Canal Corp. v. Comm'r of Internal Revenue

• Decision Date: 05 August 2010
• Docket Number: No. 14090–06.,14090–06.
• Citation: 135 T.C. No. 9,135 T.C. 199,135 T.C. No. 1359
• Parties: CANAL CORPORATION and Subsidiaries, Formerly Chesapeake Corporation and Subsidiaries, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

135 T.C. 199

135 T.C. No. 1359

135 T.C. No. 9

CANAL CORPORATION and Subsidiaries, Formerly Chesapeake Corporation and Subsidiaries, Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 14090–06.

United States Tax Court.

Aug. 5, 2010.

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.

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.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. We incorporate the stipulation of facts and the accompanying exhibits by this reference. Chesapeake's principal place of business at the time it filed the petition was Richmond, Virginia.

Background of Chesapeake and WISCO

Chesapeake is a Virginia corporation organized as a corrugated paper company in 1918. Chesapeake's business has expanded over time into several paper industry segments, including merchandising and specialty packaging, tissue, and forest and land development. Chesapeake eventually became a publicly traded company and served as the common parent of a group of subsidiary corporations filing consolidated Federal income tax returns. Each subsidiary managed its own assets and liabilities. Chesapeake received dividends from the subsidiaries and made loans to the subsidiaries as needed.

Chesapeake's largest subsidiary was Wisconsin Tissue Mills, Inc. (WISCO). Chesapeake purchased WISCO's stock from Philip Morris in 1985 in a leveraged buyout transaction. WISCO manufactured commercial tissue paper products, including napkins, table covers, towels, place mats, wipes, and facial and bathroom tissue. WISCO sold its products to commercial and industrial businesses such as restaurants, hotels, schools, offices, hospitals and airlines. WISCO accounted for 46 percent of Chesapeake's sales and 94 percent of Chesapeake's earnings before interest and tax for 1998. Chesapeake and WISCO shared most of the same executive officers.

WISCO incurred significant environmental liabilities during the 1950s and 1960s. The Environmental Protection Agency (EPA) determined that a mill WISCO operated contaminated the Fox River in Wisconsin with polychlorinated biphenyls (PCBs). The EPA designated the Fox River area as a Superfund site and held five companies, including WISCO, involved in the contamination jointly and severally liable for the cleanup costs (Fox River liability). Philip Morris indemnified Chesapeake for any Fox River liability costs up to the purchase price of WISCO. Approximately $120 million of the Phillip Morris indemnity remains. Chesapeake also purchased $100 million of environmental remediation insurance to pay costs beyond those covered by the indemnity. Chesapeake's management estimated that WISCO's remaining Fox River liability costs varied between $60 million and $70 million in 1999. In addition to the Fox River liability, WISCO and other Chesapeake subsidiaries also guaranteed a $450 million credit facility enabling Chesapeake to acquire another company in 2000.

Tissue Business

Tissue is a capital intensive commodities business, and only the largest companies have the ability to make the investment needed to compete in the industry. In the late 1990s, the tissue business experienced much consolidation. Fort Howard Corporation merged with James River Corporation to form Fort James Corporation. Kimberly–Clark Corporation purchased Scott Paper Company. These consolidations put smaller tissue businesses at a strategic disadvantage.

Chesapeake, through WISCO and Chesapeake's Mexican subsidiary, Wisconsin Tissue de Mexico, S.A. de C.V. (WISMEX), was a second tier player in the tissue industry. Chesapeake sold its retail tissue business to the Fonda Group, Inc. in 1995. WISCO and WISMEX serviced only commercial accounts and lacked the large timber bases needed to support a retail business. Chesapeake had only two paper mills, one in Wisconsin and one in Arizona, and thus was at a significant logistical disadvantage in servicing the Southeast and Northeast.

Restructuring of Chesapeake

Chesapeake hired Tom Johnson as its chief executive officer and chairman in 1997. Mr. Johnson sought to restructure Chesapeake. He wanted to move Chesapeake away from its historic commodity products business and focus on specialty packaging and merchandising services. Chesapeake's speciality packaging business involved producing high-value custom packaging for such goods as perfume, liquor and pharmaceuticals. To that end, Chesapeake sold certain assets, including a mill, corrugated box plants, a building products business and substantial land. Chesapeake acquired other businesses and assets to further its specialty packaging business.

Commercial tissue did not fit the new specialty packaging strategy. Chesapeake examined several options for the future direction of WISCO's tissue business. Chesapeake considered maintaining the status quo. Management concluded, however, that WISCO would be too small to compete. Management further determined that internal expansion would be too difficult and costly. Management also considered selling Chesapeake and all its subsidiaries. Management surmised that no one would buy all the diverse subsidiary businesses for an acceptable price.

Pete Correll, chief executive officer of Georgia Pacific (GP), made overtures to Mr. Johnson regarding GP purchasing WISCO. GP's primary business was the manufacture and distribution of building products, timber, and paper products. GP also had a small profitable tissue business that accounted for 5 to 6 percent of its total sales. GP wanted to expand its tissue business but questioned whether GP's business could grow internally. GP viewed the purchase of WISCO as a strategic piece in advancing its tissue business.

Chesapeake considered selling WISCO to generate capital for Chesapeake's new specialty packaging business. Given Chesapeake's low tax basis in WISCO, however, the after-tax proceeds would have been low compared to the pre-tax proceeds. This tax differential caused Chesapeake to decide a direct sale of WISCO would not be advantageous.

Chesapeake thereafter engaged Salomon Smith Barney (Salomon) and PricewaterhouseCoopers (PWC) to explore strategic alternatives for the tissue business. Salomon recommended to Chesapeake's management that the best alternative for maximizing shareholder value would be a leveraged partnership structure with GP.⁴ The leveraged partnership structure required 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...