In a case of first impression, the Tax Court in Canal Corp. et. al. v. Commissioner, 135 T.C. No. 9, was presented with a leveraged partnership transaction. As a result of poor planning, sloppy paperwork and a tainted opinion by PriceWaterhouseCoopers (PwC), the Tax Court held that the transaction constituted a disguised sale, resulting in a $522 million capital gain and in the imposition of a $36.7 million accuracy related penalty. There are lessons to be learned from Canal in structuring a leverage partnership transaction and in avoiding an accuracy related penalty.
What Is a Leveraged Partnership Transaction?
A leveraged partnership transaction involves the formation of a partnership to which the owner of the assets, who wants to sell the assets, transfers the assets in exchange for a minor interest in the partnership and a special cash distribution, while the other party who wants to buy the assets transfers cash and possibly other assets in exchange for a majority interest in the partnership. The special cash distribution is funded from the proceeds of debt financing of the partnership and is guaranteed by the party receiving the proceeds. Under this technique, the immediate receipt of the special distribution should not be taxable to the partner receiving it until a later time.
The success of the technique is dependent upon the validity of the guarantee to create a risk of loss in the party receiving the special distribution, so that the debt is allocated to that party under Code Section 752. To pass muster, the leveraged partnership transaction must satisfy one or more anti-abuse rules of the regulations that provide a partner’s obligation may be disregarded if undertaken in an arrangement to create the appearance of the partner’s bearing the risk of loss when the substance of the arrangement is in fact otherwise.
Facts of the Canal Case
In restructuring its business, Canal (formerly Chesapeake Corporation) wanted to sell its tissue business owned by a separate subsidiary (Sub) to Georgia Pacific (GP). Because of a low basis in the subsidiary, Canal decided against a direct sale of the subsidiary. Instead, upon the advice of its investment bankers, Canal entered into a leveraged partnership transaction with GP. The Sub and GP contributed their tissue businesses to a joint venture, with GP receiving a 95 percent interest and the Sub receiving a five-percent interest and a special cash distribution of $755.2 million financed by funds the joint venture borrowed from a third party. GP guaranteed the joint venture’s debt and the Sub agreed to indemnify GP if it had to pay under its guarantee. The indemnity agreement was limited to only the principal of the debt and GP had to first proceed against the joint venture’s assets before demanding indemnification from the Sub. In addition, the Sub would receive a proportionately increased interest in the joint venture if it had to make an indemnity payment. The indemnity agreement was silent with respect to the Sub maintaining a certain net worth. After the Sub used the special distribution to pay off certain debt, to distribute a dividend to its parent and to loan $151 million to Canal its assets amounted to the $151 million note from Canal and a corporate jet worth $6 million, while the Sub’s exposure under the indemnification agreement was $755.2 million.
PwC had provided Canal with a “should” tax opinion (the highest level of comfort PwC offers to a client regarding whether the position taken by a taxpayer will succeed on the merits) for a flat fee of $800,000. At trial, Canal could only produce a disorganized and incomplete draft of the opinion with numerous typographical errors.
Tax Court Opinion
The Tax Court held that the Sub’s contribution of assets to the joint venture and the distribution of $755.2 million was a disguised sale. A disguised sale is when a partner contributes property to a partnership and soon thereafter receives a distribution of money or other consideration from the partnership. Such contribution and distribution transactions that occur within two years of each other are presumed to be a sale, unless the facts and circumstances clearly establish otherwise.
For disguised sale purposes, the regulations except certain debt financed distributions. A distribution financed from the proceeds of partnership debt may be taken into account for disguised sale purposes only to the extent the distribution exceeds the allocable share of the partnership debt of the partner who received the proceeds. To some extent this exception mirrors the treatment of the contribution of property which is subject to debt placed on the property immediately before the contribution of the property and for which the contributing partner remains liable for the debt after the contribution to the partnership.
A partner’s share of partnership recourse liability equals the portion of the liability for which the partner bears the risk of economic loss. A partner bears the risk of economic loss to the extent that the partner would be obligated to make a non-reimbursable payment to any person (or contribute to the partnership), if the partnership was liquidated and the liability became due.
Anti-abuse regulations provide that a partner’s obligation to make a payment may be disregarded if the facts and circumstances indicate that a principal purpose of the arrangement is to eliminate the partner’s risk of loss or to create a façade of the partner’s bearing the economic risk of loss of an obligation or the facts and circumstances of the transaction indicate a plan to circumvent or avoid the obligation.
The Tax Court held that the Sub’s contribution of assets followed immediately by a special cash distribution constituted a disguised sale, unless the debt financed distribution exception applied. The Tax Court found that the Sub’s indemnity agreement should be disregarded under the anti-abuse rules for allocation of partnership debt, since it was found to have been designed to limit the risk of loss of the Sub and lacked any economic substance. Because the agreement was disregarded, none of the partnership debt was allocated to the Sub and the exception did not apply. Therefore, it held that the Sub should be treated as having sold its assets to GP when it contributed the assets to the joint venture in 1999.
Accuracy Related Penalty
The Tax Court held that Canal was liable for a $36.7 million accuracy related penalty for a substantial understatement of tax. If a taxpayer can show that it acted with reasonable cause and in good faith with respect to the transaction giving rise to the substantial understatement, the penalty does not apply. Relying on a tax advisor generally constitutes reasonable cause and good faith, but the advice must be based on reasonable assumptions and the advisor must not have a conflict of interest. Having planned the transaction, PwC was found to have a conflict of interest and therefore Canal did not act with reasonable cause or in good faith in relying upon PwC’s opinion. The most troubling facts were that PwC received a flat fee of $800,000, rather than an hourly rate, the opinion was disorganized and incomplete and was “riddled with questionable conclusions and unreasonable assumptions.” The final nail in the coffin was the Tax Court’s finding that “considering all the facts and circumstances, PwC’s opinion looks more like a quid pro quo arrangement than a true tax advisory opinion.”
Is the leveraged partnership technique dead? No! A meaningful, fully funded and real guarantee from the partner receiving the special distribution should provide the essential element missing in Canal. One can only guess whether a guarantee from Canal, rather than Sub and an opinion from an independent tax advisor would have tipped the scales in favor of Canal.
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