Tax Law

Accuracy-Related Penalties in a Disguised Sale Transaction - Canal Corp.

In Canal Corp. v Comm'r, 135 T.C. No. 9 (Aug 5, 2010), Chesapeake (the former name of Canal Corp.) wanted to exit the tissue paper industry.  For a variety of reasons, Chesapeake decided upon a leveraged partnership structure in which WISCO (Chesapeake's subsidiary), and then Georgia Pacific (an outside partner), contributed their tissue paper businesses to a newly-formed LLC.  The LLC then borrowed cash from a bank and distributed the cash to Chesapeake as a special distribution.  Georgia Pacific guaranteed the bank loan, but WISCO executed an indemnity agreement with Georgia Pacific covering the principal of the loan.

Chesapeake conditioned the closing of the entire transaction on receiving a "should" opinion from the accounting firm, PricewaterhouseCoopers, stating that the transaction was tax free.  If this structure were tax free, Chesapeake would have deferred $524 million in capital gains for 30 years or longer.

Typically, a partner's contributions to, and distributions from, a partnership are tax-free.  IRC Sec. 721(a); IRC Sec. 731(a)See also Lexis Tax Advisor -- Federal Code, IRC Sec. 721(a); Lexis Tax Advisor -- Federal Topical, Sec. 2D:1.01[4]; Lexis Tax Advisor -- Federal Code, IRC Sec. 731(a); Lexis Tax Advisor -- Federal Topical, Sec. 2D:1.01[7].  But if a partner contributes property to a partnership and then immediately receives a cash distribution or other consideration from the partnership, the tax-free transaction may be recharacterized as a taxable "disguised sale."  Disguised sales are taxable to the partner as of the date of the contribution, just as if the partner had sold the appreciated asset to a third party.  IRC Sec. 707(a)(2)(B)See also Lexis Tax Advisor -- Federal Code, IRC Sec. 707(a); Lexis Tax Advisor -- Federal Topical, Sec. 2D:7.04[4]

Chesapeake argued that the cash distribution it received fell within the debt-financed transfer exception of Treas Reg 1.707-5(b), and thus did not convert its contribution into a disguised sale.  Unfortunately, the Court concluded that the transaction was indeed a disguised sale.  The key was the Court's conclusion that WISCO's indemnity agreement should be disregarded since it created only a remote possibility that WISCO would actually be liable to Georgia Pacific for payment on the bank loan.  Since WISCO had no economic risk of loss, it should not be allocated any part of the debt incurred by the LLC.  Without this allocation, the distribution of cash to WISCO did not fit within the debt-financed transfer exception to the disguised sales rules.

In addition to the adverse ruling on the disguised sale transaction, the Court imposed a $36.7 million accuracy-related penalty for a substantial understatement of income tax.  IRC Sec. 6662(a), (b)(2), (d)See also Lexis Tax Advisor -- Federal Code, IRC Sec. 6662(a); Lexis Tax Advisor -- Federal Code, IRC Sec. 6662(b); Lexis Tax Advisor -- Federal Code, IRC Sec. 6662(d); Lexis Tax Advisor -- Federal Topical, Sec. 5A:16.04.  After noting that Chesapeake met the technical requirements for the penalty, the Court applied a two-part test in determining whether to assess the accuracy-related penalty.  The accuracy-related penalty does not apply to any portion of an underpayment if the taxpayer shows (1) that there was reasonable cause for, and (2) that the taxpayer acted in good faith with respect to, that portion of the understatement.  Reasonable cause can be shown where a taxpayer selects a competent tax adviser, provides the adviser with all relevant information, and relies upon the adviser's professional judgment as to the taxpayer's tax obligations.  Chesapeake claimed that the Court should not impose an accuracy-related penalty because it reasonably relied in good faith on PWC's tax advice and "should" opinion.

The Court first focused on whether Chesapeake's reliance on the opinion was reasonable.  Chesapeake submitted only a draft of the tax opinion to the Court, which the Court characterized as "littered with typographical errors, disorganized and incomplete."  Canal Corp. at *39.  In addition, the Court concluded that the opinion "was riddled with questionable conclusions and unreasonable assumptions."  Canal Corp. at *39.  In addressing one legal conclusion in the opinion - that WISCO needed to maintain 20 percent of the LLC debt - the Court determined that the opinion cited no Code section or case law, but instead relied upon an irrelevant Revenue Procedure.  Canal Corp. at *39.  Regarding another key element of the opinion, the Court stated that the PWC attorney "assumed that the indemnity would be effective," Canal Corp. at *41, and "failed to consider that the indemnity lacked substance."  Canal Corp. at *41.  The Court found that "Chesapeake's tax position did not warrant a 'should' opinion because of the numerous assumptions and dubious legal conclusions in the haphazard draft opinion."  Canal Corp. at *41.  The Court harshly found it "unreasonable that anyone, let alone an attorney, would issue the highest level opinion a firm offers on such dubious legal reasoning."  Canal Corp. at *39.  With regard to Chesapeake, the Court found it "inherently unreasonable for Chesapeake to have relied on an analysis based on the specious legal assumptions."  Canal Corp. at *41.

Regarding the "good faith" element of the test, the Court observed that "PWC crossed over the line from trusted adviser for prior accounting purposes to advocate for a position with no authority that was based on an opinion with a high price tag - $800,000."  Canal Corp. at *42.  "Any advice that Chesapeake received was tainted by an inherent conflict of interest."  Canal Corp. at *42.  Since PWC would receive the $800,000 payment only if it issued Chesapeake a "should" opinion, PWC had a large stake in making sure that the transaction closed.  The Court found that PWC "lacked the independence necessary for Chesapeake to establish good faith reliance."  Canal Corp. at *44.  Thus, "Chesapeake did not act with reasonable cause or in good faith in relying on PWC's opinion."  Canal Corp. at *44.

The lesson from Canal Corp. is that a taxpayer must thoroughly review and understand the transactions into which it is entering, including the legal and tax opinions that advisers might prepare.  A taxpayer cannot simply rely on the bald statements of a longtime and trusted adviser, even when these statements are in the form of a "strong" opinion letter.  A sophisticated taxpayer simply cannot abrogate its responsibilities for understanding a transaction and reviewing the key documents and opinions.  A taxpayer should also be sensitive to possible conflicts of interest when requesting an opinion letter  and avoid the situation in Canal Corp. by ensuring that the remuneration for the opinion letter is independent of the compensation for any other services.

On the tax adviser's side, the question remains as to why the PWC attorney issued a "strong" opinion on what the Court considered to be relatively weak authority, especially for a transaction that was designed to defer more than $500 million in capital gains.

View free on this site additional insights on Canal Corp. by Charles Zubrzycki on A Successful Disguised Sale Challenge - Canal Corp. v. Comm'r

View free on this site excerpts from a commentary on the Implications of Canal Corp. v. Comm'r for U.S. Taxpayers and Their Advisors

LEXIS users can view the entire commentary here. Additional fees may be incurred. (Approx. 6  pages)

Hear further analysis of Canal Corp. v. Comm'r on this site in Robert Jennings and Elizabeth Sweigart's podcast interview.

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