The United States Tax Court (Tax Court) recently upheld a tax penalty of $36.7 million imposed on Canal Corporation.[1] The penalty resulted from a disallowed “leveraged partnership” transaction in which Canal Corp. had attempted to defer substantial capital gains taxes in 1999 when it disposed of assets of a subsidiary. The leveraged partnership transaction at issue in the case involved Canal’s contributing assets valued at approximately $775 million to a partnership. The partnership borrowed funds shortly after receiving the contributed assets and made a special distribution to Canal of $755 million. The court recharacterized the transaction as a disguised sale of the transferred assets, resulting in a significant taxable gain to Canal.

With respect to the penalty, PricewaterhouseCoopers (PwC) had provided an opinion that Canal Corp. “should” prevail if the Internal Revenue Service challenged the leveraged partnership structure. Canal argued that it relied on PwC’s opinion to establish its reasonable cause and good faith to avoid the accuracy related penalty under IRC section 6662. PwC had also advised and assisted Canal in structuring the leveraged partnership transaction. The Tax Court deemed the legal opinion written by PwC to be “tainted” and found that Canal Corp. used the opinion merely as an insurance policy to avoid the penalty. The court held that Canal did not act reasonably or in good faith in relying on the PwC opinion, because of PwC’s inherent conflict of interest.

The court noted in its analysis of the penalty that “[i]ndependence of advisers is sacrosanct to good faith reliance.” The court ruled that PwC lacked the necessary independence based on its inherent conflict arising from the fact that the transaction would not close and PwC would not receive its fee if PwC did not issue a “should” level opinion to Canal Corp. The court viewed the opinion as merely an “insurance policy” as to the taxability of the transaction and that Canal Corp. acted unreasonably in relying on such an opinion in the face of the “inherent and obvious” conflict of interest.

What should taxpayers do to help protect themselves from the application of the accuracy related penalties under IRC Section 6662?

The Canal decision emphasizes the need for independent tax advice to establish the taxpayer’s reasonable cause and good faith for potentially challenged tax planning. In cases where the receipt of the payment by the primary tax adviser is dependent on the transaction’s completion, the Canal court would appear to advise that the only way to establish independence is to consult with a separate advisor whose economics are not so dependent.