Procedure & Administration
The Tax Court held that a corporation was liable for an accuracy-related penalty for a substantial understatement of tax related to a joint venture transaction even though the corporation had received an opinion from a national accounting firm that the transaction was not taxable. The Tax Court found that the firm’s opinion was based on unreasonable assumptions and that the corporation did not rely on the opinion in good faith.
Background
Chesapeake Corporation (now renamed Canal Corporation) is the parent corporation of a group of corporations in the paper industry. In the 1990s, the group was involved in merchandising and specialty packaging, tissue paper products, and forest and land development. Chesapeake’s largest subsidiary was Wisconsin Tissue Mills, Inc. (WISCO), which manufactured commercial tissue paper products. Due to its relatively small share of the tissue market and consolidation in the paper industry, Chesapeake found that it was no longer competitive in the tissue market. Thus, after hiring a new CEO in 1997, Chesapeake sought to restructure and refocus its business on specialty packaging and merchandising and to move out of the commercial tissue business.
At this time, Georgia Pacific (GP), another company in the tissue business, was seeking to expand its tissue operations and discussed with Chesapeake the possibility of acquiring WISCO. Chesapeake was interested in disposing of WISCO to generate capital for its specialty packaging business; however, the company had a low tax basis in WISCO, making a sale of the company an unattractive option. Therefore, Chesapeake hired an investment banking firm and the accounting firm that had been Chesapeake’s longtime financial auditor to explore other alternatives for transferring WISCO to GP.
The investment bank recommended to Chesapeake that the best alternative for maximizing shareholder value would be a leveraged partnership structure with GP. The leveraged partnership structure would require WISCO to first transfer its tissue business assets to a joint venture. GP would then transfer its tissue business assets to the joint venture. Next, the joint venture would borrow funds from a third party and distribute the proceeds to Chesapeake (special distribution). Chesapeake would guarantee the third-party debt through a subsidiary. WISCO would hold a minority interest in the joint venture after the distribution, and GP would hold a majority interest. The investment bank presented the leveraged partnership structure as tax advantageous to Chesapeake because it would allow the company to get cash out of the business without recognizing a taxable gain when it received the distribution of the borrowed funds.
Generally partners may contribute capital to a partnership tax free and may receive a tax-free return of previously taxed profits through distributions. However, under Sec. 707 and the regulations, these nonrecognition rules do not apply when the transaction is found to be a disguised sale of property (Sec. 707(a)(2)(B)). A transaction may be deemed a sale if, based on all the facts and circumstances, the partnership’s distribution of money or other consideration to the partner would not have been made but for the partner’s transfer of the property. Contribution and distribution transactions that occur within two years of one another are presumed to effect a sale unless the facts and circumstances clearly establish otherwise (the two-year presumption) (Regs. Sec. 1.707-3(c)(1)).
The regulations offer an exception from the disguised sale rules for debt-financed transfers of consideration. Under the exception, to the extent that a distribution of money or other consideration to a partner is attributable to the partner’s allocable share of a partnership liability, the disguised sale rules do not apply to the distribution (Regs. Sec. 1.707-5(b)).
According to the investment bank and the accounting firm, the special distribution to Chesapeake would not be treated as a currently taxable sale of WISCO’s assets because the debt-financed distribution exception to the disguised sale rules would apply. Chesapeake was interested in the joint venture transaction because of the tax deferral it offered, which would allow Chesapeake to accept a lower price for WISCO. However, the company made it clear to the investment bank and the accounting firm that the asset transfer and special distribution had to be nontaxable and that it required a “should” tax opinion letter (the highest level of assurance that a position will succeed on the merits) from the accounting firm regarding the tax results of the transaction.
GP was indifferent to Chesapeake’s tax results but agreed to the proposed structure of the transaction to make the deal work. The accounting firm agreed to provide the “should” opinion letter requested by Chesapeake for a flat fee of $800,000. Chesapeake and GP undertook the transaction in 1999 as planned, with WISCO providing the required indemnity guarantee to GP. Chesapeake disclosed the transaction on its 1999 consolidated return, reporting no taxable gain on the special distribution under the theory that it was a debt-financed transfer of consideration and not the proceeds of a sale.
In 2001, GP was required for antitrust purposes related to the purchase of another paper company to sell its interest in the joint venture. The buyer GP found required GP to sell it the entire joint venture, so it purchased Chesapeake’s interest first. On its 2001 tax return, Chesapeake reported a $524 million gain from the sale of its interest in the joint venture.
The IRS determined that the joint venture transaction was a disguised sale that resulted in a $524 million gain in 1999 and issued a deficiency notice for $183.5 million for that year. Chesapeake appealed the IRS’s determination in Tax Court. In its amended answer to Chesapeake’s petition, the IRS also asserted a $36.7 million accuracy-related penalty under Sec. 6662 for a substantial understatement of tax.
The Disguised Sale
The Tax Court held that the joint venture transaction between Chesapeake and GP was a disguised sale of WISCO’s assets and upheld the deficiency assessment against Chesapeake. While the court agreed with the general proposition that Chesapeake would be entitled to the exception, it determined that it must analyze the indemnity agreement in the joint venture transaction to see if Chesapeake did bear a risk of loss for the joint venture’s debt under the anti-abuse rule in Regs. Sec. 1.752-2(j). Under the anti-abuse rule, a partner’s obligation to make a payment would be disregarded if
(1) the facts and circumstances indicate that a principal purpose of the arrangement between the parties is to eliminate the partner’s risk of loss or to create a facade of the partner’s bearing the economic risk of loss with respect to the obligation, or (2) the facts and circumstances of the transaction evidence a plan to circumvent or avoid the obligation. [Slip op. at 23]
The Tax Court, reviewing the terms of the indemnity agreement and the surrounding circumstances, concluded that the agreement was crafted to limit any potential liability to WISCO’s assets and that WISCO did not have any real assets from which to satisfy the indemnification agreement. Therefore, the indemnity agreement lacked economic substance, and Chesapeake had used the indemnity agreement to create the appearance that WISCO bore the economic risk of loss for the joint venture’s debt when in substance the risk was borne by GP. Because WISCO had no risk of loss for the debt from which the joint venture made the distribution, the court determined that the exception from the disguised sale rules for debt-financed transfers of consideration did not apply to the distribution and that it should be treated as a taxable disguised sale of WISCO’s business assets to GP in 1999.
The Accuracy-Related Penalty
The Tax Court also held that Chesapeake was liable for a Sec. 6662 accuracy-related penalty for a substantial underpayment of tax on its 1999 return. Chesapeake had argued that the penalty should not apply since it had reasonable cause for and acted with good faith with respect to the joint venture transaction because it relied on an opinion from a competent tax adviser that it obtained before entering into the transaction. The Tax Court found that Chesapeake was both unreasonable in relying on the opinion and had not acted with reasonable cause or in good faith.
The Tax Court found that due to the quality of the opinion, it was unreasonable for Chesapeake to rely on it. The court was highly critical of all aspects of the opinion. It noted that it was “littered with typographical errors, disorganized and incomplete” and was “riddled with questionable conclusions and unreasonable assumptions.” Most important, the court found that the accounting firm partner preparing the opinion had simply assumed that the indemnity would be effective and did not consider whether the indemnity lacked substance. According to the court, it was unreasonable “that anyone, let alone an attorney, would issue the highest level opinion a firm offers on such dubious legal reasoning” as was contained in the opinion, and it was unreasonable for Chesapeake to have relied on the opinion.
The Tax Court also concluded that Chesapeake did not act with reasonable cause or in good faith based on the conflict of interest of the partner preparing the opinion and the opinion’s large fixed fee cost. The court asserted that because the partner was intimately involved in all aspects of designing and drafting the joint venture agreement and the indemnity agreement, as well as researching and preparing the tax opinion, the partner had an obvious and inherent conflict of interest. The court stated that “[i]ndependence of advisors is sacrosanct to good faith reliance.” The court also found it suspicious that Chesapeake had paid a large fixed fee for an opinion that was a condition of closing in the joint venture transaction. It stated that Chesapeake essentially bought an insurance policy as to the taxability of the transaction and that the opinion looked more like a quid pro quo arrangement than a true tax advisory opinion.
Reflections
The Tax Court’s opinion is a stark reminder of the real function of professional tax opinions and tax advice: to help taxpayers properly comply with the tax law and pay the lowest amount of tax, not to insulate taxpayers from responsibility and aid them in avoiding taxes by advocating unreasonable and unsupportable positions. While the Tax Court and other courts will sometimes allow unsophisticated taxpayers to avoid penalties when they rely on erroneous and/or unreasonable advice, they will generally not be forgiving in cases where there is real evidence of bad faith on the part of a taxpayer.
Canal Corp., 135 T.C. No. 9 (2010)
