Disguised sales are a risk, especially if the parties are trying to come close economically to a sale without triggering taxes.

GAF negotiated for the sale of assets from its surfactants chemical business to Rhone-Poulenc, but ended up structuring the transaction so that it looked like GAF contributed the assets to a joint venture with Rhone-Poulenc and then borrowed against its expected future cash distributions from the joint venture. The idea was to have immediate use of the cash value of the assets, but to defer any tax on gain.

The parties originally negotiated a sales price of $480 million.

However, GAF ultimately made a capital contribution of the assets to a joint venture with Rhone-Poulenc in exchange for a 49% limited partner interest. It then put the joint venture interest in a trust with Citibank. The trust borrowed $460 million from Credit Suisse on a nonrecourse basis against the expected future cash distributions from the joint venture. The trust distributed $450 million to GAF and put the other $10 million in a reserve account to backstop payment of debt service on the loan from Credit Suisse.

The transaction gave GAF immediate use of the cash value of the assets, but the company argued the transaction did not trigger any taxes. Contributing assets to a joint venture does not trigger tax. Neither does borrowing money.

A federal district court in New Jersey disagreed. The IRS argued that the entire business was sold for $450 million in cash plus a partnership interest that unencumbered was worth $30 million. Cutting through everything, the court also saw a sale, but only of $450 million in value, with $30 million remaining invested in a joint venture with Rhone-Poulenc.

The court said the most telling facts were the history of the negotiations and the fact that GAF spent $11.8 million on legal fees implementing the transaction for what both its expert and the government’s expert agreed was potential to earn about $8 million in true income and left it with exposure to a maximum of $26.3 million in loss under the particular terms of the joint venture. The joint venture made priority distributions to the GAF-Citibank trust to cover the interest on the loan from Credit Suisse. GAF was guaranteed that its capital account — or claim on the joint venture assets — would never fall below the remaining principal amount of the Credit Suisse loan. It also had a “put” to force Rhone-Poulenc to buy it out, after a loan default, for the amount of its capital account.

The transaction was supposed to save GAF $70 million in taxes.

The IRS has authority under the US tax code to recast transactions where partner A contributes property to a partnership and partner B contributes cash that is then distributed by the partnership to partner A within two years as, in substance, a sale of the property by partner A to the partnership. Congress said in a committee report, when it adopted the disguised sale provision, that the provision will also come into play where partner A “receives the proceeds of a loan related to the property to the extent responsibility for the repayment of the loan rests, directly or indirectly, with the partnership (or its assets) or the other partners.”

The case is In re: G-I Holdings, Inc. et al. The decision was rendered on December 14.

The IRS won on the substance, but ultimately lost the war. The transaction occurred in 1990. The case had been in and out of the US Tax Court and a federal appeals court. GAF declared bankruptcy in the meantime. The court said the IRS was barred by the statute of limitations from collecting any tax. 

Keith Martin