A disguised sale led to a huge tax bill for a paper company. The company is in bankruptcy.

The US Tax Court found in August that the company failed to report a gain of $524.5 million in 1999 on which it owed $183 million in taxes plus another $36.7 million as a penalty for substantially understating its taxes. The company paid PricewaterhouseCoopers a flat fee of $800,000 for a “should”-level tax opinion that the transaction in 1999 would not trigger taxes, but it was only able to produce a draft of the opinion at trial that the court said was poorly reasoned, “littered with typographical errors, disorganized and incomplete.” The court said the company lacked good faith in relying on the opinion. The company reported the $524 million gain, but not until two years later when the transaction unraveled.

Chesapeake Corporation — now called Canal Corporation — decided to sell its principal subsidiary that made paper napkins, toilet paper, facial tissue and similar products. The problem was that it had a low tax basis in the stock. The company retained Salomon Smith Barney and PricewaterhouseCoopers to advise on the sale. Georgia-Pacific was interested in combining the business with its own. The advisers recommended a leveraged partnership structure where the Chesapeake subsidiary contributed its assets to a partnership with Georgia-Pacific. The Chesapeake subsidiary took back a 5% interest in the partnership plus received a “special cash distribution” of $755.2 million, which was 97% of the agreed value of the asset it contributed.

Georgia-Pacific contributed its own tissue business to the partnership with an agreed value of $376.4 million for a 95% interest in the partnership.

The partnership borrowed the $755.2 million that it used to make the special cash distribution to Chesapeake from Bank of America. Georgia-Pacific guaranteed repayment of the loan, but the Chesapeake subsidiary then promised to repay Georgia-Pacific if it had to repay the loan.

US tax rules have a presumption that if one partner contributes assets to a partnership and is distributed cash within two years, the partner really sold the assets to the partnership.

However, there are a number of exceptions where there is no presumed sale.

One exception is if the partner receiving the cash distribution can put the debt in his “outside basis” in his partnership interest. He can if he is the one ultimately exposed on the debt.

Chesapeake argued that its agreement to indemnify Georgia-Pacific for any loan repayments made Chesapeake ultimately liable. The court said the indemnity was illusory. The indemnity had been set up so that it was unlikely ever to be invoked. The Chesapeake subsidiary had limited assets. If Georgia-Pacific collected, it would have to give Chesapeake a larger interest in the partnership commensurate with the payment. A Chesapeake executive told the rating agencies that the company’s only real risk in the transaction was tax risk associated with its effort to defer taxes.

Chesapeake reported the transaction as a sale of the tissue business for book purposes. The rating agencies treated it as a sale. Within a month after closing, the partnership refinanced most of the loan from Bank of America by replacing it with a loan to the partnership from Georgia-Pacific.

Two years later in 2001, Georgia-Pacific had to sell its interest in the partnership for antitrust reasons so that it could make another acquisition. The Swedish paper company to whom it sold was not interested in buying unless it could buy the whole partnership. Therefore, Georgia-Pacific bought the remaining 5% interest from Chesapeake and paid the company an additional $196 million to compensate it for the loss of tax deferral on the original transaction.

The case is Canal Corp. v. Commissioner. The lesson is to be careful of highly structured transactions that purport to produce tax results that are at odds with the underlying substance of the transaction.

Keith Martin