More than a decade ago, the Internal Revenue Service disallowed a loss claim related to the sell-off of a Nortel manufacturing plant. On November 8, the U.S. Tax Court sided with the company that bought the plant, striking down the IRS decision. The case involved a so-called basis bump transaction, designed to provide a U.S. taxpayer with a stepped-up basis in assets (a basis in excess of the value of such assets) without the usual cost associated with such a phenomenon. Indeed, the cost is a U.S. tax imposed tied to the transferor of the assets.
In a case of first impression, the Tax Court ruled that such a transaction ought to be “respected” for tax purposes. The case facts are as follows: On May 28, 1998, Canadian Parent (CP) and Northern Telecom Inc. (Nortel) executed an asset purchase agreement with respect to a property owned by Nortel; namely, the Creedmoor manufacturing facility. Pursuant to the agreement, CMAC-I, a Canadian subsidiary of CP, was authorized to purchase the inventory of the Creedmoor facility. On July 2, 1998, CMAC-I, using working capital and borrowed funds, paid Nortel $12.1 million for the inventory. On the same date, Nortel executed a bill of sale and assignment providing for the sale of its rights and title to — and interest in — the inventory to CMAC-I.
On July 7, 1998, CMAC-I borrowed $5.4 million and CMAC-GP, a CP affiliate, borrowed a total of $46.2 million. On that same date, CMAC-I pledged the inventory of the Creedmoor facility as security for payment of the $51.6 million in liabilities (incurred by CMAC-I and CMAC-GP).
Then, on July 10, the inventory, which was subject to the $51.6 million in liabilities, was transferred to two different entities. First, CMAC-I transferred the inventory to CMAC-H, a U.S. corporation, in exchange for 10,107 shares of the latter’s common stock and a $9.5 million promissory note, and CP transferred $4 million to CMAC-H in exchange for 17,124 shares of the latter’s common stock. After CMAC-H’s capitalization, CP owned approximately 63% of its stock and CMAC-I owned the remaining 37%.
Next, CMAC-H transferred the inventory and $2.3 million to CMAC-NS in exchange for 10,107 shares of CMAC-NS’s common stock and a $9.5 million promissory note. After CMAC-NS’s capitalization, CMAC-H owned 100% of CMAC-NS’s outstanding stock. Finally, on July 24, 1998, CMAC-GP lent CMAC-NS $42.2 million, which the latter employed to purchase the remaining Creedmoor assets from Nortel.
On its federal income-tax return, CMAC-H reported a $37.3 million loss, taking into account the $39.8 million increase to the inventory’s basis resulting from the fact that the inventory transferred to CMAC-H was subject to liabilities. The IRS disallowed the loss. However, the Tax Court found in favor of the taxpayer; see Flextronics America, LLC v. Commissioner, T.C. Memo. 2010-245. (CP was acquired by Solectron Corp. in December 2001, and the latter was acquired by Flextronics in October 2007.)
The court was called upon to determine whether the “inventory transactions” should be disregarded and the step-up in basis disallowed. The step-up arose from the application of the tax code, specifically Section 357(c) and Section 362(a). Indeed, Section 357(c) provides that in the case of an exchange to which Section 351 applies, if the liabilities assumed plus the liabilities to which the property is subject exceed the total adjusted basis of the property transferred, as is the case here, the excess is recognized as gain to the transferor. That would be the case even though CMAC-I is a foreign person not subject to U.S. tax with respect to the gain. (Note that the exchange to which Section 351 applies is the transfer of inventory from CMAC-I to CMAC-H and the concurrent transfer of cash from CP to CMAC-H. The deal constituted an exchange to which Section 351 applies because the transferors of property to CMAC-H were in control of CMAC-H — within the meaning of
Section 368(c) — immediately after their exchanges of property for stock of CMAC-H.)