Canal Corporation & Subsidiaries v. Commissioner,
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Paper details
Subject:
Accounting
Topic:
Canal Corporation & Subsidiaries v. Commissioner,
CANAL CORPORATION & SUBSIDIARIES, FORMERLY CHESAPEAKE CORPORATION AND SUBSIDIARIES,
Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent. Case Information:
135 T.C. No. 9
Code Sec(s): 707; 752
Docket: Dkt. No. 14090-06.
Date Issued: 08/5/2010 .
Judge: Opinion by Kroupa, J.
Tax Year(s): Year 1999.
Disposition: Decision for Commissioner.
HEADNOTE
1. Partner-partnership transactions-contributions and distributions-disguised sales-debt-financed transfer
exception-risk of loss-anti-abuse. Contribution of assets and liabilities to newly formed LLC/joint venture that
tissue paper merchandising-manufacturing sub./5% partner made simultaneous with receipt of “special
distribution,” which LLC financed through bank loan and in respect to which LLC’s other/95% partner and sub.
agreed to serve as guarantor and indemnitor, respectively, was disguised sale under Code Sec. 707(a)(2)(B) for
which gain should have been reported on consolidated return in contribution-distribution year. Rejecting taxpayer’s
argument that distribution qualified for debt-financed transfer exception to disguised sale rules, Tax Court found
that it had to be taken into account because sub. didn’t bear any allocable share of/economic risk of loss (ERL) on
debt funding distribution. Although sub. did agree to indemnify guarantor/other partner, agreement was
disregarded under Reg § 1.752-2(j) ‘s anti-abuse rule because it lacked economic substance and created no more
than remote possibility that sub. would actually be liable for payment. Taxpayer’s claims to distinguish instant
transaction from that described in anti-abuse rule or that it should otherwise be found to bear ERL in accord with
Rev. Proc. 89-12 ,1989-1 CB 798 and/or on basis of speculative fraudulent conveyance theory were
unpersuasive.
Reference(s): ¶ 7075.01(60) Code Sec. 707 ; Code Sec. 752
2. Accuracy-related substantial understatement penalties-burden of proof-corp.
understatements-reasonable cause; good faith-reliance on professional. Accuracy-related substantial
understatement penalty was upheld against tissue paper merchandising-manufacturing corp. parent in respect to
massive deficiency resulting from disguised sale transaction involving sub. and other parties: IRS, which raised
penalty by way of amended answer and so bore burden of proving same under Tax Court Rule 142, met that
burden with proof that understatement, exceeding both 10% of correct tax and $10,000, was substantial within
meaning of Code Sec. 6662(d)(1)(B) ; and taxpayer didn’t show it acted with reasonable cause or in good faith.
Although taxpayer claimed reliance on “should” tax opinion of longtime preparer/tax firm and firm principal’s
advice, such reliance wasn’t reasonable or in good faith where opinion was riddled with errors and based on
unreasonable assumptions for which there was no support in applicable case law or IRC. Moreover, considering
“exorbitant” flat fee firm received and that it/its principal wore multiple hats in giving opinion on transaction it helped
plan, there was inherent conflict of interest and lack of sufficient independence to justify taxpayer’s reliance. In end,
tax opinion was seen more as quid pro quo arrangement than real tax opinion.
Reference(s): ¶ 66,625.01(20) ; ¶ 74,536.1426(90) ; ¶ 66,625.01(45) Code Sec. 6662
Syllabus
Official Tax Court Syllabus
W, a wholly owned subsidiary of parent, P, proposed to transfer its assets and most of its liabilities to a
newly formed LLC in which W and GP, an unrelated corporation, would have ownership interests. P
hired S, an investment bank, and PWC, an accounting firm, to advise it on structuring the transaction
with GP. P also asked PWC to issue an opinion on the tax consequences of the transaction and
conditioned the closing on receiving a “should” opinion from PWC that the transaction qualified as tax
free. PWC issued an opinion that the transaction should not be treated as a taxable sale but rather as a
tax free contribution of property to a partnership.
W contributed approximately two-thirds of the LLC’s total assets in 1999 in exchange for a 5-percent
interest in the LLC and a special distribution of cash. W used a portion of the cash to make a loan to P in
return for a note from P. W’s only assets after the transaction were its LLC interest, the note from P and a
corporate jet. The LLC obtained the funds for the cash distribution by receiving a bank loan. GP
guaranteed the LLC’s obligation to repay the loan. W agreed to indemnify GP if GP were called on to pay
the principal of the bank loan pursuant to its guaranty. The LLC thereafter borrowed funds from a
financial subsidiary of GP to retire the bank loan.
GP entered into a separate transaction in 2001 that required it to divest its entire interest in the LLC for
antitrust purposes. W subsequently sold its LLC interest to GP, and GP then sold the entire interest in
the LLC to an unrelated party. P reported gain from the sale on its consolidated Federal income tax
return for 2001. R determined that P should have reported a gain when W contributed its assets to the
LLC in 1999. R has also asserted a substantial understatement penalty under sec. 6662(a), I.R.C.,
against P in his amended answer.
1. Held: W’s asset transfer to the LLC was a disguised sale under sec. 707(a)(2)(B), I.R.C. P must
include gain from the sale on its consolidated Federal income tax return for 1999.
2. Held, further, P is liable for an accuracy-related penalty for a substantial understatement of income tax
under sec. 6662(a), I.R.C.
Counsel
Clifton B. Cates III, Robert H. Wellen, and David D.Sherwood, for petitioner. Curt M. Rubin, Matthew I. Root, and Steven
N. Balahtsis, for respondent.
KROUPA, Judge
Respondent determined a $183,458,981 1 deficiency in petitioner’s (Chesapeake) 2 Federal income tax for 1999, the year
at issue. Respondent asserts in his amended answer that Chesapeake owes a $36,691,796 substantial understatement of
income tax penalty under section 6662(a) 3 for 1999. We must determine whether Chesapeake’s subsidiary’s contribution
of its assets and most of its liabilities to a newly formed limited liability company and the simultaneous receipt of a $755
million distribution should be characterized as a disguised sale, requiring Chesapeake to recognize a $524 million gain in
1999, the year of contribution and distribution. We hold that the transaction was a disguised sale, requiring Chesapeake to
recognize the gain. We must also determine whether Chesapeake is liable for the substantial understatement penalty
under section 6662(a). We hold Chesapeake is liable for the penalty.
Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent. Case Information:
135 T.C. No. 9
Code Sec(s): 707; 752
Docket: Dkt. No. 14090-06.
Date Issued: 08/5/2010 .
Judge: Opinion by Kroupa, J.
Tax Year(s): Year 1999.
Disposition: Decision for Commissioner.
HEADNOTE
1. Partner-partnership transactions-contributions and distributions-disguised sales-debt-financed transfer
exception-risk of loss-anti-abuse. Contribution of assets and liabilities to newly formed LLC/joint venture that
tissue paper merchandising-manufacturing sub./5% partner made simultaneous with receipt of “special
distribution,” which LLC financed through bank loan and in respect to which LLC’s other/95% partner and sub.
agreed to serve as guarantor and indemnitor, respectively, was disguised sale under Code Sec. 707(a)(2)(B) for
which gain should have been reported on consolidated return in contribution-distribution year. Rejecting taxpayer’s
argument that distribution qualified for debt-financed transfer exception to disguised sale rules, Tax Court found
that it had to be taken into account because sub. didn’t bear any allocable share of/economic risk of loss (ERL) on
debt funding distribution. Although sub. did agree to indemnify guarantor/other partner, agreement was
disregarded under Reg § 1.752-2(j) ‘s anti-abuse rule because it lacked economic substance and created no more
than remote possibility that sub. would actually be liable for payment. Taxpayer’s claims to distinguish instant
transaction from that described in anti-abuse rule or that it should otherwise be found to bear ERL in accord with
Rev. Proc. 89-12 ,1989-1 CB 798 and/or on basis of speculative fraudulent conveyance theory were
unpersuasive.
Reference(s): ¶ 7075.01(60) Code Sec. 707 ; Code Sec. 752
2. Accuracy-related substantial understatement penalties-burden of proof-corp.
understatements-reasonable cause; good faith-reliance on professional. Accuracy-related substantial
understatement penalty was upheld against tissue paper merchandising-manufacturing corp. parent in respect to
massive deficiency resulting from disguised sale transaction involving sub. and other parties: IRS, which raised
penalty by way of amended answer and so bore burden of proving same under Tax Court Rule 142, met that
burden with proof that understatement, exceeding both 10% of correct tax and $10,000, was substantial within
meaning of Code Sec. 6662(d)(1)(B) ; and taxpayer didn’t show it acted with reasonable cause or in good faith.
Although taxpayer claimed reliance on “should” tax opinion of longtime preparer/tax firm and firm principal’s
advice, such reliance wasn’t reasonable or in good faith where opinion was riddled with errors and based on
unreasonable assumptions for which there was no support in applicable case law or IRC. Moreover, considering
“exorbitant” flat fee firm received and that it/its principal wore multiple hats in giving opinion on transaction it helped
plan, there was inherent conflict of interest and lack of sufficient independence to justify taxpayer’s reliance. In end,
tax opinion was seen more as quid pro quo arrangement than real tax opinion.
Reference(s): ¶ 66,625.01(20) ; ¶ 74,536.1426(90) ; ¶ 66,625.01(45) Code Sec. 6662
Syllabus
Official Tax Court Syllabus
W, a wholly owned subsidiary of parent, P, proposed to transfer its assets and most of its liabilities to a
newly formed LLC in which W and GP, an unrelated corporation, would have ownership interests. P
hired S, an investment bank, and PWC, an accounting firm, to advise it on structuring the transaction
with GP. P also asked PWC to issue an opinion on the tax consequences of the transaction and
conditioned the closing on receiving a “should” opinion from PWC that the transaction qualified as tax
free. PWC issued an opinion that the transaction should not be treated as a taxable sale but rather as a
tax free contribution of property to a partnership.
W contributed approximately two-thirds of the LLC’s total assets in 1999 in exchange for a 5-percent
interest in the LLC and a special distribution of cash. W used a portion of the cash to make a loan to P in
return for a note from P. W’s only assets after the transaction were its LLC interest, the note from P and a
corporate jet. The LLC obtained the funds for the cash distribution by receiving a bank loan. GP
guaranteed the LLC’s obligation to repay the loan. W agreed to indemnify GP if GP were called on to pay
the principal of the bank loan pursuant to its guaranty. The LLC thereafter borrowed funds from a
financial subsidiary of GP to retire the bank loan.
GP entered into a separate transaction in 2001 that required it to divest its entire interest in the LLC for
antitrust purposes. W subsequently sold its LLC interest to GP, and GP then sold the entire interest in
the LLC to an unrelated party. P reported gain from the sale on its consolidated Federal income tax
return for 2001. R determined that P should have reported a gain when W contributed its assets to the
LLC in 1999. R has also asserted a substantial understatement penalty under sec. 6662(a), I.R.C.,
against P in his amended answer.
1. Held: W’s asset transfer to the LLC was a disguised sale under sec. 707(a)(2)(B), I.R.C. P must
include gain from the sale on its consolidated Federal income tax return for 1999.
2. Held, further, P is liable for an accuracy-related penalty for a substantial understatement of income tax
under sec. 6662(a), I.R.C.
Counsel
Clifton B. Cates III, Robert H. Wellen, and David D.Sherwood, for petitioner. Curt M. Rubin, Matthew I. Root, and Steven
N. Balahtsis, for respondent.
KROUPA, Judge
Respondent determined a $183,458,981 1 deficiency in petitioner’s (Chesapeake) 2 Federal income tax for 1999, the year
at issue. Respondent asserts in his amended answer that Chesapeake owes a $36,691,796 substantial understatement of
income tax penalty under section 6662(a) 3 for 1999. We must determine whether Chesapeake’s subsidiary’s contribution
of its assets and most of its liabilities to a newly formed limited liability company and the simultaneous receipt of a $755
million distribution should be characterized as a disguised sale, requiring Chesapeake to recognize a $524 million gain in
1999, the year of contribution and distribution. We hold that the transaction was a disguised sale, requiring Chesapeake to
recognize the gain. We must also determine whether Chesapeake is liable for the substantial understatement penalty
under section 6662(a). We hold Chesapeake is liable for the penalty.
Homework #1: Chesapeake/Canal Corp Case
1. Explain your understanding of each of the two following terms and give an example from the
case where Chesapeake violated each of these doctrines to arrive at the results it wanted .
a. Step transaction doctrine
b. Substance over form
2. Explain at least two ways Chesapeake sabotaged its own tax position in 1999 on its tax return
and/or financial statements (from the court case). What could they have done differently to
strengthen its arguments that this entire transaction was not merely tax avoidance with no
business purpose?
3. What happened with PwC as part of this transaction? Do you think the partners were aware of
the position they were putting their firm in by the manner in which they structured their
engagement? What could PwC have done differently to remove perceived bias towards its
client?
1. Explain your understanding of each of the two following terms and give an example from the
case where Chesapeake violated each of these doctrines to arrive at the results it wanted .
a. Step transaction doctrine
b. Substance over form
2. Explain at least two ways Chesapeake sabotaged its own tax position in 1999 on its tax return
and/or financial statements (from the court case). What could they have done differently to
strengthen its arguments that this entire transaction was not merely tax avoidance with no
business purpose?
3. What happened with PwC as part of this transaction? Do you think the partners were aware of
the position they were putting their firm in by the manner in which they structured their
engagement? What could PwC have done differently to remove perceived bias towards its
client?
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