When will a so-called “leveraged partnership” involving a substantial debt-financed cash distribution to a contributing partner run afoul of the tax rules that allow such transactions to be accomplished on a tax-free basis? The Tax Court recently shed light on this question in the case of Canal Corporation v. Commissioner, 135 T.C. 9 (2010).
In the case, the court held that the formation of a joint venture between a subsidiary of Chesapeake Corporation (now known as Canal Corporation), and Georgia Pacific (GP), an unrelated third party, was actually a disguised sale within the meaning of Code Section 707(a)(2)(B). As a result, Chesapeake had to include an additional $524 million of income on its consolidated return.
At issue in the case was whether the formation of a joint venture between Wisconsin Tissue Mills, Inc. (WISCO), a wholly-owned subsidiary of Chesapeake, and GP should be tax-free or instead should be treated as a disguised sale. WISCO owned and operated a commercial tissue paper business that Chesapeake wanted to get rid of. After engaging Salomon Smith Barney and PricewaterhouseCoopers (PWC) to explore strategic alternatives for WISCO (including an outright sale of the business, which was rejected due to the substantial tax cost), it was ultimately decided that a leveraged partnership with GP would be the best option. If respected, it would be completely tax-free to Chesapeake upon formation.
To accomplish the transaction, WISCO and GP formed Georgia Pacific Tissue LLC, which would be treated as a partnership for tax purposes. GP contributed its tissue business assets with an agreed value of $376.4 million in exchange for a 95% interest in the LLC, and
WISCO contributed its tissue business assets with an agreed value of $775 million in exchange for a 5% interest in the LLC. The LLC then borrowed $755.2 million and immediately distributed the borrowed funds to WISCO as a special distribution. GP guaranteed repayment of the loan, and WISCO agreed to indemnify GP in the event GP made payment on its guarantee, subject to certain limitations contained in the indemnity agreement.
GP did not require that WISCO provide the indemnity; rather, PWC advised that it was necessary to defer tax on the transaction. The parties agreed that WISCO, rather than Chesapeake, would indemnify GP because Chesapeake wanted to limit the reach of the indemnity to WISCO rather than expose the entire Chesapeake group. The indemnity was limited to cover only the principal amount of the loan, not any accrued interest, and it was also agreed that GP would have to first proceed against the LLC before demanding indemnity from WISCO. Finally, if WISCO made a payment under the indemnity, WISCO would receive a proportionately increased interest in the LLC.
WISCO used the distributed funds to repay certain intercompany debt and to pay a dividend. It also loaned $151 million to Chesapeake in exchange for a promissory note. Following the transaction, WISCO’s assets consisted of the intercompany note and a corporate jet worth approximately $6 million. WISCO’s net worth after the transaction, excluding its LLC interest, was approximately $157 million, which was approximately 21% of its maximum exposure under the indemnity.
Disguised Sale Rules
Under Code Section 707(a)(2)(B), when a partner contributes property to a partnership and soon thereafter receives a distribution from the partnership, the transaction may be treated as a sale of property by the partner to the partnership, resulting in the recognition of taxable gain. In general, a transaction may be treated as a sale for tax purposes if, based on all the facts and circumstances, the partnership’s distribution to the partner would not have been made but for the partner’s transfer of the property.1 In addition, a contribution and distribution that occur within two years of one another are presumed to be a sale unless the facts and circumstances clearly establish otherwise.2 Because WISCO transferred assets to the LLC and the LLC immediately thereafter transferred $755.2 million to WISCO, the Tax Court presumed that a disguised sale took place, unless the facts and circumstances indicated otherwise.
Chesapeake argued that the debt-financed transfer exception to the disguised sale rules applied. Certain debt-financed transfers are excluded in determining whether a partner’s property contribution to a partnership and a related cash distribution by the partnership to that partner constitute a disguised sale for tax purposes.3 In general, if a partner contributes property to a partnership, and the partnership incurs a liability and promptly distributes the proceeds of that liability to the contributing partner, the transaction can escape treatment as a disguised sale, provided that the entire partnership liability is allocable to the contributing partner.4 A partner’s allocable share of a recourse partnership liability is equal to the amount of the liability for which the partner bears the economic risk of loss.5 A partner bears the economic risk of loss to the extent that the partner would be obligated to make an unreimburseable payment to any person (or contribution to the partnership) if the partnership were constructively liquidated and the liability became due and payable.6
Chesapeake argued that because of the indemnity, WISCO bore the economic risk of loss. While conceding that an indemnity is generally recognized as a valid contractual obligation to be considered in determining who bears the ultimate risk of loss, the Service argued that WISCO’s indemnity should be disregarded under the anti-abuse rule applicable to partnership debt allocations, which provides that a partner’s obligation may be disregarded if (1) 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 facade of the partner bearing the economic risk of loss, or (2) the facts and circumstances evidence a plan to circumvent or avoid the obligation.7 Therefore, the Tax Court had to determine if the indemnity was used as a device to make it appear that WISCO had an obligation for which it did not in substance bear the actual economic risk of loss.
The court found that WISCO did not in substance bear the economic risk of loss for the partnership’s loan. In reaching this conclusion, the court relied on the following factors: (i) GP did not require the indemnity; (ii) the indemnity covered only the loan’s principal amount, not interest; (iii) GP was required to proceed against the LLC before it could pursue an indemnity claim against WISCO; and (iv) if WISCO made a payment under the indemnity, it would receive a proportionately increased interest in LLC. In addition, the court found it highly relevant that WISCO was not required to maintain a minimum net worth, and that the indemnity was limited to WISCO, rather than its much more substantial parent corporation (Chesapeake). In fact, WISCO’s net worth, excluding its LLC interest, was only about 21% of its maximum exposure under the indemnity. The $151 million intercompany note made up the vast majority of this value, but WISCO was not required to retain the note. Further, because Chesapeake’s management had absolute control over WISCO, Chesapeake could have easily canceled the note at its discretion.
Based on these facts, the court found that the indemnity created only the appearance of WISCO bearing the economic risk of loss, and, as a result, the court disregarded the indemnity as lacking economic substance. Consequently, the special distribution to WISCO did not fit within the debt-financed transfer exception to the disguised sale rules, with the result that WISCO’s contribution of property to the LLC was fully taxable. As such, the Chesapeake group had to include an additional $524 million of income on its consolidated return for the year the LLC was formed.
The Tax Court’s decision in Canal Corporation illustrates the importance of structuring a leveraged partnership transaction so that the contributing partner’s liability for the partnership’s debt has true economic substance. If the party seeking tax deferral attempts to limit its exposure to the point where there is no real risk or only limited risk, the taxpayer will likely meet the same fate as Chesapeake. Based on this decision, it is advisable for a taxpayer seeking tax deferral in a leveraged partnership involving a partner indemnity to distinguish its indemnity in several key areas. First, the taxpayer or a related party should have a net worth capable of economically supporting the indemnity. Second, the indemnity should cover both principal and interest, as well as any other fees or expenses for which the guarantor might become liable under the guarantee. And third, the party who is indemnified should be able to proceed directly against the indemnitor without limitations or conditions. In this manner, the transaction should withstand an attempt by the Service to characterize the transaction as a disguised sale based on a reallocation of the partnership debt.