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In a case decided in early November, the U.S. Tax Court reverses an IRS decision and upholds a tax loss claimed by a company that bought a manufacturing plant from Nortel.
Robert Willens, CFO.com | US
November 29, 2010
More than a decade ago, the Internal Revenue Service disallowed a loss claim related to the sell-off of a Nortel manufacturing plant. On November 8, the U.S. Tax Court sided with the company that bought the plant, striking down the IRS decision. The case involved a so-called basis bump transaction, designed to provide a U.S. taxpayer with a stepped-up basis in assets (a basis in excess of the value of such assets) without the usual cost associated with such a phenomenon. Indeed, the cost is a U.S. tax imposed tied to the transferor of the assets.
In a case of first impression, the Tax Court ruled that such a transaction ought to be "respected" for tax purposes. The case facts are as follows: On May 28, 1998, Canadian Parent (CP) and Northern Telecom Inc. (Nortel) executed an asset purchase agreement with respect to a property owned by Nortel; namely, the Creedmoor manufacturing facility. Pursuant to the agreement, CMAC-I, a Canadian subsidiary of CP, was authorized to purchase the inventory of the Creedmoor facility. On July 2, 1998, CMAC-I, using working capital and borrowed funds, paid Nortel $12.1 million for the inventory. On the same date, Nortel executed a bill of sale and assignment providing for the sale of its rights and title to — and interest in — the inventory to CMAC-I.
On July 7, 1998, CMAC-I borrowed $5.4 million and CMAC-GP, a CP affiliate, borrowed a total of $46.2 million. On that same date, CMAC-I pledged the inventory of the Creedmoor facility as security for payment of the $51.6 million in liabilities (incurred by CMAC-I and CMAC-GP).
Then, on July 10, the inventory, which was subject to the $51.6 million in liabilities, was transferred to two different entities. First, CMAC-I transferred the inventory to CMAC-H, a U.S. corporation, in exchange for 10,107 shares of the latter's common stock and a $9.5 million promissory note, and CP transferred $4 million to CMAC-H in exchange for 17,124 shares of the latter's common stock. After CMAC-H's capitalization, CP owned approximately 63% of its stock and CMAC-I owned the remaining 37%.
Next, CMAC-H transferred the inventory and $2.3 million to CMAC-NS in exchange for 10,107 shares of CMAC-NS's common stock and a $9.5 million promissory note. After CMAC-NS's capitalization, CMAC-H owned 100% of CMAC-NS's outstanding stock. Finally, on July 24, 1998, CMAC-GP lent CMAC-NS $42.2 million, which the latter employed to purchase the remaining Creedmoor assets from Nortel.
On its federal income-tax return, CMAC-H reported a $37.3 million loss, taking into account the $39.8 million increase to the inventory's basis resulting from the fact that the inventory transferred to CMAC-H was subject to liabilities. The IRS disallowed the loss. However, the Tax Court found in favor of the taxpayer; see Flextronics America, LLC v. Commissioner, T.C. Memo. 2010-245. (CP was acquired by Solectron Corp. in December 2001, and the latter was acquired by Flextronics in October 2007.)
The court was called upon to determine whether the "inventory transactions" should be disregarded and the step-up in basis disallowed. The step-up arose from the application of the tax code, specifically Section 357(c) and Section 362(a). Indeed, Section 357(c) provides that in the case of an exchange to which Section 351 applies, if the liabilities assumed plus the liabilities to which the property is subject exceed the total adjusted basis of the property transferred, as is the case here, the excess is recognized as gain to the transferor. That would be the case even though CMAC-I is a foreign person not subject to U.S. tax with respect to the gain. (Note that the exchange to which Section 351 applies is the transfer of inventory from CMAC-I to CMAC-H and the concurrent transfer of cash from CP to CMAC-H. The deal constituted an exchange to which Section 351 applies because the transferors of property to CMAC-H were in control of CMAC-H — within the meaning of
Section 368(c) — immediately after their exchanges of property for stock of CMAC-H.)
Correlatively, Section 362(a) of the tax code provides that the transferee's basis in the transferred property (acquired in connection with a transaction to which Section 351 applies) is equal to the transferor's basis plus the gain recognized to the transferor with respect to the transfer.
The parties agreed that the inventory transactions, including the capitalizations of CMAC-H and CMAC-NS, met the literal requirements of Section 351. The IRS contended, however, that the inventory transactions must be disregarded because of the following four reasons: the transactions (1) fall outside the statutory purpose of Section 351; (2) lack Section 351 "business purpose"; (3) lack "economic substance"; and (4) are subject to disallowance under the "step transaction doctrine." However, the Tax Court disagreed.
The court noted that about three months after the taxpayer completed the inventory transactions, Internal Revenue Code amendments were enacted to ensure that the "bump-up" in basis, with respect to the transfer of property subject to a liability, did not exceed the fair-market value of the property. As a result, Section 362(d) provides that "in no event" shall the basis of any property be increased (under Section 362(a) or Section 362(b)) above the value of the property by reason of any gain recognized to the transferor as a result of the assumption of a liability.
In effect, the IRS asked the court to apply the provisions of Section 362(d) to the Nortel case. The court, however, was unwilling to accommodate the Service. The IRS emphasized the inequity inherent in this transaction: CMAC-NS received the tax benefit of the loss (arising from the basis bump) but CMAC-I, a foreign entity, was not subject to U.S. tax and did not incur a corresponding gain. The court was unmoved. It simply noted that the inventory transactions were "valid substantive transactions." Only the creation and use of entities and transactions that lack substance fall outside the statutory purpose of Section 351.
To add insult to injury, the court even questioned whether there was a business purpose requirement ingrained in Section 351. The court noted that "Neither Sec. 351 nor any of the cited sources explicitly set forth a business purpose requirement for Sec. 351." Whether or not there is such a requirement, there were, in the court's view, several business purposes for the inventory transactions. For example, the inventory transactions provided for part of the capitalization of CMAC-NS and enabled the Creedmoor business to be operated as a separate subsidiary of CP's U.S. consolidated operating group.
The inventory transactions, which were not entered into for the sole purpose of evading taxes, had economic substance, and were legally valid transactions that did what they purported to do. CMAC-I purchased the inventory from Nortel, pledged the inventory as security for bank loans needed to purchase Creedmoor, and transferred the inventory to CMAC-H. CMAC-H capitalized CMAC-NS by contributing the inventory and other assets to CMAC-NS. In addition, the inventory was legally transferred and was subject to a valid lien.
Finally, the IRS contended that CMAC-I and CMAC-H were "mere conduits" for CMAC-NS's purchase of the inventory; that is, neither CMAC-I nor CMAC-H conducted any business with the inventory, and their ownership of the inventory was "transitory at best." The court again disagreed: it found that CMAC-I and CMAC-H were bona fide entities that used the inventory in their businesses. After all, the inventory was employed to capitalize CMAC-NS. Therefore, in the court's estimation, the inventory transactions were valid transactions fully worthy of respect for tax purposes. The loss claimed by the CMAC-H group was actually sustained and was therefore allowed for tax purposes.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.