T.C. Memo. 2005-254
UNITED STATES TAX COURT
CLAYMONT INVESTMENTS, INC., AS SUCCESSOR IN INTEREST TO NEW CCI,
INC. AND SUBSIDIARIES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 14384-99, 9129-00. Filed October 31, 2005.
F is a foreign corporation. P, a U.S. subsidiary
of F, is a film processing company. On its amended
1992 and 1993 Federal income tax returns, P claimed
sec. 165, I.R.C., loss deductions relating to the
alleged termination of three customer relationships.
In 1988, S1, a U.K. subsidiary of F, lent £29,498,525
(i.e., the equivalent of $50 million) to S2, a
subsidiary of P. In 1996, S2 and S3 (i.e., another
subsidiary of P), entered into a note assumption
agreement, which provided that S3 would assume S2’s
obligations relating to the 1988 loan. Because of the
favorable currency exchange rates (i.e., between the
dollar and the pound), at the time of the assumption,
S2 could have repaid S1 with $45,811,209 instead of $50
million. As a result, S2 realized $4,188,791 in
foreign exchange gain when its obligations were
assumed. On its 1996 consolidated return, P reported
the interest expense paid by S3 to S1 and deferred the
foreign exchange gain relating to the intercompany
transaction between S2 and S3. R determined that P was
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not entitled to the sec. 165, I.R.C., loss deductions,
interest expense deduction, or deferral of foreign
exchange gain.
1. Held: P did not establish that it had a tax basis
in each of the three terminated relationships and,
thus, is not entitled to deduct losses related to these
relationships.
2. Held, further, R’s section 482, I.R.C.,
adjustments, relating to the intercompany transaction,
are arbitrary and capricious.
3. Held, further, the economic substance doctrine is
inapplicable.
4. Held, further, pursuant to sec. 1.1502-13, Income
Tax Regs., P is entitled to defer foreign exchange gain
relating to the intercompany transaction between S2 and
S3.
William E. Bonano, Richard E. Nielsen, and Annie Huang
(specially recognized), for petitioners.
James P. Thurston, Kevin G. Croke, and Usha Ravi, for
respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
FOLEY, Judge: The issues for decision are whether:
(1) Petitioners’1 claimed losses relating to customer
1
All references to petitioners are to Claymont
Investments, Inc., and its consolidated subsidiaries. All
references to petitioner are to Claymont Investments, Inc.
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relationships are deductible pursuant to section 165;2 (2)
petitioners’ arm’s-length loan may, pursuant to section 482, be
recast as a new loan to reflect the interest rate at the time of
the subsequent assumption of the arm’s-length loan; and (3)
petitioners are allowed to defer recognizing foreign exchange
gain relating to 1996.
FINDINGS OF FACT
I. The Technicolor Acquisition
Carlton Communications Plc (Carlton), a United Kingdom (UK)
corporation, is the parent company of petitioner, Colorado
Acquisition Corp., and Technicolor Holdings, Ltd. (Holdings).3
Petitioner and Colorado Acquisition Corp. are U.S. corporations,
and Holdings is a U.K. corporation. Carlton International Corp.
(CIC) and Carlton International Holdings, Inc. (CIHI), are wholly
owned U.S. subsidiaries of petitioner.
On October 7, 1988 (the acquisition date), Colorado
Acquisition Corp. acquired from the Revlon Group, Inc., all the
stock of Technicolor Holdings, Inc. (Technicolor).4 The parties
2
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.
3
Holdings was formerly known as Colorado Holdings, Ltd.
4
As a result of several internal reorganizations of
Carlton’s domestic subsidiaries during the years in issue,
petitioner acquired the stock of Technicolor.
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to the acquisition jointly elected, pursuant to section
338(h)(10), to treat the acquisition of the stock as an asset
acquisition. At the time of the acquisition, Technicolor’s
primary activities were film processing and videocassette
duplication. The film division provided film processing and
related services to major film studios. The videocassette
duplication division manufactured prerecorded videocassettes for
home video and nontheatrical markets.
Technicolor, a leading film processing company, had an
experienced management team, sophisticated equipment, and
proximity to the studios’ filming locations. In addition,
personal relationships, between Technicolor’s and the major film
studios’ executives, facilitated client development and
retention.
The film processing market was extremely competitive, and
major studios used their strong bargaining power to negotiate
large up-front payments (e.g., Technicolor made a $65 million
payment to renew a contract with Walt Disney Pictures), volume
discounts, “most-favored-nation” provisions,5 and other
contractual concessions from film processing companies.
Technicolor’s major competitors were Deluxe Laboratories, Inc.
5
Most-favored-nation provisions ensured that a customer
would get the same pricing as any other customer ordering the
same volume of services.
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(Deluxe); Metrocolor; and CFI, a division of Republic Pictures
Corp.
A. The Preacquisition Review
Prior to the acquisition, Carlton hired Coopers & Lybrand
(C&L) to value Technicolor’s assets. C&L allocated, pursuant to
section 1.338(b)-2T, Temporary Income Tax Regs., 51 Fed. Reg.
3591 (Jan. 29, 1986), in effect during 1988, $619,194,000 of the
proposed purchase price to the basis of Technicolor’s assets.
Section 1.338(b)-2T, Temporary Income Tax Regs., supra, required
that acquired assets be divided into four classes. Class I
assets are cash and cash equivalents. Class II assets are
certain liquid tangible assets including readily marketable
securities. Class III assets are all assets other than those in
classes I, II, and IV. Class IV assets are intangible assets
(i.e., in the nature of goodwill and going concern value) not
allocated to class I, II, or III. The basis allocated to each
successive class is based on the fair market value (FMV) of a
company’s assets.
Because there were no class I or II assets, C&L allocated
the basis attributable to Technicolor’s assets first to class
III. Class III consisted of Technicolor’s tangible assets,
current assets (e.g., accounts receivable), investments in
subsidiaries, and amortizable intangibles. C&L then allocated
the remaining basis to class IV.
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B. Technicolor’s Customer Relationships
In 1986, Paramount Pictures Corp. (Paramount), a
noncontractual customer of Technicolor since 1923, entered into
its first contract with Technicolor. Under this contract,
Technicolor received one-half of Paramount’s film processing
business. In 1987, Technicolor became Paramount’s exclusive film
processor. In 1992, after the expiration of its contract with
Technicolor, Paramount entered into a contract with Deluxe.
After Paramount signed with Deluxe, it continued to do business
with Technicolor under an exception to an exclusivity provision
(i.e., a contractual provision in which a customer agrees to
purchase a particular product or service from only one company)
in Paramount’s contract with Deluxe.
Metro-Goldwyn-Mayer/United Artists (MGM/UA) became a
Technicolor customer in 1924. In 1987, MGM/UA split its film
processing work between Technicolor and Deluxe and became a
significant noncontractual customer of Technicolor. At the time
of the acquisition, Technicolor did not have a film processing
contract with MGM/UA. In addition, the preacquisition review did
not project 1989 revenues relating to MGM/UA. In 1991, MGM/UA
entered into a contract with Deluxe, but continued to do business
with Technicolor.
On October 21, 1988, Management Co. Entertainment Group,
Inc. (MCEG), a newly formed independent film production company,
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entered into a film processing contract with Technicolor.
Technicolor lent MCEG $5.5 million to induce MCEG to enter into
the contract. Because of concerns about MCEG’s long-term
viability, Technicolor secured the loan with video distribution
royalty rights from four MCEG films. If the distribution
royalties were insufficient, MCEG was obligated to repay the loan
by October 31, 1991 (1988 loan). Technicolor’s sales plan, dated
October 18, 1988, for fiscal year 1989, did not list MCEG as a
customer. On October 31, 1990, MCEG was placed into involuntary
bankruptcy, and on March 19, 1992, the U.S. Bankruptcy Court
approved MCEG’s chapter 11 reorganization plan. The successor
entity, MCEG Sterling, Inc., did not continue doing business with
Technicolor.
C. The 1989 Asset Valuation
On June 23, 1989, C&L prepared a valuation report (1989
Valuation) that determined the FMV of Technicolor’s assets for
purposes of allocating the purchase price to those assets. C&L
divided the acquired assets into four classes, discussed supra in
section I.A. Class III included Technicolor’s customer
relationships. C&L determined the value of the relationships by
computing the present value of the net realizable earnings that
these assets would generate over their remaining lives. The
remaining lives were determined by adding a 3-year projected
extension to each relationship’s termination date. The remaining
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lives for the Paramount, MGM/UA, and MCEG relationships were
6.25, 6.33, and 6.08 years, respectively. Beginning in 1989,
Technicolor claimed amortization deductions based on the values
C&L determined for the Paramount, MCEG, and MGM/UA relationships.
Petitioners, on their 1992 tax return, deducted the remaining
adjusted basis of the Paramount relationship. Similarly, on
their 1993 tax return, petitioners deducted the remaining
adjusted bases of the MGM/UA and MCEG relationships.
D. The Closing Agreement
During the examination of petitioners’ 1988 through 1992
returns, respondent challenged the bases and lives ascribed to
the relationships. The parties resolved the valuation dispute
under the Intangibles Settlement Initiative Program. In a
closing agreement (i.e., executed on September 16, 1994, by
petitioners and April 29, 1997, by respondent) the parties agreed
to reduce the bases of the relationships by 15 percent with no
adjustment to the remaining lives as determined in the 1989
Valuation. In addition, the parties agreed that the basis
amounts allocated to the class IV nonamortizable intangible
assets would be increased by $36,458,000.
E. The 1994 Goodwill Valuation
In a letter dated September 30, 1994 (1994 Valuation), C&L
determined the value of film customer relationships acquired in
the purchase of Technicolor. In preparing the 1994 Valuation,
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C&L relied on the 1989 Valuation and the preacquisition review.
C&L determined a total value of the customer relationships using
a capitalization of earnings approach. It further determined
that the appropriate earnings stream to a potential acquirer of
these relationships would be the after-tax earnings generated by
each relationship projected into perpetuity. Thus, it assigned
value to the portions of the relationships extending beyond the
initial periods Technicolor attributed to the relationships. In
both the 1989 and 1994 valuations, C&L used projected annual
pretax earnings to value the Paramount, MCEG, and MGM/UA customer
relationships. After it valued the customer relationships, C&L
subtracted the value of the customer relationships (i.e., as
modified by the closing agreement) and determined that the values
of the Paramount, MCEG, and MGM/UA customer relationships were
$27,496,000, $5,569,000, and $2,698,000, respectively.
On July 7, 1997, petitioners filed amended tax returns
relating to fiscal years ending September 30, 1992 and 1993, and
claimed deductions based on the 1994 Valuation. On their amended
return for 1992, petitioners reported a $27,496,000 loss
deduction attributable to the alleged termination of the
Paramount relationship.6 Similarly, on their amended return
relating to 1993, petitioners reported a $5,569,000 loss
6
The $27,496,000 claimed loss contributed to a net
operating loss that petitioners carried forward and deducted in
the fiscal years ending Sept. 30, 1993 and 1994.
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deduction attributable to the alleged termination of the MCEG
relationship and a $2,698,000 loss deduction attributable to the
alleged termination of the MGM/UA relationship.7
II. Loan Assumption and Foreign Exchange Gain Deferral
On October 7, 1988, Holdings and CIC entered into a note
purchase agreement (Holdings/CIC transaction). The agreement
provided that Holdings would lend CIC £29,498,525 (i.e., the
equivalent of $50 million) in exchange for a promissory note
(note). The note had a 10-year term and required interest
payments calculated at an 11.5-percent rate, compounded semi-
annually and payable annually. All principal and accrued and
unpaid interest were due on October 7, 1998, but the principal
could be repaid at any time without penalty.
In 1996, Carlton’s board of directors decided to acquire RSA
Advertising, Ltd. (RSA), and Cinema Media, Ltd., a subsidiary of
RSA. A portion of this acquisition would be funded with funds
from CIHI. On June 28, 1996, CIC and CIHI entered into a note
assumption agreement (CIC/CIHI transaction). This agreement
provided that CIC would pay CIHI $49,784,881 in exchange for
CIHI’s assumption of CIC’s obligations to Holdings. The
$49,784,881 was the amount necessary to pay off the outstanding
7
In a third amendment to petition, petitioner, in the
alternative, contends that the loss relating to MCEG is properly
deductible for the year ending Sept. 30, 1992, 1993, or 1995.
With respect to MGM/UA, petitioner contends that the loss is
properly deductible for the year ending Sept. 30, 1992.
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principal and accrued interest due on the note (i.e., principal
of £29,498,525, then equivalent to $45,811,209, and accrued
interest of $3,973,672). The note assumption agreement further
provided that CIC remained liable to Holdings but had recourse
against CIHI if CIHI defaulted. CIHI performed all of its duties
pursuant to the terms of the agreement. Holdings was not a party
to the agreement.
The dollar gained value relative to the pound from the date
Holdings and CIC executed the note (i.e., on October 7, 1988, $1
was equivalent to £.59050) to the date CIHI assumed the note from
CIC (i.e., on June 28, 1996, $1 was equivalent to £.6460). On
the latter date, CIC realized a $4,188,791 foreign exchange gain
(i.e., on June 28, 1996, CIC could have repaid the principal
balance of £29,498,525 with $45,811,209 rather than $50 million).
Petitioners, on their 1996 consolidated return, which included
CIC and CIHI, reported the foreign exchange gain and, pursuant to
section 1.1502-13, Income Tax Regs., deferred recognition of the
gain as an intercompany transaction (i.e., a transaction between
corporations that are members of the same consolidated group).
On June 2, 1999, and August 30, 2000, respondent issued
notices of deficiency to petitioners relating to tax years ending
September 30, 1993, 1994, and 1995,8 and 1996, respectively, and
determined the following deficiencies in Federal income taxes:
8
The 1995 taxable year is no longer at issue.
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Year Deficiency
1993 $4,196,196
1994 2,626,712
1995 307,496
1996 34,839,469
In the August 30, 2000, notice of deficiency, respondent,
pursuant to section 482, made adjustments to reflect the arm’s-
length interest rate applicable at the time of the assumption and
determined that petitioners should recognize the foreign exchange
gain realized in 1996. On November 6, 2000, the Court granted
the parties’ joint motion to consolidate docket Nos. 14384-99
(i.e., relating to 1993 through 1995) and 9129-00 (i.e., relating
to 1996) for purposes of trial, briefing, and opinion. In
respondent’s amendment to answer in docket No. 9129-00, filed
July 16, 2002, respondent asserted the economic substance
doctrine as an alternative theory in support of his determination
that the assumption agreement between CIC and CIHI should be
restructured.
Petitioner’s principal place of business was Claymont,
Delaware, at the time the petition was filed.
OPINION
I. The Valuation of Customer Relationships
Section 165(a) allows a deduction for a business loss
sustained during a year where the loss is not compensated for by
insurance or otherwise. The amount of a deduction pursuant to
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section 165(a) is limited to the taxpayer’s adjusted tax basis in
the asset lost. Sec. 165(b).
Petitioners contend that, pursuant to section 165, they are
entitled to deduct the losses attributable to their customer
relationships with Paramount, MGM/UA, and MCEG because the
relationships were irrevocably lost when Paramount and MGM/UA
executed film processing contracts with Deluxe and MCEG went
bankrupt. Respondent contends that petitioners have not
accurately established their adjusted tax bases in the
relationships.
Petitioners’ expert determined that immediately prior to the
Technicolor acquisition the total value of the Paramount, MGM/UA,
and MCEG relationships was $23,882,000.9 In determining the
value of the relationships, he assumed that each relationship
would continue in perpetuity. He asserted that his assumption
was based on Carlton’s expectation at the time of the acquisition
and stated that “it is reasonable and likely, that Carlton’s
management in reviewing the acquisition, would have assumed that
the historical patterns of long-term client relationships would
be expected to continue.” We disagree.
9
Petitioners, in accordance with their expert’s analysis,
reduced the value attributable to the Paramount, MGM/UA, and MCEG
customer relationships from $27,496,000, $2,698,000, and
$5,569,000 (i.e., the amounts calculated in the 1994 Valuation
and claimed on petitioners’ amended 1992 and 1993 returns) to
$18,328,000, $1,814,000, and $3,740,000, respectively.
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In the 1980s, the film processing industry became extremely
competitive, and studios were readily changing film processing
companies and negotiating lower prices, large up-front incentive
payments, and most-favored-nation provisions. As a result,
Technicolor was experiencing a high rate of client turnover. In
fact, only 2 of Technicolor’s 12 major contractual customers in
1983 was a customer on the acquisition date. Carlton’s
expectation that MCEG, MGM/UA, and Paramount would remain
customers in perpetuity is unreasonable and not supported by the
evidence.
With respect to MCEG, petitioners’ expectation is
unreasonable because MCEG did not, prior to the acquisition date,
have a contractual relationship with, or generate any income for,
Technicolor. Moreover, MCEG had no track record, a dubious
future, and no film processing history with Technicolor or any
other film processing companies. Indeed, Technicolor had
concerns about MCEG’s long-term viability (i.e., subsequently
validated by MCEG’s 1992 bankruptcy) and required MCEG to
collateralize the 1988 loan. Thus, petitioners failed to
establish a value relating to the MCEG relationship. See Rule
142(a)(1); Newark Morning Ledger Co. v. United States, 507 U.S.
546, 566 (1993).
Similarly, petitioners’ expectation, that MGM/UA and
Paramount would remain customers in perpetuity, was unreasonable.
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Bernard Cragg, Carlton’s finance director, testified that at the
time Carlton agreed to the purchase price of the acquisition, he
did not know exactly how long Paramount or MGM/UA would remain a
customer, and that Carlton did not have detailed information
relating to Technicolor customers. In addition, with respect to
MGM/UA, documents contemporaneous with the acquisition stated
that Technicolor’s relationship with MGM/UA was “uncertain”. For
example, the disclosure schedule to the stock purchase agreement
and the preacquisition review stated that “MGM/UA is a company in
a state of change”, “Technicolor has no written agreement with
MGM/UA”, and “it is unclear whether Technicolor will receive any
business from MGM/UA at all in the future.” Furthermore, with
respect to Paramount, although it had a history of doing business
with Technicolor at the time of the acquisition, it had been a
contractual customer for less than 2 years. At trial, Earl
Lestz, president of Paramount’s Studio Group, testified that
Paramount never gave Technicolor or Carlton any reason to expect
that Paramount would remain a customer for any extended period of
time. Mr. Lestz’s testimony, the competitive nature of the film
processing market, and Technicolor’s high client turnover rate
before the acquisition, establish that Carlton’s expectation of a
permanent relationship with Paramount was not reasonable.
In short, petitioners did not establish tax bases with
respect to the customer relationships with MCEG, Paramount, and
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MGM/UA. See Newark Morning Ledger Co. v. United States, supra at
566; Capital Blue Cross & Subs. v. Commissioner, 122 T.C. 224,
248 (2004). Moreover, we are unable to ascribe to any of the
relationships a limited useful life of a specific duration. Cf.
Capital Blue Cross & Subs. v. Commissioner, supra at 255-257.
Accordingly, we sustain respondent’s determinations disallowing
petitioners’ claimed deductions.
II. Tax Consequences of the Loan Assumption
Respondent, relying on section 482, contends that the
CIC/CIHI transaction was not arm’s length and should be:
recast * * * [as] a payment by CIC of $49,784,881 to
Holdings to fully extinguish its debt followed by a new
loan from Holdings to CIHI in the same amount at the
arm’s length rate of 8%. The excess 3.5% interest paid
by CIHI to Holdings should be disallowed as a deduction
and deemed distributed by CIHI to Petitioner and by
Petitioner to Carlton followed by a constructive
contribution of this amount by Carlton to Holdings.
Under section 482, the Commissioner has the authority to
reallocate income among members of a controlled group where a
controlled taxpayer’s taxable income is not equal to what it
would have been had the taxpayer been dealing at arm’s length
with an uncontrolled taxpayer. Sec. 1.482-1(f)(1), Income Tax
Regs. If the Commissioner, however, abuses his discretion and
makes a determination that is arbitrary, capricious, or
unreasonable, that determination will not be sustained. See
Seagate Tech., Inc. v. Commissioner, 102 T.C. 149, 164 (1994);
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Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 582 (1989),
affd. 933 F.2d 1084 (2d Cir. 1991).
A. The Applicability of Section 1.482-2(a)(1), Income Tax
Regs., to the Holdings/CIC Transaction or CIC/CIHI
Transaction
Section 482 allows the Commissioner to make adjustments to
reflect an arm’s-length rate of interest “Where one member of a
group of controlled entities makes a loan or advance * * * or
otherwise becomes a creditor of, another member of such group and
* * * charges interest at a rate which is not equal to an arm’s
length rate of interest”. Sec. 1.482-2(a)(1)(i), Income Tax
Regs.; Latham Park Manor, Inc. v. Commissioner, 69 T.C. 199, 210-
211 (1977), affd. without published opinion 618 F.2d 100 (4th
Cir. 1980).
Section 1.482-1(i)(7), Income Tax Regs., broadly defines a
transaction as “any sale, assignment, lease, license, loan,
advance, contribution, or any other transfer of any interest in
or a right to use any property * * * or money”. Because the
Holdings/CIC transaction was a loan and CIC/CIHI transaction
involved a transfer of an “interest in or a right to use * * *
money”, both transactions meet that definition. The Holdings/CIC
and CIC/CIHI transactions, however, are separate transactions.
The CIC/CIHI transaction was entered into 8 years after the
Holdings/CIC transaction, and there is no evidence that this
transaction was under consideration at the time Holdings lent the
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$50 million to CIC. Thus, the Holdings/CIC transaction and the
CIC/CIHI transaction must be analyzed separately. See sec.
1.482-1(f)(2)(i), Income Tax Regs. (stating transactions will be
analyzed on a transaction by transaction basis unless “such
transactions, taken as a whole, are so interrelated that
consideration of multiple transactions is the most reliable means
of determining the arm’s length consideration for the controlled
transactions”).
1. Holdings/CIC Transaction
In 1988, Holdings lent £29,498,525 (i.e., $50 million) to
CIC at an 11.5-percent interest rate. Both parties agree that,
at the time of the loan, 11.5 percent was an arm’s-length
interest rate. Thus, section 1.482-2(a)(1), Income Tax Regs., is
inapplicable to the Holdings/CIC transaction.
2. CIC/CIHI Transaction
CIC and CIHI, petitioner’s subsidiaries, are members of the
same consolidated group. In 1996, CIC and CIHI executed an
assumption agreement in which CIHI agreed to assume all of CIC’s
obligations, pursuant to the note, in exchange for $49,784,881.
Both parties agree that, at the time of the transfer, CIHI could
have borrowed the $49,784,881 at an arm’s-length rate of 8,
rather than the 11.5, percent. Pursuant to the assumption
agreement, if CIHI failed to make any of its payments, CIC was
entitled to seek legal recourse against CIHI. Section 1.482-
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2(a)(1), Income Tax Regs., is applicable to the CIC/CIHI
transaction because CIC became a creditor of CIHI and the 11.5-
percent interest rate was not arm’s length. Del. Code Ann. tit.
6, sec. 1301(3) and (4) (2005) (a creditor is defined as a person
who has a right to payment).
Respondent cites section 1.482-1(d)(3)(ii)(B) and
(f)(2)(ii), Income Tax Regs., as authority for restructuring the
transfer between CIC and CIHI as a new loan between Holdings and
CIHI. Section 1.482-1(d)(3)(ii)(B), Income Tax Regs., states:
The contractual terms, * * * agreed to in writing * * *
will be respected if such terms are consistent with the
economic substance of the underlying transactions. In
evaluating economic substance, greatest weight will be
given to the actual conduct of the parties, and the
respective legal rights of the parties * * *. If the
contractual terms are inconsistent with the economic
substance of the underlying transaction, the district
director may disregard such terms and impute terms that
are consistent with the economic substance of the
transaction.
Respondent contends that the terms of the transaction are
inconsistent with the transaction’s economic substance.
Respondent further contends that arm’s-length parties would not
have entered into this transaction because the market rate of
interest was 8 percent at the time of the assumption. As a
result, respondent recast the CIC/CIHI transaction as a repayment
by CIC to Holdings of the $49,784,881 followed by a new loan from
Holdings to CIHI at an 8-percent interest rate. Respondent
further asserts that the excess 3.5 percent interest paid to
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Holdings by CIHI must be redistributed as a “deemed * * *
[distribution] by CIHI to Petitioner and by Petitioner to Carlton
followed by a constructive contribution of this amount by Carlton
to Holdings.” We disagree for reasons set forth below.
First, the interest rate Holdings charged CIC was arm’s
length and, as a result, section 1.482-2(a)(1), Income Tax Regs.,
is not applicable to the Holdings/CIC transaction. Because the
Holdings/CIC and CIC/CIHI transactions are separate transactions,
respondent may make reallocations only between CIC and CIHI.
Respondent, however, seeks to consolidate and recast both
transactions as a repayment of the loan between Holdings and CIC
followed by a new loan between Holdings and CIHI, thus triggering
the recognition of foreign exchange gain by CIC.
Second, respondent was not authorized, pursuant to section
1.482-1(d)(3)(ii)(B), Income Tax Regs., to recast the
Holdings/CIC and CIC/CIHI transactions because these transactions
had economic substance. Respondent does not contend that the
Holdings/CIC transaction lacked economic substance. Moreover,
CIC’s and CIHI’s conduct established that the terms of their
agreement were consistent with the economic substance of the
underlying transaction. See sec. 1.482-1(d)(3)(ii)(B), Income
Tax Regs. In 1996, Carlton contemplated various financing
options to acquire RSA and Cinema Media, Ltd. One of those
options was to fund a part of the acquisition internally with
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funds from CIHI. On June 28, 1996, CIC and CIHI signed an
assumption agreement in which CIC agreed to transfer $49,784,881
to CIHI in exchange for CIHI’s assuming all of its obligations
relating to the note. Subsequent to the agreement, CIC
transferred the $49,784,881 to CIHI, and CIHI began making
payments pursuant to the terms of the agreement. Although the
note provided that the principal and accrued interest were not
due until October 7, 1998, CIHI paid the note in full on November
17, 1997. From June 28, 1996, through November 17, 1997, CIHI
performed all of its duties pursuant to the terms of the
agreement. Had CIHI not performed all of its duties, CIC had a
legal right to enforce the terms of the agreement. Furthermore,
petitioners were aware that by delaying repayment of the note
they could take advantage of the favorable fluctuations in the
currency exchange rates (i.e., the repayment amount could
continue to decrease if the dollar strengthened relative to the
pound). Petitioners raised, and respondent failed to adequately
refute, these factors. Accordingly, we conclude that the
contractual terms were consistent with the economic substance of
the transaction.
Finally, because the transaction had economic substance,
section 1.482-1(f), Income Tax Regs., prohibits respondent from
restructuring the terms as if his alternative had been adopted by
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petitioners. More specifically, section 1.482-1(f)(2)(ii),
Income Tax Regs., provides:
the district director will evaluate the results of a
transaction as actually structured by the taxpayer
unless its structure lacks economic substance.
However, the district director may consider the
alternatives available to the taxpayer in determining
whether the terms of the controlled transaction would
be acceptable to an uncontrolled taxpayer faced with
the same alternatives and operating under comparable
circumstances. In such cases, the district director
may adjust the consideration charged in the controlled
transaction based on the cost or profit of an
alternative as adjusted to account for material
differences between the alternative and the controlled
transaction, but will not restructure the transaction
as if the alternative had been adopted by the taxpayer.
* * * [Emphasis added.]
While respondent was not authorized to restructure the
transaction as if petitioners had adopted his proposed
alternative, he could have adjusted the terms of the CIC/CIHI
transaction (e.g., reduced the interest rate). Id. Instead,
respondent seeks to collapse two separate transactions (i.e., the
Holdings/CIC and CIC/CIHI transactions), which were 8 years apart
in execution, and create a contractual relationship (i.e.,
between Holdings and CIHI) that never existed. Accordingly, we
conclude that respondent exceeded his section 482 grant of
authority, and his determination is arbitrary and capricious.
B. The Economic Substance Doctrine Is Inapplicable
In the alternative, respondent contends that the economic
substance doctrine is applicable because “the transaction was
structured * * * solely to generate an inflated interest
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deduction and defer recognition by Petitioner of a currency
exchange gain.” Respondent further contends that the CIC/CIHI
transaction should be restructured because it had no objective
economic consequences. Respondent concedes that his economic
substance contention is a new matter and, as a result, he bears
the burden of proof. We conclude that respondent has failed to
carry his burden and that the economic substance doctrine is
inapplicable.
In determining whether the CIC/CIHI transaction has
sufficient economic substance for tax purposes, the Court must
consider both the objective economic substance and the subjective
business motivation behind the transaction. See IRS v. CM
Holdings, Inc., 301 F.3d 96, 102-103 (3d Cir. 2002). If the
transaction has no substance other than to create deductions, it
must be disregarded for tax purposes. See United States v.
Wexler, 31 F.3d 117, 122 (3d Cir. 1994).
There is no credible evidence that the Holding/CIC and
CIC/CIHI transactions were designed solely for the reduction of
taxes or that the above-market interest rate alone would have
precluded an arm’s-length party from entering into a similar
transaction. Indeed, petitioners had independent and legitimate
business purposes for the CIC/CIHI transaction. As previously
discussed in section II.A.2, Carlton decided to fund a portion of
the RSA and Cinema Media, Ltd. acquisition with funds from CIHI
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and wanted to delay repayment of the note to take advantage of
the favorable fluctuations in the currency exchange rates.
Respondent failed to adequately refute either purpose. See Frank
Lyon Co. v. United States, 435 U.S. 561, 583-584 (1978) (genuine
multiple-party transactions with economic substance compelled by
business realities, imbued with tax-independent considerations,
and shaped not solely by tax avoidance features should be
respected for tax purposes); IRS v. CM Holdings, Inc., supra at
102-103.
C. Deferral of Foreign Exchange Gain
Section 1.1502-13(a)(2), Income Tax Regs., provides that
members of a consolidated group can generally defer the
recognition of gain relating to intercompany transactions until
entering into a transaction with a nonmember. In 1996, CIC could
have retired the note by paying $49,784,881 to Holdings. Upon
repayment of the note, CIC would have recognized a $4,188,791
foreign exchange gain (i.e., on June 28, 1996, CIC could have
repaid the principal balance of £29,498,525 with $45,811,209
rather than $50 million). See sec. 988(a). This gain, however,
was deferred, until 1997, as a result of the CIC/CIHI
transaction. Consistent with our holding, respondent was not
authorized, pursuant to section 482 or the economic substance
doctrine, to restructure the assumption as the repayment of the
loan by CIC, a member of petitioner’s consolidated group, to
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Holdings, a nonmember, followed by a new loan from Holdings to
CIHI. Because there was an intercompany transaction between CIC
and CIHI, pursuant to section 1.1502-13(b)(1)(i), Income Tax
Regs., petitioners were entitled to the deferral of foreign
exchange gain.
Contentions we have not addressed are irrelevant, moot, or
meritless.
To reflect the foregoing,
Decisions will be entered
under Rule 155.