No real partnership was created, a US appeals court said.

Dow Chemical did two partnership transactions with foreign banks that used a financial product developed by Goldman Sachs called SLIPs, for special limited investment partnerships.

The transactions allowed Dow to claim large deductions on assets that had already depreciated.

Dow identified assets with a high value but zero or little tax basis, contributed them to a partnership and brought in foreign banks as limited partners. Each partnership lasted about five years.

In the first deal, Dow had its subsidiaries contribute 73 patents worth $867 million. Dow had a zero tax basis in 71 of the patents. It also contributed $110 million in cash and a shell corporation.

Five foreign banks contributed $200 million for the limited partner interests. The partnership was owned 18% by the foreign banks.

Dow continued to use the patents and paid royalties to the partnership that were not tied to the patent use. It indemnified the banks against any liabilities tied to the assets or taxes.

The partnership — called Chemtech I — operated from April 1993 through June 1998. The Dow royalty payments were its main source of income. The banks received 99% of profits until the profits reached a 6.947% priority return plus a relatively small distribution to cover Swiss tax liability, since the partnership was considered to be managed from Switzerland.

The partnership contributed the remaining cash from the Dow royalty payments to the shell corporation, which lent most of it back to Dow. If profits fell short of the priority return, then the partnership still had to pay the banks 97% of their priority return.

Here are numbers for 1994 as an illustration. Dow paid deductible royalties of $143.3 million. The partnership distributed $13.9 million to the banks. It contributed $136.9 million to the shell corporation that the shell corporation lent back to Dow. The partnership had taxable income of $122.4 million. It allocated $115 million of this income to the banks and $28.1 million to Dow.

The partnership agreement listed 23 things that could cause the partnership to terminate. Many were typical of default triggers in loan agreements. Upon termination, the banks would receive the balance in their capital accounts plus 1% of any gain or less 1% of any loss resulting from any change in the partnership’s asset value. The banks were compensated for any shortfall in their expected return if the partnership terminated before seven years.

Dow terminated the partnership in February 1998 because of new US tax regulations that could subject the banks to 30% withholding taxes.

Dow would have had to indemnify them for the withholding taxes. The banks were repaid their capital account balances plus 1% of the increase in value of the patents.

Dow then formed a new partnership to do the same thing. It contributed a chemical plant in Louisiana worth $715 million but with a tax basis of $18.5 million. The new partnership leased the plant to Dow. Dow paid rent. A US affiliate of Rabobank contributed $200 million in June 1998 as limited partner in exchange for a 20.45% interest. The bank had a 6.375% priority return and could terminate the partnership after roughly five years.

In March 2003, the bank and Dow negotiated a new partnership agreement that reduced the bank’s priority return to 4.207%. The partnership continued to operate under the new terms for roughly another five years through June 2008.

A federal district court said no real partnerships were formed between Dow and the banks. In reality, the banks made loans to Dow.

A US appeals court agreed in September that no partnerships were formed. It rejected Dow’s argument that it first had to decide whether the banks were lenders or partners. Dow said they could not be lenders because there was no fixed maturity for repayment of their investments.

The court said the following persuaded it that no real partnerships were formed. The banks earned a fixed annual return regardless of the success of the underlying business. They had only a 1% interest in any appreciation in asset value. They took virtually no risk tied to the patents or the chemical plant. Dow indemnified the banks for any liabilities tied to the patents or chemical plant and for any tax liability.

Various steps were taken to eliminate what little risk there was, such as requiring each partnership to hold collateral worth 3.5 times the unrecovered capital contributions of the banks. If the banks perceived any risk, they could terminate the partnership and get their money back. For example, they could terminate if the partnership failed to distribute at least 97% of the expected preferred return each quarter.

The bottom line, the court said, is there was no intention to join together to form a real business with a sharing of profits from that business. The assets were assembled with tax attributes in mind and, in the case of the patents, did not include all the rights that any licensee would need to function as a real business. The banks had downside protection and virtually no upside.

The case is Chemical Royalty Associates, L.P. v. United States. Dow said it was disappointed by the decision and is evaluating its options.

— contributed by Keith Martin in Washington