Plains Petroleum Co. v. Commissioner

T.C. Memo. 1999-241

UNITED STATES TAX COURT

PLAINS PETROLEUM COMPANY AND SUBSIDIARIES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 25636-96. Filed July 23, 1999.

David D. Aughtry, Shelley J. Cashion, Arnold B. Sidman, and

Craig M. Bergez, for petitioners.

William L. Blagg and Mark S. Mesler, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WELLS, Judge: Respondent determined deficiencies in

petitioners Federal income tax and accuracy-related penalties as

follows:
 - 2 -

Penalties
Year Deficiency Sec. 6662

1991 $3,009,338 $601,868
1992 1,704,166 340,833
1993 605,629 121,125

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure. After concessions by the parties, the issues we must

decide are: (1) Whether an acquisition by petitioner was made

for the principal purpose of avoiding or evading tax as defined

by section 269(a), and (2) whether petitioner is liable for

accuracy-related penalties pursuant to section 6662(a).

References to petitioner in the singular are to Plains Petroleum

Company.

FINDINGS OF FACT

Pursuant to Rule 91, some of the facts have been stipulated

for trial, which stipulations are incorporated herein by

reference and are found as facts in the instant case. When

petitioner filed the petition, its principal place of business

was located in Denver, Colorado. Petitioner is the common parent

of an affiliated group of corporations that filed consolidated

Federal income tax returns for the years in issue. Petitioners

are engaged in the oil and gas business.
 - 3 -

I. Petitioner and Tri-Power Before the Acquisition

A. Petitioner

1. Organization and Operations

Petitioner was incorporated on November 30, 1983, as a

wholly owned subsidiary of KN Energy, Inc. (KN Energy), a

publicly traded company.1 Effective October 1, 1984, KN Energy

assigned its ownership interests in substantially all of its

then-remaining oil and natural gas producing properties to

petitioner.2 On September 13, 1985, as the result of a spinoff,

petitioner became an independent, publicly owned company. Stock

1
KN Energy, Inc. (KN Energy), was formed in 1936 as a
pipeline company to purchase supplies of natural gas in the Otis
field in central Kansas and deliver those supplies through a
single transmission line to markets in northern Kansas and
central Nebraska.
2
KN Energy had previously spun off a portion of its assets
pursuant to a plan to thwart a 1983 takeover attempt. During
1983, KN Energy had two types of natural gas reserves, (1) "old"
natural gas reserves (natural gas reserves associated with wells
drilled before July 1, 1978), and (2) "new" natural gas reserves
(natural gas reserves associated with wells drilled on or after
July 1, 1978).
As a defensive mechanism to the 1983 takeover attempt, KN
Energy decided to spin off its oil and natural gas reserves. KN
Energy accomplished the spinoff using two subsidiaries, Midlands
Energy Co. (Midlands) and petitioner. The first spinoff took
place on Dec. 13, 1983, after KN Energy transferred its new
natural gas reserves and undeveloped properties to Midlands. The
second spinoff was delayed because transfer of KN Energy's old
natural gas reserves, which were subject to regulation by the
Federal Energy Regulatory Commission (FERC), required FERC
approval which had not yet been sought. On Jan. 29, 1985, FERC
issued an order approving the Oct. 1, 1984, transfer of the
remaining oil and old natural gas reserves to petitioner.
 - 4 -

in petitioner began trading on the New York Stock Exchange on

September 16, 1985.

After the spinoff, petitioner's holdings consisted primarily

of properties that produced "old" natural gas (i.e., those with

wells that had been drilled prior to July 1, 1978).3 The

properties were located primarily in the Hugoton field in

southwest Kansas and in the Guymon-Hugoton area of Oklahoma

(collectively referred to as the Hugoton field or Hugoton).4 At

the time of the spinoff, petitioner was required by contract to

sell substantially all (approximately 90 percent) of its natural

gas production to KN Energy at an average sales price of 53 cents

per thousand cubic feet (Mcf).5 In addition, KN Energy had a

contractual first right of refusal to purchase any additional gas

supplies that petitioner might acquire or develop in the future.

Essentially, petitioner had one field (Hugoton), one product (old

natural gas), and one customer (KN Energy).

3
Petitioner, however, also held (1) a few properties that
produced some oil along with old natural gas, (2) some properties
that produced new natural gas, and (3) a small amount of
undeveloped acreage.
4
The Hugoton field in Kansas and the Guymon-Hugoton field in
Oklahoma are essentially one continuous field that straddles the
border between Kansas and Oklahoma.
5
KN Energy serves a predominantly rural market, providing gas
for space heating purposes. Accordingly, KN Energy's market is
highly sensitive to weather conditions.
 - 5 -

During 1986, petitioner's executive management team

consisted of Elmer J. Jackson as its chief executive officer

(CEO), Roger L. Billings as its chief operating officer (COO),

Darrel Reed as its vice president of finance, and Robert W.

Wagner as its land manager.6 Mr. Billings, a petroleum

geologist, and Mr. Wagner each had over 30 years of experience in

the oil and gas business when they joined petitioner during 1985.

Robert Miller served as petitioner's general counsel.7

Petitioner's board of directors (board) was composed of Mr.

Jackson, Mr. Billings, and three individuals who were not

involved with petitioner's management.

Petitioner was subject to the regulatory control of both the

Kansas Corporation Commission (KCC), a State agency, and the

Federal Energy Regulatory Commission (FERC). The KCC had

regulatory control over the production and development of the

Hugoton field. At the time petitioner became public, the KCC had

6
Mr. Jackson, an attorney with over 30 years of experience in
the oil and gas business, joined petitioner at KN Energy's
request prior to the Sept. 13, 1985, spinoff. Mr. Jackson joined
KN Energy in 1952 as an attorney after working 4 years for a
major oil company. During the spring of 1984, Mr. Jackson left
KN Energy to serve as Midlands' executive vice president and
general counsel until it was acquired, during December 1984, by
Freeport McMoRan, Inc. Then, prior to the Sept. 13, 1985,
spinoff of petitioner, KN Energy asked Mr. Jackson to return to
KN Energy to serve as petitioner's CEO.
7
Like Mr. Jackson, Mr. Miller began his legal career with KN
Energy.
 - 6 -

under its consideration a proposal to allow "infill drilling"8 in

the Hugoton field. In its third quarterly report dated September

30, 1985 (1985 third quarter report), the first shareholder

report issued by petitioner after its spinoff from KN Energy,

petitioner indicated that it expected that infill drilling would,

if allowed, add approximately 31 percent to its proven9 natural

gas reserves. Petitioner further anticipated that, as a result

of deregulation, it could expect to receive a price for those

reserves that would be between three and four times the average

price it was then receiving for its production from the Hugoton

field. On April 24, 1986, the KCC issued an order that permitted

infill drilling by petitioner in the Hugoton field beginning on

January 1, 1987 (the KCC infill drilling order). On November 18,

1986, petitioner announced that it would receive $1.63 per Mcf

for infill gas production from the Hugoton field. The KCC infill

drilling order in the Hugoton field was challenged10 but

ultimately affirmed by the Kansas Supreme Court on January 20,

8
An "infill well" is defined as "A well drilled on an
irregular pattern disregarding normal target and spacing
requirements." Williams & Meyers, Oil & Gas Terms 529 (9th ed.
1994).
9
The term "proven" or "proved" reserves is frequently used to
denote the amount of oil in known deposits which is estimated to
be recoverable under current economic and operating conditions.
See id.
10
Mobil Oil and other interested parties contested the KCC
infill drilling order in the Hugoton field.
 - 7 -

1989. See Southwest Kansas Royalty Owners Association v. Kansas

Corporation Commn., 769 P.2d 1 (Kan. 1989).

FERC also had regulatory control over the production and

sale of old natural gas from the Hugoton field. During June 1986

FERC issued Order 451, 51 Fed. Reg. 22168 (June 18, 1986) (FERC

Order 451), which permitted, but did not require, gas pipelines

and producers to renegotiate the price of old natural gas with

the purchase price not to exceed $2.57 per Mcf. FERC Order 451

was hotly contested. The Court of Appeals for the Fifth Circuit

in Mobil Oil Exploration & Producing Southeast, Inc. v. FERC, 885

F.2d 209 (5th Cir. 1989), struck down FERC Order 451 as exceeding

FERC's authority. During 1991, however, the Supreme Court upheld

FERC Order 451 in Mobil Oil Exploration & Producing Southeast,

Inc. v. United Distribution Cos., 498 U.S. 211 (1991).

During 1986, pursuant to FERC Order 451, petitioner and KN

Energy renegotiated the purchase price for petitioner's

production of old natural gas from the Hugoton field. Subject to

a judicial determination of the validity of FERC Order 451,

petitioner and KN Energy established a 1987 price of $1.40 per

Mcf. In addition, KN Energy agreed to reimburse petitioner, in

full, for the production and property taxes on petitioner's

Hugoton production. The increased revenues that petitioner

expected to receive from the renegotiated gas sales were, of
 - 8 -

course, subject to refund until the appeals of FERC Order 451

became final.

2. Acquisition Strategy and Efforts Before the
Acquisition

a. Publicly Announced Acquisition Policy

During 1986, petitioner's gas reserves were projected to

last for approximately 25 years. Oil and natural gas reserves

are, however, by their very nature depleting assets. Because oil

and natural gas reserves are nonregenerative, they must be

replaced either through exploration and development or by

acquisition. Petitioner's board and management team elected,

from the outset, to replace production and add reserves through

acquisition. In petitioner's 1985 third quarter report, Mr.

Jackson wrote a letter to the shareholders announcing

petitioner's acquisition plans as follows:

Although the decrease in oil and gas prices has not
significantly affected your Company's earnings, it has
affected the industry in general. Plains sees the drop in
other companies' values as a strategic opportunity to make a
profitable acquisition that will expand its size and area of
operations. [Emphasis added.]

Similarly, in petitioner's first annual report, issued for the

year ended December 31, 1985, Mr. Jackson again publicly

announced petitioner's acquisition plans. In a letter to the

shareholders, Mr. Jackson stated:

Your management also is taking steps to develop
additional reserve sources and new markets. The fact
that substantially all of our properties are developed
 - 9 -

and are producing gas dedicated to the KN Energy, Inc.
(KN) system has two inevitable consequences. The first
is that our sales of gas are directly affected by
weather conditions on the KN system in the Midwest and
High Plains. With space heating as the primary
service, gas sales revenues from KN will vary from
season to season and year to year. The second
consequence is that with essentially all of our acreage
already developed (except for the infill program
described above), we must replace the gas reserves that
are sold each year.

In developing new supplies we will not neglect the KN
market, but will endeavor to develop others as well.
Initially, we are looking to do this principally by
acquisition. The current weak conditions in the
industry and our strong financial base offer the
possibility of favorable acquisitions which we are
continuing to explore. [Emphasis added.]

Later in the 1985 annual report, petitioner identified the States

in which it sought to acquire producing properties and

developmental opportunities, as well as the buying opportunity it

perceived going into 1986, as follows:

The Company is focusing on the development
opportunities of its properties, and has only minor
amounts budgeted for exploration. The Company is
seeking to acquire producing properties and
developmental opportunities in Texas, Oklahoma and
Louisiana so as to diversify geographically and enter
new markets. The Company believes that the sharply
lower oil and gas prices represent a buying
opportunity; however, it does not look for prices to
recover in the next year or two. [Emphasis added.]

Upon becoming public, petitioner immediately began looking

for acquisition opportunities. During the fall of 1985,

petitioner commissioned its investment banking firm, Kidder,

Peabody & Co. (Kidder Peabody), to do, inter alia, an acquisition
 - 10 -

earch. Petitioner obtained a report from Kidder Peabody, dated

November 12, 1985, in which Kidder Peabody identified 33 oil and

gas companies as potential acquisition targets. The Kidder

Peabody report selected 8 of the 33 potential targets for further

review.

The Kidder Peabody report and petitioner's acquisition plans

were discussed at the November 15, 1985, meeting of petitioner's

board. According to the minutes of that board meeting:

Mr. Jackson explained the reason why the Company was
currently looking for an acquisition. He stated that
if the Kansas Corporation Commission were to order no
infill drilling in the Hugoton field in 1986 or even in
1987, then the Company must do more than sell its
inventory off the shelf, but must look for ways to
maintain its reserve position. Management had
concluded that currently the best opportunities to add
reserves would be found through the purchase of an oil
and gas exploration and production company, rather than
through the process of building an exploration position
from the ground up. Mr. Jackson advised that Mr.
Billings and Mr. Reed had been actively reviewing many
potential candidates, and that Kidder Peabody had
provided research assistance on acquisitions
candidates. Mr. Jackson stressed that the Company
would consider nothing other than a friendly
acquisition. The characteristics of the ideal
acquisition candidate were discussed in detail.
[Emphasis added.]

Petitioner regularly reported on its acquisition efforts at

its board meetings. Petitioner also reported on its acquisition

efforts, reiterating its commitment to add value through its oil

and gas acquisition strategy, in every quarterly shareholder and

annual report during the period 1986 through 1990.
 - 11 -

b. Acquisition Limitations

During this period, Mr. Billings formed an in-house

acquisition screening team consisting of himself, Mr. Wagner, Mr.

Reed, Mr. Miller, and Lee Van Ramshorst, a petroleum engineer.

Petitioner's management team adopted certain limitations for

screening and selecting acquisition targets. In particular,

petitioner was looking for companies with significant oil and gas

reserves. Further, petitioner sought both geographic and

geologic diversification. Petitioner wanted to (1) expand

outside of the Hugoton field into the Gulf Coast region, and (2)

broaden its production mix by acquiring more oil reserves. With

an initial line of credit in the amount of $25 million,

petitioner decided to target acquisitions in the range of $10 to

$25 million. Management decided to make smaller acquisitions in

order to spread the risk and avoid betting the entire company on

a single acquisition. Finally, petitioner hoped to gain, by way

of acquisition, access to otherwise unavailable proprietary

information, which is critical in the oil and gas exploration and

production business. Proprietary information, generally

available only to owners with a working interest in a field,

helps the owner/producer make decisions concerning whether to

pursue additional working interests or pull out of that field.

The use of reserve reports in connection with the purchase

and sale of oil and gas reserves is a common practice. A reserve
 - 12 -

report typically states the discounted net present value of the

specified reserves. The discounted net present value is

dependent upon three factors: (1) An estimate of the proved,

developed, and producing reserves, (2) an estimate of the

anticipated future net revenue using price forecasts provided by

the oil and gas company, and (3) a range of discount rates used

to determine the net present value of the future net revenues

expected to be received upon the recovery and sale of the

reserves. Petitioner's standard practice was to rely on the

seller's reserve report if it was prepared by a reputable outside

engineer.11 Petitioner's standard practice also included

engaging the seller's reserve engineer to update or "roll

forward"12 his earlier projections using petitioner's oil and gas

price forecasts.13 Petitioner would then perform an in-house

review of the updated reserve report in connection with its

evaluation of the prospective acquisition. Petitioner adopted

11
The "major" oil and gas companies typically do not rely on
outside engineers. Thus, in acquisitions involving reserves
owned by major oil and gas companies, it is common for a buyer to
rely on the seller's in-house reserve report.
12
A reserve report is "rolled forward" or updated by revising
the previous projections to take into account the intervening
production and the buyer's oil and gas price forecast.
13
Petitioner also used rollforwards in connection with the
evaluation of its own reserves. Petitioner typically evaluated
its reserves midyear and then rolled its projections forward at
the end of the year.
 - 13 -

this practice because its management believed that it was more

efficient to use the existing data, produced by an engineer

already familiar with the reserves, than to start back at square

one, with an independent reserve engineer who was unfamiliar with

the properties.

c. Attempted and Failed Acquisitions

From the time it became public until the acquisition of Tri-

Power Petroleum, Inc. (Tri-Power), during November 1986,

petitioner's management team contemplated a large number of

acquisition opportunities. During 1986, they considered over 40

acquisition targets. Several of those companies did come on the

market, but petitioner was unsuccessful in acquiring them either

because the price was too high or because they were already

committed before petitioner had the opportunity to make an offer.

During January 1986, Petitioner opened discussions relating

to the acquisition of Brock Exploration Co. (Brock Exploration),

an oil and gas company headquartered in New Orleans, Louisiana.

Brock Exploration was owned and operated by Lawrence E. Brock, a

longtime friend of Mr. Jackson. Negotiations with Brock

Exploration progressed through the summer and fall of 1986.

During that time, however, petitioner's acquisition efforts

continued.

During March 1986, Messrs. Billings and Wagner met on a

number of occasions with representatives from Kennedy & Mitchell
 - 14 -

(KM), an oil and gas company located in Lakewood, Colorado.

Petitioner pursued the acquisition and investigated KM's

reserves. In investigating the reserves, petitioner analyzed the

report prepared by KM's reserve engineers without investing the

time and expense of commissioning a new reserve report from a new

petroleum engineering firm. Petitioner's board, at its March 7,

1986, meeting, discussed and authorized an offer for the KM

properties located in the States of Oklahoma and Texas at a price

not to exceed $10.6 million. The price proposed by petitioner

for the KM properties was not acceptable to the seller, and the

acquisition failed. At petitioner's next board meeting on May 8,

1986, Mr. Billings reported on the failure to make the authorized

acquisition and the ongoing search for an oil and gas acquisition

within the limitations set by the board:

Mr. Billings advised that the Company had been
unsuccessful in acquiring those properties which had
been shown to the Board of Directors at the last
regular meeting. Although there is no current follow-
up activity on that prospect, Mr. Billings advised that
the properties may remain available for purchase, and
that, at a later date in 1986, the party owning those
properties may be more inclined to sell them.
Otherwise, Mr. Billings advised that the Company
continues to look for an attractive acquisition within
the parameter earlier defined for the Board.
Currently, there are no candidates for acquisition
which are appropriate to bring before the Board.
[Emphasis added.]

During petitioner's discussions with Mr. Brock concerning

Brock Exploration, Mr. Brock identified several other acquisition
 - 15 -

opportunities. One of those was Equitable Oil, a potential

acquisition target that had also been recommended to petitioner

by its investment banking firm, Kidder Peabody. During June

1986, Mr. Jackson traveled to New York to meet with Equitable

Oil's management. Consideration of the acquisition of Equitable

Oil, however, was deferred until the conclusion of the Brock

Exploration deal.

At the August 8-9, 1986, meeting of petitioner's board, Mr.

Billings reported on petitioner's ongoing acquisition efforts,

including two specific targets:

Mr. Billings reviewed the status of acquisition
activities including a general description of two
potential acquisition candidates that are currently
being evaluated by the Company's staff and outside
consultants. Mr. Billings indicated that because the
process of gathering information on these acquisition
candidates had not been completed, no specific
proposals would be brought before the Board at this
time. Mr. Billings indicated, however, that a
recommendation with respect to at least one candidate
should be finalized in the next few weeks.

Sometime during the summer of 1986, as negotiations with

Brock Exploration continued, petitioner commissioned an

independent petroleum engineering firm to prepare a reserve

report relating to Brock Exploration's reserves. Mr. Jackson

directed petitioner to engage an independent reserve study for

the Brock Exploration acquisition because he wanted to avoid any

appearance that his longtime friendship with Mr. Brock, the owner

of Brock Exploration, influenced the transaction. On September
 - 16 -

9, 1986, petitioner's management team recommended to its board

that an offer be made to acquire Brock Exploration in exchange

for common stock of petitioner. By resolution dated September 9,

1986, petitioner's board authorized an offer of petitioner's

common stock having a fair market value between $7 million and

$10 million in exchange for 100 percent of Brock Exploration.

Although Brock Exploration had net operating losses (NOL's),

petitioner's offer did not include consideration for those

losses. On September 16, 1986, Messrs. Jackson, Billings, and

Reed met in New Orleans, Louisiana, with Mr. Brock to discuss

petitioner's offer to acquire Brock Exploration. Petitioner's

offer was rejected, and the Brock Exploration deal died.

When the Brock Exploration acquisition fell through, Mr.

Jackson reopened communications with Equitable Oil. Discussions

with Equitable Oil soon terminated, however, because it became

apparent that petitioner could not offer enough to make the deal

work.

During November 1986, prior to its acquisition of Tri-Power,

petitioner's acquisition efforts were wholly unsuccessful.

3. Plans To Adopt a Holding Company Structure

It is common for publicly owned oil and gas companies to

operate using a holding company structure (i.e., a parent company

with an operating subsidiary). Shortly after its organization,

petitioner's management team began considering the idea of
 - 17 -

adopting a holding company structure for petitioner. By the

summer of 1986, management concluded that a holding company

structure would be the best structure for petitioner because it

would offer petitioner greater flexibility in making acquisitions

and in addressing shareholders and others with hostile

intentions. Petitioner initially contemplated using one

operating subsidiary. Petitioner contemplated that the Brock

Exploration acquisition would be the vehicle for establishing the

preferred holding company structure. Mr. Brock was interested in

a stock transaction, the result of which would have been that

Brock Exploration would have become a wholly owned subsidiary of

petitioner, facilitating management's plan to adopt a holding

company structure.

As the Brock Exploration transaction progressed into the

summer of 1986, Mr. Jackson asked Paul Hocevar of Arthur Andersen

& Co. (Arthur Andersen) to determine the tax consequences to

petitioner if it transferred its oil and gas properties to a

subsidiary. By memorandum dated June 25, 1986, Arthur

Andersen transmitted a "discussion draft" memorandum that

concluded favorable tax consequences would flow if petitioner

formed a subsidiary and made an installment sale of its assets to

the subsidiary. Arthur Andersen suggested this plan partially in

response to management's concern about the possibility of a

hostile takeover attempt. It was believed that the installment
 - 18 -

sale would have the effect of a poison pill to a hostile

bidder.14 The plan had no adverse tax consequences to

petitioner. Rather, in addition to creating a poison pill, the

plan offered certain tax advantages.15 Petitioner obtained

authorization to sell its assets to a newly formed subsidiary

from the board at its August 1986 meeting. Petitioner, however,

never implemented that plan.

14
Arthur Andersen believed that the installment sale would act
as a poison pill because acquisition of petitioner's stock by a
hostile bidder would, if the hostile bidder made a sec. 338
election, trigger recognition of the unrecognized gain from the
installment sale. The resulting tax would effectively increase
the cost to a potential hostile bidder trying to acquire
petitioner. In the absence of a sec. 338 election, the hostile
bidder would derive no additional depletable tax basis in the gas
reserves and would have little cost depletion in the future to
offset the significant gas revenues that would be received.
15
According to the Arthur Andersen memorandum, the plan would
yield an 18-percent after-tax benefit to petitioner.
 - 19 -

4. Market Conditions During 1986

During 1986, oil and gas prices were on the decline.16 At

the same time, the cost of drilling for oil and gas was on the

rise. As a result, many oil and gas companies cut back their

16
The posted per-barrel price for West Texas Intermediate
Crude as of the beginning of each month during 1986 was as
follows:

Month Price

Jan. $25.00
Feb. 23.00
Mar. 18.75
Apr. 15.00
May 13.25
June 14.00
July 14.00
Aug. 12.25
Sept. 14.25
Oct. 14.25
Nov. 14.25
Dec. 14.25

The posted per-Mcf price for gas as of the beginning of each
month during 1986 was as follows:

Month Price

Jan. $2.00-2.25
Feb. 1.90-2.20
Mar. 1.80-2.15
Apr. 1.55-1.95
May 1.35-1.70
June 1.35-1.50
July 1.35-1.55
Aug. 1.40-1.55
Sept. 1.35-1.50
Oct. 1.25-1.45
Nov. 1.30-1.50
Dec. 1.35-1.50
 - 20 -

exploration and development activities. These two factors,

declining prices and rising costs, combined to produce a highly

competitive market for the acquisition of developed oil and gas

reserves.

During 1986, Strevig & Associates (Strevig) was the leading

publisher of oil and gas transactional data. Strevig tracks oil

and gas acquisitions, collecting all the available published

information on completed transactions. Upon confirmation of the

data from both the buyer and the seller, Strevig publishes a

quarterly report showing the median price per barrel of oil

equivalent (price/BOE) paid by buyers in those transactions

reported.

Gas reserves are converted to equivalent barrels of oil to

provide a common unit of comparison when there is a mixture of

oil and gas reserves. The standard conversion ratio is 6000

cubic feet (cf) of gas to 1 barrel of oil.17 The price/BOE is

determined by dividing the purchase price by the number of BOE

acquired.

17
We note that the same conversion ratio is used in the Code.
Sec. 613A(c)(4) equates 6,000 cubic feet (cf) of gas with 1
barrel of oil for purposes of computing the taxpayer's daily
depletable natural gas quantity, which in turn is used in the
computation of the taxpayer's allowance for depletion pursuant to
secs. 611 and 613.
 - 21 -

Strevig's quarterly reserve report for the fourth quarter of

1986 reports the following median price/BOE paid by buyers in

those transactions followed by Strevig during 1986:

Number
of
Quarter $/BOE Transactions

First $5.41 37
Second 5.00 23
Third 5.33 33
Fourth 6.45 55

Petitioner's acquisition of Tri-Power was among the 55

transactions reported by Strevig for the fourth quarter of 1986.

As reserve estimates are updated, Strevig revises its

price/BOE computations and publishes those results. During

February 1990, Strevig reported the following revised price/BOE

figures for those transactions followed by Strevig during 1986:

Number
of
Quarter $/BOE Transactions

First $5.41 37
Second 4.97 23
Third 4.41 33
Fourth 5.18 55

B. Tri-Power

Tri-Power, prior to November 18, 1986, was a wholly owned

subsidiary of Tri-Power Petroleum Corp. (TPC), a publicly traded

Canadian corporation. Tri-Power owed, as of November 18, 1986, a

total of $10 million ($5 million each) to the Toronto-Dominion

Bank New York Branch and the Canadian Imperial Bank of Commerce
 - 22 -

(the banks). Tri-Power also owed $46.5 million to its parent,

TPC.

On November 18, 1986, pursuant to a Plan of

Recapitalization, Tri-Power underwent a debt restructuring.

Pursuant to the plan, Tri-Power issued 46,250 shares of preferred

stock having a par value of $100 per share to each of the two

banks in full satisfaction of Tri-Power's indebtedness to the

banks. Also pursuant to the plan, Tri-Power issued 5,000 shares

of preferred stock having a par value of $100 per share to TPC in

full satisfaction of its intercompany debt to TPC. Accordingly,

when petitioner acquired Tri-Power on November, 21, 1986, TPC

owned 100 percent of Tri-Power's common stock and 5,000 shares of

its preferred stock. Tri-Power's remaining shares of preferred

stock were owned by the banks.

Tri-Power's principal place of business was in Houston,

Texas, and its properties were located primarily in Texas and

Wyoming. At the time of its acquisition by petitioner, Tri-Power

owned seven groups of properties, six of which were acquired by

way of merger (the properties owned by Tri-Power, and acquired by

petitioner, will be referred to as the Tri-Power properties).

Tri-Power's NOL's by that time were $84,817,122.

During 1986, Tri-Power began seeking investors to help

develop seven different prospects in various locations throughout

the Rocky Mountains, the Permian Basin, and the Gulf Coast.
 - 23 -

Although it presented the investment package to numerous parties,

Tri-Power failed to attract any investors.18 Sometime during

July or August 1986, TPC decided sell Tri-Power in its entirety.

II. Petitioner's Acquisition of Tri-Power

A. TPC's Offer

Tri-Power first came to petitioner's attention about the

time that the Brock Exploration deal collapsed. Laura Dichter,

an independent oil and gas landman out of Denver, Colorado,

identified Tri-Power as a possible acquisition candidate for

petitioner. Sometime during early September 1986, Ms. Dichter

delivered to Mr. Reed, petitioner's vice president of finance, a

package of materials containing information about Tri-Power and

its properties. The package included the following: (1) A list

showing the average monthly production of Tri-Power's 79

producing wells for the first half of 1986, (2) excerpts from the

February 17, 1986, L.A. Martin & Associates, Inc. (LAM), "Reserve

Estimate and Economic Analysis" report, effective as of January

1, 1986 (the 1986 LAM reserve report), (3) LAM's updated

production history curves (through June 1986), (4) monthly

production statistics for each of Tri-Power's 79 wells from

inception to the most recent information then available, (5)

descriptions and locations for all of Tri-Power's leasehold

18
Although Tri-Power found no investors for its development
proposal, it did sell one minor property during that period.
 - 24 -

interests, both developed and undeveloped, (6) information

concerning 4 major leased, but undrilled, prospects in which Tri-

Power had an interest, (7) a list of Tri-Power's unleased,

geologically-geophysically defined prospects, and (8) schedules

showing Tri-Power's tax losses. Larry A. Martin, of LAM, was a

well-known petroleum engineer.

During October 1986, Mr. Billings contacted Dwight Cassell,

TPC's contact person with respect to the sale of its subsidiary,

Tri-Power. Mr. Cassell, a petroleum geologist, served as Tri-

Power's exploration manager. On October 2, 1986, following a

telephone conversation with Mr. Cassell earlier that day, Mr.

Billings wrote a letter to Mr. Cassell describing petitioner's

objectives and intentions as follows: "Plains is seeking a Gulf

Coast presence and hopes to seek property acquisitions from

there. It will probably explore in only modest amounts in the

current economic climate." By letter dated October 2, 1986, TPC

offered to sell two of its subsidiaries, Tri-Power and Bonanza

Petroleum, Inc. (Bonanza), to petitioner.

The assets of Tri-Power and * * * [Bonanza] are
being offered for sale. These assets include 100
percent of the stock of Tri-Power and Bonanza, which in
turn represents ownership in producing oil and gas
wells, non-producing prospective leaseholds, unleased
oil and gas prospects plus office equipment and
records. The data transmitted herewith provides the
basis for determining worth of both producing
properties and non-producing leaseholds that relate to
defined drillable prospects.
 - 25 -

Within the enclosed loose leaf volume is (1) a
listing of the 79 currently producing wells showing the
average monthly production for the first half of 1986
(2) * * * [Excerpts] from the L.A. Martin and
Associates, Inc., "Reserves Estimate and Economic
Analysis" report dated February 17, 1986. Martin's
production history curves have been updated through
June 1986. Also included with the Martin data are
monthly production statistics for each of the 79 wells
from inception to the most recent information
available. (3) Description and location for all of
Tri-Power's leasehold interest both developed and
undeveloped, and; (4) The final section deals with the
four major leased, undrilled prospects in which Tri-
Power has an interest and a listing of unleased,
geologically-geophysically defined prospects.

* * * * * * *

[Tri-Power] will sell all of its U.S. producing
properties for $10,500,000.00 with a minimum of
$500,000.00 to be paid in cash with assumption by Buyer
of * * * [Tri-Power's] $10,000,000.00 U.S. bank debt,
but reserving to * * * [TPC] a 20% net profit interest
in the properties on a project basis. This would
result in * * * [TPC] backing in for a 20% net profit
interest after Buyer recovers all of his costs out of
production from the sold properties.

Previously, on August 18, 1986, TPC had made a similar offer

to United Oil and Minerals. In both instances, TPC offered to

sell only the stock of Tri-Power, not its individual assets.

Shortly after TPC's offer to petitioner, on October 10,

1986, Bonanza merged into Tri-Power.

B. Petitioner's Examination of Tri-Power's Properties

Upon receiving the offer from TPC, petitioner's acquisition

team began investigating the Tri-Power properties. Petitioner's

acquisition team studied not only the 1986 LAM reserve report,
 - 26 -

effective as of January 1, 1986, but also the other information

provided in conjunction with TPC's offer.

Sometime during October 1986, petitioner engaged LAM, Tri-

Power's independent reserve engineer since at least 1985,19 to

update the 1986 LAM reserve report. Petitioner requested LAM to

roll forward its earlier projections to November 1, 1986, using

petitioner's oil and gas price forecast. The Society of

Petroleum Evaluation Engineers (SPEE) conducts an annual survey

of oil and gas price forecasts by producers, consultants, and

bankers. The SPEE survey published during July 1986 (1986 SPEE

survey) provides an accurate compilation of the responses to that

survey. The oil and gas price forecast provided by petitioner to

LAM for use in the rollforward was higher than the mean reported

by the 1986 SPEE survey (1986 SPEE mean), but within one standard

deviation of the 1986 SPEE mean.

Tri-Power provided its updated 1986 production data to both

petitioner and LAM. Accordingly, LAM had available its

production curves, updated through June 1986, and the production

data necessary to plot production curves through October 1986.

LAM's updated reserve report (the 1986 LAM updated reserve

report), however, did not incorporate any of the updated

19
The record indicates that LAM began work for Tri-Power's
predecessor during 1982. Aside from a reserve report dated Jan.
22, 1985, however, the record contains no evidence that LAM was
involved with the Tri-Power properties prior to 1985.
 - 27 -

production data from 1986. During 1986, some of the wells valued

in the 1986 LAM reserve report experienced improved performance,

and some experienced deteriorated performance.

The 1986 LAM updated reserve report, dated October 14, 1986,

estimated the discounted future net revenue from Tri-Power's

proved and producing reserves to be $19,114,541 as of November 1,

1986, using a 10-percent discount rate. In a schedule to the

1986 LAM updated reserve report, LAM also presented a range of

present worth estimates using different discount rates. LAM

estimated the present net worth of Tri-Power's proved and

producing reserves to be $14,447,362, using a 20-percent

before-tax discount rate. The 1986 LAM updated reserve report

indicated that the estimated future net revenues presented

therein were not to be construed as LAM's opinion of the fair

market value of the properties included in the report. Instead,

the report presented LAM's opinion of the future net revenue that

would be derived from the recovery of the estimated reserves

under the assumed timing and economic conditions.

The 1986 LAM updated reserve report estimated Tri-Power's

proved and producing reserves, as of November 1, 1986, to be as

follows:
 - 28 -

Oil Gas
MBBL1 MMCF2

Gross reserves 2264.159 51521.452
Net reserves 404.925 10136.649
1
MBBL is the abbreviation for 1,000 barrels of crude oil
or liquid petroleum products.
2
MMCF is the abbreviation for 1 million cf of gas.

At the standard conversion ratio of 6,000 cf of gas to 1 barrel

of oil, these reserves translate into 2.1 million BOE

(rounded).20 The 1986 LAM updated reserve report indicated that

several of the wells evaluated in the report had a "relatively

short or no production history and therefore production

extrapolations are subject to a higher degree of inaccuracy."

LAM made available to petitioner, for inspection and review,

the data underlying both the 1986 LAM reserve report and the 1986

LAM updated reserve report. Much of the data underlying LAM's

1986 reserve reports is no longer available.

As part of petitioner's investigation into Tri-Power,

Messrs. Billings and Wagner traveled to Houston on at least two

occasions to interview Tri-Power's personnel and evaluate the

20
The barrel of oil equivalent (BOE), on the basis of the
reserves reflected in the 1986 LAM updated reserve report, is
computed as follows:

Oil BBL 404,925.0
Gas BOE
10,136,649,000 cf
6000 cf = 1,689,441.5

Total BOE 2,094,366.5
 - 29 -

Tri-Power properties. During these visits, Mr. Billings and Mr.

Cassell reviewed, in detail, the geological and seismic data

relating to the Tri-Power reserves and the 1986 LAM reserve

report. Mr. Cassell was candid with Mr. Billings and Mr. Wagner,

disclosing Tri-Power's strengths as well as its weaknesses. In

addition, Mr. Billings visited the LAM offices, where he reviewed

the Tri-Power properties with Mr. Martin.

Petitioner's policy was to use its in-house personnel to

evaluate prospective properties, and during its investigation of

the Tri-Power properties, petitioner's acquisition team consulted

petitioner's in-house petroleum engineers and geologists. In-

house personnel also conducted title and lease reviews. Messrs.

Wagner and Miller reviewed Tri-Power's contracts for the purchase

and sale of its oil and natural gas production. Mr. Wagner also

took the lead investigating those Tri-Power properties with which

he had prior experience, including the Meeteetse field located in

Wyoming's Big Horn Basin. In connection with that investigation,

Mr. Wagner reviewed Tri-Power's land files and met with Tri-

Power's landman, Paul Vandergriff.

In addition to its in-house review, petitioner engaged

Gerald Swonke, an oil and gas attorney from Houston, Texas, to

review Tri-Power's major producing properties. Mr. Swonke's

investigation included, inter alia, a review of Tri-Power's
 - 30 -

leases and an examination to confirm that Tri-Power held good

title to its properties.

Petitioner concluded from its investigation of the Tri-Power

properties that the 1986 LAM reserve report undervalued certain

properties and overvalued others. In particular, petitioner's

acquisition team believed that the 1986 LAM reserve report

underestimated Tri-Power's reserves located in the Meeteetse and

Hough fields and that it overestimated the value of Tri-Power's

reserves located in a Texas field known as South Atlanta. With

respect to the Meeteetse field, Mr. Wagner discovered at least

two promising wells that had been excluded from the 1986 LAM

reserve report. Discussions with Mr. Cassell also revealed that

a well owned and operated by Tri-Power in the Hough field,

located in Mississippi, was producing at a rate 10 times greater

than had previously been projected for that well. Mr. Billings

discovered, also through discussions with Mr. Cassell, that the

Tri-Power properties located in the South Atlanta field were

troubled. South Atlanta produced "sour gas",21 and one of Tri-

Power's two South Atlanta wells suffered from mechanical problems

that severely limited its production. On the whole, however,

petitioner's management found the 1986 LAM reserve report to be a

reliable estimate of Tri-Power's reserves.

21
"Sour gas" contains large amounts of hydrogen sulfide.
 - 31 -

C. Petitioner's Examination of Tri-Power's NOL's and
Financial Condition

Petitioner first became aware of Tri-Power's NOL's when it

received the sales package from Ms. Dichter. Sometime during

early October 1986, petitioner engaged Arthur Andersen to review

Tri-Power's tax returns and to verify Tri-Power's NOL's.

In a letter dated October 22, 1986, Arthur Andersen

communicated to petitioner the results of its investigation up to

that point. In that letter, Arthur Andersen indicated that it

had reviewed (1) the tax returns and related workpapers of Tri-

Power and its predecessors for the years 1976 through 1985,

representing $65.9 million of the total NOL's of $84 million, (2)

tax returns representing 94 percent of the total loss

carryforward, and (3) the various acquisitions and

reorganizations that resulted in the formation of Tri-Power.

Arthur Andersen opined that the Federal income tax returns it

reviewed were prepared in accordance with Federal tax law. In

reviewing the tax returns of Tri-Power and its predecessors,

Arthur Andersen identified several issues that it believed needed

to be addressed before the acquisition became final. Arthur

Andersen, in the October 22, 1986, letter, recommended that

petitioner obtain, before closing on the acquisition of Tri-

Power, tax opinions concerning (1) the tax consequences of the

various acquisitions and reorganizations of Tri-Power's
 - 32 -

predecessors, (2) the application of sections 382 and 269 to

petitioner's acquisition of Tri-Power, and (3) the tax

consequences of Tri-Power's recapitalization.

By letter dated November 17, 1986, Arthur Andersen issued

its opinion concerning the issues earlier identified for

resolution in the October 22, 1986, letter. In rendering its

opinion, Arthur Andersen obtained the opinion of Chamberlain,

Hrdlicka, White, Johnson & Williams (Chamberlain), Tri-Power's

counsel, on certain issues. On the basis of its review of

Chamberlain's opinion and petitioner's representations,22 Arthur

Andersen issued a favorable opinion relating to the acquisition

of Tri-Power, its prior activities, and the future use of its

NOL's.23

During the weeks leading up to the acquisition, petitioner's

management had regular discussions with Arthur Andersen

concerning its investigation of Tri-Power and its NOL's.

Finally, sometime prior to the November 1986 acquisition of Tri-

22
Petitioner represented to Arthur Andersen that its principal
purposes for acquiring Tri-Power were to diversify geographically
its oil and gas operations, enter a new market area, create a
holding company structure, and acquire oil and gas reserves and
leases at an attractive price.
23
Accompanying that opinion was a copy of the Chamberlain
opinion, concerning the tax consequences of various acquisitions
and reorganizations of Tri-Power's predecessors, reviewed by
Arthur Andersen; and three internal memoranda concerning the
remaining issues addressed by Arthur Andersen.
 - 33 -

Power, Arthur Andersen made a presentation to petitioner's

management concerning the potential use of Tri-Power's NOL

carryforwards. The potential use of Tri-Power's NOL

carryforwards was also discussed, on at least one occasion, by

petitioner's board. Petitioner's management was aware that

unless the acquisition was made before the end of 1986, pending

legislation, amending section 382, would limit petitioner's

ability to use the NOL's of an acquired corporation.

Sometime during October 1986, Messrs. Billings and Reed

traveled to Canada to meet with TPC's representatives. During

that trip, Wes Ismond, TPC's vice president of finance, revealed

that Tri-Power owed $10 million to the banks, and that the banks

were putting pressure on Tri-Power. On the return trip, Mr. Reed

discovered, while reviewing Tri-Power's balance sheet, the $46.5

million intercompany debt that Tri-Power owed to TPC.

Uncomfortable acquiring Tri-Power with its debt position, Mr.

Reed consulted with Arthur Andersen, which later recommended a

put option.

Subsequently, on November 18, 1986, Tri-Power underwent a

recapitalization, discussed supra, pursuant to which Tri-Power's

debts to the banks and to TPC were eliminated in exchange for the

issuance of Tri-Power preferred stock. The next day, as

discussed infra, petitioner, TPC, Tri-Power, Bonanza, and the

banks entered into a "Stock Purchase and Put Option Agreement",
 - 34 -

pursuant to which petitioner purchased all of the common and

preferred stock of Tri-Power from TPC and the banks.

D. The Acquisition

At a special meeting of the board, held on October 16, 1986,

petitioner's management presented the Tri-Power acquisition for

consideration by the board. Management explained that while its

investigation into Tri-Power was ongoing, on the basis of the

information then developed, management recommended that the board

authorize the acquisition of Tri-Power because the acquisition

satisfied all of petitioner's acquisition limitations.

Specifically, Tri-Power possessed oil and gas reserves located

primarily in Texas and Wyoming. Accordingly, the acquisition of

Tri-Power presented petitioner with the opportunity to expand

outside the Hugoton field and establish a Gulf Coast presence.

Further, the acquisition of Tri-Power presented petitioner with

the opportunity to expand its product base with oil reserves, as

well as to make contacts with new markets for natural gas

production. Finally, TPC's asking price, $10.5 million, fit

petitioner's budget and size limitations. Management also

explained that the proposed acquisition would be a purchase of

all the outstanding capital stock of Tri-Power, and that if

successful, petitioner would maintain the Tri-Power corporate

entity as its wholly owned subsidiary. After an extended

discussion, petitioner's board resolved:
 - 35 -

if further investigation and analysis verifies * * *
[that] the data and projections respecting Tri-Power
meet those expectations outlined to the Directors in
this meeting, the officers of the Company are
authorized to make a bid not to exceed ten and one half
million dollars ($10,500,000) for all the capital stock
of * * * [Tri-Power].

Petitioner's board rejected TPC's proposed retention of a

20-percent net profits interest.

On October 22, 1986, 8 days after the issuance of the 1986

LAM updated reserve report, petitioner issued a letter of intent

to enter into a definitive agreement to purchase 100 percent of

the stock of Tri-Power for $9.75 million. Petitioner conditioned

the acquisition on, inter alia, the receipt of a favorable

opinion from its tax adviser. The letter of intent states as

follows:

Plains will not consummate the transaction contemplated
hereby until it receives an opinion letter from its tax
advisor * * * stating the Plains' tax advisor has reviewed
all tax information relevant to the business of Tri-Power
and Tri-Power's predecessors, that the tax returns and data
supporting those returns are accurate, complete and
verifiable as such and that in such advisor's opinion
Plains' acquisition of Tri-Power as provided for in the
definitive Agreement should achieve the tax consequences
intended by the parties thereto.

Petitioner further conditioned the acquisition on the receipt of

an opinion from Tri-Power's tax counsel, in a form satisfactory

to petitioner, that (1) Tri-Power and its predecessors had filed

timely all tax returns required by Federal, State, county and

local taxing authorities, (2) the information contained in those
 - 36 -

returns was complete and accurate in all respects, and (3) that

Tri-Power had paid all the taxes it was obligated to pay. The

letter of intent contained no provision conditioning the

acquisition on the receipt of a favorable opinion concerning Tri-

Power's reserves. The letter of intent, however, did require

Tri-Power to represent that it had no information or reason to

dispute, in the aggregate, the accuracy of LAM's reserve

estimates. In a letter dated October 27, 1986, Tri-Power refused

to make the requested representation, stating that "we have

provided engineering reports to you for your information,

however, you must satisfy yourself as to their adequacy for your

purposes."

At its regular quarterly meeting on November 6, 1986,

petitioner's board authorized the acquisition of Tri-Power.

Petitioner's board also authorized the transfer of petitioner's

existing oil and gas properties to Tri-Power.

On November 14, 1986, petitioner issued a second letter of

intent to acquire the stock of Tri-Power. The second letter of

intent also conditioned the acquisition on petitioner's receipt

of an opinion from its tax advisers.

On November 17, 1986, Arthur Andersen issued a favorable tax

opinion, discussed supra, relating to the acquisition of Tri-

Power, its prior activities, and the future use of its NOL's.
 - 37 -

On November 19, 1986, petitioner, TPC, Tri-Power, Bonanza,24

and the banks entered into a "Stock Purchase and Put Option

Agreement". Petitioner granted each of the banks a put option

pursuant to which each bank could, at its option, sell to

petitioner 46,250 shares of Tri-Power preferred stock at a price

of $100 per share.25 Pursuant to the stock purchase agreement,

petitioner purchased all of the capital stock of Tri-Power by

paying (1) $549,08926 to TPC and (2) $9.25 million ($4.625

million each) to the two banks. The parties to the stock

purchase agreement closed the transaction on November 21, 1986,

and, on that date, petitioner and Tri-Power became members of an

affiliated group.

The total proved, developed, and producing reserves that

petitioner acquired from Tri-Power were less than the net

reserves of several single wells that petitioner already owned.

Nonetheless, the acquisition of Tri-Power replaced approximately

50 percent of petitioner's 1986 production. Through the

24
As discussed supra, Bonanza was merged into Tri-Power on
Oct. 10, 1986. Accordingly, it is unclear why Bonanza was a
separate party to this agreement.
25
Pursuant to the agreement, each put option was to terminate
if not validly exercised on or before Nov. 24, 1986.
26
The parties stipulated that petitioner paid TPC $500,000
plus the amount of Tri-Power's adjusted net working capital of
$235,367 less a postclosing adjustment of $186,279, for a total
of $549,089.
 - 38 -

acquisition of Tri-Power, petitioner also acquired interests in

nonproducing prospective leaseholds, undeveloped acreage, and

Tri-Power's records concerning the acquired properties.

E. Public Announcements Concerning the Acquisition

In a letter to the shareholders dated November 15, 1986, Mr.

Jackson announced that petitioner had signed a letter of intent

to acquire the stock of Tri-Power. In that letter, Mr. Jackson

reported that Tri-Power owned proved and producing reserves,

estimated by independent engineers to be 10.1 billion cf of gas

and 404,925 barrels of oil. In addition, Mr. Jackson indicated

that Tri-Power had certain tax loss carryforwards available from

prior operations. Petitioner again announced the pending

acquisition in a press release issued on November 18, 1986.

Finally, petitioner reported the acquisition agreement in its

September 30, 1986, Form 10-Q filed with the Securities and

Exchange Commission during November 1986. The press release and

Form 10-Q each contained substantially the same information as

Mr. Jackson's November 15, 1986, letter to the shareholders.

Petitioner's 1986 annual report announced the completed

acquisition of Tri-Power for $9.75 million, the estimated

quantity of reserves acquired, and the fact that Tri-Power had

certain loss carryforwards available from prior operations.

Among the favorable developments for 1986, the 1986 annual report

recited petitioner's expectation of "lower income taxes for the
 - 39 -

future". The notes to the financial statements explained that,

as a result of the acquisition of Tri-Power, petitioner gained

access to "substantial tax loss carryforwards which are available

to reduce future income taxes." The 1986 annual report also

reiterated petitioner's continued commitment to its acquisition

program.

III. Petitioner's Operations After the Acquisition

A. Transfer of Petitioner's Oil and Gas Properties to
Tri-Power

On December 1, 1986, Tri-Power's name was changed to Plains

Petroleum Operating Co. (to avoid confusion, however, we will

continue to refer to Plains Petroleum Operating Co. as Tri-

Power). Also on December 1, 1986, petitioner transferred all of

its oil and gas properties to Tri-Power (the December 1, 1986,

property transfer will sometimes be referred to as the dropdown

and the properties transferred will be referred to as the

dropdown properties).27 Petitioner intended to maintain Tri-

Power as a wholly owned subsidiary, and the dropdown was an

integral part of petitioner's plan to acquire Tri-Power.

For each of the years 1987 through 1996, the Tri-Power

properties produced oil and gas amounting to approximately 5

percent of the production from the dropdown properties during

27
Petitioner used only one operating subsidiary, Tri-Power,
until 1992, when it organized Plains Petroleum Gathering Co.
 - 40 -

that same period. The Tri-Power properties generated a total net

cash-flow in the amount of $6,819,185 during the period 1987

through 1997.

B. Pursuit of the Tri-Power Properties

After the acquisition, petitioner continued to market

production from its preacquisition properties primarily to KN

Energy. As management continued to evaluate the Tri-Power

properties, petitioner divested itself of certain properties and

pursued others.

Upon acquisition of Tri-Power, petitioner inventoried the

acquired properties and identified certain properties for

disposal. On the basis of past experience, petitioner's

management was not interested in retaining the Tri-Power

properties located in California, Kentucky, and Pennsylvania.

Additionally, petitioner decided not to pursue development of

certain Tri-Power properties located in the Northern Rocky

Mountains, an area with geologic faults that is difficult to

explore.

Petitioner pursued development of the Tri-Power properties

located in the Meeteetse field. Petitioner sought and acquired

the right to operate the Meeteetse wells, giving it the power to

control both the costs and the timing of work done on the

property. Additionally, petitioner successfully pursued and

acquired additional working interests in the Meeteetse field.
 - 41 -

The Meeteetse wells were experiencing problems: they were not

flowing regularly, and there were problems transporting the

production from the field to the market. Accordingly, petitioner

took steps to improve its production in the Meeteetse field by

increasing the field compression to allow the gathering system to

take more gas through the transmission line that took it to

market. Petitioner made arrangements with the owner of the

gathering facility and a nearby market to sell its Meeteetse

production directly to that market. Petitioner also renegotiated

a new contract with Tennessee Gas Pipeline (a division of

Tenneco, Inc.) relating to the Meeteetse properties. Finally,

during 1995, petitioner drilled a new well in the Meeteetse

field.

Petitioner retained the Tri-Power properties located in the

Powder River Basin and acquired additional reserves in that

region. In addition petitioner acquired McAdams Roux, a high-

tech company, to assist in its exploration and development

efforts in that region. Petitioner also drilled a second well on

the Schoenfeld property, a Tri-Power property located in the

Deckers Prairie field. Finally, petitioner made efforts to

improve production in the troubled South Atlanta field.

Petitioner believed it could better produce and market the South

Atlanta production and attempted to takeover as the operator of

the South Atlanta wells. An audit ordered and paid for by
 - 42 -

petitioner and the other working interest owners revealed that

the incumbent South Atlanta operator, Strago, had an undisclosed

interest in the "sweetening" plant that removed the sulfur from

the gas. Petitioner looked for alternative sweetening plants and

unsuccessfully tried to take over as the operator. Petitioner

ultimately sold its interests in the South Atlanta field during

1992.

Through the years petitioner divested other properties as

well. By the end of 1995, petitioner sold or abandoned many of

the wells acquired in the Tri-Power acquisition.

C. Continued Acquisition Efforts

During the years subsequent to the Tri-Power acquisition,

petitioner continued its acquisition program. During the period

from 1988 to 1994, petitioner added and replaced reserves through

the acquisition of over 17 oil and gas companies.28

28
Petitioner's acquisitions included the following:

Year Reserves Acquisition
Acquired Name Location Acquired Price

1988 Alpar Oil Texas Panhandle Oil & Gas $6,000,000
Midlands Resources West Texas Oil & Gas 15,700,000
Miscellaneous Meeteetse/Wyoming Gas 694,118
Wedge Oil & Gas West Texas Oil & Gas 2,500,000

(continued...)
 - 43 -

D. Petitioner's Use of the Tri-Power NOL's

Following the December 1, 1986, dropdown, petitioners

applied Tri-Power's NOL's against the income of the dropdown

properties. For the years 1986 through 1990, petitioners

reported taxable income, before taking into consideration any NOL

deductions, and NOL deductions as follows:

Year Taxable Income NOL Deductions

1986 $2,015,639 $457,733
1987 4,144,056 4,144,056
1988 8,399,084 8,399,084
1989 10,770,299 10,770,299
1990 12,640,852 12,640,852

During the years in issue, petitioners deducted over $18 million

of the Tri-Power NOL's. Petitioner, as a result of the NOL

28
(...continued)
Year Reserves Acquisition
Acquired Name Location Acquired Price

1990 Devon Oil Meeteetse/Wyoming Unknown 436,417
McAdams, Roux & Wyoming Oil & Gas 7,100,000
Associates
Morgan Energy West Texas Gas 2,500,000
Partners
Murphy Oil New Mexico Oil 2,250,000
Permian Minerals/ West Texas Oil & Gas 9,200,000
Michael Cass

1991 Arch Petroleum West Texas Gas $17,300,000
Michael Cass West Texas Oil 1,500,000

1992 ARCO Wyoming Gas 10,000,000
Phillips Petroleum Wyoming Unknown 635,000

1993 Miscellaneous Various locations Oil & Gas 1,600,000

1994 Anadarko Petroleum Utah, Wyoming Oil & Gas 24,300,000
Ensign Oil & Gas Wyoming Gas 1,850,000
Raydon Exploration Oklahoma Gas 1,825,000

105,390,535
 - 44 -

carryforwards in issue, paid no regular Federal income tax during

the period 1987 to 1993.

Respondent disallowed petitioner's deductions for the Tri-

Power NOL carryforwards on the ground that the principal purpose

for petitioner's acquisition of Tri-Power and subsequent dropdown

of its oil and gas producing properties to Tri-Power was the

evasion or avoidance of Federal income tax.

IV. Petitioners' Return Preparation and Tax Advice From Arthur
Andersen

From petitioners' inception through the years in issue,

Arthur Andersen audited petitioners, certified their financial

statements, and prepared their Federal corporate income tax

returns. Petitioners selected Arthur Andersen because it

performed similar services for petitioner's former parent, KN

Energy, and because it represents more independent oil and gas

companies than any other accounting firm. During 1991, 1992, and

1993, petitioners' lacked the available accounting staff needed

to assist in the preparation of their Federal corporate income

tax returns because of commitments created by several

acquisitions. Accordingly, petitioners engaged a certified

public accountant (C.P.A.) in Denver, Colorado, to assist

petitioners' controller in preparing certain schedules and

workpapers for review by Arthur Andersen. Petitioners provided

those schedules and workpapers to Arthur Andersen for use in
 - 45 -

preparing their Federal corporate income tax returns. Arthur

Andersen had access to all of petitioners' books and records.

Petitioner also relied on Arthur Andersen for tax advice in

connection with the acquisition of Tri-Power, including the

proper treatment of the NOL's in issue in the instant case. As

discussed supra, Arthur Andersen conducted an extensive

investigation into the tax issues surrounding the acquisition,

and based, in part, on petitioner's representations29 issued an

opinion concerning the proper tax treatment.

OPINION

I. Principal Purpose for the Acquisition and Dropdown

The first issue we must decide is whether petitioner is

entitled to carry over and deduct the NOL's incurred by Tri-Power

before the acquisition and dropdown. Respondent contends that

petitioner is not entitled to the benefit of the NOL deductions

because petitioner's principal purpose for the acquisition and

subsequent dropdown was the evasion or avoidance of Federal

income tax. Petitioner contends that the acquisition and

subsequent dropdown were not occasioned primarily by the desire

to obtain tax losses but, instead, by business considerations.

Section 269(a) provides that if a corporation (or, in

certain situations, its property) is acquired for the principal

29
See supra note 22.
 - 46 -

purpose of evading or avoiding Federal income tax by securing the

benefit of deductions, credits, or other allowances that the

acquiring person or corporation would not otherwise enjoy, the

Secretary may disallow such deductions, credits or other

allowances.30 Accordingly, section 269(a) is not applicable31

30
Sec. 269(a) provides, in part, as follows:

SEC. 269(a). In General.--If--

(1) any person or persons acquire, or acquired on
or after October 8, 1940, directly or indirectly,
control of a corporation, or

(2) any corporation acquires, or acquired on or
after October 8, 1940, directly or indirectly, property
of another corporation, not controlled, directly or
indirectly, immediately before such acquisition, by
such acquiring corporation or its stockholders, the
basis of which property, in the hands of the acquiring
corporation, is determined by reference to the basis in
the hands of the transferor corporation,

and the principal purpose for which such acquisition was
made is evasion or avoidance of Federal income tax by
securing the benefit of a deduction, credit, or other
allowance which such person or corporation would not
otherwise enjoy, then the Secretary may disallow such
deduction, credit, or other allowance. * * *
31
The instant controversy has its origin in petitioner's
acquisition of Tri-Power and the subsequent dropdown. The
parties dispute whether sec. 269(a)(2) can separately apply to
the dropdown. We conclude that it is unnecessary to address the
dropdown dispute because, as discussed supra in our findings of
fact, we found that the dropdown was an integral part of
petitioner's plan to acquire Tri-Power. Accordingly, we shall
look to the purposes of the overall plan of acquisition to decide
whether the principal purpose for the acquisition and dropdown
was tax avoidance. See, e.g., Key Buick Co. v. Commissioner,
T.C. Memo. 1976-303 (where the issue of whether the transactions
(continued...)
 - 47 -

unless the tax evasion or avoidance motive is the principal

purpose for the acquisition. See sec. 269(a). In the context of

section 269, "principal purpose" means that the evasion or

avoidance purpose must outrank, or exceed in importance, any

other purpose. See Capri, Inc. v. Commissioner, 65 T.C. 162, 178

(1975); D'Arcy-MacManus & Masius, Inc. v. Commissioner, 63 T.C.

440, 449 (1975); S. Rept. 627, 78th Cong., 1st Sess. (1943), 1944

C.B. 973, 1017. Petitioners bear the burden of proof.32 See

Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933). To

prevail, petitioners need prove only that the avoidance of tax

was not the principal purpose. See Capri, Inc. v. Commissioner,

supra at 178.

The resolution of the dispute concerning the purpose of the

acquisition presents a question of fact which must be resolved by

considering all of the facts and circumstances of the entire

transaction. See Capri, Inc. v. Commissioner, supra at 178;

31
(...continued)
were an integral plan and the determination of whether the
principal purpose of the transactions was tax avoidance were
inseparable).
32
Internal Revenue Service Restructuring & Reform Act of 1998
(RRA), Pub. L. 105-206, sec. 3001, 112 Stat. 685, 726-727, added
sec. 7491, which shifts the burden of proof to the Secretary in
certain circumstances. Sec. 7491 is applicable to "court
proceedings arising in connection with examinations commencing
after the date of the enactment of this Act." RRA sec. 3001(c).
RRA was enacted on July 22, 1998. Accordingly, sec. 7491 is
inapplicable to the instant case.
 - 48 -

D'Arcy-MacManus & Masius, Inc. v. Commissioner, supra at 449;

sec. 1.269-3(a), Income Tax Regs. We must look to the intent or

purpose of the acquiring person or corporation at the time of the

acquisition. See Southern Dredging Corp. v. Commissioner, 54

T.C. 705, 718 (1970). As the acquisition and dropdown were

integral steps in petitioner's plan to acquire Tri-Power, we

shall consider the overall plan of acquisition to determine

whether tax avoidance was the primary purpose.

Business Considerations

Petitioner contends that it acquired Tri-Power principally

to replace its reserves and diversify its operations; that it

transferred its oil and gas properties to Tri-Power principally

to aid its business operations and acquisition efforts; and that

the acquisition of Tri-Power and subsequent transfer of its oil

and gas properties to Tri-Power were motivated principally by

business considerations.

Respondent does not challenge petitioner's need for

diversification but contends that petitioner greatly exaggerates

the need for replacement reserves during 1986. Respondent points

out that during 1986 petitioner's gas reserves were projected to

last for approximately 25 years and that, as a result of the KCC

infill drilling order, petitioner expected to increase its proven

natural gas reserves by approximately 31 percent. Accordingly,

respondent contends that petitioner had no immediate need for
 - 49 -

replacement reserves. Additionally, respondent contends that the

acquisition of Tri-Power did not significantly add to

petitioner's reserve base because the total reserves acquired

amounted to less than the reserves of several single wells

already owned by petitioner.

We disagree with respondent's contentions. Notwithstanding

its existing supply of gas reserves at the time of the

acquisition of Tri-Power, petitioner needed to continue the

growth of its reserve base. Several witnesses testified that

reserve growth is necessary for survival in the oil and gas

business: oil and gas companies must replace diminishing

reserves; otherwise they simply produce themselves out of

business. Additionally, although the KCC infill drilling order

allowed petitioner to increase its gas reserves, it did nothing

to diversify petitioner's production mix. Petitioner still

needed oil reserves. Finally, although Tri-Power's reserves were

small in comparison to petitioner's existing reserves, the

acquisition was wholly consistent with petitioner's initial

strategy to make smaller acquisitions. Furthermore, the

acquisition of Tri-Power replaced over half of petitioner's 1986

production.

Respondent also contends that the dropdown served no real

business purpose except to enable petitioner to use Tri-Power's

NOL's. We disagree. Petitioner transferred its oil and gas
 - 50 -

properties to Tri-Power pursuant to a preexisting plan to adopt a

holding company structure, a structure commonly used in the oil

and gas business. Long before it knew about Tri-Power or its

NOL's, petitioner decided to adopt a holding company structure to

aid its business operations and acquisition efforts. Petitioner

long held the belief that an operating subsidiary would provide

it with greater flexibility to make acquisitions and protection

against hostile takeover attempts. Accordingly, petitioner's

plan to adopt a holding company structure was, from the

beginning, an integral part of its reserve acquisition and

hostile takeover defense strategy. On the basis of the extensive

evidence in the record in the instant case, we conclude that the

dropdown served valid business purposes aside from facilitating

petitioner's use of Tri-Power's NOL's.

Tax Considerations

Petitioners have demonstrated legitimate business purposes

for petitioner's acquisition of Tri-Power and the subsequent

transfer of petitioner's oil and gas properties to Tri-Power.

Respondent contends, however, that the circumstances surrounding

the acquisition and dropdown demonstrate that tax considerations,

not business considerations, were petitioner's primary motive.

Respondent contends that petitioner was a profitable oil and gas

company that set out to acquire a loss corporation to provide

NOL's to offset its income. Respondent points to several facts.
 - 51 -

During 1986, petitioner expected increased future revenues as a

result of the KCC infill drilling order and FERC Order 451.

Petitioner knew, at the time of the acquisition, that Tri-Power

had NOL's in excess of $84 million, and that amendments to

section 382, which were to become effective by the end of 1986,

would limit its ability to use Tri-Power's NOL's. Petitioner

commissioned an extensive investigation of Tri-Power's NOL's.

During the weeks leading up to the acquisition, petitioner's

management had regular discussions with Arthur Andersen

concerning its investigation of Tri-Power and its NOL's. Arthur

Andersen made a presentation to petitioner's management

concerning the potential use of Tri-Power's NOL's, and the NOL's

were discussed with petitioner's Board. Then, within days of the

acquisition, and before the end of 1986, petitioner transferred

its profitable oil and gas properties to Tri-Power, enabling it

to use Tri-Power's NOL's.

Petitioner admits and we agree that tax considerations

played a role in the acquisition and dropdown. The question,

however, is not whether tax considerations were present, but

whether those considerations were the principal purpose for the

acquisition of Tri-Power and the subsequent dropdown.

Primary Purpose for the Acquisition and Dropdown

After careful consideration of all of the facts and

circumstances surrounding the transactions in issue, we conclude
 - 52 -

that the business considerations were the principal purpose for

the acquisition and dropdown. Several factors support our

conclusion.

Initially, we give great weight to the fact that petitioner

purchased Tri-Power pursuant to a preexisting plan to replace its

reserves and diversify its operations through acquisition.

Petitioner's acquisition policy, established shortly after its

spinoff from KN Energy, is corroborated by contemporaneous public

announcements. Beginning with its first shareholder report, the

1985 third quarter report, and continuing with every report

thereafter, petitioner publicly and repeatedly committed itself

to a program of reserve replacement and diversification through

acquisition. Accordingly, petitioner established its acquisition

policy long before it ever knew about Tri-Power or its NOL's.

Petitioner's formally documented policy of expansion and

diversification through acquisition rather than through internal

growth tends to establish a non-tax-avoidance motive. See, e.g.,

U.S. Shelter Corp. v. United States, 13 Cl. Ct. 606, 624 (1987).

We also consider petitioner's actions leading up to and

following the acquisition and dropdown. See D'Arcy-MacManus &

Masius, Inc. v. Commissioner, 63 T.C. at 451. After forming an

in-house acquisition screening team, petitioner's management

adopted specific acquisition limitations. Petitioner sought

targets with significant oil and gas reserves. Petitioner
 - 53 -

further sought geographic and geologic diversification. In

particular, petitioner desired to expand outside of the Hugoton

field into the Gulf Coast region and to broaden its production

mix by acquiring more oil reserves. Additionally, petitioner

sought targets in the $10 to $25 million range. During 1986,

petitioner considered numerous acquisition opportunities.

However, petitioner, prior to the Tri-Power acquisition, was

wholly unsuccessful in its acquisition efforts. Petitioner

decided to acquire Tri-Power because, after a thorough

investigation, petitioner determined that Tri-Power satisfied all

of its acquisition limitations. Following the Tri-Power

acquisition, petitioner actively pursued further development of

the Tri-Power properties. Petitioner also continued vigorously

to pursue its acquisition policy. During the years following the

Tri-Power acquisition, petitioner continued to build its reserve

base with the acquisition of over 17 oil and gas companies. On

the basis of the record in the instant case, we conclude that

petitioner's actions both before and after the acquisition of

Tri-Power are wholly consistent with its stated reserve

acquisition policy. Additionally, we note that NOL's were not

among petitioner's predefined acquisition limitations, which

supports the conclusion that petitioner did not set out to

acquire a loss company.
 - 54 -

Another important factor is the testimony of the acquiring

corporation's top management. See Capri, Inc. v. Commissioner,

65 T.C. at 179; D'Arcy-MacManus & Masius, Inc. v. Commissioner,

supra at 450. Mr. Jackson, petitioner's CEO, Mr. Billings,

petitioner's COO, and Mr. Reed, petitioner's vice president of

finance, all testified that petitioner paid nothing for Tri-

Power's NOL's. Mr. Jackson and Mr. Wagner, petitioner's land

manager, also testified that they supported the acquisition of

Tri-Power because it satisfied all of petitioner's predefined

acquisition limitations. Additionally, Harry S. Welch, a member

of petitioner's board, testified that the board was primarily

concerned with the acquisition of reserves and that the NOL's

were presented as a matter of secondary importance. The

foregoing individuals were intimately involved in the decision to

acquire Tri-Power. Their testimony was credible. In conjunction

with other corroborating evidence contained in the record, their

testimony is an important factor supporting our conclusion that

business considerations were the principal purpose for the

acquisition of Tri-Power.

The dropdown, which, as we have found supra, was an integral

part of petitioner's plan to acquire Tri-Power, facilitated

petitioner's preexisting plan to adopt a holding company

structure. We recognize, as respondent so vigorously argues,

that the dropdown also enabled petitioner to use the Tri-Power
 - 55 -

NOL's. It is well settled, however, that taxpayers are free to

arrange their business affairs so to as to minimize tax. See

Gregory v. Helvering, 293 U.S. 465 (1935); Ach v. Commissioner,

358 F.2d 342 (6th Cir. 1966), affg. 42 T.C. 114 (1964);

Briarcliff Candy Corp. v. Commissioner, T.C. Memo. 1987-487.

Accordingly, we do not believe that the dropdown, by itself,

evinces a principal purpose to evade or avoid Federal income tax.

Moreover, we do not believe that the dropdown taints the overall

plan of acquisition.

All of the factors discussed above are inconsistent with

respondent's contention that the acquisition and dropdown were

undertaken for the principal purpose of acquiring tax losses. To

the contrary, both transactions were undertaken pursuant to

petitioner's preexisting plans to acquire replacement reserves,

diversify, and adopt a holding company structure. Accordingly,

we conclude that, while tax factors were taken into

consideration, tax avoidance was not the principal purpose for

the acquisition and dropdown.

Respondent's Arguments

Although we are not persuaded that tax avoidance was the

primary motivation for the acquisition and dropdown, we shall

briefly discuss some of respondent's arguments to the contrary.
 - 56 -

Awareness, Investigation, and Discussion of Tri-Power's
NOL's

Respondent first argues that petitioner's awareness,

investigation, and discussion of Tri-Power's NOL's supports a

finding that section 269 applies. It is uncontroverted that (1)

petitioner knew that Tri-Power had NOL's in excess of $84

million, (2) petitioner engaged Arthur Andersen to conduct an

extensive investigation of Tri-Power's prior tax returns, its

NOL's, and their potential use by petitioner, and (3)

petitioner's management and board discussed Tri-Power's NOL's.

"It is clear, however, that consideration of the tax aspects of a

transaction does not mandatorily require application of section

269 and that such consideration is only prudent business

planning." D'Arcy-MacManus & Masius, Inc. v. Commissioner, 63

T.C. at 451; see also Brumley-Donaldson Co. v. Commissioner, 443

F.2d 501, 510 (9th Cir. 1971) (Trask, J., dissenting) ("In the

complexity of today's business and tax jungle a corporate

president who does not obtain tax advice before an acquisition,

or merger or substantial dollar transaction ought to be fired."),

affg. T.C. Memo. 1969-183; VGS Corp. v. Commissioner, 68 T.C.

563, 596 (1977) ("Complicated business transactions do not take

place in a vacuum and we find this to be nothing more than

prudent business planning."). We believe that petitioner's

consideration of Tri-Power's prior Federal income tax returns and
 - 57 -

its NOL's was prudent business planning. Accordingly, we do not

agree that petitioner's knowledge, investigation, or discussion

of Tri-Power's NOL's leads to the conclusion that petitioner had

a tax avoidance purpose.

Investigation of Tri-Power's Reserves

Respondent next argues that petitioner's investigation of

Tri-Power's reserves was minimal in comparison to its

investigation of Tri-Power's NOL's. To the contrary, we think

that petitioner thoroughly investigated Tri-Power's reserves. As

an initial matter, petitioner's acquisition team reviewed all of

the property information, including the 1986 LAM reserve report,

provided along with TPC's offer. Petitioner then commissioned

LAM to prepare an updated reserve report, rolling forward its

earlier projections to November 1986. In addition, Messrs.

Billings and Wagner traveled to Houston to interview Tri-Power's

personnel and evaluate the reserves. During these visits, Mr.

Billings and Mr. Cassell reviewed, in detail, the geological and

seismic data relating to Tri-Power's reserves and the 1986 LAM

reserve report. Mr. Billings also met with Mr. Martin to review

the Tri-Power reserves included in the 1986 LAM reserve report.

Mr. Wagner met with Tri-Power's landman, Mr. Vandergriff, and

reviewed Tri-Power's land files. In-house geologists and

engineers also reviewed the reserve data. Finally, petitioner

used in-house personnel as well as an outside oil and gas
 - 58 -

attorney, Mr. Swonke, to conduct title and lease reviews on the

Tri-Power properties. On the basis of the foregoing, we conclude

that petitioner's investigation of Tri-Power's reserves equaled,

if not exceeded, petitioner's investigation of Tri-Power's NOL's.

Respondent, however, is critical of petitioner's reliance on

the 1986 LAM reserve reports. Respondent contends that it was

absurd for petitioner to rely solely on the seller's reserve

report without an independent verification. We disagree. LAM

was an independent engineering firm, experienced with Tri-Power's

reserves. Moreover, it was petitioner's standard practice to use

the seller's updated (i.e., rolled-forward) reserve report to

evaluate potential acquisitions, and that practice was standard

in the industry. Next, respondent contends that the 1986 LAM

updated reserve report was unreliable because (1) it did not take

into account the 1986 updated production data, and (2) it

included several wells with little to no production history.

Respondent suggests that petitioner willingly disregarded 1986

updated production data because it would have resulted in a lower

reserve valuation. The 1986 updated production data, however,

was available to petitioner during its investigation of Tri-

Power's reserves. Petitioner was also aware that the 1986 LAM

reserve reports included wells with little to no production

history. Accordingly, petitioner had all the information

necessary to make its own determination concerning the value of
 - 59 -

Tri-Power's reserves. Moreover, we find nothing to suggest that

petitioner disregarded the 1986 updated production data. To the

contrary, we believe that petitioner considered all of the

available information in making its decision to acquire Tri-

Power.

Letters of Intent

Respondent next argues that petitioner's letters of intent

indicate that tax considerations predominated in the acquisition.

Petitioner, in its October 22, 1986, letter of intent,

conditioned the acquisition on, inter alia, the receipt of a

favorable opinion from its tax adviser. The condition states as

follows:

Plains will not consummate the transaction contemplated
hereby until it receives an opinion letter from its tax
advisor * * * stating the Plains' tax advisor has reviewed
all tax information relating to the business of Tri-Power
and Tri-Power's predecessors, that the tax returns and data
supporting those returns are accurate, complete and
verifiable as such and that in such advisor's opinion
Plains' acquisition of Tri-Power as provided for in the
definitive Agreement should achieve the tax consequences
intended by the parties thereto.

Respondent contends that the above-quoted provision

demonstrates that petitioner would not have consummated the

acquisition unless petitioner had some assurance that it would be

able to use Tri-Power's NOL's. Respondent argues that this fact

alone demonstrates that tax avoidance was the primary purpose for

the acquisition. We do not agree. The letter of intent merely
 - 60 -

confirms the fact that petitioner considered the tax consequences

of the acquisition, a fact that petitioner does not deny.

Petitioner's consideration of the tax consequences of the

acquisition, as discussed supra, does not mandate the application

of section 269. See D'Arcy-MacManus & Masius, Inc. v.

Commissioner, 63 T.C. at 451. Moreover, the condition was not

binding. Nothing in the letter of intent would have prevented

petitioner from waiving the condition and going forward with the

acquisition in the event that it received an unfavorable tax

opinion but still desired to acquire Tri-Power.

Respondent further contends that petitioner's failure to

include in its letter of intent a similar escape clause allowing

it to back out of the acquisition if the reserves did not measure

up is clear evidence that tax considerations predominated. We

disagree. Petitioner was in the oil and gas business, not the

tax business. Accordingly, it was not only necessary, but

prudent, for petitioner to seek an outside opinion concerning the

tax aspects of the acquisition. An outside opinion concerning

the reserves was unnecessary because petitioner's acquisition

team, through its own investigation, was already familiar with

the 1986 LAM reserve reports and their limitations. Accordingly,

we find that the absence of an escape clause concerning the

reserves does not evince a tax avoidance purpose.
 - 61 -

Value of Tri-Power's Reserves

Respondent contends that petitioner paid more for Tri-Power

than its assets were worth. Both parties presented expert

witness testimony concerning the value of the Tri-Power reserves.

It is well established that we may accept or reject expert

testimony according to our own judgment, and we may be selective

in deciding what parts of an expert's opinion, if any, we will

accept. See Helvering v. National Grocery Co., 304 U.S. 282, 295

(1938).

Respondent's experts estimate the fair market value of the

Tri-Power reserves, at the time of the acquisition, to be in the

range of $4.1 million to $6.2 million. Petitioner's expert

estimates the fair market value of the Tri-Power reserves, at the

time of the acquisition, to be in the range of $11.6 million to

$13 million. The 1986 LAM updated reserve report estimated the

future net revenue from the Tri-Power reserves to be

approximately $19.1 million, using a discount factor of 10

percent. Respondent contends that the fair market value

estimated by petitioner's expert and the estimated future net

revenue estimated by LAM in the 1986 LAM updated reserve report

are overstated because they (1) are based on overstated reserve

estimates, (2) employ an overly optimistic price forecast to

project the future cash-flows anticipated from the reserves, and

(3) used an improper discount factor to discount the estimated
 - 62 -

future cash-flow to its present value. Respondent contends that

the proper discount factor is 20 percent.

Overall, we believe that the 1986 LAM updated reserve

report, made coincident to the acquisition, is the best estimate

of the value of the Tri-Power reserves at the time of the

acquisition. Not only was LAM familiar with the properties, but

LAM had available information that has since been lost.

Accordingly, we find the estimated reserves, as set forth in the

1986 LAM updated reserve report, to be the most reliable estimate

of the reserves. Moreover, the oil and gas price forecast

provided by petitioner to LAM for use in the rollforward fell

within the range reported in the 1986 SPEE survey. As discussed

supra in our findings of fact, petitioner's price forecast was

within one standard deviation of the 1986 SPEE mean.

Accordingly, we reject the notion that the price forecast used in

the 1986 LAM updated reserve report was overly optimistic.

Finally, the 1986 LAM updated reserve report included a schedule

showing a range of present worth estimates using different

discount rates. LAM estimated the present net worth of Tri-

Power's proved and producing reserves to be $14,447,362, using a

20-percent discount rate. Even if we accept respondent's

assertion that 20 percent is the proper discount factor, the

record supports a finding that petitioner paid $9.75 million for

stock in a corporation with assets having a value of at least
 - 63 -

$9.75 million, if not more. Consequently, we conclude that

petitioner did not pay more for Tri-Power than its assets were

worth.

Additionally, we note that petitioner's acquisition of Tri-

Power was competitive with other acquisitions that took place

during the fourth quarter of 1986. Petitioner paid $4.64/BOE

($9.75 million ÷ 2.1 million BOE) to acquire the Tri-Power

reserves. Accordingly, the price per BOE paid by petitioner for

the Tri-Power reserves was below the fourth quarter 1986 median

of $6.45/BOE reported by Strevig in its 1986 fourth quarter

report and below the revised fourth quarter 1986 median of

$5.18/BOE reported by Strevig during February 1992. Accordingly,

petitioner actually acquired the Tri-Power reserves at a discount

rather than a premium as respondent contends.

Size of Tri-Power's NOL's

Respondent contends that the sheer enormity of Tri-Power's

NOL's in comparison to the value of its assets and their income-

producing potential indicates the primacy of tax motivations.

Respondent stresses the fact that by the end of 1993, petitioners

used almost $55 million of the Tri-Power NOL's but had yet to

recoup their $9.75 million investment through the cash-flow of

the Tri-Power properties. Respondent further emphasizes that, as

a result of the NOL carryforwards in issue, petitioner paid no

regular Federal income tax during the period 1987 to 1993.
 - 64 -

Accordingly, respondent contends that the tax benefits of the

transaction exponentially dwarfed both the potential and actual

business advantages of the acquisition and dropdown. Petitioner

contends that respondent's argument is based in substance on old

section 269(c), which was repealed by Congress during 1976. See

Tax Reform Act of 1976, Pub. L. 94-455, sec. 1901(a)(38), 90

Stat. 1771.33

The magnitude of the NOL's in issue supports an inference

that the acquisition and dropdown were undertaken, at least in

part, for the purpose of securing a tax benefit. We are not

persuaded, however, that the size of the NOL's alone calls for a

finding that petitioner's primary purpose for the transactions in

33
Prior to its repeal, old sec. 269(c) read as follows:

SEC. 269(c). Presumption in Case of Disproportionate
Purchase Price.--The fact that the consideration paid upon
an acquisition by any person or corporation described in
subsection (a) is substantially disproportionate to the
aggregate--

(1) of the adjusted basis of the property of the
corporation (to the extent attributable to the interest
acquired specified in paragraph (1) of subsection (a)),
or the property acquired specified in paragraph (2) of
subsection (a), and

(2) of the tax benefits (to the extent not
reflected in the adjusted basis of the property) not
available to such person or corporation otherwise than
as a result of such acquisition, shall be prima facie
evidence of the principal purpose of evasion or
avoidance of Federal income tax. This subsection shall
apply only with respect to acquisitions after March 1,
1954.
 - 65 -

issue was to secure the benefit of Tri-Power's NOL's. To the

contrary, after careful scrutiny of all the facts and

circumstances surrounding the transactions in issue, we conclude,

as discussed supra, that business considerations were the

principal purpose for the acquisition and dropdown.

Postacquisition Pursuit of the Acquired Properties

Respondent argues that, after the acquisition, petitioner

did not vigorously exploit the Tri-Power properties. We

disagree. Although petitioner ultimately sold or abandoned many

of the Tri-Power properties, we believe that petitioner's pursuit

of the Tri-Power properties is wholly consistent with its

contention that obtaining the reserves was the primary purpose

for the acquisition.

The Tri-Power NOL's Distort Petitioner's Tax Liability

Respondent contends that the acquisition and dropdown are

precisely the type of abusive transactions that section 269 was

designed to attack because the NOL's in issue distort

petitioner's tax liability. The purpose of section 269 is to

render ineffective "arrangements distorting or perverting

deductions, credits, or allowances so that they no longer bear a

reasonable business relationship to the interests or enterprises

which produced them and for the benefit of which they were

provided." S. Rept. 627, supra, 1944 C.B. at 1016. Section

1.269-2(b), Income Tax Regs., indicates that section 269 applies
 - 66 -

when the effect of the deduction, credit, or other allowance

would be to distort the liability of the taxpayer, as evidenced

by, inter alia, the "unreal or unreasonable relation which the

deduction, credit, or other allowance bears to the transaction."

Respondent contends that the NOL's in issue have an "unreal or

unreasonable relation" to the acquisition in issue. We disagree.

Petitioner acquired a going concern, actively engaged in the same

line of business as petitioner. After the acquisition and

dropdown, petitioner continued to operate the Tri-Power

properties along with the dropdown properties. Accordingly, we

do not believe that the acquisition and dropdown distorted the

NOL's in issue "so that they no longer bear a reasonable business

relationship to the interests or enterprises which produced

them". For the same reasons, we do not believe that the NOL's

bear an "unreal or unreasonable relation" to the acquisition and

dropdown.

Section 1.269-3, Income Tax Regs.

Next, respondent turns to the regulations for support.

Section 1.269-3(b)(1) and (c)(2), Income Tax Regs., provides

that, in the absence of additional evidence to the contrary, the

following transactions are ordinarily indicative that the

principal purpose for the acquisition was evasion or avoidance of

Federal income tax:
 - 67 -

(1) A corporation or other business enterprise (or the
interest controlling such corporation or enterprise) with
large profits acquires control of a corporation with
current, past, or prospective credits, deductions, net
operating losses, or other allowances and the acquisition is
followed by such transfers or other action as is necessary
to bring the deduction, credit, or other allowance into
conjunction with the income. * * *

* * * * * * *

(2) A subsidiary corporation, which has sustained
large net operating losses in the operation of business X
and which has filed separate returns for the taxable years
in which the losses were sustained, acquires high earning
assets, comprising business Y, from its parent corporation.
The acquisition occurs at a time when the parent would not
succeed to the net operating loss carryovers of the
subsidiary if the subsidiary were liquidated, and the
profits of business Y are sufficient to offset a substantial
portion of the net operating loss carryovers attributable to
business X * * *.

Respondent contends that these regulations perfectly

describe petitioner's acquisition of Tri-Power and subsequent

transfer of its oil and gas properties to Tri-Power. The

acquisition and subsequent dropdown do arguably fall within the

cited examples and might "ordinarily", absent contrary evidence,

lead to the conclusion that a tax avoidance purpose exists. In

the instant case, however, additional evidence to the contrary

exists, and that evidence indicates that business considerations,

not evasion or avoidance of Federal income tax, were the

principal purpose for the transactions in issue.
 - 68 -

Circumvention of the Consolidated Return Regulations

Finally, respondent contends that, through the dropdown,

petitioners sought to circumvent the separate return year

limitation rules in the consolidated return regulations.

Pursuant to section 1.1502-21A(c), Income Tax Regs., pre-

acquisition losses can be carried forward and used on the

consolidated return only to the extent that the corporation that

incurred the losses has current income reflected on the

consolidated return. Respondent contends that the dropdown

renders this limitation meaningless, and that section 269 should

be applied to avoid frustration of the regulation's purpose.

The application of section 269, however, requires a finding that

the primary purpose for the acquisition was to evade or avoid

Federal income tax by securing the benefit of a deduction,

credit, or other allowance. We concluded, supra, that the

acquisition and dropdown were principally motivated by business

considerations, and that petitioner did not have as its principal

purpose the avoidance or evasion of Federal income tax by

securing a deduction, credit, or other allowance. Absent the

requisite intent, section 269 simply does not apply.

We conclude, as discussed supra, that business

considerations predominated in the acquisition and dropdown in

issue. Accordingly, section 269 does not operate to disallow

petitioner's use of Tri-Power's NOL's.
 - 69 -

II. Penalties

The remaining issue we must decide is whether petitioners

are liable for accuracy-related penalties pursuant to section

6662(a). Respondent determined that petitioners are liable for

section 6662(a) accuracy-related penalties for 1991, 1992, and

1993. The penalties were determined with respect to the section

269 issue (i.e., the disallowed NOL deductions), as well as the

adjustments conceded by petitioners in the petition. Because we

held supra that section 269 does not operate to disallow

petitioners' use of Tri-Power's NOL's, the only issue remaining

to be decided is whether petitioners are liable for section

6662(a) accuracy-related penalties with respect to the

adjustments conceded in the petition.

Section 6662(a) imposes a penalty equal to 20 percent of the

portion of the underpayment of tax attributable to one or more of

the items set forth in subsection (b). Respondent contends that

the section 6662(a) penalty for 1992 was due to negligence or

disregard of rules or regulations and that the section 6662(a)

penalties for 1991, 1992, and 1993 were based on substantial

understatements of income tax. See sec. 6662(b)(1) and (2).

The accuracy-related penalty does not apply with respect to

any portion of the underpayment if it is shown that there was a

reasonable cause for such portion and that the taxpayer acted in

good faith with respect to such portion. See sec. 6664(c)(1).
 - 70 -

The determination of whether a taxpayer acted with reasonable

cause and in good faith is made on a case-by-case basis, taking

into account all the pertinent facts and circumstances. See sec.

1.6664-4(b)(1), Income Tax Regs.34 The most important factor is

the extent of the taxpayer's effort to assess the taxpayer's

proper tax liability. See id.

Petitioners contend that the accuracy-related penalties are

inappropriate in the instant case because they relied on their

C.P.A., Arthur Andersen, to prepare their returns accurately.

Generally, the duty of filing accurate returns cannot be avoided

by placing the responsibility on a tax return preparer. See

Metra Chem Corp. v. Commissioner, 88 T.C. 654, 662 (1987).

Reliance on a qualified adviser, however, may demonstrate

reasonable cause and good faith if the evidence shows that the

taxpayer contacted a competent tax adviser and provided the

adviser with all the necessary and relevant information. See

Jackson v. Commissioner, 86 T.C. 492, 539-540 (1986), affd. 864

F.2d 1521 (10th Cir. 1989); Daugherty v. Commissioner, 78 T.C.

623, 641 (1982); Magill v. Commissioner, 70 T.C. 465, 479 (1978),

affd. 651 F.2d 1233 (6th Cir. 1981); Pessin v. Commissioner, 59

T.C. 473, 489 (1972).

34
Sec. 1.6664-4, Income Tax Regs., revised Apr. 1, 1995,
applies to returns the due date of which (determined without
regard to extensions of time for filing) is on or before Sept. 1,
1995. See sec. 1.6664-1(b)(2), Income Tax Regs.
 - 71 -

We believe that petitioners acted with reasonable cause and

in good faith in their reliance on Arthur Andersen in connection

with the preparation of their returns for the years in issue.

Arthur Andersen, an accounting firm having substantial experience

in the oil and gas industry, qualifies as a competent tax adviser

in the instant case. Moreover, petitioners provided Arthur

Andersen with their schedules and workpapers for use in the

preparation of their Federal corporate income tax returns.

Additionally, Arthur Andersen had access to all of petitioners'

books and records. There is nothing in the record to indicate

that petitioners withheld any relevant information from Arthur

Andersen. Respondent suggests that, because petitioners were

short staffed during the years in issue, petitioners devoted less

time and resources than usual to their return preparation

activities. We disagree. When commitments created by numerous

acquisitions left petitioners without the necessary accounting

staff required to assist in the preparation of their Federal

corporate income tax returns, petitioners engaged a C.P.A. to

prepare certain schedules and workpapers for review by Arthur

Andersen. Accordingly, we believe that petitioners made

significant efforts to assess their proper tax liability.

Consequently, we hold that petitioners are not liable for the

accuracy-related penalties under section 6662(a) for the years in

issue.
 - 72 -

We have considered the parties' remaining arguments and find

them to be either without merit or unnecessary to reach.

To reflect the foregoing,

Decision will be entered

under Rule 155.