Tifd Iii-E, Inc. v. United States of America, Docket No. 05-0064-Cv

This appeal tests the power of the Internal Revenue Service to examine and re-characterize an interest which accords with its ostensible classification only in illusory or insignificant respects. The taxpayer-plaintiff TIFD III-E, Inc. (the “taxpayer” or “TIFD III-E”), a subsidiary of General Electric Capital Corporation (“GECC”), brought suit in the United States District Court for the District of Connecticut (Stefan R. Underhill, J.) to challenge adjustments made by the Internal Revenue Service (“IRS”) to the tax returns for 1993 to 1998 of a partnership named Castle Har-bour Limited Liability Company (“Castle Harbour” or the “partnership”), for which the taxpayer was the tax-matters partner. The IRS’s adjustments added $62 million to the taxpayer’s tax bill. After an eight-day bench trial, the court ruled in favor of the taxpayer, TIFD III-E Inc. v. United States, 342 F.Supp.2d 94 (D.Conn.2004), and the government brought this appeal. We reverse the judgment of the district court.

The litigation turns primarily on the propriety of the partnership’s ostensible allocation of its income as between the taxpayer and two Dutch banks, ING Bank N.V. and Rabo Merchant Bank N.V. (the “Dutch banks” or the “banks”), which invested in the partnership. The Dutch banks do not pay taxes to the United States. The partnership’s “Operating Agreement” allocates to them 98% of the “Operating Income,” which comprises the great majority of the partnership’s income. The Operating Income, calculated for tax purposes, however, vastly exceeded the amounts the banks would actually receive. The net Operating Income, of which 98% would go to the banks, was drastically reduced by huge depreciation deductions which the IRS would not recognize, as the assets in question had already been fully depreciated. The effects of the ostensible allocation of the majority of the partnership’s income to the non-taxpaying Dutch banks were to shelter most of the partnership’s income from taxation and to redirect that income tax-free to the taxpayer. What the Dutch banks were in fact to receive from the partnership was dictated by provisions of the partnership agreement calling for the reimbursement of their initial investment at an annual rate of return of 9.03587% (or, in some circumstances, 8.53587%), subject to the possibility of small adjustments and to the possibility of a slight increase in the event of unexpectedly great partnership earnings. The banks’ reimbursement at the agreed rate of return was formidably secured by a variety of contractual undertakings by the taxpayer and its parent GECC.

Castle Harbour filed a federal partnership return every year from 1993 to 1998. In 2001, the IRS issued two notices of Final Partnership Administrative Adjustments (“FPAAs”), the first covering 1993 through 1996 and the second covering 1997 through 1998. Each provided for reallocation of Castle Harbour’s income. The IRS rejected the partnership’s treatment of the *224 two banks as bona fide equity partners for tax purposes and accordingly rejected the partnership’s allocations. The effect of the reallocation was to assign a far greater percentage of Castle Harbour’s income to the taxpayer, rather than the banks. The FPAAs attributed approximately $310 million in additional income to the taxpayer, imposing on the taxpayer an additional tax liability of $62,212,010.

The taxpayer deposited this sum with the IRS and, pursuant to 26 U.S.C. § 6226, brought suit in 2001 against the United States challenging the validity of the FPAAs. The IRS claimed two primary justifications for its adjustment — first, that under the authority of cases such as ASA Investerings v. Commissioner, 201 F.3d 505 (D.C.Cir.2000), and Boca Investerings Partnership v. United States, 314 F.3d 625, 632 (D.C.Cir.2003), the arrangement was a “sham”; and, second, that the interest of the Dutch banks was not, for tax purposes, a bona fide equity partnership participation because the banks had no meaningful stake in the success or failure of the partnership. The IRS argued that their investment was in the nature of a secured loan, and that whatever aspects of their interest resembled an equity partnership participation were either illusory or insignificant.

The court conducted a bench trial in the District of Connecticut. By memorandum and order dated November 1, 2004, the district court ruled that the FPAAs were invalid and ordered the IRS to refund the taxpayer’s deposit. TIFO III-E, 342 F.Supp.2d at 121-22. The court entered judgment on November 3, 2004.

The provisions of the immensely complex partnership agreements are analyzed in the district court’s thorough, comprehensive, and detailed opinion. See id. The court essentially acknowledged that the creation of the partnership was largely tax-motivated. The court nonetheless found that the partnership had other bona fide purposes, and some genuine economic effect. It therefore rejected the government’s contention that the partnership’s construct was a sham, which should be disregarded. The court concluded that the Dutch banks were, for tax purposes, partners of Castle Harbour.

While the government raises several arguments on appeal, we focus primarily on its contention that the Dutch banks should not be treated as equity partners in the Castle Harbour partnership because they had no meaningful stake in the success or failure of the partnership. 1 In its analysis of this question, the district court made several errors of law which undermined the soundness of its conclusions. The facts of the allocation of partnership resources, as set forth in the partnership documents (and as found by the district court), compel the conclusion that the IRS correctly determined that the Dutch banks were not bona fide equity participants in the partnership. We accordingly reverse the judgment.

I. Background

The material facts of this case consist essentially of the rights and obligations created as between the taxpayer and the Dutch banks by the partnership agreement. These exceptionally complex facts are described in detail in the district court’s opinion. In most respects, and except as explained below, we have no quarrel with the district court’s precise, thor *225 ough, and careful findings. As these complex facts are fully explained in the district court’s opinion, we will not lay them out in repetitious detail, but will rather focus on those aspects of the agreements that compel the reversal of the judgment and the conclusion that the banks were not bona fide equity participants in the partnership.

A. Overview

GECC has long been in the business of owning commercial aircraft which it leased to airlines. The economic benefits of aircraft ownership are primarily two — the revenues produced by employment of the aircraft in the business of air transportation, and the depreciation deductions the aircraft generate, which can substantially reduce the owner’s tax liability. However, once an owner has taken depreciation covering its full investment in the aircraft, no further depreciation deductions may be claimed. GECC had long produced revenue by leasing the aircraft to airlines and realized beneficial tax relief through depreciation. Eventually, however, GECC found itself in the position of owning a fleet of aircraft that had been fully depreciated and could thus no longer serve as the basis for depreciation deductions. By reason of its inability to take further depreciation, its ownership of these aircraft had become less remunerative. GECC solicited proposals from investment banks for financing of these aircraft.

The Castle Harbour partnership, which is the subject of this litigation, resulted from a proposal presented to GECC by Babcock & Brown, to which GECC paid $9 million for its assistance in the creation and execution of the plan. Following Bab-cock & Brown’s proposal in 1993, GECC caused the formation of an eight-year partnership, later named Castle Harbour, and solicited foreign financial companies, which are not subject to tax in the United States, as investors in the partnership. GECC caused its subsidiaries to transfer the ownership of a fleet of fully depreciated aircraft under lease to airlines to the Castle Harbour partnership, in which its subsidiary TIFD III-E, the taxpayer in this action, became the tax-matters partner. The assets transferred by GECC entities to the partnership were the fleet of aircraft, with a market value of $272 million, $22 million in receivables from aircraft-rental agreements, and $296 million in cash, making a total investment of $590 million. Shortly thereafter, the two Dutch banks contributed $117.5 million in cash to the partnership. 2 The district court found that the taxpayer contributed 82% of the partnership’s capital and the Dutch Banks contributed 18%. See TIFD III-E, 342 F.Supp.2d at 100. The Dutch banks’ participation in the partnership was to be passive. They were to exercise no role in the management, which was assigned entirely to the taxpayer. 3 The documents of the partnership characterize the Dutch banks as equity partners. This characterization is the main focus of this dispute.

*226 B. Castle Harbour’s Division of Assets, Revenues, and Losses

An extraordinarily complex maze of partnership provisions dictates how the revenues, losses, and assets of the partnership would be allocated over the eight-year duration of the partnership.

Using complex definitions, the partnership agreement allocated 98% of what the parties and the district court referred to as the “Operating Income” of the partnership to the Dutch banks. See TIFD III-E, 342 F.Supp.2d at 102-03. Operating Income was a flexible classification. It included most of the partnership’s taxable income, while allowing the taxpayer when it so desired to reclassify an income stream, taking it out of Operating Income and designating it instead as a “Disposition Gain.” Disposition Gains were allocated (after a threshold amount) primarily to the taxpayer. For tax purposes, the allocation of 98% of the partnership’s Operating Income to the non-taxpayer Dutch banks meant that only a tiny portion of the income of the partnership would be subject to tax. 4

The partnership’s Operating Income was reduced by expenses, the largest of which was the aggressive depreciation of its aircraft. Because the aircraft had already been fully depreciated for tax purposes, however, this depreciation did not serve to reduce the partnership’s taxable income. As a result, the 98% allocation of Operating Income to the Dutch banks created an enormous discrepancy between the banks’ share of the partnership’s taxable income and their share of its book value. When it came to the actual division of the assets, revenues, and losses, the partnership did not credit the Dutch banks’ capital accounts with the same 98% of the taxable Operating Income described above, but rather with 98% of a much smaller figure, drastically reduced by depreciation charged against the already fully depreciated aircraft. The partnership agreement was designed essentially to guarantee the Dutch banks the reimbursement (according to a previously agreed eight-year schedule) of their initial investment of $117.5 million at an annual rate of return of 9.03587% (or, in some circumstances, 8.53587%), referred to in the agreement as the “Applicable Rate.” The rate of return was subject to the possibility of a small increase in the event of unforeseen, extraordinary partnership profits. The scheduled reimbursement of the Dutch banks, at the Applicable Rate of annual return, was in no way dependent on partnership performance. These payments to the Dutch banks were assured in numerous ways- — most importantly, by the guaranty of the taxpayer’s parent, GECC, and accordingly were virtually certain to be made, regardless of whether the partnership earned profits or suffered losses.

The taxpayer and the banks were each permitted to terminate the arrangement prior to its scheduled termination date by paying a small penalty. If, for example, the Dutch banks terminated their participation prematurely, the agreement provided that the Applicable Rate would drop from 9.03587% to 8.53587%. By the same token, if the taxpayer elected to terminate the arrangement early, exercising its continuing right to buy out the Dutch banks’ interest, the banks would receive a premium of approximately $150,000. Finally, through the mechanism of Disposition Gains, as described below in greater detail, the Dutch banks would receive a slightly *227 higher return if the profits of the partnership were unexpectedly great.

In short, the Dutch banks, which contributed about 18% of the partnership’s capital and contributed nothing to its management, were allocated, for tax purposes, 98% of most of its taxable income. The actual distributions to be made to the banks, however, were arranged so that they would receive, according to a previously agreed schedule, the reimbursement of their investment, plus an annual return at an agreed rate near 9%, plus a small share in any unexpectedly large profits. See TIFD III-E, 342 F.Supp.2d at 105, 107-08.

The above facts were either found by the district court or are not in dispute (or both). What is in dispute is whether for tax purposes the Internal Revenue Service acted within its power in refusing to recognize the Dutch banks’ interest in the partnership as a bona fide equity participation. We conclude for reasons set forth at greater length below that the IRS properly refused to accept the partnership’s characterization because the banks did not meaningfully share in the business risks of the partnership venture and their interest was overwhelmingly in the nature of secured debt.

C. Factors Affecting the Proper Characterization of Dutch Banks’ Interests

The partnership interests of the Dutch banks were designed to have a superficial appearance of equity participation, but in the end (in all but a negligible part) to function in the manner of a repayment of a secured loan. This was achieved either by reason of the requirements of the partnership agreement that trumped the provisions that appeared to create an equity interest, or by reason of the powers given to the taxpayer and to the Dutch banks to protect their respective interests. The banks, as a consequence of these arrangements, did not meaningfully share the risks of the partnership business. We focus on aspects of the partnership documents that had this effect.

Exhibit E of the Operating Agreement specified the amounts the Dutch banks would receive in annual cash distributions. The Exhibit E payments were calculated to reimburse the banks’ $117.5 million investment plus an annual rate of return at the agreed Applicable Rate. Whether Castle Harbour had a profit or loss did not affect the Exhibit E payments. Although the making of Exhibit E payments was not ostensibly required by the Operating Agreement, as a practical matter, it was required because in the event of a failure to pay an Exhibit E payment, the Dutch banks could unilaterally force the partnership’s dissolution and would receive in such dissolution an amount which, when combined with the previous payments, would provide, subject to the possibility of small adjustments, reimbursement of the initial investment at the Applicable Rate of return.

Each Castle Harbour partner had a “capital account” and an “Investment Account.” The capital account represented each partner’s ostensible share of the partnership capital. Annually, the Dutch banks’ capital accounts were to be credited or debited with the amount of their alloca-ble shares of Castle Harbour’s income or loss, and debited to reflect distributions of cash or property. The “Investment Account” for each Dutch bank did not hold money, but instead kept track of the minimum balance that the Dutch banks would receive upon dissolution. The opening balance was the Dutch banks’ investment, and, at the time the Dutch banks exited the partnership, the “balance was to be recalculated ... as if every year the bal- *228 anee had been increased by a defined Applicable Rate but also reduced by the Exhibit E payments.” TIFD III-E, 342 F.Supp.2d at 104. If, at the dissolution of Castle Harbour, the Dutch banks’ Investment Accounts exceeded the amount in their capital accounts, the Operating Agreement required that the Dutch banks receive a “Class A Guaranteed Payment” virtually equal to the difference between those two figures. Id. The effect of the Investment Accounts, as the district court found, was therefore to ensure that, were Castle Harbour to experience losses, the Dutch banks would nonetheless recover the reimbursement of their initial investment at the Applicable Rate of annual return. 5 Id. Thus, reimbursement at a minimum of the Applicable Rate of return was assured independent of the operating results of the partnership.

Furthermore, the Dutch banks’ receipt of reimbursement, at the annual Applicable Rate of return, was elaborately protected. First, the taxpayer was required by the partnership agreement to keep “Core Financial Assets,” consisting of high-grade commercial paper or cash, in an amount equal to 110% of the current value of the banks’ Investment Accounts. The partnership, in addition, was obliged for the banks’ protection to maintain $300 million worth of casualty-loss insurance. Finally, and most importantly, GECC — a large and very stable corporation — gave the banks its personal guaranty, which effectively secured the partnership’s obligations to the banks. As the district court correctly found, these protections collectively ensured there was no realistic chance that the Dutch banks would receive less than the reimbursement of their initial investment at the Applicable Rate of annual return. TIFD III-E, 342 F.Supp.2d at 105-06. The Dutch banks thus incurred no meaningful downside risk.

On the other hand, the banks’ investment ostensibly had unlimited upside potential. If, upon dissolution of Castle Har-bour, the banks’ capital accounts exceeded their Investment Accounts, the partnership’s Operating Agreement provided that the banks would receive the entire balance of their capital accounts. Because the agreement placed no limits on the amount of Operating Income that could be credited (at a rate of 98%) to the banks’ capital accounts, it might appear that the banks would be entitled to a significant share of any unexpectedly high income earned by the partnership. As a practical matter, however, the ability of the banks to receive a share of unexpectedly large partnership returns was severely limited.

The taxpayer could limit the Dutch banks’ participation in partnership profits through its power to transfer assets into a subsidiary of the partnership named Castle Harbour Leasing, Inc. (“CHLI”). The partnership agreement provided that the income or loss produced by any asset transferred into CHLI would no longer be classified as Operating Income but instead as “Disposition Gain” or “Disposition Loss.” 6 After an initial allocation of 90% of Disposition Gains to the Dutch banks up to a maximum of $2,854,493, Disposition *229 Gains were then allocated 99% in favor of the taxpayer. 7 Thus by reclassification of an income-producing asset, the taxpayer could reduce the banks’ participation in the income produced by the asset from 98% to 1%. The taxpayer had every incentive to make such a reclassification in the case of sufficiently large unexpected profits, as it would increase the taxpayer’s share of the income produced by the asset to 99%. Finally, the taxpayer had the ability, on payment of a negligible premium, to terminate the Dutch banks’ interest in the partnership and thereby prevent allocation of earnings to the banks. 8

In summary, the Dutch banks’ interest in the eight-year partnership was essentially as follows: (1) They were promised the reimbursement, on a previously agreed schedule, of their initial $117.5 million investment at an agreed annual rate of return; (2) their repayment at the agreed rate of return was secured by the personal guaranty of GECC; (3) they were fully protected against risk of loss, except as to a tiny amount in highly unlikely circumstances; and (4) their ability to earn in excess of the agreed annual rate by participation in unexpected gains was, as a practical matter, capped at $2,854,493 (less than 2.5% of their investment), plus 1%.

D. The District Court’s Opinion

The district court ruled in favor of the taxpayer, rejecting the government’s argument that the Castle Harbour partnership was a sham. The court stated that in applying the sham test, the two considerations are whether any non-tax business purpose motivated the taxpayer to engage in the disputed transaction and whether that transaction had any objective economic effect. The district court found that GECC was motivated to enter into the Castle Harbour transaction, at least in part, (i) by a desire to raise capital otherwise than by borrowing, as GECC was prohibited from borrowing additional amounts by covenants with its lenders; and (ii) to demonstrate to investors, rating agencies, and GECC senior management that it could raise equity capital on its fleet of fully depreciated aircraft. TIFD III-E, 342 F.Supp.2d at 111. Because the achievement of these ends depended on the Dutch banks being equity participants, rather than lenders, the court found a business purpose to the banks’ equity partnership designation. Id. at 112-14. The court also found a genuine economic effect in that the taxpayer raised $117.5 million and used it to retire debt, while the banks participated in the partnership’s profits. Id. at 111. See also id. at 109-10. The *230 court further found the opportunity to participate in “upside potential, even with some guarantee against loss, [to be] economically substantial.” Id. at 110.

The court then inquired into whether there was a basis to consider the banks not to be equity partners for tax purposes. As the court saw the question, the banks might properly be deemed not to be equity partners in two circumstances: (1) if there was no “economic substance” to the label “partner,” and (2) if the tax code classified their interest as other than a partner’s interest. Id. at 111. As for lack of economic substance, the court reasoned that it had already answered this question in the taxpayer’s favor in its resolution of the sham analysis. As for the classifications commanded by the tax code, the court found that the banks’ interest conformed to I.R.C. Section 761’s definition of a partnership as including “a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on.” TIFD III-E, 342 F.Supp.2d at 115 (quoting I.R.C. § 761). The court thus resolved the question of the propriety of the partnership designation on the basis of its sham analysis, coupled with the formal definitions of the Code.

While questioning its relevance, the court went on also to consider the government’s contention that the Dutch banks’ interest was more akin to debt than to equity. The court observed that “the only possible relevance of the debt/equity analysis is as an aid to performing ‘sham transaction’ analysis.” TIFD III-E, 342 F.Supp.2d at 115. The court rejected the government’s contention, based on its conclusion that (1) the banks were not owed a “sum certain”; (2) they enjoyed “unlimited upside” potential to participate in the partnership’s profits; (3) the payment of the banks was subordinate to payment of general creditors; (4) the banks’ interests were treated by the GECC companies as an equity interest (notwithstanding that the Dutch banks had at times described their interests as debt); and (5) insofar as GECC’s lenders allowed GECC to obtain this financing notwithstanding its exhaustion of the debt limitations of its negative covenants, those lenders accepted the characterization of the banks’ interest as other than debt. See TIFD III-E, 342 F.Supp.2d at 115-17. 9

II. Discussion

A. Errors of Law in the District Court’s Analysis

We find that the district court erred as a matter of law in several respects. In rejecting the government’s contention that the Dutch banks were not bona fide equity partners for tax purposes, the court relied essentially upon the sham-transactions test to the exclusion of the test of totality-of-the-circumstances set forth by the Supreme Court in Commissioner v. Culbertson, 337 U.S. 733, 742, 69 S.Ct. 1210, 93 L.Ed. 1659 (1949). In examining the related question whether the banks’ interest was more in the nature of debt or equity, 10 the court erred in several *231 respects—primarily by accepting at face value the appearances and labels created by the partnership, rather than assessing the underlying economic realities. The court’s conclusion was impaired by these errors of law.

We further find that the facts of the partnership agreement, as properly found by the district court, generally conceded by the taxpayer, and unquestionably established by the partnership documents, compel the conclusion that the Internal Revenue Service was on sound ground in rejecting the partnership’s purported characterization of the Dutch banks’ interest as bona fide equity participation. 11

In sum, the Dutch banks’ interest was overwhelmingly in the nature of a secured lender’s interest, which would neither be harmed by poor performance of the partnership nor significantly enhanced by extraordinary profits. The banks had no meaningful stake in the success or failure of Castle Harbour. While their interest was not totally devoid of indicia of an equity participation in a partnership, those indicia were either illusory or insignificant in the overall context of the banks’ investment. The IRS appropriately rejected the equity characterization.

i. Failure To Employ the Culbertson Test

The court should not have rejected the government’s contention that the Dutch banks’ interest was not a bona fide equity partnership participation without examining the question under the all-faets- and-circumstances test of Culbertson, 337 U.S. at 742, 69 S.Ct. 1210. The court relied on the sham—transaction doctrine, which accepts the taxpayer’s characterization of an interest as controlling unless that characterization is determined to be a sham-that is, altogether without economic substance. See TIFD III-E, 342 F.Supp.2d at 115. (“[T]he ‘sham transaction’ doctrine ... is the test by which a court is to scrutinize the partnership structure.”). 12 Using this test, the court determined that because, in addition to the strong and obvious tax motivations, the taxpayer had some additional non-tax motivation to raise equity capital, the transaction could not be considered a sham.

The IRS, however, is entitled in rejecting a taxpayer’s characterization of an interest to rely on a test less favorable to the taxpayer, even when the interest has economic substance. This alternative test determines the nature of the interest based on a realistic appraisal of the totality of the circumstances. We do not mean to imply that it was error to consider the sham test, as the IRS purported to rely in part on that test. The error was in failing to test the banks’ interest also under Culbertson after finding that the taxpayer’s characterization survived the sham test.

In Culbertson, the Supreme Court ruled that a partnership exists when, “considering all the facts—the agreement, the conduct of the parties in execution of its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, then- respective abilities and capital contributions, the actual control of *232 income and the purposes for which it is used, and any other facts throwing light on their true intent — the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.” Culbertson, 337 U.S. at 742, 69 S.Ct. 1210. This test turns on the fair, objective characterization of the interest in question upon consideration of all the circumstances. See, e.g., Estate of Kahn v. Commissioner, 499 F.2d 1186, 1189 (2d Cir.1974) (identifying factors a court might consider); Luna v. Commissioner, 42 T.C. 1067, 1077-78, 1964 WL 1259 (1964) (same). The IRS’s challenge to the taxpayer’s characterization is not foreclosed merely because the taxpayer can point to the existence of some business purpose or objective reality in addition to its tax-avoidance objective. 13 Cf. Gilbert v. Commissioner, 248 F.2d 399, 406 (2d Cir.1957). The district court recognized the existence of the Culbertson test, see TIED III-E, 342 F.Supp.2d at 111, but did not conduct a Culbertson analysis of whether the banks’ interest was a bona fide equity partnership participation. This was error.

ii. Errors in Determining the Nature of the Dutch Banks’ Interest

Consideration whether an interest has the prevailing character of debt or equity can be helpful in analyzing whether, for tax purposes, the interest should be deemed a bona fide equity participation in a partnership. See O’Hare v. Commissioner, 641 F.2d 83, 86-87 (2d Cir.1981); cf. Commissioner v. O.P.P. Holding Corp., 76 F.2d 11, 12 (2d Cir.1935) (discussing the difference between a shareholder and a creditor and noting that while the “shareholder is an adventurer in the corporate business” who “takes the risk, and profits from success,” the creditor, “in compensation for not sharing the profits, is to be paid independently of the risk of success, and gets a right to dip into the capital when the payment date arrives”). Although questioning the usefulness of the inquiry, the district court did consider whether the Dutch banks’ interest was more akin to debt than to equity and concluded it was not. In making this analysis, however, the court made errors of law, which undermined its conclusion. In large part these errors consisted in accepting at face value artificial constructs of the partnership agreement without examining all the circumstances to determine whether powers granted to the taxpayer effectively negated the apparent interests of the banks.

Neither the Internal Revenue Code nor the Regulations provide for definitions of debt and equity. We have noted that Congress appears to have intended that “the significant factor” in differentiating between the two be whether “the funds were advanced with reasonable expectations of repayment regardless of the success of the venture or were placed at the risk of the business.” Gilbert, 248 F.2d at 406; see also Nassau Lens Co. v. Commissioner, 308 F.2d 39, 47 (2d Cir.1962) (Marshall, J.).

We recognize that the cases in which this standard has developed generally differ from the present case in two respects. First, they usually involve the character *233 ization of an investment in a corporation, rather than in a partnership. See, e.g., John Kelley Co. v. Commissioner, 326 U.S. 521, 524-25, 66 S.Ct. 299, 90 L.Ed. 278 (1946) (analyzing whether certain payments to note-holders constituted “dividends” or “interest”); Matthiessen v. Commissioner, 194 F.2d 659, 661 (2d Cir.1952) (analyzing whether advances to a corporation by stockholders were contributions to capital or loans). Second, conventionally in those cases, the taxpayer has characterized the investment as debt, with the objective of securing the tax benefit of the deductibility of interest payments, while the IRS has contended that because the investor will not receive either the recovery of the investment or the purported interest payments unless the venture succeeds, the investment is properly seen as a capital contribution. See, e.g., John Kelley Co., 326 U.S. at 524-25, 66 S.Ct. 299; Matthiessen, 194 F.2d at 660; see also Gilbert 248 F.2d at 402 (“Generally we find an effort by the taxpayer to induce the Commissioner and the courts to make a finding that [the relevant] transactions are loans.”).

Given the facts and circumstances of the present case, we see these as distinctions without substantial difference. In all such cases, a taxpayer has cast a transaction representing an investment as equity or as debt with a view to obtaining tax benefits resulting from that characterization, and the government has challenged the characterization. We see no reason why the standard for distinguishing between debt and equity should not be focused in all such cases on whether “the funds were advanced with reasonable expectations of repayment regardless of the success of the venture or were placed at the risk of the business.” Gilbert, 248 F.2d at 406; see also Hambuechen v. Commissioner, 43 T.C. 90, 99, 1964 WL 1154 (1964).

Our decision in O’Hare v. Commissioner, 641 F.2d 83 (2d Cir.1981), is illustrative. In O’Hare, we found that the Tax Court had correctly determined that the taxpayer, who provided financial backing in securing a loan, had not become “sufficiently involved with the profitability of the venture to warrant treatment as a joint ven-turer,” notwithstanding the fact that the taxpayer was not indemnified against certain liabilities or losses. Id. at 85. We affirmed the Tax Court’s finding that upon a thorough analysis and appraisal of the circumstances, the taxpayer’s investment was more in the nature of debt financing than a joint venture. Noting that any risks alleged by the taxpayer were “more imagined than real, and not materially different from those borne by other lenders,” id., we found that, in sum, the “total effect” of the transaction in question “was that of a financing scheme rather than a joint venture,” id. at 87.

a. The Banks’ Share in the Upside Potential of the Partnership.

The district court recognized that the banks ran no meaningful risk of being paid anything less than the reimbursement of their investment at the Applicable Rate of return. The court concluded on the other hand that the banks were given a meaningful and unlimited share of the upside potential of the partnership. See TIFD III-E, 342 F.Supp.2d at 116-17 (“It is true that their potential downside was limited, but their upside was not.... [A]n investor with unlimited upside potential has a significant interest in the performance of the entity in question, because performance directly affects the amount of her return.”). This conclusion played a major role in supporting the district court’s conclusion that the banks’ interest *