T.C. Memo. 2010-245
UNITED STATES TAX COURT
FLEXTRONICS AMERICA, LLC, AS ALTERNATIVE AGENT PURSUANT TO TREAS.
REG. § 1.1502-77A(e)(4)(ii) FOR C-MAC HOLDINGS, INC., &
SUBSIDIARIES CONSOLIDATED GROUP, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 9543-07. Filed November 8, 2010.
William A. Schmalzl, Joel V. Williamson, Jongjit
Wongsrikasem, Jeffrey A. Goldman, C. Cabell Chinnis, Jr., Matthew
C. Houchens, and Erin G. Gladney, for petitioner.
James P. Thurston, Bryce A. Kranzthor, Cameron M. McKesson,
Rachel L. Hester, Christopher B. Sterner, Barbara M. Leonard, and
Mary E. Wynne, for respondent.
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MEMORANDUM FINDINGS OF FACT AND OPINION
FOLEY, Judge: After concessions, the issue for decision is
whether transactions relating to inventory should be disregarded
and the step-up in basis relating to such assets disallowed.
FINDINGS OF FACT
Petitioner, Flextronics America, LLC, is a Delaware limited
liability company with its principal place of business in
Milpitas, California. Petitioner is the agent for C-MAC
Holdings, Inc. (C-MAC Holdings), & Subsidiaries Consolidated
Group (collectively, C-MAC). In 1998 C-MAC was wholly owned by
C-MAC Industries, Inc. (Canadian Parent),1 a Canadian company and
parent company of all C-MAC entities. Canadian Parent and all
its direct and indirect subsidiaries are hereafter referred to as
C-MAC Worldwide Group (C-MACW).
C-MACW, a leading international manufacturer of electronic
components, owned and operated manufacturing plants. During the
years in issue, Northern Telecom, Inc. (Nortel) was one of the
largest purchasers of C-MACW’s products. Nortel manufactured
telecommunications networking and switching equipment that routed
wireless telephone calls. This equipment was housed in large
metal boxes which were fabricated in Nortel’s mechanical and test
facility in Creedmoor, North Carolina (Creedmoor). Each box
1
Canadian Parent was acquired by Solectron Corp. in December
2001. In October 2007, Solectron was acquired by petitioner.
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contained a circuit board which provided power and connectivity
for networking and switching equipment. C-MACW manufactured the
circuit boards and other component parts and supplied them to
Nortel.
I. The Creedmoor Sale
In late 1997, Nortel determined that because it was not
operating Creedmoor at full capacity it would be more cost
effective to sell Creedmoor and enter into a long-term supply
agreement with Creedmoor’s purchaser. Nortel solicited, and in
March 1998 C-MACW and at least three other electronic components
suppliers submitted, bids to purchase Creedmoor. C-MACW’s $60
million offer was the winning bid. The acquisition was an
integral part of C-MACW’s plan to become a full-service provider
of telecommunications equipment. Purchasing Creedmoor was also
important to C-MACW because sales to Creedmoor had typically
accounted for 50 percent of C-MACW’s U.S. revenues and more than
15 percent of its worldwide revenues. On May 6, 1998, Nortel
faxed proposed asset purchase and supply agreements to Canadian
Parent.2 On May 13, 1998, Canadian Parent, in response to
Nortel’s proposals, submitted its terms for the asset purchase
and supply agreements.
2
C-MACW chose Canadian Parent to execute the agreement
because Nortel required that the executing entity of the asset
purchase agreement have resources sufficient to ensure
performance obligations.
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II. The Asset Purchase Agreement
After Canadian Parent submitted its bid and offer to
purchase Creedmoor, C-MACW contacted KPMG, its accountant. KPMG,
in May 1998, advised C-MACW of possible tax planning options
relating to the Creedmoor acquisition. Those options included a
proposed advance purchase of Creedmoor’s inventory assets (the
plan). KPMG advised C-MACW’s senior management that successful
execution of the plan would require a business purpose and would
allow petitioner to deduct a significant loss relating to the
Creedmoor purchase. Pursuant to the plan C-MAC, on May 28, 1998,
would enter into an agreement with Nortel to purchase Creedmoor’s
inventory. Ten to fifteen days later, Nortel and C-MAC
Interconnect Products, Inc. (C-MAC Interconnect), one of Canadian
Parent’s Canadian subsidiaries, would enter into an agreement to
transfer, before closing, ownership of the inventory from Nortel
to C-MAC Interconnect, with the remaining assets to be
transferred at a later date. Once C-MAC Interconnect acquired
the inventory, C-MAC Interconnect would pledge the inventory as
security to C-MACW’s lenders. Pursuant to the plan, C-MAC
Holdings would incorporate a new U.S. corporation, C-MAC Network
Systems, to acquire the remaining Creedmoor assets. KPMG
referred to the inventory as “Bump Assets” because the series of
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transactions was designed to trigger sections 357(c)3 and 362(a)
and thereby increase, or “bump up”, the inventory’s basis to
equal the total amount of liabilities secured by the inventory.4
Through numerous years of acquiring manufacturing
facilities, Dennis Wood, the chief executive officer of C-MACW,
expanded C-MACW from a small Canadian company into a large
international corporation. During a meeting with senior
management regarding the acquisition of Creedmoor, Mr. Wood was
informed about the plan and its accompanying tax considerations.
Mr. Wood agreed to the plan because he believed that C-MACW could
use the inventory in several of its worldwide facilities and that
the plan would not hinder C-MACW’s ultimate objective--to
purchase Creedmoor.
On May 28, 1998, Canadian Parent and Nortel executed the
Asset Purchase Agreement (APA). Pursuant to the APA, the
purchase price (i.e., which included inventory assets with a
December 31, 1997, estimated book value of $17.94 million) would
3
Unless otherwise indicated, all section references are to
the Internal Revenue Code of 1986, as amended and in effect for
the years in issue, and all Rule references are to the Tax Court
Rules of Practice and Procedure.
4
Sec. 357(c) provides that, in the case of an exchange to
which sec. 351 applies, if the sum of the liabilities assumed
plus the amount of the liabilities to which the property is
subject exceeds the total adjusted basis of the property
transferred, then such excess shall be recognized as gain to the
transferor. Sec. 362(a) provides that the transferee’s basis in
property transferred in connection with a sec. 351 transaction
shall be equal to the transferor’s basis plus any gain recognized
to the transferor on the transfer.
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be adjusted in accordance with the physical inventory on the
closing date. On June 22, 1998, Canadian Parent sent a letter to
Nortel proposing to purchase the inventory before the APA closing
date. Nortel ultimately agreed.
III. The Inventory Purchase
From July 1 through 10, 1998, C-MACW entered into several
transactions involving the inventory (the inventory
transactions). On July 1, 1998, Nortel, Canadian Parent, and C-
MAC Interconnect executed the First Amendment to Asset Purchase
Agreement (amendment to APA). Pursuant to the amendment to APA,
C-MAC Interconnect was authorized to purchase Creedmoor’s
inventory. C-MAC Interconnect and Nortel, on July 1, 1998, also
executed a bailment agreement. The bailment agreement provided
that the inventory was to be kept, maintained, and used by Nortel
at Creedmoor pending the closing. The bailment agreement also
provided that C-MAC Interconnect and its affiliates had the
authority to pledge and encumber the inventory and transfer
rights to, title to, and interest in the inventory. Canadian
Parent, which bore the risk of loss during the bailment period,
was obligated to insure the inventory. On July 2, 1998, C-MAC
Interconnect paid Nortel $12.1 million (i.e., cash from C-MAC
Interconnect and a loan from Caisse de Dépôt et Placement du
Québec, a Canadian lender) for the inventory. On the same date,
Nortel executed a bill of sale and assignment providing for the
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sale of its rights to, title to, and interest in the inventory to
C-MAC Interconnect. During the bailment period, Nortel continued
to operate Creedmoor, acquire new inventory, and ship finished
products. The parties agreed Nortel would purchase from C-MAC
Interconnect any inventory Nortel used during the bailment
period. Nortel used computerized systems to manage and track the
inventory.
On July 2, 1998, Canadian Parent determined that C-MAC
Quartz Crystals, Ltd. (C-MAC Quartz), a member of C-MACW that
owned and operated a manufacturing facility in Harlow, Essex,
England, needed $280,000 in inventory. The bill of sale and
purchase order for the inventory were completed on July 7, 1998,
and the request for shipment of the inventory was completed on
July 8, 1998 (collectively, the Quartz sale). The inventory that
C-MAC Quartz purchased was transferred to Nortel’s Alston Avenue
facility in Durham, North Carolina.
IV. The Acquisition Financing
C-MACW financed the Creedmoor acquisition through existing
credit arrangements with Caisse de Dépôt et Placement du Québec
(Caisse Bank), the National Bank of Canada (NBC), and the Royal
Bank of Canada (RBC). On July 7, 1998, C-MACW borrowed a total
of $51.6 million. C-MAC Interconnect borrowed $5.4 million from
Caisse Bank. C-MAC General Partnership, a Canadian Parent
affiliate, borrowed $29.6 million from Caisse Bank and a total of
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$16.6 million from the New York branches of NBC (NBC New York)
and RBC (RBC New York).
On July 7, 1998, C-MAC Interconnect also entered into a
security agreement with Caisse Bank, NBC New York, RBC New York,
and General Trust of Canada and pledged the inventory as security
for payment of the $51.6 million in liabilities. The security
agreement, which stated that C-MAC Interconnect owned the
inventory free and clear, gave the lenders a continuing, first-
priority interest in all of C-MAC Interconnect’s rights in the
inventory. On July 8, 1998, the lenders filed their security
agreement with the register of deeds for the county in which
Creedmoor was located.
V. The Inventory Transfers and Purchase of Remaining Assets
On July 10, 1998, the inventory, which was subject to the
$51.6 million in liabilities, was transferred to two different C-
MAC entities. First, C-MAC Interconnect transferred the
inventory to C-MAC Holdings5 in exchange for 10,107 shares of C-
MAC Holdings stock and a $9.5 million promissory note, and
Canadian Parent transferred $4 million to C-MAC Holdings in
exchange for 17,124 shares of C-MAC Holdings stock (Holdings’
capitalization). After Holdings’ capitalization, Canadian Parent
and C-MAC Interconnect owned 62.65 and 34.37 percent,
5
At that time there was $11.8 million in inventory (i.e.,
the original $12.1 million less the $280,000 that had been sold
to C-MAC Quartz).
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respectively, of C-MAC Holdings’ outstanding stock. Second, C-
MAC Holdings transferred the inventory and $2.3 million to C-MAC
Network Systems, Inc., a newly formed U.S. subsidiary, in
exchange for 10,107 shares of C-MAC Network Systems stock and a
$9.5 million promissory note (Network Systems’ capitalization).
Canadian Parent formed C-MAC Network Systems because Canadian
Parent wanted Creedmoor to be operated by an entity that, for
Federal income tax purposes, was part of C-MAC’s consolidated
group. After its capitalization, C-MAC Network Systems had cash
and assets and C-MAC Holdings owned 100 percent of C-MAC Network
System’s outstanding stock.
On July 24, 1998, C-MAC General Partnership lent C-MAC
Network Systems $42.2 million, which C-MAC Network Systems used
to purchase the remaining Creedmoor assets (i.e., the
noninventory assets). Nortel executed a bill of sale and
assignment memorializing the transfer of its interest in the
inventory. Canadian Parent and KPMG completed a physical
inventory summary and determined that, as of July 24, 1998, the
inventory had a net value of $13.1 million. Pursuant to the
inventory summary, C-MAC Holdings paid Nortel an additional $1
million for the inventory (i.e., $13.1 million inventory value
per inventory summary less $12.1 million paid pursuant to the
amendment to APA). By the end of 1998, C-MAC had disposed of all
the inventory.
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On its 1998 Federal income tax return, petitioner reported a
$37.3 million loss, taking into account the $39.8 million
increase to the inventory’s basis. Respondent, on January 31,
2007, issued petitioner a notice of deficiency relating to 1998,
1999, and 2000, in which respondent disallowed the claimed loss
and determined deficiencies of $863,931, $6,398,534, and
$14,979,322, respectively.6 On April 30, 2007, petitioner filed
its petition with the Court seeking redetermination.
OPINION
With respect to the Creedmoor acquisition, we must determine
whether the inventory transactions should be disregarded and the
step-up in basis relating to the inventory disallowed.7 We
conclude that the inventory transactions were valid transactions
and therefore, should not be disregarded.
Section 351(a) provides that “No gain or loss shall be
recognized if property is transferred to a corporation by one or
more persons solely in exchange for stock in such corporation and
immediately after the exchange such person or persons are in
control (as defined in section 368(c)) of the corporation.” The
parties agree that the inventory transactions involving Holdings’
6
The deficiencies for 1999 and 2000 resulted from the
disallowance of the 1998 losses that had been carried forward to
1999 and 2000.
7
In the absence of the inventory transfers, the statutory
provisions petitioner relied on to calculate the losses, secs.
357(c) and 362(a), would not have been applicable. See supra
note 4.
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capitalization and Network Systems’ capitalization meet the
literal requirements of section 351. Respondent, however,
contends that the inventory transactions must be disregarded
because they “fall outside the statutory purpose of section 351”,
lack section 351 business purpose, lack economic substance, and
are subject to disallowance pursuant to the step transaction
doctrine.
Respondent’s challenge fails with respect to each
contention. We are not persuaded by respondent’s contentions and
are not inclined to stretch inapplicable judicial doctrines to
corral a transaction that escaped before Congress closed the barn
door. As of October 19, 1998, 3 months after petitioner
completed the inventory transactions, the barn door was
effectively closed by Code amendments to ensure that with respect
to the transfer of property subject to a liability, the “bump up”
in basis not exceed the fair market value of the property.8
8
Congress did not amend sec. 351, but instead amended sec.
357(c) and added secs. 357(d) and 362(d). The amendments did not
mandate that transactions similar to the inventory transactions
be disregarded but instead provided, in relevant part, that the
“bump up” in basis with respect to such transactions could not
exceed the fair market value of the property. The modifications
were not technical corrections retroactive to the date of
enactment of the statutes, but instead were prospective and
revenue-raising amendments. See Miscellaneous Trade and
Technical Corrections Act of 1999, Pub. L. 106-36, sec. 3001, 113
Stat. 181; Staff of Joint Comm. on Taxation, General Explanation
of Tax Legislation Enacted in the 106th Congress, at 9-11 (J.
Comm. Print 2001).
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Simply put, petitioner and its inventory transactions were a step
ahead of Congress and the Internal Revenue Service.
I. The Inventory Transactions Fall Within the Scope of Section
351
Respondent, citing Wolf v. Commissioner, 357 F.2d 483 (9th
Cir. 1966), affg. 43 T.C. 652 (1965), and Gregory v. Helvering,
293 U.S. 465 (1935), contends that the purported section 351
inventory transactions (i.e., Holdings’ capitalization and
Network Systems’ capitalization) “fall outside the statutory
purpose of section 351” and should be disregarded because the
purpose of section 351 is the deferral of gain or loss
recognition, not total avoidance. Respondent emphasizes that C-
MAC Network Systems received the tax benefit of the loss, but C-
MAC Interconnect was not subject to U.S. tax and did not incur a
corresponding gain. Petitioner contends, and we agree, that the
cases respondent cites are factually distinguishable. In Wolf
and Gregory, the courts considered the intent and purpose of the
relevant statutes but ultimately rendered decisions based on the
substance and nature of the transactions. See Wolf v.
Commissioner, supra at 484-485 (stating that “the incidence of
taxation depends upon the substance of a transaction. * * * What
is decisive in a case such as is before the court is what
actually occurred.”); Gregory v. Helvering, supra at 470 (stating
that “The whole undertaking * * * was in fact an elaborate and
devious form of conveyance masquerading as a corporate
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reorganization”). Nevertheless, respondent relies on the court’s
statement in Wolf v. Commissioner, supra at 486, that “In looking
to the substance of the present transaction the ‘net effect’
would not be a postponement of recognition of a gain on an
exchange, but the escape of the tax upon a dividend * * * which
is contrary to the meaning of section 351”. Respondent focuses
on the words “escape of the tax” and “contrary to the meaning of
section 351” yet ignores the words “the substance of the present
transaction” and “upon a dividend”--key elements of the court’s
analysis. The determining factor in Wolf was not that the
transactions resulted in an avoidance of tax. See id.; Wolf v.
Commissioner, 43 T.C. at 660 n.9 (quoting Gregory v. Helvering,
supra at 469 (“The legal right of a taxpayer to decrease the
amount of what otherwise would be his taxes, or altogether avoid
them, by means which the law permits, cannot be doubted.”)). The
determining factor was that several transactions lacked substance
and were used to disguise the primary transaction’s true nature--
a dividend. See Wolf v. Commissioner, 357 F.2d at 485.
Certainly the creation and use of entities and transactions that
lack substance “fall outside the statutory purpose of section
351.” The inventory transactions, however, were valid
substantive transactions. See infra secs. III. and IV.
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II. The Inventory Transactions Had Business Purpose
Respondent contends that the purported section 351 inventory
transactions fail because they lack the requisite section 351
business purpose. Respondent cites caselaw and administrative
rulings to support his contention that there is a section 351
business purpose requirement.9 Neither section 351 nor any of
the cited sources explicitly set forth a business purpose
requirement for section 351 transactions. Irrespective of
whether there is a section 351 business purpose requirement,
there were business purposes for the inventory transactions. The
inventory transactions (i.e., Holdings’ capitalization and
Network Systems’ capitalization) provided for part of the
capitalization of C-MAC Network Systems and enabled the Creedmoor
business to be operated as a separate subsidiary of Canadian
Parent’s U.S. consolidated operating group.
Respondent emphasizes KPMG’s role with respect to the
inventory transactions. Certainly Canadian Parent and KPMG
contemplated different ways to bolster the appearance of a
business purpose relating to the inventory transactions. There
is no doubt KPMG fervently encouraged the use of the planning
technique. Receiving KPMG’s advice did not, however, nullify
9
Respondent cites Gregory v. Helvering, 293 U.S. 465 (1935),
Wolf v. Commissioner, 357 F.2d 483 (9th Cir. 1966), affg. 43 T.C.
652 (1965), Stewart v. Commissioner, 714 F.2d 977 (9th Cir.
1983), affg. T.C. Memo. 1982-209, Rev. Rul. 55-36, 1955-1 C.B.
340, and Rev. Proc. 83-59, sec. 4.06, 1983-2 C.B. 575, 580.
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petitioner’s bona fide business purposes for the transactions.
KPMG was simply advising a client on different ways to minimize
the tax consequences of a proposed transaction--precisely what
tax accountants are paid to do. The inventory transactions were
valid section 351 transactions.
III. The Inventory Transactions Had Economic Substance
Respondent contends that the inventory transactions should
be disregarded because they lack economic substance. “Although
the taxpayer may structure a transaction so that it satisfies the
formal requirements of the Internal Revenue Code, the
Commissioner may deny legal effect to a transaction if its sole
purpose is to evade taxation.” Zmuda v. Commissioner, 731 F.2d
1417, 1421 (9th Cir. 1984) (emphasis added), affg. 79 T.C. 714
(1982) (citing Stewart v. Commissioner, 714 F.2d 977, 987 (9th
Cir. 1983), affg. T.C. Memo. 1982-209). The standard in
determining whether a transaction has economic substance (i.e.,
is not a sham) is whether the transaction has any practical
economic effects other than the creation of income tax losses
(i.e., whether the taxpayer has shown that there was a nontax
business purpose for engaging in the transaction and whether the
taxpayer has shown that the transaction had economic substance
beyond the creation of tax benefits). See Sochin v.
Commissioner, 843 F.2d 351 (9th Cir. 1988), affg. Brown v.
Commissioner, 85 T.C. 968 (1985); Bail Bonds by Marvin Nelson,
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Inc. v. Commissioner, 820 F.2d 1543, 1548-1549 (9th Cir. 1987),
affg. T.C. Memo. 1986-23. 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. C-MAC Interconnect purchased the
inventory from Nortel; sold part of the inventory to C-MAC
Quartz, which needed the inventory for its business; pledged the
inventory as security for the bank loans needed to purchase
Creedmoor; and transferred the remaining inventory to C-MAC
Holdings. The lenders perfected the security lien by filing the
security agreement with the register of deeds in the county in
which the inventory was located. C-MAC Holdings capitalized C-
MAC Network Systems by contributing the inventory and other
assets to C-MAC Network Systems. In addition, the inventory was
legally transferred and subject to a valid lien.
Respondent contends that C-MAC Interconnect’s purchase of
the inventory from Nortel was, in substance, an advance deposit
on the inventory that was acquired at closing. Respondent
further contends that C-MAC Interconnect had no right to
possession or control of the inventory and did not benefit from
the inventory until after the closing. To the contrary, upon
purchase of the inventory and execution of the bailment
agreement, C-MACW had the right to pledge and encumber the
inventory and transfer rights to, title to, and interest in the
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inventory. Not only did C-MACW have rights to the inventory, but
it also benefited from the inventory purchase. As previously
mentioned, C-MAC Interconnect sold some of the inventory (i.e.,
to C-MAC Quartz) and made it available for use in its other
operations. The advance inventory purchase had economic
substance.
Respondent contends that the Quartz sale was contrived. In
support of his contention, respondent emphasizes that the
inventory purchased by C-MAC Quartz was transferred to Nortel’s
Durham, North Carolina, facility and not C-MAC Quartz’s facility
in England. Regardless of where C-MAC Quartz chose to store the
inventory after purchase, C-MAC Quartz purchased the inventory
and Mr. Wood established that it was important to make the
inventory available for use in other parts of its business.
Further, it does not matter what C-MAC Quartz actually did with
the inventory. What matters is petitioner’s intent. Mr. Wood
credibly testified that petitioner intended to use the inventory
in other operations. Respondent further contends that the Quartz
sale was invalid because C-MAC Interconnect “had no right to
possession or control of the inventory during the bailment
period.” As previously stated, the bailment agreement gave C-MAC
Interconnect the right to pledge and encumber the inventory and
transfer rights to, title to, and interest in the inventory. In
sum, the inventory transactions should not be disregarded.
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IV. The Step Transaction Doctrine Is Not Applicable
Respondent, citing Jacobs v. Commissioner, 224 F.2d 412 (9th
Cir. 1955) (holding that purported stock sale transactions should
be collapsed because the taxpayer’s corporation was merely a
conduit through which the taxpayer effectuated a sale of his
land), affg. 21 T.C. 165 (1953), contends that C-MAC Interconnect
and C-MAC Holdings were mere conduits for C-MAC Network’s
purchase of the inventory and that “The transfers * * * were
without economic effect: neither Interconnect nor Holdings
conducted any business with the inventory and their ownership of
the inventory was transitory at best.” To the contrary, C-MAC
Interconnect and C-MAC Holdings were bona fide entities that used
the inventory in their businesses. As previously stated, C-MAC
Interconnect sold part of the inventory it acquired from Nortel
to C-MAC Quartz for use in C-MAC Quartz’s business and C-MAC
Holdings, which helped finance and set up the operating structure
of C-MAC Network Systems, used the inventory to capitalize C-MAC
Network Systems. Further, the inventory transactions allowed C-
MACW to create a separate U.S. subsidiary to operate Creedmoor
and for that subsidiary to obtain the necessary capital (i.e.,
the funds to purchase Creedmoor). The step transaction doctrine
is not applicable.
In conclusion, the inventory transactions were valid
transactions, and we reject respondent’s determination.
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Contentions we have not addressed are irrelevant, moot, or
meritless.
To reflect the foregoing,
Decision will be entered
under Rule 155.