The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 4, November 2002, Panel Publishers, New York, NY.


By Robert W. Wood

"Business purpose" is one of those phrases that tax lawyers like to mention. It is one of those amorphous overlays to the field of corporate acquisitions. The requirement that a reorganization have a business purpose has never been added to the reorganization provisions of the Code. Yet, its importance in securing tax-qualified treatment is clear.

The business purpose requirement emanates from many court decisions. The seminal case is Gregory v. Helvering, 293 U.S. 465 (1935). The business purpose doctrine is included in the regulations, even if not in the Code. Essentially, the regulations adopt the position that a reorganization (of any type) must be:

Admittedly, reorganizations are frequently undertaken to accomplish several purposes, one of which is to achieve favorable tax treatment. The regulations are explicit, however, that a "purported" business purpose may not be sufficient to disguise the true character of the transaction.

Business purpose issues come up in a whole variety of ways. The requisite business purpose for reorganization treatment is a corporate, as opposed to a shareholder, business purpose. Reg. §1.368-1(c). However, the courts have occasionally treated the business objectives of the shareholders as sufficient to satisfy the business purpose requirement. One area in which there is an unusual volume of authority concerning shareholder business purposes is our old friend Section 355. There, perhaps more than in other contexts, it is often difficult to discern a corporate purpose separate and distinct from the purposes of its respective shareholders.

Purposeful Purpose

Sometimes, one has the impression that an overall smell test is applied. Even if the 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 a reorganization is the distribution of a dividend. See Commissioner v. Estate of Bedford, 325 U.S. 283 (1945).

The "net effect" test asks whether, if the transaction had been cast as a redemption of stock or partial liquidation, the distribution would be viewed as essentially equivalent to a dividend by reason of its failure to fall within one of the nondividend treatment exceptions. If the distribution is neither a substantially disproportionate redemption, a complete termination of a shareholder's interest, nor a redemption in partial liquidation, then it may be at risk.

Of course, the business purpose requirement is often uttered in the same breath as the twin demonic sisters of substance over form and the step transaction doctrine. The step transaction doctrine merits separate treatment. For recent discussion, see Wood, "More Step Transaction Authority," Vol. 11, No. 1, M&A Tax Report, August 2002, p. 1; see also Wood, "Step Transaction Doctrine and Mergers," Vol. 10, No. 6, The M&A Tax Report, January 2002, p. 6.

Economic substance, on the other hand, is a phrase that primarily seems to emanate from the tax shelter era. Still, every once in a while there is a resurgence of interest. One case that may be worth watching is the pending Second Circuit case, Nicole Rose Corp. f/k/a Quintron Corp. v. Commissioner, 2nd Cir. Dkt. No. 02-4110 (Aug. 1, 2002). In that case, the Second Circuit has to consider whether the Tax Court was correct in disallowing a corporation's deduction for $22 million in business expenses. The Tax Court slapped down the company because the $22 million in deductions related to a series of transactions that the IRS and Tax Court found lacked business purpose and economic substance. Now, the Second Circuit has to decide.

Funny Facts

Back in 1992, Quintron Corp. negotiated with Loral Aerospace Corp. for the sale of Quintron's stock or assets. Enter Intercontinental Pacific Group, Inc. (IPG), the parent of QTN Acquisition, Inc. IPG suggested that it and QTN could participate as an intermediary in the transaction, so that the stock in Quintron could be sold and Loral could purchase the Quintron assets.

As a result, in September 1993, QTN purchased Quintron stock for $23.3 million, financing the purchase with a bank loan. QTN was merged into Quintron, with Quintron surviving, then being controlled by IPG. In a pre-arranged transaction that occurred simultaneously with the stock purchase, Quintron sold its assets to Loral for $20.5 million, plus the assumption by Loral of Quintron's liabilities. Quintron's name was changed in 1993 to Nicole Rose Corp. Quintron used the $20.5 million sales proceeds from the asset sale to pay off the bank loan.

The IRS disallowed the transaction. More specifically, it issued a notice of deficiency to Quintron, disallowing the more than $21 million in business expense deductions Quintron claimed.

According to the Tax Court, under any version of the business purpose and economic substance tests, these transactions lacked 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. The court reasoned 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.

While the Tax Court seemed to have an easy time in throwing out this transaction, the Second Circuit has not yet ruled. In its brief, the Justice Department is arguing that the Tax Court was quite correct in determining that Quintron's acquisition and immediate transfer of interests in computer leases was a sham, engaged in solely to generate tax benefits. Such a transaction, argues the government, should simply not be respected for tax purposes. Moreover, the government argues that Quintron's legal arguments on appeal are based on a flawed reading of precedent.

Anyone care to weigh in on how this will come out?


The sham transaction doctrine is connected, metaphysically if nothing else, to the business purpose doctrine and the principle of substance over form. Oftentimes, the sham transaction doctrine is thrown together with the economic substance doctrine, the Service relying on each. Indeed, sham transactions, lack of economic substance, and lack of business purpose, represent a kind of three-pronged attack, much like being skewered by a pitchfork.

A recent field service advice, FSA 200238045, Tax Analysts Doc. No. 2002-21405, 2002 TNT 184-17, invokes yet another old friend, this one a statutory provision, Section 269. Section 269, of course, allows the Service to do all sorts of nefarious things if the taxpayer first has been nefarious — engaging in transactions with a principal purpose of evading tax. I've always found Section 269 to be a fairly weak weapon in the Service's arsenal, and the Service typically has not had a lot of success with it in the case law. Still, the provision is asserted from time to time. It is therefore not surprising to see it coming up in a field service advice.

Sham On You!

In FSA 200238045, the Service concluded that Section 269 could be invoked to disallow a consolidated group's deductions on the acquisition of newly-formed subsidiaries. The FSA also concludes that the deductions can be disallowed because the transactions lacked economic substance. The parent of the consolidated group created a subsidiary (Newco 1), transferring cash to Newco 1 in exchange for its stock. Two other subsidiaries, Sub 1 and Sub 2, transferred various nonperforming loans and built-in loss assets to Newco 1 in exchange for preferred stock and cash. The parent also formed Newco 2. Newco 2 was not capitalized, and Newco 2 borrowed cash from Newco 1 in exchange for a note receivable.

Sub 1 and Sub 2 then sold all of their preferred stock in Newco 1 to an unrelated company for a substantial loss. For tax purposes, the formation of all of these companies and the sale of the stock were treated as Section 351 exchanges, and everything was completed on the same day.

Later, Newco 1 sold a portion of its built-in loss assets and recognized the loss, reporting this loss on the consolidated group's return. The parent accomplished a similar transaction involving the transfer of common stock in a real estate investment trust from the parent to Newco 1 in exchange for preferred stock. However, the parent transferred the preferred stock to five of its managers and recognized a loss.

Bad Purpose

Examining these orchestrated transactions, the Service determined that all three conditions for the application of Section 269(a) were met. Notably, there was a principal purpose of tax evasion. Deductions were disallowed under Section 269. Plus, Section 269 was held to trump Section 351, thus denying Section 351 treatment for the formation of the new companies. Instead, the transfers pursuant to these formations were all treated as taxable exchanges.

If all this wasn't enough, the Service also concluded that the deductions could be disallowed because of a lack of economic substance, because they were engaged in solely to avoid tax, and because they lacked a business purpose.

Business Purpose And Economic Substance: Catch Me If You Can, Vol. 11, No. 4, M&A Tax Report (November 2002), p. 5.