Correlatively, Section 362(a) of the tax code provides that the transferee’s basis in the transferred property (acquired in connection with a transaction to which Section 351 applies) is equal to the transferor’s basis plus the gain recognized to the transferor with respect to the transfer.
The parties agreed that the inventory transactions, including the capitalizations of CMAC-H and CMAC-NS, met the literal requirements of Section 351. The IRS contended, however, that the inventory transactions must be disregarded because of the following four reasons: the transactions (1) fall outside the statutory purpose of Section 351; (2) lack Section 351 “business purpose”; (3) lack “economic substance”; and (4) are subject to disallowance under the “step transaction doctrine.” However, the Tax Court disagreed.
The court noted that about three months after the taxpayer completed the inventory transactions, Internal Revenue Code amendments were enacted to ensure that the “bump-up” in basis, with respect to the transfer of property subject to a liability, did not exceed the fair-market value of the property. As a result, Section 362(d) provides that “in no event” shall the basis of any property be increased (under Section 362(a) or Section 362(b)) above the value of the property by reason of any gain recognized to the transferor as a result of the assumption of a liability.
In effect, the IRS asked the court to apply the provisions of Section 362(d) to the Nortel case. The court, however, was unwilling to accommodate the Service. The IRS emphasized the inequity inherent in this transaction: CMAC-NS received the tax benefit of the loss (arising from the basis bump) but CMAC-I, a foreign entity, was not subject to U.S. tax and did not incur a corresponding gain. The court was unmoved. It simply noted that the inventory transactions were “valid substantive transactions.” Only the creation and use of entities and transactions that lack substance fall outside the statutory purpose of Section 351.
To add insult to injury, the court even questioned whether there was a business purpose requirement ingrained in Section 351. The court noted that “Neither Sec. 351 nor any of the cited sources explicitly set forth a business purpose requirement for Sec. 351.” Whether or not there is such a requirement, there were, in the court’s view, several business purposes for the inventory transactions. For example, the inventory transactions provided for part of the capitalization of CMAC-NS and enabled the Creedmoor business to be operated as a separate subsidiary of CP’s U.S. consolidated operating group.
The inventory transactions, which were not entered into for the sole purpose of evading taxes, had economic substance, and were legally valid transactions that did what they purported to do. CMAC-I purchased the inventory from Nortel, pledged the inventory as security for bank loans needed to purchase Creedmoor, and transferred the inventory to CMAC-H. CMAC-H capitalized CMAC-NS by contributing the inventory and other assets to CMAC-NS. In addition, the inventory was legally transferred and was subject to a valid lien.
Finally, the IRS contended that CMAC-I and CMAC-H were “mere conduits” for CMAC-NS’s purchase of the inventory; that is, neither CMAC-I nor CMAC-H conducted any business with the inventory, and their ownership of the inventory was “transitory at best.” The court again disagreed: it found that CMAC-I and CMAC-H were bona fide entities that used the inventory in their businesses. After all, the inventory was employed to capitalize CMAC-NS. Therefore, in the court’s estimation, the inventory transactions were valid transactions fully worthy of respect for tax purposes. The loss claimed by the CMAC-H group was actually sustained and was therefore allowed for tax purposes.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.