressed interest in the investment. Babcock & Brown determined that these Dutch banks would not be subject to United States taxation on any income from Castle Harbour due to tax treaties between the United States and the Netherlands. Negotiations took place in Bermuda, lasting about 3 weeks, concluding on October 6, 1993. On that date the GE entities, TIFD III-E and TIFD III-M, and the Dutch banks signed the "Amended and Restated Operating Agreement" ("operating agreement"), the principal document for the operation of Castle Harbour. The Dutch banks contributed $117 million in cash to Castle Harbour. The operating agreement provided that the Dutch banks would receive periodic payments over eight (8) years, which in substance reflected a return of the $117 million, plus an additional amount which was a rate of return of approximately 9.03587%. The

operating agreement also memorialized the 98% income allocation to the Dutch banks for both taxable income and capital account purposes. The anticipated income allocation was reflected in the schedule of periodic payments, which amounted to a return of the $117 million, plus 9.03587%. Return of the $117 million was assured by terms in the operating agreement. The operating agreement required that Castle Harbour hold liquid assets like GECC commercial paper in an amount at least equal to 110% of the remaining balance in the Dutch banks' "investment accounts." These accounts formed part of the financial statements prepared each year for Castle Harbour in accordance with the operating agreement. The investment accounts detailed the balances remaining to be repaid the Dutch banks. The account balances were reduced by the annual distributions pursuant -6-

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to Exhibit E of the operating agreement and increased by interest earned at the rate of 9.03587%. If Castle Harbour did not maintain such a balance, the Dutch banks had

the right to demand a liquidation of Castle Harbour. The operating agreement also provided that if any of the periodic payments were missed, the Dutch banks had the right to immediate liquidation of Castle Harbour, resulting in the immediate repayment of the $117 million, assured by the 110% liquid asset requirement.8 Indeed, under these provisions of the operating agreement, Castle Harbour could not use the $117 million contributed by the Dutch banks, except to purchase commercial paper paying a lower rate of return (3.22 to 5.93%) than that owed to the Dutch banks. GECC also provided a separate performance guarantee to the Dutch banks. Direct assurances from GECC with respect to the operation of Castle Harbour, in addition to the liquidation rights and 110% liquid asset requirements, were necessary ("deal breakers") for the Dutch banks to join Castle Harbour. The Dutch banks would not have agreed to an arrangement by which return of their $117 million depended solely on the success of Castle Harbour. 9

The 110% requirement was effected through a subsidiary of Castle Harbour, Castle Harbor Leasing, Inc. (CHLI), which held GE commercial paper in an amount necessary to satisfy the 110% requirement. While Castle Harbour had to pay the Dutch banks a return of 9.03587%, the commercial paper it held earned only 3.22 to 5.93%. And as demonstrated in Part C.3 below, the Dutch banks' risk of loss was substantially diminished after the first two and one-half years, as they had already received a return of more than half their "investment" by then. -79

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3.

Why GE Would Agree to Allocate 98% of the Income to the Dutch Banks A 98% allocation of Castle Harbour's income to the Dutch banks did not mean

the Dutch banks would receive a 98% distribution of the lease payments. That would not have made economic sense in view of the contributions of each of the participants. The operating agreement and the accounting system adopted in it were carefully crafted to ensure a predictable return for the Dutch banks of their $117 million plus 9.03587%; a return far less than the $310,138,800 of taxable income allocated on paper to the Dutch banks. During 1993 through 1998, income from the leases, which would have been taxable to GE but for the Castle Harbour arrangement, was allocated to the Dutch as follows: Taxable Income Allocated to Dutch Banks, 1993-1998 1993 1994 1995 1996 1997 1998 Total: $16,073,453 $75,061,872 $62,406,532 $49,874,972 $50,776,164 $55,945,807 $310,138,800

Castle Harbour did not have to distribute the $310,138,800 in taxable income to the Dutch banks (even though that income was no longer subject to tax on GE's returns) per the operating agreement. The operating agreement also incorporated 704(b) book accounting procedures. Although the airplane assets had zero tax basis, 704(b) book accounting permitted depreciation based on fair market value on the date of contribution to Castle Harbour of the fully tax depreciated airplanes. Thus, the 98% income allocation was decreased by 98% of the depreciation. Each year's depreciation

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was calculated by dividing the fair market value of the planes by the remaining useful life of the planes. The "capital accounts" (which are the accounts upon which final distributions to the Dutch banks are based, in part, in the event of liquidation) were thus increased each year by the income from the leases, and reduced by depreciation and actual distributions. The § 704(b) book income allocated to the Dutch banks, as adjusted, results in actual cash payments upon liquidation, assuming a positive balance in the capital accounts. Yet, even when added to the operating distributions, this is far less than the taxable income allocated to the Dutch banks. The actual § 704(b) book income allocations, after § 704(b) book depreciation, to the Dutch banks during 1993 through 1998 are as follows: Book Income Allocations to Dutch Banks, 1993-98 1993 1994 1995 1996 1997 1998 Total: $ $ $ $ $ $ 332,000 9,660,000 6,548,000 1,340,000 2,258,000 7,560,000

$27,698,000

This sum, $27,698,000, pales in comparison to the $310,138,798 that GECC sought to shelter through the Castle Harbour arrangement. The $27,698,000 is part of the price GECC apparently decided it was willing to pay to avoid the federal income tax on the $310,138,798 of sheltered income, which approximates the deposit at issue here, $62,212,010. Without these accounting protocols for Castle Harbour income, the transaction would not have made any economic sense for GE. It is difficult to imagine GE entering

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a transaction that carried costs equal to or greater than a tax savings of $62,212,010.10 In addition to allocating § 704(b) book income to the Dutch banks in the amount of $27,698,000, there were other, very substantial, initial transaction costs. Through 1994, these costs totaled $13,751,486. This amount included the $9,000,000 fee to the investment firm, Babcock & Brown. Such a cost could not be justified even to obtain use of the Dutch banks' $117 million, since GE could borrow that money at much lower rates from other sources, including issuing GECC commercial paper which paid between 3.22 and 5.93% during this period. The Castle Harbour arrangement could only be economically justifiable to GE when seen (as it was) as a device to obtain the $62,212,010 tax savings, less its out-ofpocket expenses.11 4. GECC Maintained Control Over Castle Harbour's Assets At formation in July 1993, Castle Harbour was entirely a GECC operation.12 In addition to the operating agreement, there were several agreements between GECC, its subsidiaries, and Castle Harbour but none changed the fact that GECC kept the assets entirely within its control.

This is the amount of the deposit at issue. The amount of tax adjustment varies slightly under the alternative theories utilized by the government to defend the IRS determination, ranging from approximately $56 million to $62 million. While the motivation of the Dutch banks may not be relevant (see ASA Investerings Partnership, 201 F.3d at 515), we note that pursuant to the operating agreement and the GECC Guaranty, the banks made a good return on their $117 million, approximately 9.03587%, with more than a fair amount of security to protect themselves from loss.
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At its inception, Castle Harbour was called GE Capital Summer Street-I, LLC. -10-

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The management of the airplane leases remained in GECC control through the appointment of GECC employed individuals as general manager and managers. The original general manager (located in Hong Kong) and managers (residing in Mexico and Switzerland) apparently were selected for their non-US locations rather than their airplane management experience. Only the general manager had an aviation background, but he was no longer working in the field. Castle Harbour began with $595 million in assets, but the general manager's compensation from Castle Harbour was limited by the operating agreement to $12,000 per year. The individuals selected as general manager and managers at the formation of Castle Harbour were all GECC employees, with compensation packages independent of Castle Harbour. The general manager and managers did not need particular expertise as Castle Harbour entered into a management (administrative services) agreement with a GECC subsidiary based in London, GE Capital Advisory Services, Ltd., on the date of its formation. This entity was engaged to provide finance, accounting, aircraft lease portfolio activities, and general administrative services to Castle Harbour. Subsequently, another GECC entity, GE Aviation Services, Ltd. (GECAS), based in Shannon, Ireland, took over the administrative services for Castle Harbour. 5. The $240 Million GECC Cash Contribution Was Also Tax Motivated

An important element of the Castle Harbour structure is the cash contribution from GECC. Castle Harbour did not have a non-tax need for this cash. The cash was moved to a Castle Harbour subsidiary (CHLI), and invested in GECC commercial paper, i.e., recirculated back to the contributor. The $240 million cash contribution from GECC to Castle Harbour was tax motivated. With a tax basis of zero in the contributed -11-

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airplanes, and the non-recourse liabilities associated with the airplanes allocated to the Dutch banks, the $240 million cash contribution was needed to increase the basis of TIFD III-E's partnership interest. Otherwise, distributions to TIFD III-E would have brought the basis below zero and required a recognition of income by TIFD III-E, and ultimately GECC. Income recognition would have collapsed the tax shelter plan as planes and cash were distributed to TIFD III-E ­to GECC­during the life of Castle Harbour. 6. Castle Harbour Lacked a Non-tax Purpose

The Castle Harbour transaction lacked any credible non-tax business purpose. Plaintiff's effort to connect this 1993 transaction to a 1991 effort to stimulate a troubled sector of GECC's operations falls short. While it is true that the Gulf War in 1991 led to difficult times in the airline business, this business is cyclical and apparently the industry has run a net loss over the past century, even though GECC claims it has never had a losing year in the airplane business. It is clear that by 1993, GECC resolved most if not all of the difficulties faced in 1991 and was concluding a significant expansion of its airplane leasing sector through a major acquisition. GECC had begun a major expansion of its commercial airline business in 1986 through the acquisition of a West Coast based airline leasing business, Polaris. In 1993, GECC had approximately 200250 airplanes in its portfolio and Polaris had a similar number, approximately 200-250. GECC also expanded its portfolio in the fall of 1993 by effectively purchasing an Ireland-based commercial leasing business, at the same time frame as the Dutch banks joined Castle Harbour. This added another 400-500 planes to the GECC portfolio. This

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scenario does not provide support for the Castle Harbour transaction beyond the need to find shelter for the income stream from 63 fully depreciated airplanes. Further undermining plaintiff's purported business purpose are inconsistencies in the chronology of events plaintiff is using in an attempt to link Castle Harbour to the 1991 downturn in the airline business. GECC issued a request for proposals to various investment banks in May 1992 to assist its aviation sector. None of the responses proposed the Castle Harbour transaction. Though Babcock & Brown received the 1992 request and responded then, Castle Harbour did not emerge as a possible transaction until a year later. Meanwhile the business sector, particularly GECC's, had improved substantially. Rather, the motivation for the Castle Harbour arrangement was the existence of 63 fully depreciated planes in its portfolio with a predictable and reliable income stream that no longer could be reduced for tax purposes by depreciation deductions. C. The Dutch Banks Were Creditors Not Equity Owners 1. The Investments Have More Characteristics of Debt Than Equity The Dutch banks each transferred to Castle Harbour $58,643,578, for a total of $117,287,156, to become members of Castle Harbour, LLC. These transfers should be characterized as debt (and the Dutch banks as lenders/creditors) rather than equity. The risks assumed by the Dutch banks and the potential for loss was not unusual for creditors. The debt instrument is not analogous to preferred stock, as the plaintiff contends. The Dutch banks were to receive a return "range" between 8% and 9.5% for the use of their $117 million. There was a target return rate (9.03587%) and a regular -13-

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payment schedule from Castle Harbour to the Dutch banks, set forth on Exhibit E to the operating agreement. The payment schedule was strictly followed; any failure to make the agreed upon payments timely permitted the Dutch banks to demand the liquidation of Castle Harbour. The final payment to the Dutch banks upon their early buyout by GECC on December 31, 1998, varied the overall return approximately $80,000 from the target return (9.03587%) with respect to overall payments of $143,516,000. The Dutch banks did face the risk of a return lower than 9.03587%, but it was not likely to fall outside the range of 8% to 9.5% due to the income stream associated with the airplanes contributed by GECC. Declines in the residual values of the aircraft after the leases expired were the most significant risk faced by the Dutch banks. Although the Dutch banks considered the annual payments pursuant to Exhibit E as advances with repayment characteristics, the risk of repayment to Castle Harbour was minimal. This aspect of the arrangement did not change the Dutch banks' own characterization of the transaction as debt for financial and Dutch tax purposes. The Dutch banks $117 million was highly collateralized, particularly through the requirement that Castle Harbour maintain liquid assets equal to 110% of the remaining, unpaid investment. The Dutch banks participation in management was de minimus, at best. There was a prepayment penalty and the Dutch banks could force liquidation if they were not repaid periodically, as scheduled. always made in a timely fashion. Contrary to plaintiff's expectations at the beginning of the transaction, the Dutch banks themselves treated the transaction with Castle Harbour as debt for Dutch tax The scheduled payments were

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purposes and their own financial accounting purposes. The banks recognized that the transaction had elements of equity as well as debt, but treated the investments as debt. The plaintiff contends that the Dutch banks' characterization of debt or equity for their own reporting purposes or Dutch tax reporting purposes is not relevant to this inquiry. To the contrary, GECC was careful to insist that the Dutch banks characterize their investment as equity and instructed the independent accounting firm preparing Castle Harbour's financial statements that the Dutch banks' characterization would be that of equity. Apparently, however, the characterization was debt. 2. The Investment Accounts Tracked the Dutch Banks' Return

The mechanism used by Castle Harbour to compensate the Dutch banks for their contribution of $117 million can be understood and considered by examining the "investment accounts" maintained for the Dutch banks as part of the annual financial statements of Castle Harbour.13 No such accounts were prepared for the GECC entities, TIFD III-E and TIFD III-M. These statements monitored the Dutch banks' initial payment of $117 million, the annual adjustments at the "applicable rate" of 9.03587% as defined in the operating agreement, and the annual cash distributions set forth in Exhibit E to the operating agreement. Each year, 1993 through 1998, the annual adjustments increased the investment account by the amount determined by multiplying the applicable rate times the average daily balance in the investment account. Similarly, every year from 1993 through 1997, the cash distributions provided for by Exhibit E to the operating agreement reduced the investment account. The buyout on

These "investment accounts" were maintained separately from the the "capital accounts" required by the Treasury Regulations (discussed above, and further below). -15-

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December 31, 1998, reduced the investment account for each Dutch bank to zero. A summary of the investment account balances is as follows: Dutch Banks' Investment Account Balances Year Adjustments at 9.03587% $ 3,494,000 $10,374,000 $ 7,776,000 $ 4,518,000 $ 3,260,000 $ 2,654,000 Cash Distribution Balance

Opening 1993 1994 1995 1996 1997 1998

$ 5,856,000 $39,128,000 $42,846,000 $19,620,000 $10,992,000 $30,930,000

$117,286,000 $114,924,000 $ 86,170,000 $ 51,100,000 $ 36,098,000 $ 28,366,000 0

3.

Repayment Schedule for the Dutch Banks-Exhibit E

The annual Exhibit E cash distributions were sizable and mandatory. These distributions played an integral role in the financial relationship between GECC and the Dutch banks. These payments reduced the Dutch banks' investment accounts and capital accounts. As explained above, the capital account § 704(b) book income allocated to the Dutch banks was far less than taxable income, as § 704(b) book income was reduced by depreciation. These payments were the vehicle for the repayment to the Dutch banks of their $117 million contribution and interest at the applicable rate, 9.03587%. The Dutch banks demanded, and received, a Guaranty Agreement, between GECC and the Dutch banks­not with Castle Harbour­that the terms of the operating agreement would be executed faithfully. The Exhibit E distributions were among the most important terms in that agreement. Failure of Castle Harbour to pay the amounts entitled each Dutch bank to demand liquidation of the enterprise. Castle Harbour made the Exhibit E payments as required from 1993 -16-

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through 1997. The buyout of the Dutch banks on December 31, 1998, relieved the obligation to make an Exhibit E payment on that date. The total Exhibit E payments made to the Dutch banks during 1993 through 1997 were as follows: Exhibit E Payments to Dutch Banks 1993 1994 1995 1996 1997 Total: $ 5,856,789 $39,127,597 $42,846,678 $19,620,374 $10,991,784 ___________ $118,443,222

Exhibit E set forth additional payments to the Dutch banks for 1998, 1999 and 2000. These were not made since GECC decided to end the relationship on December 31, 1998. The scheduled 1998 payment was included in the final payments to the Dutch banks. The additional payments were $6,770,862 for 1999 and $26,032,067 for 2000. These would have brought the total Exhibit E cash distributions to $154,053,947 which would have been a return of their capital plus interest at the applicable rate of 9.03587%. 4. Dutch Banks' Return--Capital Accounts with 98% Income Allocation

Castle Harbour maintained capital accounts for all participants. The key components of the capital accounts, as far as the Dutch banks were concerned, were the 98% income allocations and the Exhibit E cash distributions, discussed above. Like the investment accounts, the capital accounts measured the return of the Dutch banks on their contributions. Both had a targeted return rate of 9.03587%, per the operating agreement. The opening balances were the combined investment of $117 million. Allocations of income (98%) and gains/losses (which were allocated under -17-

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another formula not challenged here) increased or decreased the account balances. The Exhibit E cash distributions decreased the account balances. A summary of the capital account balances for the Dutch banks is set forth below Dutch Banks' Capital Account Balances-98% Income Allocation Opening Balance 1993 1994 1995 1996 1997 1998 $117,556,000 $112,032,000 $ 85,432,000 $43,224,000 $24,920,000 $16,186,000 $23,746,000 (before buyout) 0 (after buyout)

Not surprisingly, the buyout of the Dutch banks on December 31, 1993, with the final payment made in early 1999, produced a return on investment of approximately 9.03587%, the applicable rate identified in the operating agreement signed in October, 1993. D. The Special Allocations to the Dutch Banks Fail the Statutory Requirement of "Substantial Economic Effect" After October 6, 1993, when the Dutch banks joined Castle Harbour, the putative ownership interests were TIFD III-E, 81.1964%, TIFD III-M, 1%, ING, 8.9018%, and Rabo, 8.9018 %. The operating agreement did not follow ownership interests in allocating each partner's distributive share of income, gain, loss, deduction or credit. Instead, the Dutch banks were each allocated 49% of profit and loss, for a total of 98%. TIFD III-E and TIFD III-M were each allocated 1%. There were different allocations for capital gains and losses. The 98% income allocation to the Dutch banks is a key component to GECC and the Dutch banks achieving the target 9.03587% applicable rate return for the Dutch -18-

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banks. This can be demonstrated by considering hypothetical capital accounts based on an ownership percentage allocation of income, rather than the 98% income allocation set forth in the operating agreement. Using the comparative liquidation method (CLM) (which recognizes that Dutch banks' "ownership" percentages declines each year as their initial investments were repaid), it is evident that the 98% income allocation increases the payments to the Dutch banks by over $25 million. Impact of 98/2 Allocation on Dutch Banks' Capital Accounts Castle Harbour's Allocation to Banks Under Book Income 98/2 CLM $ 339,000 $ 332,000 $ 58,113 9,857,000 9,660,000 1,371,560 6,682,000 6,548,000 566,299 1,368,000 1,340,000 70,488 2,304,000 2,258,000 78,519 7,736,000 7,560,000 380,578 $28,286,000 $27,698,000 $2,525,557 Increase Under 98/2 $ 273,887 8,288,440 5,981,701 1,269,512 2,179,481 7,179,422 $25,172,443

Year/Period 10/6/93 ­ 12/31/93 1994 1995 1996 1997 1998 Totals

The distortion of income resulting from the 98% allocation of income to the Dutch banks is enormous. Considering the income tax consequences of the 98% income allocation, the Dutch banks suffered no increased tax liability as a tax indifferent party. GECC, however, avoided taxation on approximately $284,073,938 through this allocation. The tax liability on this amount would have been $56,814,788, as set forth below:14

This amount, $56,814,788, is less than the deposit at issue, $62,212,010. As explained in footnote 10, the tax liability of GECC at issue here varies slightly under the alternative theories advocated by the government here. Here, the reallocation of income to the GECC entities is not 100% of the income previously allocated to the Dutch banks. The allocation is by ownership percentages, which decrease over time, as the Dutch banks transfer to Castle Harbour is repaid with interest. -19-

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Impact of 98/2 Special Allocation of Income on GE Entities Tax Liabilities
Year/Period 10/6/93­12/31/93 1994 1995 1996 1997 1998 Totals Castle Harbour's Taxable Income $ 16,401,481 76,593,747 63,680,135 50,892,829 51,812,412 57,244,395 $316,624,999 $ Allocation to GE Entities 98/2 CLM 328,028 $13,589,867 1,531,875 65,936,055 1,273,603 58,283,247 1,017,857 48,270,512 1,036,248 50,046,674 1,298.588 54,433,782 $ 6,486,199 $260,264,106 Increase Under CLM $ 13,261,839 64,404,180 57,009,644 47,252,655 49,010,426 53,135,194 $284,073,937 Tax on Increase at 20% Rate 15 $ 2,652,368 12,880.836 11,401,929 9,450,531 9,802,085 10,627,039 $56,814,788

Thus, both parties benefitted from the 98% income allocation, at the expense of only the U.S. Treasury. Although the 98% income allocation produced a pre-tax detriment to GECC by reducing the amount of income to which it would have been entitled if the capital accounts had been calculated on the basis of ownership, this reduction ($25,173,443) was less than the tax savings ($56,814,788) producing an after-tax economic benefit of $31,641,345. This after-tax benefit is further reduced by the costs of the transactions, particularly the start-up costs described above (p. 15) which totaled $13,751,486 by the end of 1994. The banks of course benefitted by receiving an almost guaranteed return in excess of 9% on the use of there funds, which were securely held in GE paper (earning between 3.22 and 5.93%).

The 20% rate is used because the GE consolidated group was subject to the alternative tax during the years at issue, and thus subject to a 20% tax rate. -20-

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ARGUMENT A. Castle Harbour Was Not a Valid Partnership for Tax Purposes In order to enjoy federal income tax treatment as a partnership, parties must join together in good faith to conduct an enterprise and to share profits and losses. Commissioner v. Culbertson, 337 U.S. 733, 744-45 (1949). This is a question of federal law determined by examining all the facts and circumstances of the enterprise. Ibid.; Estate of Kahn v. Commissioner, 499 F.2d 1186 (2d Cir. 1974). The intent of the parties controls, and that intent is ascertained by considering all the facts and circumstances of the enterprise. Culbertson, 337 U.S. at 742; Burde v. Commissioner, 352 F.2d 995, 1002 (2d Cir. 1965); ASA Investerings Partnership, 201 F.3d at 511; Boca Investerings Partnership vs. United States, 314 F.3d 625, 631 (D.C. Cir. 2003). All the facts and circumstances surrounding the participation in Castle Harbour by two Dutch banks supports a conclusion that GECC did not have the requisite intent to join together with the Dutch banks for the purposes of carrying on a partnership for non-tax business reasons. GECC did not need the money sent to Castle Harbour by the Dutch Banks, nor did the operating agreement allow Castle Harbour to use the money­it became simply collateral for the Dutch banks' loans to Castle Harbour. The Dutch banks brought no management expertise to Castle Harbour; management was entirely a GECC operation. The Dutch banks' management participation was virtually nil. The purpose of Castle Harbour was to provide shelter for a large stream of income from leased aircraft owned by GECC for which depreciation deductions had been exhausted. The Dutch bank's role was as the "tax-indifferent party" willing to accept, for a fee, any allocation of taxable income since its tax burden would always be zero. -21-

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GECC initially formed Castle Harbour, contributing cash and airplanes under lease, using solely GECC entities as members. This arrangement could not accomplish the purpose of sheltering taxable income from the lease rents. To shelter the income, GECC needed the Dutch banks. Accepting the role of tax-indifferent party is not the same as joining together in good faith to conduct an enterprise and to share profits and losses. Culbertson, 337 U.S. at 742, 744-45; ASA Investerings Partnership, 201 F.3d at 513; National Investors Corp., 144 F.2d at 468. The plaintiffs' tax shelter scheme fails ab initio for want of a partnership between GECC and the Dutch banks. ASA Investerings Partnership; Boca Investerings, supra. Partnership. Adherence to the formalities of a partnership are not enough to establish a partnership for federal income tax purposes. Estate of Kahn, 499 F.2d at 1189 (state court determination of partnership under state law not controlling). Many factors can be considered in evaluating an arrangement for federal income tax purposes. Estate of Kahn, Ibid., citing Luna v. Commissioner, 42 T.C.1067, 1077-78 (1964). 1. Agreements Between the Parties and Their Conduct a. The Operating Agreement's Legend The agreement between the members and their conduct in executing its terms is an important factor. Luna, 42 T.C. at 1077. Here there are several agreements which detail the relationship between GECC and the Dutch banks within Castle Harbour. The structure, formation, and operation of Castle Harbour are governed primarily by the Amended and Restated Operating Agreement of October 6, 1993, which was adopted by the GECC members and the Dutch banks following a few weeks of negotiations in Bermuda­the offshore location necessary to avoid United States taxation on the -22-

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taxable income allocated to the Dutch banks. The tax sheltering purpose is clear in the "Legends for All Investors" set forth on the second page of the agreement. It provides that:: NO INVESTOR MAY DIRECTLY OR INDIRECTLY, OFFER SELL, RESELL, OR DELIVER LLC INTERESTS IN THE UNITED STATES OR TO OR FOR A U.S. PERSON. Sale of a Castle Harbour interest to a United States person could have the effect, inter alia, of subjecting income of that new owner to United States taxation and GECC to indemnify that owner for such United States taxes. b. Tax Indemnification Agreement Participation of the Dutch banks was sought, and the banks' compensation was dependent on their role as a tax indifferent party, rather than the good faith conduct of an enterprise and to share profits and losses. The Tax Indemnification Agreement executed by the Dutch banks and TIFD III-E (a GECC subsidiary) on October 6, 1993, emphasizes this purpose. This agreement provides that the Dutch banks would be indemnified for covered taxes imposed with respect to income or distributions from Castle Harbour. Its terms sought to assure that the Dutch banks continued to qualify for the tax benefits of the treaty between the Netherlands and the United States without which they never would have agreed to join Castle Harbour. The agreement also shows that if the Dutch banks had to pay taxes, they would have demanded greater compensation for their participation, which in turn would have raised the cost of the tax savings to GECC. In fact, a change in the possible tax liabilities of the Dutch banks in the Netherlands with respect to Castle Harbour income and distributions led to the early -23-

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buyout of the Dutch banks on December 31, 1998. The Tax Indemnification Agreement was amended in late 1998 in an attempt to resolve this possibility­and to limit costs to GECC­ but, to the Dutch banks' surprise, GECC decided to end the Dutch Banks' relationship with Castle Harbour rather than face a possible increase in cost. This conduct demonstrated the tax-driven nature of Castle Harbour for GECC. GECC could unilaterally decide to close down Castle Harbour because it preserved that right for itself when the Dutch banks became members. ¶ 14.3 Operating Agreement. The Dutch banks did not have a corresponding right to buyout the GECC entities. c. GECC's Guaranty GECC's purpose in forming Castle Harbour is obvious­to shelter the income stream from the leased airplanes with respect to which depreciation deductions were exhausted. Despite all the formalities of the Operating Agreement, Contribution Agreement, Tax Indemnification Agreement, and Services Agreements, the Dutch banks would not join Castle Harbour until GECC in its own capacity rather than through its subsidiaries agreed to "absolutely, unconditionally and irrevocably" guarantee the performance­including making scheduled payments--by the GECC entities and the individual managers appointed by such subsidiaries. Guaranty, ¶ 2. Negotiated in Bermuda, the Guaranty recites the activities of the various GECC entities in forming Castle Harbour and operating its business. The Guaranty recognizes that the Dutch banks have no role in appointing the managers for Castle Harbour. The Guaranty looks to GECC entities, not the Dutch banks, to contribute additional capital if necessary. This document hardly suggests that the Dutch banks joined the members of Castle Harbour -24-

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to conduct an enterprise and to share profits and losses. Rather it reveals the limited but critical role of the Dutch banks­to facilitate the sheltering of income from United States taxation. 2. Capital and Service Contributions a. $117 Million Cash Contribution The Dutch banks' contributions to Castle Harbour, $117 million, pale in comparison to GECC's contribution of cash and airplanes totaling $595 million. Nonetheless, the operating agreement allocates 98% of the income to the Dutch banks and caps their capital gains and losses. Castle Harbour had more than sufficient cash to operate before the Dutch banks' infusion. All the airplanes contributed by GECC were under lease and producing income. This income was sufficient to cover all costs and generate substantial cash holdings. GECC contributed $296 million in cash at formation. This money was moved to Castle Harbour's subsidiary (CHLI) and used to purchase commercial paper. This cash contribution had two discernible purposes: (1) create a tax basis in the partnership for GECC sufficient to allow it to receive distributions without recognizing taxable income and (2) provided liquidity to comfort the Dutch banks. The operating agreement required Castle Harbour to maintain, at all times, a balance of high grade commercial paper equal to 110% of the remaining balance in the Dutch banks' investment accounts. ¶ 5.8(b), Operating Agreement. This effectively limited the use of the Dutch banks' investments to provide security for their own investments. From 1994 onward, the commercial paper held by CHLI consisted solely of GECC commercial paper. Thus, there was a circulation of the Dutch money from -25-

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Castle Harbour to the subsidiary back to GECC through the purchase of commercial paper. The Dutch funds were effectively blocked for all purposes except the purchase of GECC commercial paper. This arrangement makes no sense other than to encourage the Dutch banks to join Castle Harbour and provide the foreign, tax neutral partner that GECC desired. The Dutch banks could have purchased GECC commercial paper directly, without going through Castle Harbour. The return rate targeted for the Dutch banks by Castle Harbour (9.03587%) significantly exceeded the cost of GECC commercial paper. The only rationale for such activity by GECC was the tax shelter. The Dutch banks' participation made the shelter work; the Dutch wanted Castle Harbour to hold liquid assets ready to buy them out, rather than rely on the sale of airplanes to raise cash. The security provided the Dutch banks is inconsistent with a conclusion that the Dutch banks joined Castle Harbour to conduct an enterprise and to share profits and losses. Culbertson, 337 U.S. at 744-45. b. De Minimus Management Role for Dutch Banks The Guaranty issued by GECC to the Dutch banks and the operating agreement make clear that the Dutch banks had virtually no role in the management of Castle Harbour. In addition to appointing GECC (or other General Electric subsidiary) employees to serve as managers of Castle Harbour (many of whom did not have aircraft leasing experience), Castle Harbour contracted with GECC entities to manage the aircraft portfolios. The Dutch banks were allowed to attend manager's meetings but it is clear that they did not seek nor were they awarded any management role in Castle Harbour. The managers themselves were also mere figureheads. Castle Harbour was -26-

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run by GECC headquarters in Stamford, Connecticut, and from GECAS headquarters in Shannon, Ireland. Indeed, no one at Castle Harbour has offered an explanation for the $12,000 annual payment to the General Manager from a business with initial capitalization of $595 million. ¶ 5.7(b), Operating Agreement. And, the managers all received much more significant compensation packages from other GE subsidiaries for whom they worked. 3. Dutch Banks' Payment Rights

The Dutch banks received annual payments pursuant to Exhibit E of the Operating Agreement. These were substantial payments, ranging from approximately $39 million in 1994 to approximately $10 million in 1997. Failure to make these payments entitled the Dutch banks to demand liquidation of Castle Harbour. ¶ 14.1(d), Operating Agreement. Upon liquidation or purchase of the Dutch banks' interests, additional cash payments would be made. The amounts paid depended on the balance of the Dutch banks' capital accounts, and any Class A Guaranteed Payment or Indemnification Premium due the Dutch banks. ¶ 1.10, Operating Agreement. These mechanisms were in place to repay the Dutch banks their contributions plus interest at the target yield of 9.03587%. In contrast, the GECC entities were only guaranteed a Class B Guaranteed Payment, which when paid, did not exceed $500,000, even though their investment was $595 million. ¶ 4.1, Operating Agreement. The nature of the relationship to Castle Harbour of the GECC entities was very different than the nature of the Dutch banks' relationship to Castle Harbour. The payment schedule on Exhibit E and the payment

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guarantees available to them indicate relative control over cash distributions also differed substantially from the GECC entities. 4. Sharing Risk of Profits and Losses

The Dutch banks and GECC did not join together to share in profits and losses. Culbertson, 337 U.S. at 744-45; Estate of Kahn, 499 F.2d at 1189; Luna, 43 T.C. at 1078. In reality, the Dutch banks joined Castle Harbour to obtain essentially a fixed return on their money of 9.03587%. This rate is set forth in the operating agreement within the definition of "applicable rate." ¶ 1.10, Operating Agreement. The allocation of 98% of income to the Dutch banks and the annual cash distributions to the Dutch banks according to Exhibit E were finely tuned by GECC's investment bankers, Babcock & Brown, to realize a 9.03587% return to the Dutch banks upon their exit from Castle Harbour. Despite the early exit of the Dutch banks and over five years of existence, the return of the Dutch banks varied by only approximately $80,000 from a 9.03587% return on their contributions to Castle Harbour. The security provisions, described above, further insulated the Dutch banks from risk of loss. The structure of the agreements also precluded any appreciable ability to share in profit beyond that scripted by the agreements through the payment schedule. Indeed, the 98% allocation to the Dutch banks was only with respect to the lease income, and did not include capital gains or losses on the sale or disposition of the planes. a. Class A Investment Accounts The clearest picture of the importance of the 9.03587% return rate is the Class A Investment Accounts prepared each year as part of Castle Harbour's Financial Statements. ¶ 1.10 ("Class A Investment Account; Class A Investment Account -28-

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Adjustment"); 8.2(b), Operating Agreement. These investment accounts measured the balance of the Dutch banks contributions to Castle Harbour. No such report was prepared for the GECC entities. The account was decreased by the distributions set forth in Exhibit E to the operating agreement and increased by an annual adjustment, i.e., the balance in the account multiplied by the applicable rate, 9.03587%. ¶ 1.10, Operating Agreement. Though by definition the applicable rate could vary during the Dutch banks participation in Castle Harbour, it never did and for each year, 1994 through 1998, the applicable rate was 9.03587%. The investment accounts for the Dutch banks demonstrate that the banks did not join Castle Harbour to share the risks of profit or loss but rather to derive a 9.03587% gain on their contribution. Despite the fact that the Dutch banks remained participants in Castle Harbour for five years, during which hundreds of millions of dollars of lease rents were collected, leases were extended, some airplanes were distributed to GECC, and other airplanes were acquired, the overall return to the Dutch banks deviated approximately only $80,000 from the 9.03587% target or "applicable rate." Clearly the intent, and reality, of Castle Harbour's structure was to "collar" the potential upside and downside to the Dutch bank's risk. Limiting the ultimate risk of the Dutch banks is antithetical to the existence of a true partnership for federal income tax purposes. b. Capital Accounts and Federal Income Tax Returns The lack of sharing the risk of profit or loss by the Dutch banks can also be demonstrated by comparing the Capital Accounts and the federal income tax returns filed by Castle Harbour. The vast allocation of taxable income to the Dutch banks on -29-

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the tax returns suggests that they shared in the profits of Castle Harbour. In fact, however, the Dutch banks' return on their contribution had little to do with the amounts of income allocated to them on federal income tax returns of Castle Harbour. The difference between the federal income tax returns and the Capital Accounts is not the amount of revenue received by Castle Harbor, the amount of distributions to the Dutch banks, nor the role of the Applicable Rate (9.03587%). The key is depreciation. Castle Harbour's taxable income was computed without taking depreciation (a deduction allowed for "wear and tear") since GECC had fully depreciated the airplanes prior to contributing them to Castle Harbour in 1993. The tax returns demonstrate the full measure of taxable income sheltered by GECC by allocating 98% of Castle Harbour's taxable income to the Dutch banks. Of course, this allocation was of no consequence or concern to the Dutch banks. As tax indifferent parties, allocating some or all of Castle Harbour's income on the tax returns to the Dutch banks would not have mattered since their tax bill would remain the same: zero. Nor did the tax return allocations of income determine the actual return received by the Dutch banks on their contributions to Castle Harbour. The applicable rate of 9.03587% was not a tax return component. The situation was quite different with respect to the capital accounts prepared for Castle Harbour. Required by the operating agreement (and in an attempt to comply with certain Treasury Regulations), the income component of the capital accounts was calculated by taking into account deductions for depreciation based on the fair market value of the airplanes when contributed. This resulted in a much lower "income" -30-

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amount for capital account purposes than for federal income tax purposes. The capital account income was easily calculable also. Income consisted primarily of rental income from leases; the deductions were almost entirely composed of interest and depreciation. From these highly predictable amounts, GECC's objective of "collaring" the return of the Dutch banks at 9.03587% became highly manageable since the cash distributions to the Dutch banks were determined solely through the agreement between GECC and the Dutch banks, i.e., the operating agreement's Exhibit E. Plaintiff's contention that the Dutch banks simply joined Castle Harbour to share the risk of obtaining profits or suffering losses is without merit. The "collaring" of risk here is similar to the de minimis risks for another foreign bank (ABN­also Dutch) in ASA Investerings Partnership, 201 F.3d at 514. The court of appeals there reasoned that accepting a de minimis risk of loss was not sufficient to recognize an arrangement as a partnership for federal income tax purposes. The Dutch banks had a de minimis risk of not receiving their 9.03587% return. Exhibit E to the operating agreement required annual payments which were predetermined to deliver the target return; if the payments were not made timely or the required 110% of the remaining balance in their investment accounts was not maintained, the Dutch banks could call for the liquidation of the partnership. The GECC Guaranty made sure that these events did not happen through negligence or malfeasance on the part of GECC subsidiaries or employees. The Class A Guaranteed Payment and Indemnification Premiums provided further guarantees that the target rate of 9.03587% would be achieved. In fact it was. The $80,000 variation from the 9.03587% return is

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precisely the type of de minimis variation that the court in ASA Investerings Partnership found belied a partnership for tax purposes. Ibid. B. Castle Harbour is a "Sham" 1. Substance Over Form The tax law is concerned with the economic substance of transactions, not the form or labels chosen by the taxpayer to describe those transactions. Thus, it is a wellestablished principle that tax benefits claimed to arise out of a transaction that was contrived to create tax benefits, but that lacked independent economic substance, will not be allowed. Gregory v. Helvering, 293 U.S. 465, 465-67 (1935). Such transactions are referred to as "sham transactions." Knetsch v. United States, 364 U.S. 361 (1960); Nicole Rose v. Commissioner, 320 F.3d 282 (2d. Cir. 2003); Boca Investerings Partnership vs. United States, 314 F.3d 625, 631 (D.C. Cir. 2003); ASA Investerings Partnership, 201 F.3d at 512; In Re CM Holdings, Inc., 301 F.3d 96, 102 (3 rd Cir. 2002); Lee v. Commissioner, 155 F3d. 584 (2d Cir. 1998); Kirchman v. Commissioner, 862 F.2d 1486, 1490 (11th Cir. 1989). The Second Circuit applies a flexible analysis to determine whether a transaction should be considered a sham and disregarded for federal income tax purposes. Gilman v. Commissioner, 933 F.2d 143, 147-48 (2d. Cir. 1991). While endorsing the "business purpose/economic effect analysis" of sham transactions, this Circuit has endorsed the "flexible nature of the analysis" demonstrated by the Ninth Circuit. Ibid. at 148, citing Casebeer v. Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990); Sochin v. Commissioner, 843 F.2d 351, 354 (9 th Cir.), cert. denied, 488 U.S. 824 (1988); Zmuda v. Commissioner, 731 F.2d 1417, 1420 (9th Cir. 1984). -32-

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In Casebeer, the Court rejected the notion that to determine that a transaction is a sham, "a court must find that the taxpayer was motivated by no business purpose other than obtaining tax benefits and that the transaction has no economic substance." Ibid. (emphasis in original). The Ninth Circuit held that "[t]his argument has no merit." Ibid. Thus it is clear that this Court can determine that a transaction is a sham even if the taxpayer can establish either a "business purpose" for the transaction or that the transaction had some "economic substance." The question is whether "the transaction was motivated by tax consequences and not by business or economic consequences." Gilman at 148. Determining business or economic consequences requires examining substance over form and avoiding exalting "artifice over reality." Gregory v. Helvering, 293 U.S. at 469. 2. Purpose of Castle Harbour was to Avoid Taxes

Considering all the facts and circumstances of this transaction, it is clear that Castle Harbour was formed to avoid federal income taxes. It is true that GECC was in the airplane leasing business prior to forming Castle Harbour but only 63 planes were involved in this transaction. A common characteristic of these 63 airplanes was certainly not a coincidence: all 63 airplanes had been fully depreciated for tax purposes and being under lease had healthy and predictable income streams for future years. The Castle Harbour planes formed a small part of the GECC portfolio. By 1994, GECC had 400 to 500 planes in its portfolio. Plaintiff's contention that weak conditions in the airline industry forced it to "take action" in the early 1990s collapses upon consideration of GECCs acquisition of -33-

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Guiness Peat Airways (GPA) in 1993, the improving conditions of the airline industry at that time, and the small number of planes involved in Castle Harbour. Further, although the form of Castle Harbour suggests that these planes left the GECC umbrella, its substance indicates otherwise. The airplane leases were managed by a GECC entity based in Ireland, GECAS (General Electric Aviation Services), as was most, if not all, of GECC's other airplanes under lease. Castle Harbour was a GECC managed enterprise, from top to bottom. The Dutch banks' management role was de minimus, at best. There was little if any difference between the management of the Castle Harbour planes and the other 400 plus planes managed by GECC. GECC never lost control over the Castle Harbour planes, even though their management became more cumbersome, if only to keep the form of the transaction eligible for the tax shelter purpose. The managers of Castle Harbour were GECC employees, although for accounting and cost purposes they may have been "seconded" to Castle Harbour. But for the tax avoidance purpose, Castle Harbour had no purpose; it increased costs across the board and only made sense because of the effort to shelter its income. The plaintiffs further contend that the inclusion of outside, i.e., non-GECC, investors in Castle Harbour had the business purpose of obtaining additional capital for GECC's airplane business. That may have been the apparent form of the transaction, but its substance was much different. The Dutch banks' contribution was $117 million. This would seem to satisfy the apparent goal of raising outside capital and there will likely be extensive trial testimony in an attempt to establish this point. The substance of the arrangement with the Dutch banks suggests otherwise. The operating agreement -34-

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required Castle Harbour to retain a balance equal to 110% of the unpaid balance of the Dutch banks investments in liquid assets, e.g. GECC commercial paper. For example, on December 31, 1993, the Dutch banks "investment accounts" (representing the unpaid balances) totaled $114,924,000. The operating agreement required Castle Harbour to maintain 110% of this amount (approximately $126,416,400) in liquid assets, as security for the Dutch banks. Thus the "outside capital" supposedly raised by Castle Harbour was not available for use and of little value except for the Dutch banks' role in the tax shelter as tax-indifferent parties willing to receive a paper allocation of 98% allocation of taxable income. 3. GECC $240 Million Contribution Solely for Tax Purposes

Another aspect of the Castle Harbour structure that demonstrates that it was a sham transaction designed to shelter income is GECC's contribution of $240 million in cash. This cash contribution had the singular purpose of providing a tax basis for the plaintiff's interest in Castle Harbour. The 63 airplanes contributed had been fully depreciated and had a zero tax basis. A cash infusion of $240 million provided a tax basis equal to that amount which permitted tax-free distributions of airplanes or cash back to GECC through TIFD III-E, the plaintiff here. Castle Harbour moved the cash to its subsidiary, Castle Harbour Leasing, Inc. (CHLI) which invested the money in commercial paper, primarily GECC's. This circular movement of cash--unnecessary for the operations of Castle Harbour--clearly indicates the sham nature of this entity. 4. Castle Harbour Was Economically Empty

Economic substance is a question of fact. Nicole Rose, 320 F.3d at 284; Lee, 155 F3d. at 586. Determining economic effect requires examining substance over -35-

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form and avoiding exalting "artifice over reality." Helvering, 293 U.S. at 469. The Castle Harbour transaction served no economic purpose beyond tax avoidance; as such it was "economically empty" save for tax considerations. Nicole Rose, 320 F.3d at 284 Lee, 155 F.3d at 586. An examination of the transaction which created Castle Harbour and Castle Harbour's structure and very existence supports a conclusion that Castle Harbour is nothing more than an artifice and it should be disregarded for federal income tax purposes. Nicole Rose, 320 F.3d at 284. GECC created Castle Harbour in July 1993 by contributing cash and its interest in 63 commercial airplanes under lease to domestic airlines. The airplanes were under "leveraged leases," which generally means GECC owned a small equity stake, perhaps 20%, and an institutional lender had financed the remaining 80% of the airplane's cost. Lease payments from the airlines usually were committed to first payoff the institutional lender rather than being prorated between the equity stakeholder and the lender. The income stream from airplane assets was predetermined by their pre-existing leases. Transferring the leases to Castle Harbour di