New Capital Fire, Inc. v. Comm'r
| Decision Date | 02 June 2021 |
| Docket Number | Docket No. 25505-06.,T.C. Memo. 2021-67 |
| Parties | NEW CAPITAL FIRE, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
Upon a merger with T on Dec. 4, 2002, P acquired appreciated assets, sold the assets, reported a carryover basis in the assets and capital gains on the asset sale, and engaged in option transactions to generate loss deductions to offset the reported gains. T did not file its own tax return for its 2002 taxable year. Instead, P attached a pro forma return for T to P's return for the year of the merger. R prepared a substitute for return for T for a short taxable year ending on the merger date. R issued a notice of deficiency to T determining that the merger was a taxable event and T had capital gains on the transfer of its assets to P. We held in New Capital Fire, Inc. v. Commissioner, T.C. Memo. 2017-177, that P's return began the running of the period of limitations as to T's 2002 taxable year, the notice of deficiency issued to T was untimely, and the statute of limitations barred assessment of the determined deficiency for that year.
After our decision there had become final, P filed an amended petition in this case alleging that it did not realize capital gains on the sale of T's assets on the basis that the merger was a taxable event, i.e., the position that R had taken against T in T.C. Memo. 2017-177. Accordingly, P asserted that it did not realize the capital gains it had reported on its return. P and T are in privity for tax reporting purposes.
R argues, in part, that P should be estopped from changing its reporting of the asset sale after T's tax year has closed to the detriment of R, under the doctrine of equitable estoppel. P argues that the doctrine of equitable estoppel does not apply.
Held: P is estopped under the doctrine of equitable estoppel from changing its reporting of its bases in T's assets that P acquired in the merger because the statute of limitations bars assessment of tax against T.
Held, further, P realized capital gains on the sale of T's assets in the amount that P reported on its return.
Jasper G. Taylor III and Richard L. Hunn, for petitioner.
Courtney L. Frola, Jeffrey B. Fienberg, Ruba Nasrallah, and M. Jeanne Peterson, for respondent.
GOEKE, Judge: Respondent issued to petitioner a notice of deficiency for its short taxable year November 6 through December 31, 2002 (2002 tax year), in which he disallowed the deductions of $9,662,707 in short-term capital losses from the sale of digital S&P 500 Index options (SPX options), interest, and consulting fees and determined a 40% accuracy-related penalty for a gross valuation misstatement on the portion of the underpayment attributable to the SPX option capital losses and a 20% accuracy-related penalty on the remaining portion of the underpayment. Respondent disallowed the SPX option capital loss deduction on the basis that the SPX option transactions were tax shelters. He determined that petitioner entered into the transactions for tax avoidance purposes and the transactions had no business purpose other than tax avoidance, lacked economic substance, and were economic shams. Petitioner concedes the disallowance of the SPX option loss, interest, and consulting fee deductions that respondent disallowed in the notice of deficiency. The parties have settled the penalties.
Petitioner engaged in the SPX options to generate losses to offset capital gains of approximately $7.6 million from the sale of marketable securities. Petitioner reported the capital gains but now argues that it should not have. Without such capital gains, there would have been no need for any artificially generated losses as an offset. Petitioner acquired the securities in a merger and argues that the target corporation that merged out of existence should have reported the capital gains. The target corporation did not report the capital gains, and the statute of limitations bars assessment against it.
The sole issue is whether the capital gains are includible in determining petitioner's taxable income for its 2002 tax year. We hold they are. The resolution depends on whether petitioner is equitably estopped from changing its tax reporting of the capital gains. We hold it is.
The parties have submitted this case for decision without trial under Rule 122.1 After filing simultaneous opening briefs, the parties filed a joint motion to supplement the record, which we granted on March 9, 2020. After filing answering briefs, the parties also filed a joint motion for leave to file simultaneous reply briefs, which we granted on July 7, 2020. When the petition was filed, petitioner had its principal place of business in New York.
I. Merger Transaction
Petitioner was organized as a Delaware corporation on November 6, 2002, as a wholly owned subsidiary of the Capital Fire Insurance Co., which we refer to as Old Capital. Old Capital was the sole owner of petitioner from November 6, 2002, until December 4, 2002. On December 4, 2002, petitioner and Old Capitalmerged with petitioner surviving. The merger of Old Capital and petitioner was the first step in a two-step merger.
To accomplish the two-step merger, two other corporations were organized, CF Merger Corp. (CF Merger), on October 4, 2002, and CF Acquisition Corp. (CF Acquisition), on October 28, 2002, which became the sole owner of CF Merger. The second step of the merger was a merger of petitioner into CF Merger with petitioner surviving. Both steps of the mergers occurred on the same date, one hour apart. After the two-step merger, petitioner was wholly owned by CF Acquisition.
At the time of the merger, Old Capital held a portfolio of marketable securities worth approximately $16.3 million that had appreciated by approximately $7.9 million over their cost basis, i.e., built-in capital gains (Old Capital's securities). As explained further below, Old Capital's shareholders wanted to divest themselves of ownership in a manner that would minimize the overall tax on the built-in gains at the corporate and shareholder levels. The two-step merger was structured with the help of Diversified Group, Inc. (DGI), and James Haber, its founder and president. DGI represents itself as being in the business of designing tax-oriented structures and solving tax problems. Mr. Harber was the president, secretary, and treasurer of CF Acquisition.
Under the first step of the merger, Old Capital's securities were transferred to petitioner. One day before the merger, December 3, 2002, Mr. Haber executed a binding agreement for CF Acquisition to sell substantially all of Old Capital's securities to PaineWebber, and Old Capital transferred the securities to a newly opened account in its own name at PaineWebber to facilitate the subsequent sale by CF Acquisition. CF Acquisition sold the securities on December 5, 9, or 12, 2002, pursuant to the binding agreement. On December 5, 2002, PaineWebber transferred $13.5 million in connection with its agreement to purchase Old Capital's securities. The $13.5 million payment was transferred to repay a loan that was used to buy Old Capital's stock. Thus, in substance, the built-in gains funded the payout to Old Capital's shareholders for their stock.
On December 9, 2002, petitioner purchased stock in Northmoy Ltd. (Northmoy), foreign private limited company (Northmoy stock purchase). On December 10, 16, and 30, 2002, Northmoy purchased the SPX options. It sold the SPX options on December 30, 2002, for a capital loss of $9,662,707, as follows:
Name Acquired Cost basis Sale price Gain/loss Call Dec. 10 $18,957,641 $15,784,081 ($3,173,560) CMBO Dec. 16 25,055,881 -0- (25,055,881) Call Dec. 30 433,266 19,000,000 18,566,734 Total 44,446,788 34,784,081 (9,662,707)
II. Return Reporting
Petitioner filed Form 1120, U.S. Corporation Income Tax Return, for its 2002 tax year, listing its business activity as investment. It reported that it was wholly owned by CF Acquisition at the end of the tax year. On the first page of the return, it reported that it had assets of over $13.8 million as of the end of the tax year. Mr. Haber signed the return as petitioner's president.
Petitioner reported that it had merged with Old Capital with petitioner surviving, with the following statement attached to the return:
A copy of the certificate of merger and an incumbency certificate for CF Acquisition were attached to the return. The certificate of merger stated that the merger agreement was on file with the New Hampshire Insurance Department (NHID). The incumbency certificate stated that there was a merger agreement among CF Acquisition, CF Merger, Old Capital, and petitioner. The return did not report that the first step of the merger was a reorganization under section 368(a)(1)(F) (F reorganization) or any other Code section. Nor did it use the terms nontaxable or tax free to describe the first merger. It did not expressly identify the first merger as a taxable or nontaxable event. The return did not disclose the second step of the merger.
Petitioner attached an unsigned Form 1120-PC, U.S. Property and Casualty Insurance Company Income Tax Return (pro forma return), to its return and marked it as Old Capital's final return. The pro forma return did not report an end date for Old Capital's 2002 tax year. It reported that Old Capital owed tax of $12,454. Schedule L, Balance Sheets per Books, of the pro forma return reported that Old Capital had yearend assets of approximately $13 million.
On its return, petitioner reported Old Capital's $12,454 tax as...
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