Canal Corp. & Subs. v. Commissioner

• Citation: 135 T.C. No. 9,135 T.C. 199
• Decision Date: 05 August 2010
• Docket Number: Docket No. 14090-06.
• Parties: CANAL CORPORATION AND SUBSIDIARIES, FORMERLY CHESAPEAKE CORPORATION AND SUBSIDIARIES, Petitioner,<BR>v.<BR>COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: United States Tax Court

135 T.C. 199

CANAL CORPORATION AND SUBSIDIARIES, FORMERLY CHESAPEAKE CORPORATION AND SUBSIDIARIES, Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

Docket No. 14090-06.

08-05-2010

[135 T.C. 200]

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

[135 T.C. 201]

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.

[135 T.C. 202]

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

[135 T.C. 203]

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 hold a majority interest. Salomon presented the leveraged partnership structure as tax advantageous to Chesapeake because it would allow Chesapeake to get cash out of the business yet still protect Chesapeake from recognizing a gain when the partnership distributed to Chesapeake the proceeds from the third-party loan.

[135 T.C. 204]

Chesapeake's board liked the leveraged partnership idea and thought GP seemed like a good fit as a partner. Chesapeake made clear to PWC and Salomon that the asset transfer and special distribution had to be nontaxable for it to approve the transaction. Tax deferral enabled Chesapeake to accept a lower price.

GP's executives accepted the leveraged partnership structure to expand its tissue business. GP did not have any interest in Chesapeake receiving a tax deferral. GP recognized, however, that it was a necessary part of bridging the purchase price gap. Chesapeake agreed to a lower up-front valuation of WISCO,^[5] $775 million, because of the tax deferral benefit.

PWC assisted Salomon in negotiating and structuring the joint venture. PWC examined the transaction from both an accounting and a tax perspective. PWC had served as Chesapeake's auditor and tax preparer for many years. Donald Compton (Mr. Compton), a partner in PWC's Richmond office, managed the Chesapeake account and had given Chesapeake advice on different tax matters in the past. David Miller (Mr. Miller)^[6] worked with Mr. Compton on the Chesapeake and GP joint venture. PWC advised that Chesapeake did not need to guarantee the debt but needed only to provide an indemnity to the guarantor to defer tax. PWC also determined that the transaction should be treated as a sale for accounting purposes. Mr. Miller helped structure the indemnity agreement and aided in writing the partnership agreement.

Indemnity Agreement

GP agreed to guarantee the joint venture's debt and did not require Chesapeake to execute an indemnity. Mr. Miller advised Chesapeake, however, that an indemnity was required to defer tax on the transaction. Chesapeake's executives wanted to make the indemnity an obligation of WISCO rather than Chesapeake to limit the economic risk to...