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August 30, 2012 The Tax Lawyer

The Tax Court Capsizes a Leveraged Partnership in Canal Corp.

Vol. 65, No. 3 - Spring 2012

Tom King


    In Canal Corp. v. Commissioner, the Tax Court decided a disguised sale holding against the taxpayer. The case involved a leveraged partnership between the taxpayer Chesapeake Corporation (Chesapeake)—via its subsidiary Wisconsin Tissue Mills, Inc. (WISCO)—and Georgia Pacific. In 1999, Chesapeake and Georgia Pacific contributed their tissue paper manufacturing assets to a newly created leveraged partnership, Georgia-Pacific Tissue LLC (the Partnership), in exchange for a five percent interest and a 95% interest, respectively. Chesapeake also received—via WISCO—a leveraged distribution from the Partnership, and WISCO served as the indemnitor to the guarantor of the debt financing the distribution. Chesapeake claimed the Partnership’s obligation was allocated to its subsidiary WISCO as a leveraged distribution and did not have to recognize any gain on the distribution until Georgia Pacific later bought out WISCO’s Partnership interest. The court disagreed, holding that Chesapeake had deferred tax for two years and had to recognize the gain from the distribution in 1999. In total, Chesapeake had to recognize $524 million in taxable gain, leading to a deficiency of $183,458,981 for the year 1999 and an accuracy-related penalty of $36,691,796.

    The court relied on the section 707 disguised sale rules and the Regulation section 1.752-2(j) anti-abuse rule concerning debt allocation among partners (the anti-abuse rule). The court held that Chesapeake’s contribution of its business to the Partnership and the subsequent leveraged distribution constituted a disguised sale of Chesapeake’s business. Furthermore, even though WISCO was the indemnitor of the guarantor for the Partnership obligation financing the leveraged distribution, the leveraged distribution rules did not apply. Rather, the court held WISCO had no economic risk of loss on the debt under the anti-abuse rule, and WISCO was allocated none of the Partnership’s debt. Finally, the court held the indemnity agreement to be invalid because WISCO was a thinly capitalized subsidiary and an intercompany note between Chesapeake and WISCO was not genuine.

    This Note will analyze the Tax Court’s holding against Chesapeake’s leveraged partnership with Georgia Pacific. First, this Note will argue that the Tax Court followed an incorrect standard in applying the anti-abuse rule. When the court applied the anti-abuse rule to determine WISCO’s economic risk of loss under the indemnity agreement, the court applied a likely standard rather than a possibly standard—the standard found in the regulations. The court’s holding overreaches, creating further uncertainty for tax professionals relying on the regulations.

    Second, this Note will argue that the court’s analysis of the intercompany note was unsound. The court believed that Chesapeake’s ability to freely cancel the intercompany note rendered it illusory. Yet, the court ignored Peracchi v. Commissioner, which provides an analysis for determining the genuineness of an obligation if it has real world consequences—even if the note is freely cancelable. The Tax Court’s holding overlooks an important standard by which debt should be judged.

    Part II of this Note will cover the facts of the case. Part III will outline the partnership taxation law relevant to the case. Lastly, Part IV will argue that the court should have applied a different standard when determining WISCO’s economic risk of loss and that the court should have analyzed the genuineness of the intercompany note in accordance with Peracchi.

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