Canal Corp. v. Commissioner

The predecessor to Canal Corporation (plaintiff), Chesapeake Corporation, considered selling stock in its subsidiary Wisconsin Tissue Mills (WISCO) to Georgia Pacific (GP), but Chesapeake’s low basis meant a sale would trigger taxes. Instead Chesapeake contributed WISCO’s assets to a partnership, Georgia-Pacific Tissue LLC (the LLC). GP contributed over $376 million in assets for a 95 percent interest, while WISCO contributed $775 million in assets for a 5 percent interest. The LLC borrowed $755.2 million from the bank, which was immediately transferred to Chesapeake’s account. WISCO’s $775 million contribution less the $755.2 million distribution equaled the $19.8 million value of its 5 percent interest. GP guaranteed the loan, but Chesapeake’s tax advisor said that deferring tax required indemnity and WISCO maintaining a $151 million net worth. WISCO indemnified GP in limited ways and used the special distribution to repay an intercompany loan, pay Chesapeake a dividend, and lend Chesapeake $151 million for another intercompany note. At that point WISCO’s assets totaled $157 million, just 21 percent of its indemnity exposure for the bank loan. A Chesapeake executive told credit-rating agencies that the transaction’s only risk was tax risk, and both the executive and the agencies referred to the transaction as a sale. Chesapeake reported no tax gain, treating the special distribution as a non-taxable debt-financed transfer of consideration, not a sale, and later canceled the intercompany note. The commissioner assessed a deficiency—and a penalty for inaccurate reporting. Canal petitioned the tax court for review.