                      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.
                                  -2-

             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.
                                -3-

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.
                                 -4-

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
                                  -5-

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.
                                 -6-

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
                                  -7-

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
                                -8-

$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).
                                -9-

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.
                               -10-

     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.
                                -11-

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).
                               -12-

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
                               -13-

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.
                                 -14-

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.
                                 -15-

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,
                                -16-

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
                                 -17-

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.
                               -18-

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.
                                 -19-

     Contentions we have not addressed are irrelevant, moot, or

meritless.

     To reflect the foregoing,


                                             Decision will be entered

                                        under Rule 155.
