The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 12, July 2002, Panel Publishers, New York, NY.


By Robert W. Wood

The business purpose doctrine has never been explicitly added to the reorganization provisions of the Code. Yet, its importance in securing tax-qualified treatment is clear. It emanates from many court decisions. Perhaps the most famous of them all is Gregory v. Helvering, 293 U.S. 465 (1935). As is so often the case, the Treasury Department puts its own spin on the hoary case law. As the business purpose requirement is enunciated in the Regulations, a reorganization of any type must be:

See Reg. §368-1(b), (c). Admittedly, reorganizations are frequently undertaken to accomplish several purposes, one of which is unabashedly to achieve favorable tax treatment. The regulations are explicit, however, that a "purported" business purpose cannot be used to disguise the true character of the transaction.

Go Forth and Multiply?

As we all know, of course, the Revenue Service typically has a greater incentive to scrutinize the business purpose of a Section 355 transaction than to make the same inquiry with respect to some types of nondivisive reorganizations (for example, E and F reorganizations). The authorities arising under Section 355 relating to the identity and strength of the business purpose should, therefore, help to establish that the business purpose requirement has been met in a nondivisive reorganization, too.

Even if a corporation has a valid business purpose for accomplishing a reorganization, there is sometimes danger that a "net effect" test will be applied. Under case law, even though the business purpose requirement has nominally been satisfied, tax-free reorganization treatment will not apply if the net effect of the reorganization is the distribution of a dividend. See Commissioner v. Estate of Bedford, 352 U.S. 283 (1945).

Recall, too, that there is a significant volume of authority concerning shareholder business purposes under Section 355. The Regulations under Section 355 recognize that it is frequently difficult to discern a corporate purpose separate and distinct from the purposes of a company's shareholders. A corporation's distributions to its shareholders of stock or securities in a controlled corporation with respect to its own stock will qualify under Section 355 only if it is carried out for "real and substantial nontax reasons germane to the business of the corporation." Reg. §1.355-2(b)(2).

Of course, a shareholder purpose for a transaction may be merely coextensive with the corporate business purpose, precluding any meaningful distinction between the goals sought by the shareholders and those pursued by the corporation. The Regulations under Section 355 treat such a coextensive business purpose of the corporation and shareholder as germane to the business of the corporation. Conversely, when a transaction is motivated solely by the personal reasons of a shareholder, no corporate business purpose will be deemed to exist, because the transaction is not carried out for purposes germane to the business of the corporation. See Reg. §1.355-2(b)(2).

Business Purpose Outside of Reorganizations

Although the business purpose requirement has been most often explained in the context of reorganizations, it has application elsewhere, too. Take the recent Tax Court case, Nicole Rose Corp. v. Commissioner, 117 T.C. No. 27 (Dec. 28, 2001). The Tax Court there disallowed a $22 million deduction because the court found that the transactions lacked business purpose and economic substance (the latter being a related but technically distinct doctrine).

In 1992 Quintron Corp. negotiated with Loral Aerospace Corp. for the sale to Loral of Quintron stock or assets. In 1993 representatives of Intercontinental Pacific Group Inc. (IPG), the parent of QTN Acquisition Inc. (QTN), suggested that with IPG's and QTN's participation as an intermediary in the transaction, the stock in Quintron could be sold, and Loral could purchase the Quintron assets. In September 1993 QTN purchased the Quintron shareholders' stock for $23,369,125. QTN financed the purchase through a bank loan. QTN was merged into Quintron, and Quintron survived, controlled by IPG.

By prearrangement and simultaneously with the stock purchase, Quintron sold its assets to Loral for $20.5 million plus the assumption by Loral of Quintron liabilities. Quintron's name was changed in 1993 to Nicole Rose Corp. Quintron used the $20.5 million to pay off the loan used to purchase the Quintron stock. Quintron, QTN, IPG, and other entities controlled by Douglas Wolf, the controlling shareholder of IPG, planned and participated in a series of complicated tax-oriented transactions involving the establishment and transfer of Quintron's interests in leases of computer equipment and related trusts. The IRS issued a deficiency notice to Quintron for 1992-1994, disallowing the business expense deductions for $400,000 and $21,840,660 relating to the transaction that Quintron claimed on its 1994 return. The IRS also disallowed a claimed net operating loss carryback deduction to 1992-1993.

No Way...

The Tax Court noted that under any version of the business purpose and economic substance tests, the transactions in this case lacked both business purpose and economic substance. The court dismissed Quintron's reasoning that the transfer should be treated as a payment by Quintron to a bank in exchange for cancellation of Quintron's obligation on an onerous lease. Quintron claimed that the certificate it received had significant value and potential for profit, and that the profit potential explained and supported Quintron's participation in a legitimate for-profit transaction.

The IRS claimed that the transfers to the bank and its assumption of Quintron's obligations lacked economic substance, and the court agreed. The Tax Court noted that Quintron never was genuinely obligated under the transactions and that Quintron's sole purpose for the transfers to the bank was to create the claimed tax deduction. Noting that Quintron's claimed deduction related to interests that were held for less than a day in the leaseback and in the trust fund, the court found that they were "merely a tax ploy, a sham, without business purpose." Finally, noting that Quintron participated in an obvious scheme to reap the benefits of ordinary business expense deductions with no business purpose, the Tax Court concluded that Quintron was liable for accuracy- related penalties under Section 6662. Nicole Rose Corp. v. Commissioner, 117 T.C. No. 27 (Dec. 28, 2001).

Business Purpose: A Universal Maxim?, Vol. 10, No. 12, The M&A Tax Report (July 2002), p. 1.