T.C. Memo. 2000-361
UNITED STATES TAX COURT
SEAGATE TECHNOLOGY, INC., SUCCESSOR IN INTEREST TO SEAGATE
PERIPHERALS, INC., f.k.a. CONNER PERIPHERALS, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15086-98. Filed November 27, 2000.
P’s controlled foreign corporation, S, sold its
operating assets to an unrelated corporation, C, in
exchange for stock of C. The parties to the asset sale
executed a lockup agreement prohibiting S from selling
the C stock during a restricted period because C was in
the process of making its initial public offering.
During the restricted period, the price of the C stock
increased. When the sale restrictions lapsed, S sold
the C stock and realized a gain. Under secs. 951 and
954, I.R.C., P must include in its U.S. income its pro
rata portion of S’ foreign personal holding company
income (FPHCI). Under sec. 1.954-2T(e)(3)(iv),
Temporary Income Tax Regs., 53 Fed. Reg. 27505 (July
21, 1988), gain from the sale of operating assets used
in S’ trade or business does not give rise to foreign
personal holding company income (FPHCI). Under sec.
954(c)(1)(B)(i), I.R.C., gain from the sale of a
passive investment in stock does give rise to FPHCI.
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The parties seek to determine, as a matter of law,
whether the relation-back doctrine, established in
Arrowsmith v. Commissioner, 344 U.S. 6 (1952), applies
for purposes of sec. 954, I.R.C., in characterizing S’
portion of the gain relating to the increase in the
value of the C stock during the period in which S was
prohibited from selling the stock. P contends that,
under the relation-back doctrine, the sale of the C
stock was integrally related to the sale of the
operating assets due to the lockup agreement and the
restrictions on re-sale of the C stock, and that the
gain on the sale of the stock must take its character
from the sale of the assets and does not constitute
FPHCI. R contends that the relation-back doctrine does
not apply and S’ gain on the sale of C stock
constitutes gain from a separate investment in stock
giving rise to FPHCI taxable to P.
Held: The relation-back doctrine established in
Arrowsmith does not apply based on the facts of this
case to characterize S’ gain on the sale of C stock for
purposes of sec. 954, I.R.C., and accordingly the gain
on the sale of the C stock constitutes FPHCI.
Mark A. Oates, Thomas V.M. Linguanti, John M. Peterson, Jr.,
Mary E. Wynne, and Andrew P. Crousore, for petitioner.
Debra K. Estrem, Michael J. Cooper, Bryce A. Kranzthor,
Jeffrey L. Heinkel, Lavonne D. Lawson, Ewan D. Purkiss, and Mark
S. Heroux, for respondent.
MEMORANDUM OPINION
GERBER, Judge: Pursuant to Rule 121,1 this matter is before
the Court on the parties’ cross-motions for partial summary
1
Unless otherwise indicated, all Rule references are to the
Tax Court Rules of Practice and Procedure, and all section
references are to the Internal Revenue Code in effect for the
taxable years at issue.
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judgment.2 The parties seek to determine, as a matter of law,
whether the “relation-back doctrine” established in Arrowsmith v.
Commissioner, 344 U.S. 6 (1952), applies in characterizing
petitioner’s gain on the sale of stock for purposes of section
954.
Summary judgment may be granted if the pleadings and other
materials demonstrate that no genuine issue exists as to any
material fact and that a decision may be entered as a matter of
law. See Rule 121(b); Sundstrand Corp. v. Commissioner, 98 T.C.
518, 520 (1992), affd. 17 F.3d 965 (7th Cir. 1994). There is no
genuine issue as to any material fact with respect to the
specific legal issue before us, and, accordingly, this matter is
ripe for judgment on the contested issue as a matter of law.3
See Rule 121(b).
2
Petitioner has filed two motions for partial summary
judgment. This opinion considers what has been denominated in
one of those motions as the section 954 “Read-Rite issue”. The
other motion for partial summary judgment concerns what has been
denominated as the “section 482 cost-sharing issue”, which
involves the question of whether the cost, if any, of employee
stock options should be included as part of petitioner’s cost-
sharing agreement with its foreign subsidiaries.
3
While respondent originally believed and argued in his
brief that material facts were in dispute, respondent later
conceded that the parties’ disagreements over the facts focused
on interpretations and conclusions drawn from the underlying
facts and not on the facts themselves.
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Background
Petitioner is the successor-in-interest to Conner
Peripherals, Inc., (Conner U.S.), a Delaware corporation.
Conner U.S. developed and manufactured hard disk drives for sale
to personal computer manufacturers and other customers. Conner
Malaysia, a third-tier, wholly owned Malaysian manufacturing
subsidiary of Conner U.S. manufactured hard disk drives and
head-stack assemblies for hard disk drives in Malaysia.
An Asset Purchase Agreement between Conner Malaysia, Read-
Rite Corp. (Read-Rite) and Conner U.S. was executed on August
30, 1991. Pursuant to the Asset Purchase Agreement, Conner
Malaysia sold its head-stack assembly operating assets (the
“assets”) to Read-Rite, an unrelated third party. The deal
negotiated between Conner Malaysia and Read-Rite called for
Conner Malaysia to sell its assets in exchange principally for
Read-Rite stock. At the time the sale was negotiated, Read-Rite
was preparing to make its initial public offering of stock
(IPO).
Pursuant to the Asset Purchase Agreement, the consideration
for the assets consisted of the following:
2.1 Read-Rite Shares. On the Delivery Date (as
defined in Section 3.2) Read-Rite shall deliver to
Conner shares of capital stock of Read-Rite (the
“Shares”) determined as follows:
(a) In the event of an initial public
offering of Read-Rite Common Stock pursuant to a
registration statement on Form S-1 (an “Initial Public
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Offering”) which closes within sixty (60) days of the
Closing Date, Read-Rite shall issue to Conner that
number of shares of Common Stock $.0001 par value of
Read-Rite determined by dividing $27,500,000 (subject
to adjustment as provided in Section 2.2) by the per
share price to the public in the Initial Public
Offering. Any fractional share shall be rounded to the
nearest whole share.
The Asset Purchase Agreement also provided for an
adjustment to the purchase price as follows:
2.2 Adjustment to Purchase Price. The
$27,500,000 aggregate consideration described in
Section 2.1 shall be subject to adjustment, on a dollar
for dollar basis, to the extent that the aggregate net
value of the Inventory and Fixed Assets at the Closing,
as determined in accordance with this Section 2.2, is
greater than or less than $14,000,000. Notwithstanding
the foregoing, no adjustment shall be made for an
aggregate deviation from $14,000,000 less than or equal
to $500,000, and any adjustment shall be made only to
the extent that such aggregate net value exceeds
$14,500,000 or is less than $13,500,000. To the extent
that the Purchase Price after such adjustment exceeds
$27,500,000, Read-Rite shall pay such excess amount to
Conner in cash on the Closing Date. To the extent that
the Purchase Price after such adjustment is less than
27,500,000, the number of shares delivered to Conner
shall be appropriately reduced.
Ernst and Young appraised the inventory and fixed assets in
the amount of $5,266,237. As a result, there was a net downward
adjustment to the purchase price from $27,500,000 to
$19,266,237. Thus, while it was originally contemplated that
Conner Malaysia would exchange its assets for 2,391,304 shares
of Read-Rite stock, representing approximately 8.9 percent of
Read-Rite’s outstanding shares after the IPO, the actual number
of Read-Rite shares that were delivered to Conner Malaysia was
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1,675,325. Read-Rite’s underwriter, Hambrecht & Quist,
announced the purchase price adjustment in its Read-Rite company
report as follows:
The original purchase price for the Conner HSA
operation was $27.5 million in stock at the IPO price
of $11.50. Read-Rite, however, was able to
dramatically lower the inventory levels of its own
heads at the Conner HSA location before the transaction
closed, resulting in a reduction in the actual purchase
price to less than $20 million, and thus fewer shares.
* * * [Emphasis omitted.]
In order to prevent Conner Malaysia from selling its shares
into the market immediately following the IPO, Read-Rite
required Conner Malaysia as part of the deal to agree to
restrictions upon how soon Conner Malaysia could sell the Read-
Rite shares. Specifically, Read-Rite and Conner Malaysia agreed
that the Read-Rite shares that Conner Malaysia was to receive
would be freely tradeable at the closing of the IPO, subject to
a lockup agreement that prevented Conner Malaysia from selling:
(1) Any of the Read-Rite shares for 180 days following the
closing of the IPO; (2) two-thirds of the shares for 270 days
following the closing of the IPO; and (3) one-third of the
shares 1 year following the closing of the IPO.
These restrictions on the sale of the Read-Rite stock were
expressly included in the Asset Purchase Agreement. In order to
prevent Read-Rite from amending the Asset Purchase Agreement to
allow a waiver or release of the sale restrictions, Read-Rite’s
underwriters entered into separate agreements with Read-Rite.
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These underwriting agreements prevented Read-Rite from
unilaterally releasing Conner Malaysia from the restrictions on
sale without the underwriters’ express written consent.
On October 18, 1991, Read-Rite launched its IPO, and on
October 26, 1991, the asset sale between Read-Rite and Conner
Malaysia closed. The delivery date of the shares under the
Asset Purchase Agreement was November 14, 1991.
Conner Malaysia obtained a valuation by Unterberg Harris,
an investment banking firm, of the appropriate discount
applicable to the Read-Rite shares based upon the restrictions
on sale. The discount applied to the Read-Rite shares took into
account the lockup provisions applied to the shares. The
discounted value or book “cost” of the Read-Rite shares was
calculated to be $16,648,542. For financial reporting purposes,
Conner Malaysia calculated the gain realized on the sale of the
its assets to be $11,282,490. This figure was derived by
subtracting the book value of the assets from the discounted
value of the Read-Rite stock.
Pursuant to the Asset Purchase Agreement, the restrictions
on Conner Malaysia’s sale of the Read-Rite stock lapsed 180
days, 270 days and 1 year following the closing of the date of
the Read-Rite IPO. Once the restrictions lapsed, Conner
Malaysia was free to keep or sell the shares as it wished.
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On April 22, 1992, 180 days after the closing of the IPO,
the sale restriction on the first one-third of Conner Malaysia’s
Read-Rite shares lapsed. On this date, the closing price of
Read-Rite shares was $21-1/4 per share. On June 1, 1992, Conner
Malaysia sold the first third of its Read-Rite shares (558,442
shares) at an average price of $20.31, yielding total proceeds
of $11,341,147.65.
The price of Read-Rite shares fell by $.50 from April 22,
1992, the date the first restriction on the sale of shares
lapsed, to June 1, 1992, the date Conner Malaysia sold the first
one-third of its shares. Thus, by holding the 558,442 shares
beyond April 22, 1992, Conner Malaysia lost $279,221 in proceeds
that it would have received had it sold the shares on April 22,
1992.
On July 21, 1992, 270 days following the closing date of
the IPO, the second restriction on sale lapsed. On this day,
the closing price of Read-Rite shares was $23-1/8 per shares.
On this day, Conner Malaysia sold 500,000 shares out of the
558,442 shares that it was then entitled to sell. Conner
Malaysia sold the 500,000 shares for an average price of $23 per
share, yielding proceeds of $11,500,000. Conner Malaysia sold
the remaining 58,442 shares from the second one-third of its
shares on November 11, 1992, at an average price of $26-1/2 per
share, yielding proceeds of $1,548,713.
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Between July 21, 1992, the date the second restriction
lapsed, and November 11, 1992, the price at which Conner
Malaysia sold the Read-Rite shares increased by $3-1/2 per
share. Thus, by holding the 58,442 shares beyond the date the
second sale restriction lapsed, Conner Malaysia earned an
additional $204,547 over the amount it would have earned if it
had sold the 58,442 shares on the date the restrictions lapsed.
On October 25, 1992, 1 year following the IPO closing date,
the final restriction on sale lapsed. The closing price of
Read-Rite shares at this time was $28-3/8. On November 11,
1992, Conner Malaysia sold all of its remaining Read-Rite shares
(558,441 shares) at an average price of $26-1/2 per share. This
sale yielded proceeds of $14,798,686.50.
Between October 26, 1992 and November 11, 1992, the price
of Read-Rite shares fell by $1-7/8 per share. Thus, by holding
the 558,441 Read-Rite shares beyond the date of the lapse of the
third sales restriction, Conner Malaysia lost $1.05 million in
proceeds that it would have received had it sold the shares on
October 26, 1992.
In 1992, Conner Malaysia received gross proceeds of
$39,188,546 from the sale of the Read-Rite shares. Conner
Malaysia subtracted $16,648,542 (the discounted value of the
Read-Rite Shares) from the gross proceeds of sale and reported a
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book gain from the sale of the Read-Rite shares in the amount of
$22,540,004.
Discussion
The subpart F provisions (sections 951 through 964) require
U.S. shareholders of a controlled foreign corporation (CFC) to
recognize certain income (subpart F income) at the time the CFC
earns that income, rather than later when such earnings are
distributed as a dividend.4 Subpart F income includes foreign
base company income as determined under section 954. See sec.
952(a)(2). Under section 954(a)(1), foreign base company income
includes foreign personal holding company income (FPHCI).
Current taxation of FPHCI under the subpart F regime is
intended to tax “income which is passive in character.” S.
Rept. 1881, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 707, 788.
In enacting the FPHCI subpart F provisions, Congress intended to
tax income that arose from “portfolio types of investments” or
“where the company [was] merely passively receiving investment
income.” Id. at 789.
Accordingly, gains arising from a CFC’s passive or
portfolio investments typically create FPHCI under section 954.
See, e.g., sec. 954(c)(1)(A) (treating dividends, interest,
rents and annuities as FPHCI) and (B)(i) (treating the proceeds
4
The parties agree that Conner Malaysia is a CFC of Conner
U.S.
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on the sale of property that gives rise to dividends, interest,
rents and annuities as FPHCI).
Consistent with the general congressional scheme of not
including a CFC’s income from conduct of an active trade or
business within the definition of subpart F income, the
regulations specifically exclude from the FPHCI definition gain
from the sale of the operating assets of a CFC’s active trade or
business. See sec. 954(c)(1)(B)(iii); sec. 1.954-2T(e)(3)(iv),
(v), and (vi), Temporary Income Tax Regs., 53 Fed. Reg. 27505
(July 21, 1988). Thus, under the subpart F income regime and
the definition of FPHCI, a CFC’s gain on the sale or exchange of
property used in its trade or business does not constitute
FPHCI.
The parties in this case agree that any gain from Conner
Malaysia’s sale of the assets constitutes gain from the sale of
operating assets used in its trade or business and that,
therefore, such gain does not constitute FPHCI. The issue
before us is whether the portion of the gain relating to the
increase in the value of the Read-Rite shares during the period
in which Conner Malaysia was prohibited from selling the stock
should be characterized by reference to the sale of the assets
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or characterized as arising from a passive investment in the
Read-Rite shares unrelated to the sale of the assets.5
Petitioner contends that Conner Malaysia’s receipt and sale
of the restricted Read-Rite shares were part and parcel of, and
integrally related to, its sale of the assets. Therefore,
petitioner argues that under the relation-back doctrine, the
gain on the sale of the shares was inexorably tied to the gain
on the sale of the assets and does not constitute foreign
personal holding company income. Respondent contends that the
facts in this case do not support the application of the
relation-back doctrine and the gain on the sale of the stock
cannot be characterized by reference to the earlier asset sale.
Generally, the relation-back doctrine, established by the
Supreme Court in Arrowsmith v. Commissioner, 344 U.S. 6 (1952),
stands for the principle that a subsequent event which is so
integrally related to a prior event that the two events are in
effect part and parcel of the same transaction, should be
treated as having the same character as the prior event. The
doctrine is premised on the idea that the tax consequences
5
Petitioner admits that any net gain resulting from an
increase in stock price after the lapsing of the sales
restriction should constitute FPHCI.
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should be the same as if the subsequent event had occurred at
the time of the prior event.6
In Arrowsmith v. Commissioner, supra at 7, the taxpayers
liquidated a corporation in which they had equal stock
ownership. Partial distributions were made from 1937 to 1940,
and the taxpayers classified and reported these distributions as
capital gains in each year. In 1944, 4 years after the last
distribution, a judgment was entered against the taxpayers as
the corporation’s transferees. Each taxpayer paid his or her
share of the judgment and deducted his or her payment as an
ordinary business expense. The Commissioner characterized the
taxpayers’ payments made pursuant to the judgment in 1944 as
capital losses, not ordinary expenses, that arose out of the
original 1940 liquidation. The Commissioner maintained that
“the payment of the judgment ‘grew out of, was related to, and
took its character from a capital transaction’” and that the
judgment payments could not be disassociated in their ultimate
6
The relation-back doctrine is commonly employed to
distinguish between capital and ordinary treatment of a
transaction. The problem usually arises when a court must
distinguish between capital and ordinary treatment in determining
the character of a subsequent gain or loss which is directly
related to an earlier transaction. To that end, courts routinely
hold that if there has been an “adjustment”, “renegotiation”, or
“revision” of the original selling price of the asset, the
character of the subsequent transaction follows the character of
the initial transaction. The relation-back doctrine has also
been used to prevent taxpayers from receiving what is effectively
a double benefit.
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character from the distributions in liquidation which such
payments would have served to diminish. Bauer v. Commissioner,
15 T.C. 876, 878-79 (1950), revd. sub nom. Commissioner v.
Arrowsmith, 193 F.2d 734 (2d Cir. 1952), affd. 344 U.S. 6
(1952). The Supreme Court agreed with the Commissioner’s
position and held that the payments by the taxpayers were
allowable only as capital losses because they arose from the
earlier capital transaction.
Courts have applied the Arrowsmith v. Commissioner, supra,
relation-back doctrine in favor of both the taxpayer and the
Government in a myriad of factual settings.7 The relation-back
doctrine has also been invoked under different labels, such as
the “tax benefit rule” of United States v. Skelly Oil, 394 U.S.
678 (1969) or the “origin of claim” rule established in cases
such as Clay v. Commissioner, T.C. Memo. 1981-375. Regardless
of the label given to the principle, this Court has consistently
framed it as follows:
the most appropriate tax treatment of the transaction
in the later year is obtained by examining the
7
For example, the relation-back doctrine has been utilized
not only in the context of corporate liquidations, but also in
the context of: (1) Settling lawsuits or paying attorneys’ fees
in connection with a previous disposition of property, Kimbell v.
United States, 490 F.2d 203 (5th Cir. 1974); (2) refunding or
adjusting purchase prices, United States v. Skelly Oil Co., 394
U.S. 678 (1969); and (3) cases dealing with section 16(b) of the
Securities and Exchange Act of 1934 (currently codified at 15
U.S.C. sec. 78p(b)), Brown v. Commissioner, 529 F.2d 609 (10th
Cir. 1976), revg. T.C. Memo. 1973-275.
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circumstances surrounding the related transaction in
the earlier year, because of the relationship between
the transactions, and it is immaterial whether such a
result favors the taxpayer or the Government.
Bresler v. Commissioner, 65 T.C. 182, 186-187 (1975). In
Bresler, the taxpayers sold their small business corporation’s
section 1231 property at a significant loss in 1964. The
taxpayers reported their share of the loss on their own returns
as a net operating loss that reduced their ordinary income. In
the same year, they commenced a lawsuit against a competitor for
alleged antitrust violations, claiming damages that included the
full amount of their loss from the sale of assets. In 1967, the
case was settled. On the 1967 income tax return, the taxpayers
claimed that the majority of the settlement proceeds was to
reimburse them for the loss they realized upon the sale of their
corporation’s assets and that those proceeds were taxable as
capital gain and not as ordinary income. The Commissioner
maintained that the proceeds should be treated as ordinary
income. The Tax Court, agreeing with the Commissioner and
treating the proceeds as ordinary income, stated:
If * * * [taxpayers’ corporation] had received the
antitrust settlement in * * * [1964], any portion
representing compensation for the loss on the sale of
its section 1231 property would have merely reduced its
ordinary loss * * *. Arrowsmith requires that the gain
realized in 1967 be treated in the same manner as if it
had been received in 1964.
Since the gain, if received in 1964, would have
resulted in an increase in ordinary income, it is not
transformed into capital gain by a mere delay in
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receipt. The subsequent gain is part and parcel of the
original loss transaction and cannot be segregated for
tax purposes. The gain in 1967 is merely an adjustment
of the prior sale price; it is not a new and
independent sale or exchange of section 1231 property.
The receipt of the payment in 1967 was merely the
completion of a prior transaction. Arrowsmith requires
us to treat both events as a unified transaction. * * *
[Id. at 187; citations omitted; emphasis supplied.]
Simply stated, the doctrine set forth in Arrowsmith v.
Commissioner, supra, is that the tax treatment of a transaction
occurring in 1 year may control the tax treatment afforded a
second transaction in a subsequent year where both transactions
are integrally related. This doctrine does not breach the
principle of the annual accounting period because no attempt is
made to reopen and readjust the treatment of the original
transaction. See id. at 8, 9. In order for Arrowsmith v.
Commissioner, supra, to apply, however, there must be a
relationship between two transactions which is sufficient to
require the conclusion that both transactions are parts of a
unified whole.
In Arrowsmith, the Supreme Court found such relationship in
part because the payment at issue would have been offset against
the capital gain had both transactions occurred in the same
year. Likewise in Bresler v. Commissioner, supra, a sufficient
relationship was found because the settlement proceeds paid in a
subsequent year would have been offset against the original loss
transaction had both events occurred in the same year.
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The question we must ask, then, is whether the two
transactions in this case were “part and parcel of one”. Wener
v. Commissioner, 24 T.C. 529, 532 (1955), affd. 242 F.2d 938
(9th Cir. 1957). If so, then the gain or loss in the subsequent
year must take its character from the transaction in the earlier
year. See Bresler v. Commissioner, 65 T.C. at 187; Arrowsmith
v. Commissioner, 344 U.S. 6, 8 (1952).
We addressed an analogous situation in Slater v.
Commissioner, 64 T.C. 571 (1975), and concluded that the
relation-back doctrine did not apply. In Slater the taxpayer
was granted an option to purchase restricted shares of his
employer’s stock. The taxpayer exercised his option in June
1968 and, when the restrictions lapsed in July 1969, recognized
the difference between the stock’s exercise price and its fair
market value as ordinary income. The following year, in
December 1970, the shares were sold at a loss. The taxpayer
attempted to argue that, under the relation-back doctrine, the
loss should be characterized as an ordinary loss by reference to
the character of the gain that had been recognized when the
restrictions lapsed. The taxpayer argued that because he had
received the options as part of his employment, the loss on the
shares should relate back to his employment.
We rejected the taxpayer’s argument, finding instead that
no relationship existed between the taxpayer’s employment and
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the loss on the sale of the shares. We concluded that when the
taxpayer purchased the stock, he became an investor in the
stock, and any subsequent gain or loss is due to the fortunes of
the company. Accordingly, his loss was not found to be
integrally related to the circumstances under which he acquired
the stock, and we declined to apply the Arrowsmith v.
Commissioner, supra, doctrine.
Petitioner argues that Slater v. Commissioner, supra, is
inapposite because the sale giving rise to the recognition of
the entire loss at issue in that case occurred 17 months after
the restrictions on the stock lapsed. Petitioner contends that
no one, including the Commissioner, doubted that the
restrictions on the shares of stock linked the taxpayer’s
exercise of the options in 1968 to his income from the shares in
1969.8
It is true that the taxpayer sold the stock 17 months after
the restrictions lapsed and no argument was ever made that a
portion of the loss was attributable to the restricted period.
Indeed, the restricted period was addressed in Slater v.
Commissioner, supra, only to the extent that the taxpayers
8
The reporting of the bargain element as ordinary income by
the taxpayers in 1969 when the restrictions lapsed was not
governed by the relation-back doctrine. As such, we do not view
petitioner’s statement regarding the link between the exercise of
the option and the reporting of the bargain element as
instructive in determining whether the relation-back doctrine
applies to the facts of this case.
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reported additional ordinary income for the bargain element of
the stock when the restricted period ended. What is important
about Slater, however, is our statement that “When * * * [the
taxpayer] purchased the stock at a bargain, it was as if he had
been paid additional compensation which was used to purchase the
stock; thereby, he became an investor in the stock, and any
subsequent gain or loss is due to the fortunes of the company.”
Id. at 575. Thus, we considered the taxpayer in Slater v.
Commissioner, supra, to have become an investor in the stock in
June 1968, and we did not view the restricted period as altering
when the taxpayer became an investor.
Similarly in the present case, we view petitioner as an
investor in Read-Rite at the time the shares were received. We
do not find the gain on the sale of the Read-Rite stock to be
integrally related to the circumstances under which petitioner
acquired the stock. After receiving the Read-Rite shares as
consideration for the assets, Conner Malaysia became an investor
in the stock, and any subsequent gain or loss was due to the
fortunes of Read-Rite in the marketplace.
In addition, the value of the Read-Rite shares was
independently determined upon sale by investors in the stock
market, and was not integrally related to Conner Malaysia’s
former sale of assets to Read-Rite. Further, any gain or loss
on the Read-Rite shares during the restricted period had no
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impact on the agreed upon sales price of the assets. The Asset
Purchase Agreement did not provide for an adjustment or revision
of the purchase price at the end of the restricted period. As
such, the first transaction terminated when the assets were
sold, and the subsequent sale of the Read-Rite stock was a new
transaction that should be considered entirely separate and
independent for tax purposes. Accordingly, the facts of this
case provide no basis for applying the relation-back doctrine of
Arrowsmith v. Commissioner, supra.
Petitioner makes several contrary arguments. First,
petitioner contends that the lockup agreement and restrictions
on the Read-Rite shares were the integral links tying Conner
Malaysia’s sale of the Read-Rite shares to its receipt of the
shares in exchange for the assets. According to petitioner,
both the receipt of the Read-Rite shares and the sale
restrictions imposed on Conner Malaysia by Read-Rite and its
underwriters was an integral part of Conner Malaysia’s sale of
the assets. Thus, petitioner argues that the sale of the Read-
Rite shares upon lapse of the sale restrictions arose out of and
was part and parcel of the same transaction.
The fact that restricted stock was used as consideration
for the asset sale does not integrally tie the two transactions
together. Regardless of when Conner Malaysia could sell the
Read-Rite shares, the subsequent sale of those shares did not
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involve any adjustment, renegotiation, or revision of the
original selling price of the assets. The restrictions simply
prevented Conner Malaysia from selling the shares during the
lockup period. The restrictions did not in any way change the
value of the assets, or the aggregate consideration as stated in
the Asset Purchase Agreement, that the parties agreed upon.
Once the assets were sold, any fluctuations in the Read-Rite
stock during the restricted period were due to the fortunes of
Read-Rite and market forces and had nothing to do with the value
of the assets sold. The two transactions were not tied
together. For example, if the Read-Rite shares became worthless
during the restricted period, it would not then follow that the
assets became worthless as well. The assets had an agreed upon
value, and any subsequent gain or loss on the Read-Rite shares
had no effect on such value. As such, the fact that the
consideration for the assets was restricted stock does not
provide the requisite link for the application of the relation-
back doctrine.
Petitioner also contends that the fact that the assets were
purchased for stock, rather than cash, also provides the
requisite link to apply the relation-back doctrine. While it is
true that Read-Rite shares were ultimately received in exchange
for the assets, it is also true that a purchase price was agreed
upon and then paid in stock. The parties initially agreed to
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sell the assets for $27,500,000, payable in Read-Rite shares. A
subsequent adjustment based on an appraisal of the inventory and
fixed assets reduced the aggregate consideration to $19,266,237.
This amount represented the fixed, noncontingent purchase price
for which Conner Malaysia agreed to sell its assets. The number
of Read-Rite shares to be delivered to Conner Malaysia as
consideration for the assets was determined by dividing this
amount by the IPO per share price of Read Rite stock.
Nothing in the Asset Purchase Agreement gave any indication
that the sales price for the assets could not be determined
until the restrictions on the Read-Rite stock lapsed. There is
also no indication in the Asset Purchase Agreement that any
subsequent gain on Conner Malaysia’s sale of the Read-Rite
shares merely represented an adjustment or additional portion of
the purchase price of the assets. Thus, the fact that the
consideration for the assets was Read-Rite stock does not, by
itself, provide an integral link between the two transactions.
Petitioner also cites several cases that were decided under
the open transaction doctrine.9 These cases, however, are
9
Under the open transaction doctrine, the original
transaction is held open and the resulting tax consequences are
suspended, while under the relation-back doctrine, the original
transaction is closed, and the subsequent taxable transaction
receives its character based on the original transaction. Unlike
the relation-back doctrine, the touchstone for use of the open
transaction doctrine is the inability to value what was received
in the original transaction.
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irrelevant to our analysis since neither party is advocating for
the application of the open transaction doctrine in the present
case. Indeed, the fact that Conner Malaysia discounted and
valued the restricted shares in 1991 indicates that they treated
the asset sale as a closed transaction in 1991. Petitioner
nevertheless argues that the logic and analysis used in Likins-
Foster Honolulu Corp. v. Commissioner, 840 F.2d 642 (9th Cir.
1988), affg. T.C. Memo. 1985-572 and Dimond v. United States (In
re Steen), 509 F.2d 1398 (9th Cir. 1975), are controlling in the
instant case, even though those cases did not cite Arrowsmith v.
Commissioner, supra, and were decided using the open transaction
doctrine. We disagree. While similarities may exist between
relation-back cases and open transaction cases, they nonetheless
involve different principles, and we simply cannot rely on cases
that were decided based on the open transaction doctrine in
order to decide a case that, neither party disputes, involved a
closed transaction.
Petitioner acquired the Read-Rite shares at a set price
which was not at all dependent on what it subsequently obtained
from unrelated third parties upon the sale of the restricted
shares. Petitioner did not introduce any evidence that Conner
Malaysia and Read-Rite intended the asset price to be determined
after the Read-Rite shares were sold or the restrictions lapsed.
The fact that Conner Malaysia assumed the risk that it was
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selling its assets in exchange for stock that could be worthless
by the time Conner Malaysia was free to dispose of it does not
change the fact that any such decrease in the value of the
shares was unrelated to the asset sale. Furthermore, the
restrictions addressed the ability of Conner Malaysia to trade
the Read-Rite shares and did not specifically prohibit Conner
Malaysia from pledging the shares as collateral or borrowing
against the shares during the lockup period. Thus, despite the
restrictions, it was possible for Conner Malaysia to realize
value from the Read-Rite shares during the restricted period,
and any such value would be separate and independent from the
asset sale.
In short, Conner Malaysia’s receipt of the Read-Rite shares
in exchange for its assets represents a transaction that is not
part and parcel of Conner Malaysia’s subsequent sale of such
shares. The facts simply do not demonstrate the requisite link
between the receipt of the Read-Rite shares and the subsequent
sale of those shares necessary to apply the relation-back
doctrine.10
10
Respondent stresses that the relation-back doctrine has
never been applied in the subpart F setting. We note that our
conclusion that the relation-back doctrine is not applicable in
the instant case does not necessarily bar the use of the
relation-back doctrine in other situations within the subpart F
arena.
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In light of the foregoing and considering the facts of this
case, we hold that the relation-back doctrine established in
Arrowsmith v. Commissioner, supra, does not apply for purposes
of characterizing Conner Malaysia’s gain on the sale of the
Read-Rite stock. Accordingly, petitioner’s gain on the sale of
the Read-Rite stock constitutes FPHCI.
We have considered the parties’ remaining arguments and
find them either irrelevant or unnecessary for resolving the
parties’ controversy. To reflect the foregoing,
An order will be issued denying
petitioner’s motion for partial summary
judgment and granting respondent’s
motion for partial summary judgment.