Use of formula clauses for income tax advantage

In early 1985, Nestlé Holdings Inc. (Nestlé US), a first-tier wholly owned subsidiary of Nestlé S.A. (Nestlé Switzerland), acquired Carnation Co. and made an election under section 338 for that acquisition.¹ Under section 338, Nestlé US would obtain a step-up in the tax basis of Carnation’s assets.² Nestlé US retained an appraisal firm, which valued Carnation’s intangible assets at $425,630,700, and on April 30, 1985, Nestlé US sold those intangible assets to Nestlé Switzerland for that amount. The IRS disputed Nestlé US’s valuation of the intangible assets acquired from Carnation and asserted that the correct value was much lower. Ultimately, the Tax Court held that the correct value of the Carnation intangible assets was $219,482,000, and this was held to be Nestlé US’s tax basis in the assets after the section 338 election. But recall, Nestlé US had sold the assets to Nestlé Switzerland for $425,630,700. Thus, the Tax Court concluded that Nestlé US had realized a taxable gain of $206,148,700. The Second Circuit disagreed with the Tax Court’s valuation method and remanded the case on that ground, but it agreed that Nestlé US had realized a taxable gain based on the difference between $425,630,700 and the fair market value of the Carnation intangible assets.