# Nestle Holdings v. Commissioner

> United States Tax Court · September 14, 1995 · 70 T.C.M. 682

URL: https://www.frixlaw.com/law-library/cases/4624723

## Case

- **Full name:** NESTLE HOLDINGS, INC., ON BEHALF OF ITSELF AND CONSOLIDATED SUBSIDIARIES, AND AS THE SUCCESSOR IN INTEREST TO NESTLE ENTERPRISES, INC. AND CONSOLIDATED SUBSIDIARIES v. COMMISSIONER OF INTERNAL REVENUE
- **Court:** United States Tax Court
- **Decided:** September 14, 1995
- **Citations:** 70 T.C.M. 682; 1995 T.C. Memo. 441; 1995 Tax Ct. Memo LEXIS 439
- **Precedential status:** Unpublished
- **Opinion:** Opinion
- **Judges:** COHEN
- **Cited by:** 23 later opinions in the Frix Law Library

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## Opinion text

NESTLE HOLDINGS, INC., ON BEHALF OF ITSELF AND CONSOLIDATED SUBSIDIARIES, AND AS THE SUCCESSOR IN INTEREST TO NESTLE ENTERPRISES, INC. AND CONSOLIDATED SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Nestle Holdings v. Commissioner
Docket No. 21562-90.
United States Tax Court
T.C. Memo 1995-441 ; 1995 Tax Ct. Memo LEXIS 439 ; 70 T.C.M. (CCH) 682 ;
September 14, 1995 , Filed
*439 Decision will be entered under Rule 155.
Joel V. Williamson , Joseph R. Goeke , Daniel A. Dumezich , Roger J. Jones , Alexander Spitzer , Gary P. Kirschenbaum, David A. Hyman, David F. Abbott, Glenn A. Graff , Stephen A. Kubiatowski , Scott M. Stewart, Jeffrey B. Frishman , Thomas L. Kittle-Kamp , and M. Ellen Robb , for petitioner.
Theodore J. Kletnick, Jeannette D. Pappas , Rose E. Gole , Curt M. Rubin , Peter J. LaBelle , Suzanne L. Corbin , Paul L. Darcy , Elizabeth A. Maresca , Melanie M. Garger , Rajiv Madan , and Nicholas G. Kokis , for respondent.
Table of Contents
Findings of Fact
I. Corporate Structure and Business
II. Carnation Acquisition
A. Background
B. Evaluation
C. Negotiation and Board Approval
D. Merger Agreement
E. Tender Offer and Subsequent Events
F. Carnation Stock Trading
III. Financing of Petitioner's Acquisition of Carnation
A. Background
B. Nestle Analysis of Acquisition Financing
C. Acquisition Financing
1. Commercial Borrowings: 4(2) Note Program
2. Related-Party Financing
D. Petitioner's Offerings on the European Financial Market
E. Subsequent Related-Party Advances
F. Repayments on the Related-Party Financing
1. NSA Advance
2. NSA Subsequent Advances
*440 3. Maggi Advance
G. NCC-Carnation Loans
H. Petitioner's Financial Statements
I. Summary of Disallowed Interest Expense
IV. Section 338 Election: Valuation of Carnation Assets
A. Background
B. Carnation Inventory
C. Trademarks and Trade Names
D. Unpatented Technology
1. Flash-18
2. Drying/Instantizing
3. Coating
4. Mibolerone Dog Food
5. Low-pH/Hot-Fill-and-Hold
V. Sale of Trademarks and Technology
Opinion
I. Introduction
II. Interest Deduction
A. Intention to Create Debt
B. Reasonable Expectation of Repayment
C. Economic Reality
III. Valuation Under Section 338 Election
A. Inventory
1. Disposal Costs
a. SG&A Expenses
b. Intangibles' Charge
2. Holding Costs
3. Profit
4. Test of Reasonableness
B. Trademarks and Trade Names
1. Petitioner's Expert Report
a. Profit-Split Method
b. Selling-Price-Differential Method
c. Econometric Method
d. Relief-from-Royalty Method
2. Respondent's Experts: Relief-from-Royalty Method
C. Unpatented Technology
1. Graham's Analysis
2. Reilly's Analysis
D. Goodwill and Going Concern Value
1. Arm's-Length Bargain and Adequate Information
2. Control Premium
3. Insider-Trading Premium
IV. The Carnation Sale of Technology *441 and Trademarks
V. Section 6661 Addition to Tax
VI. Summary
COHEN , Judge
COHEN
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN , Judge : Respondent determined deficiencies in petitioner's Federal income taxes as follows: Taxable Year Ended Amount
December 31, 1983 $ 38,934,552
December 29, 1984 21,764,946
December 28, 1985 285,591,539
Respondent also determined an addition to tax of $ 61,514,950 under section 6661 for the taxable year ended December 28, 1985. 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 settlement of numerous significant issues, the issues remaining for decision pertain to the acquisition of Carnation Co. (Carnation) by petitioner Nestle Holdings, Inc. (petitioner), and are:
(1) Whether petitioner and Carnation are entitled to interest deductions of $ 131,739,791;
(2) what was the fair market value (FMV) of Carnation's inventory, trademarks and trade names, unpatented technology, and goodwill and going concern as of January 10, 1985;
(3) whether Carnation must recognize capital gain on its *442 sale of certain assets to Nestle S.A. (NSA); and
(4) whether petitioner is liable for an addition to tax under section 6661.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated facts are incorporated in our findings by this reference.
Petitioner filed consolidated Federal income tax returns on an accrual basis during the years in issue and filed an amended Federal income tax return for the taxable year ended December 28, 1985.
I. Corporate Structure and Business
Petitioner is a U.S. domestic corporation, with its principal place of business in Stamford, Connecticut. At all material times, petitioner was a first-tier subsidiary of NSA, a publicly held corporation headquartered in Vevey, Switzerland. Through at least 25 subsidiaries, NSA was engaged in worldwide business activities, and the term "Nestle" in this opinion refers to the global family of NSA affiliated entities.
In many instances, NSA did not directly own its subsidiaries. For example, petitioner was the holding company for various Nestle operating subsidiaries located in the United States, including The Nestle Co. (later Nestle Foods Corp.); Libby McNeill & Libby, Inc.; the Stouffer *443 Corp.; and, after 1985, Carnation. Petitioner had relatively strong brands in the U.S. market, including Nestle Crunch.
Nestle's specific products included roast and ground coffee, chocolates, milk, frozen foods, culinary products, food ingredients, soups, fruit drinks, and baby food. Nestle also engaged in the hotel, restaurant, pharmaceutical, cosmetic, and other businesses.
II. Carnation Acquisition
A. Background
During the early 1980's, Nestle was not satisfied with the performance of its operations in the United States, its internal growth in the United States, or the percentage of its worldwide sales that came from the U.S. market. NSA believed that its U.S. operating companies had weaknesses that included management, market share, sales organization, distribution, and an inadequate food service business. NSA did not, however, consider brand weakness as a reason for its shortcomings in the United States.
Due to the global nature of the food industry, Nestle considered the improvement of its position in the U.S. market to be an important long-term objective. Nestle desired to increase the U.S. portion of its total worldwide sales with products that complemented *444 its worldwide product portfolio. To achieve this objective, Nestle planned to employ a strategy of both internal growth and acquisitions of U.S. companies. Petitioner acquired Paul F. Beich; Hills Bros. Coffee, Inc.; MJB Co.; and Chase and Sanborn, Inc., as part of this objective.
J.M. Biggar (Biggar) was the president and a member of the board of directors of petitioner. Helmut Maucher (Maucher) was the chief executive of NSA. The top level management of NSA was a three-person group called the Executive Committee, and, during the summer of 1984, Maucher, Carl L. Angst (Angst), and Jose Daniel (Daniel) served on that committee. Angst and Daniel were both general managers and members of the NSA board of directors. Angst was also a member of petitioner's board of directors.
NSA formed an acquisitions group to study major food companies for potential acquisition. E.J. Bignami (Bignami), a senior vice president of NSA, was in charge of the acquisitions group and reported to Angst. As the head of the acquisitions group, Bignami continuously gathered information on food companies and potential acquisition candidates.
Carnation was a publicly traded California corporation with 20 domestic *445 divisions, 13 domestic subsidiaries/affiliates, and 47 foreign subsidiaries/affiliates. Primarily, Carnation made and sold human and pet food products; however, Carnation was also involved in other businesses, such as the scholastic market and the manufacture of cans.
In January 1984, NSA became aware that Carnation might be available for acquisition. NSA initially was not interested in pursuing an acquisition. In March 1984, Angst was contacted by First Boston and informed that Carnation was "on the market" because certain of the major Carnation shareholders, the Stuart family group (family group), wanted to sell the group's shares and thought that a sale to Nestle might be beneficial. Members of the family group were the relatives of E.A. Stuart, who individually or beneficially owned 9,389,189 shares of Carnation stock, or approximately 26.9 percent of the outstanding shares of Carnation common stock. Angst was not enthusiastic about Carnation. Maucher, however, persuaded Angst that the Carnation brand image and pet food products were worth investigating.
On March 28, 1984, the Executive Committee discussed Carnation and decided that a contact by Maucher was to be arranged. In *446 April 1984, Maucher asked Angst to take responsibility for evaluating Carnation as an acquisition, and Angst became the primary representative of Nestle in discussions with Carnation concerning the acquisition.
On May 18, 1984, the Carnation board of directors retained Kidder, Peabody & Co. Inc. (Kidder) for advice on takeover-defense measures because of speculation that Carnation was a takeover candidate. In August 1984, Kidder prepared a Leveraged Buyout Analysis (LBO analysis) for Carnation. That analysis contained a series of computations analyzing the feasibility of an LBO at various stock prices and leverage ratios, assuming interest rates in the range of 15 to 17 percent.
B. Evaluation
Nestle engaged First Boston as its adviser with respect to the Carnation acquisition. In July 1984, First Boston prepared materials that included a description of Carnation and its subsidiaries, a financial comparison of Carnation to selected food companies, comparable acquisitions in the food and beverage industry, and market price data. A separate set of materials that was prepared by First Boston in July 1984 analyzed various acquisition prices as a multiple of earnings per share, revenues, *447 cash-flow, and book value.
In July 1984, Daniel N. Regolatti (Regolatti), senior vice president of NSA and head of the finance department, prepared a financial study of the operations and stock price of Carnation and financial "reflections" on an acquisition of Carnation. Regolatti suspected that the Carnation stock price was high because of takeover rumors. However, Regolatti also noted that the financial analyst community had made favorable comments about the domestic performance and expected operating earnings of Carnation. Regolatti further noted that Carnation was overcapitalized and had an excess of cash over bank debt that could reduce Nestle's cash payment for Carnation if Nestle followed its usual practice of financing working capital with debt.
The first meeting between Nestle and Carnation took place on July 19, 1984, in Los Angeles, California. Angst, representing Nestle, met with H.E. Olson (Olson), chairman of the board and chief executive officer of Carnation, and T.F. Crull (Crull), president and member of the board of directors of Carnation. One purpose of the meeting was for Angst to "get a feel" for the Carnation management, and Angst determined that the Carnation *448 management would not be opposed to a takeover by Nestle and might even welcome it. At the July 19, 1984, meeting, Angst expressed concern that leaks and rumors had caused a rise in the price of Carnation stock and that additional leaks would cause further increases that could jeopardize the potential acquisition. Angst also requested, and Olson agreed to provide, certain information so that Nestle could evaluate Carnation. In a memorandum to Maucher written after the meeting, Angst stated: Mr. Olson agreed to delegate a trustworthy member of their staff to provide the information we require. Among others, I mentioned that I would like to understand a little bit better their policy with regard to capitalization and depreciation and, above all, we must have turnover and profit information per major product lines and per country.
Once this information is in hand, we can then proceed to assess the value of the company to us. At this point in time we shall get together with Mr. Olson and Mr. Crull to negotiate a take-over price.
As a first approximation of an acceptable take-over price, the share value on Monday July 23rd is $ 62.-, amounting for 347 million shares to $ 2.15 *449 billion. A bid of $ 75.-/share would amount to some $ 2.6 billion, which, at the current rates, exceeds Sw.Fr. 6 billion.
In case we decided to pursue this acquisition, absolute secrecy is of utmost importance. On the Carnation side, only Messrs. Olson, Crull and Stewart [sic] know about our meeting in Los Angeles. On the Nestle side there is a larger number, but what I am really concerned about is First Boston. We shall impress upon them that there will be no transaction if confidentiality cannot be assured.
On August 9, 1984, a second meeting was held in New York, New York. Olson requested this meeting in order to assess the seriousness of the intentions of Nestle before giving NSA the nonpublic information that had been requested by Angst at the first meeting. This meeting was not intended to be a negotiation session; but the price of $ 75 per share was mentioned by Angst as a potential offering price, and Olson indicated that this price was too low.
The third meeting took place on August 20 through August 22, 1984, in Vevey, Switzerland. Prior to this meeting, Nestle management had accumulated data on the U.S. operations of Carnation and felt that it had enough information *450 about the U.S. operations to make a reasoned judgment as to the U.S. business. Through petitioner, a U.S. competitor of Carnation, Nestle had information pertaining to the quality of the distribution, warehousing, and raw material purchasing of Carnation as well as a qualitative evaluation of Carnation products. However, Nestle wanted to receive input from Crull personally and also to discuss Carnation's business outside the United States.
Crull and J.N. Kvamme (Kvamme) of Carnation met with Nestle personnel to discuss Carnation operations in various countries. Because of the secrecy concerns of Nestle, a minimal number of Nestle personnel were involved. The meetings on August 20 and 21, 1984, focused on international operations, and Nestle personnel probed Crull and Kvamme with questions about Carnation, including why Carnation had "written off" Mexico, what kind of equipment Carnation had, and why the costs of production of Carnation were lower than those of Nestle. Crull gave his personal evaluation of various Carnation managers. Also, Crull and Kvamme provided Nestle with the confidential and nonpublic information that had been requested, including financial information for different *451 product lines in various countries.
On August 22, 1984, Crull and Kvamme met with Angst and Maucher, who informed Crull and Kvamme that Nestle had a serious interest in Carnation and that Nestle personnel were already "grinding numbers" and looking at synergism to see whether that interest could turn into an offer.
After the Vevey meeting, the Executive Committee unanimously decided to propose the Carnation acquisition to the board of directors. At an NSA Committee of the Board of Directors meeting on August 24, 1984, Angst noted that he had been told by Crull that the majority shareholder of Carnation would ask for $ 90 per share. Angst stated that he believed that the most important element in determining the price was the stock exchange value, which, he said, on average, corresponds to 10 times the profits. Angst stated that a price of $ 90 per share could be justified based on the profits realized by Carnation in 1983, the estimated profits for 1984, and the effects of synergy. Maucher indicated that these estimates did not take into account qualitative and quantitative advantages that would result from the increased market share in the United States and the synergy that would *452 occur in the future. Angst indicated that he would prefer to have his authorization to negotiate limited to $ 85 per share so that he could say, if the price asked by Carnation exceeded $ 85 per share, that he had to submit the matter to the board.
Prior to formal price negotiations, NSA prepared several studies of Carnation including: NSA and Carnation consolidated balance sheet and the effect of the acquisition on NSA's balance sheet; justification of a $ 90-per-share purchase price; Carnation acquisition price analysis; and sales and net income figures for Carnation's products and businesses for 1982 through 1985 (estimated).
C. Negotiation and Board Approval
On August 30, 1984, Angst met with Olson and Crull in New York to engage in price negotiations. Angst opened the meeting by offering $ 80 per share, which Olson immediately rejected. Olson contended that the price should be determined with regard to the earnings anticipated for 1985, which justified a price of $ 90 per share. In response, Angst stated that Nestle would make the $ 80-per-share offer directly to the family group, which owned approximately 26.9 percent of the outstanding shares of Carnation. In response, *453 Olson raised the possibility that a leveraged buyout might bring between $ 88 and $ 90 per share. Crull expressed regret that there was no concession from Nestle; Angst concluded that a $ 80-per-share offer made directly to the family group might cause an unfriendly atmosphere and, thus, he decided to raise the offer to $ 82 per share. When Olson insisted that the $ 82-per-share offer could not be accepted, Angst suggested that Olson show some flexibility. Olson then made an $ 87-per-share counteroffer, which Angst rejected. The meeting ended without agreement.
The remainder of the negotiations took place through many telephone conversations. First Boston suggested that an offer of $ 83-1/2 per share be offered. Angst believed that $ 83 per share was a negotiable price. A final agreement was reached at the price of $ 83 per share, subject to the approval of the Nestle board of directors.
The NSA board of directors met on September 3, 1984, and approved the acquisition of Carnation at $ 83 per share. The minutes from that meeting reflect comments made by the directors, including the following evaluation by board member H. Strasser: Mr. H. Strasser has evaluated this transaction *454 favorably after having studied the file which was submitted. It is a solid business, benefiting from an interesting goodwill and good products, certain of which will open new markets to us. It is necessary to be courageous to propose an investment as great as this.
Angst stated at the board meeting: "The price of US$ 83 is high but if one considers the future prospects of Carnation and the forecasts for the company for 1985, the price is fully justified." Angst was praised at the meeting for his handling of the negotiations.
Kidder provided the Carnation board with a written opinion letter and report as to the fairness of the $ 83-per-share offer. The Carnation board of directors met on September 3, 1984, and unanimously adopted a resolution approving the $ 83-per-share offer and recommending the offer to the Carnation shareholders.
On September 4, 1984, Angst and Maucher sent a telex to Olson and Crull stating: Our negotiations, while sometimes difficult, were always fair and we greatly appreciated your open and frank approach to the solving of problems.
We consider it a privilege to have you as partners and we are looking forward to a fruitful and mutually interesting *455 cooperation with your esteemed company.
D. Merger Agreement
Prior to September 3, 1984, petitioner formed a subsidiary, NHI Sub., Inc. (NHI Sub.), to facilitate the acquisition of Carnation. On September 3, 1984, petitioner, NHI Sub., and Carnation entered into an agreement entitled "Agreement and Plan of Merger" (merger agreement), which provided that petitioner would make a tender offer at $ 83 per share for any and all outstanding common shares of Carnation stock. The merger agreement provided that, after the tender offer was completed, NHI Sub. and Carnation would merge and that Carnation would be the surviving legal entity. The merger agreement also provided that, at the time of the merger, each outstanding common share of Carnation not owned by petitioner would be converted into a right to receive $ 83 in cash from petitioner. On September 3, 1984, petitioner also entered into a stock purchase agreement with the family group, which provided that the members of the family group would sell all of their shares of Carnation common stock to petitioner for $ 83 per share.
E. Tender Offer and Subsequent Events
Petitioner made the tender offer to purchase the outstanding *456 shares of Carnation common stock on September 5, 1984. The tender offer provided that petitioner, as the purchaser, could amend or terminate the offer if it became aware of any facts that, in its sole judgment, might have material adverse significance with respect to the value of the Carnation shares to petitioner or Nestle.
Representatives from NSA and petitioner and accountants from Peat, Marwick, Mitchell & Co. (PMM) and from Price Waterhouse (PW) visited Carnation in Los Angeles from September 18 through 27, 1984. The main purpose of this visit was to evaluate Carnation's corporate organization; reporting, planning, and controls; external auditing; internal auditing; income tax situation; and employee benefits. Another purpose of the visit was to meet with Carnation management in an effort to create "goodwill" for Nestle.
Pursuant to the stock purchase agreement, petitioner acquired all of the stock owned by the family group, and the majority of the remaining outstanding stock of Carnation was acquired through the tender offer.
On January 4, 1985, the Federal Trade Commission (FTC) approved the acquisition of Carnation by Nestle. On January 10, 1985, Carnation became a subsidiary *457 of petitioner. Pursuant to the merger agreement, on January 30, 1985, NHI Submerged into Carnation. Immediately before the merger, petitioner owned approximately 98.5 percent of the then-outstanding shares of common stock of Carnation. As provided in the merger agreement, Carnation was the surviving legal entity in the merger, and each outstanding common share of stock of Carnation not owned by petitioner was converted into the right to receive $ 83 in cash from petitioner.
F. Carnation Stock Trading
During the spring of 1984, the Carnation stock price was in the mid-to-low $ 50's per share. Sometime around July 1984, the price of Carnation stock began to rise. During this time, there were rumors and stories in various newspapers and business publications that the family group wanted to sell its holdings and also that Carnation was a potential acquisition candidate. A June 1984 Wall Street Journal "Heard on the Street" column reported that Carnation was an attractive acquisition candidate because it has "tremendous brand-name strength but management hasn't done anything with it." During July 1984, releases from Reuters stated, among other things, that, according to industry *458 analysts, Carnation was an attractive buyout candidate because of its cash reserves, marketable securities, low amount of long-term debt, consistent earning growth from year to year, and well-known products.
During 1984, Carnation retained Kidder to provide various investment banking services. Martin A. Siegel (Siegel) was a vice president, shareholder, and managing director of Kidder and, from this position, learned of material nonpublic information regarding Carnation. Sometime between May 31 and August 1, 1984, Siegel stated his opinion to Ivan F. Boesky (Boesky) that Boesky should purchase Carnation stock. Siegel repeated his recommendation to Boesky after August 21, 1984.
From June 1984 through January 1985, entities controlled by Boesky purchased a large quantity of Carnation stock based, in part, on information that was provided to Boesky by Siegel. The Boesky-controlled entities subsequently disposed of most of the Carnation stock through sales or in accordance with the Nestle tender offer. Siegel obtained the information given to Boesky, at least in part, through his work for Carnation. Siegel received at least $ 700,000 from Boesky in exchange for information on various *459 matters during 1982 to 1985.
On December 23, 1986, Siegel entered into an agreement with the U.S. Government in which he agreed to plead guilty to two felony charges and to cooperate with the United States. On April 23, 1987, Boesky was charged by the United States with criminal acts and pleaded guilty.
III. Financing of Petitioner's Acquisition of Carnation
A. Background
Initially, Nestle planned to finance the acquisition of Carnation with a $ 525 million capital contribution to petitioner and borrowings of $ 2.5 billion from outside sources. In September 1984, petitioner stated, in a Securities and Exchange Commission (SEC) filing, that NSA would make a $ 525 million capital contribution. Nestle also contemplated that the trademarks, know-how, and foreign subsidiaries of Carnation would be transferred to NSA because it was the policy of Nestle that trademarks were owned by the central company in Switzerland and that the international companies were always managed within one entity in one country.
On August 31, 1984, Regolatti, head of finance for Nestle, met with an officer of Citibank, N.A. (Citibank), to ascertain the amount that Nestle could borrow if it made *460 a large acquisition. Citibank indicated that Nestle could borrow up to $ 5 billion, and Regolatti stated that he needed $ 2.5 billion by that evening. Citibank put together a syndicate to loan petitioner $ 2.5 billion under a revolving credit agreement, which was guaranteed by NSA and served as bridge financing for the acquisition. The Citibank bridge financing was able to be arranged in a matter of hours because NSA agreed to guarantee petitioner's debt. The guarantee by NSA permitted Citibank to offer the financing without consideration of the creditworthiness of petitioner on a "stand alone" basis.
Ultimately, petitioner did not borrow funds pursuant to the proposed revolving credit agreement. While waiting for the FTC to approve the acquisition, Nestle had an opportunity to organize alternative financing, which would be less expensive than the hastily negotiated Citibank bridge financing. Petitioner terminated the revolving credit agreement on December 26, 1984.
As early as October 10, 1984, an alternative financing structure was contemplated, and, sometime prior to October 29, 1984, the planned financing structure of the acquisition was revised. The revised plan was to fund *461 the acquisition with: (1) A capital contribution of $ 400 million from Maggi Enterprises, Ltd. (Maggi), a Swiss subsidiary of NSA that sometimes provided funds in the form of loans to companies within the Nestle group; (2) an unsecured related-party debt of $ 925 million; and (3) up to $ 2.1 billion of commercial paper. On December 7, 1984, petitioner stated in an SEC filing that a $ 400 million capital contribution would be made by Maggi.
B. Nestle Analysis of Acquisition Financing
As of December 29, 1984, petitioner had a total debt of $ 517,313,000, which consisted of $ 449,309,000 in affiliated notes payable and $ 68,004,000 in other debt, and had total stockholder's equity of $ 653,180,000. Nestle had a policy that each affiliated company should be able to finance its own activities and, thus, studied what level debt petitioner could support after its acquisition of Carnation. As of December 1984, Nestle believed that interest rates in the United States would decrease and that, therefore, petitioner could service a larger amount of acquisition debt than had originally been contemplated.
A PMM report that was sent to petitioner on December 17, 1984, explained that interest *462 paid on bona fide debt is deductible, whereas dividends paid on equity are not deductible. In this report, PMM, among other things, analyzed the criteria used by the Internal Revenue Service (IRS) and courts to determine whether a purported debt instrument constituted bona fide debt or disguised shareholder equity; evaluated the ability of petitioner to service debt; and identified the approximate amount of debt that petitioner could maintain on its balance sheet from a debt/service and debt/equity point of view. In the report, PMM recommended that equity contributions be eliminated.
On December 20, 1984, employees of Nestle, including Regolatti, met with Robert Decelles (Decelles) of PMM and discussed the approximate proportion of debt that a postacquisition petitioner could maintain without creating a significant risk that respondent would recharacterize debt as equity. Decelles stated that the projected postacquisition petitioner group debt/equity ratios were well within acceptable U.S. tax guidelines and recommended that all of the projected amount of contributed equity be substituted with related-party debt. Decelles also noted that, if, in the future, the equity of petitioner *463 were not sufficient, a capital contribution could be made at that time.
Ultimately, petitioner structured the financing of the Carnation acquisition as follows: Commercial borrowings (approximately) $ 1,600,000,000
Related-party advances 1,325,000,000
Capital contribution -0-
In a January 7, 1985, filing with the SEC, petitioner stated that the funds from related parties would be provided as unsecured loans.
The business reasons for selecting a financing structure with no capital contribution were based upon the following factors: (1) Projected cash-flow that would permit debt service; (2) anticipation that the combined petitioner-Carnation entities would have a high level of cash and investments on hand that could be used to pay down debt; (3) the amount of Carnation assets to be divested; (4) acquisition debt would include short-term or floating-rate debt to take advantage of the anticipated decline in interest rates, thereby reducing the interest expense and cash-flow requirements associated with acquisition debt; and (5) NSA money management policy. The audited financial statements of Carnation for December 31, 1984, reported cash and marketable securities of *464 $ 368,504,000 and a net worth of $ 1,208,623,000. NSA had a policy to hedge debt but not equity. NSA believed that the fall of the U.S. dollar against the Swiss franc was imminent and, thus, did not want to make an equity investment in the United States because such investment would be unhedged.
From a rate of approximately 12 percent in August 1984, the 3-month London Interbank Offer Rates for Interest (LIBOR) fell to 8.56 percent by January 8, 1985; 8 percent by December 1985; and 6.44 percent by December 1986.
C. Acquisition Financing
1. Commercial Borrowings: 4(2) Note Program
Petitioner raised approximately $ 1.6 billion for the acquisition of Carnation through commercial paper obligations made pursuant to an offering under the private offering exemption of section 4(2) of the Securities Act of 1933, 15 U.S.C. secs. 77a-77aa (1980) (4(2) note program). The 4(2) note program consisted of short-term paper, not to exceed 270 days (4(2) notes). Merrill Lynch and Salomon Bros. were retained as codealers for the 4(2) note program. On December 19, 1984, Standard & Poor's Corp. gave the 4(2) note program an investment grade rating of "A-1+".
*465 The 4(2) note program was supported by a note purchase agreement between NSA and petitioner dated November 29, 1984. The note purchase agreement provided that NSA would, if requested by petitioner, repurchase the maturing commercial paper of petitioner if the amount due exceeded the funds available for payment. The 4(2) note program was also supported by unsecured credit lines in the aggregate amount of $ 700 million from 13 unrelated banks. Documents from one of these lines of credit indicate that the Bank of Montreal authorized a $ 50 million line of credit, which was solely at the risk of petitioner, at an interest rate of LIBOR plus 3/8 percent. Those Bank of Montreal documents, approved by bank officials in January and February 1985, also indicated that the Bank of Montreal believed that the debt service capacity of petitioner would be "greatly enhanced with the integration of Carnation" and that "the asset being acquired, Carnation, has historically exhibited strong financial performance".
The 4(2) note program was further supported by a $ 1 billion international short-term note facility (International Note Facility) made on December 21, 1984, among petitioner, several banks, *466 including Credit Suisse First Boston Ltd. as lead manager and facility agent, and Bankers Trust Co. as advance agent. The International Note Facility was legally guaranteed by NSA and included a $ 500 million swing-line credit agreement.
Petitioner repaid the entire amount borrowed under the 4(2) note program during 1985, and NSA was not called upon to perform under the note purchase agreement.
The unsecured credit lines were terminated on February 15, 1985, and the International Note Facility was terminated on November 25, 1985.
2. Related-Party Financing
On January 8, 1985, petitioner received two related-party advances of $ 600 million and $ 725 million from NSA and Maggi, respectively (NSA advance and Maggi advance). On January 25, 1985, NSA sent a confirmation letter, signed by Regolatti, relating to the $ 600 million NSA advance. That letter set forth the terms of the advance, which provided that the advance was short term, on a 3-month revolving basis, and that interest would be calculated at the 3-month LIBOR rate increased by 3/8 percent. The letter also provided that prepayments could be made without penalty. The NSA confirmation letter was executed by Neil Green *467 (Green), treasurer of petitioner, on behalf of petitioner on January 30, 1985.
On January 25, 1985, Maggi sent a confirmation letter relating to the terms of the $ 725 million Maggi advance. The letter provided that the advance was to be repaid by a first installment of $ 25 million on March 31, 1987, followed by 20 equal annual payments of $ 35 million on March 31, with the final installment due on March 31, 2007. Prepayments were permitted without penalty. The letter also provided that interest would be calculated at the 3-month LIBOR rate increased by 3/8 percent. The Maggi confirmation letter was executed by Green on behalf of petitioner on January 30, 1985.
Neither the NSA advance nor the Maggi advance was subordinated to other debt incurred by petitioner. Although the confirmation letters referred to the financing as "advances", other letters and documents referred to the financing as "loans". For example, on February 10, 1987, Maggi sent a letter to petitioner requesting that petitioner confirm, for the Maggi auditors, the $ 725 million loan. There were no closing binders for the NSA and Maggi advances; however, petitioner recorded the intercompany advances as loans on its *468 books and records.
During 1985, the Wall Street Journal reported that the 3-month LIBOR fluctuated between a high of 9.56 percent and a low of 7.88 percent.
D. Petitioner's Offerings on the European Financial Market
On or about March 15, 1985, petitioner offered a series of promissory notes on the European financial market in denominations of $ 5,000, aggregating $ 100 million in total principal amount (the 9-7/8 bonds). The 9-7/8 bonds matured on March 15, 1988, and required annual interest payments at the rate of 9-7/8 percent beginning March 15, 1986. One of the terms of the 9-7/8 bonds was that bondholders had an option to require petitioner to redeem the bonds at par if NSA reduced its direct or indirect shareholding in petitioner below 51 percent before maturity of the bonds. NSA did not provide a legal guarantee or enter into a purchase agreement for the 9-7/8 bonds. The 9-7/8 bonds were not supported by any swing line of credit.
On or about June 6, 1985, petitioner made a second offering of bonds on the European financial market (extendible bonds). The extendible bonds were offered in denominations of $ 5,000 and $ 50,000 and aggregated $ 100 million in total principal *469 amount. The extendible bonds matured June 5, 1991, but were repayable at the option of the holder on June 6, 1988. Interest accrued on the extendible bonds at an annual rate of 9-7/8 percent. One of the terms of the extendible bonds was that the bondholders had the option to require petitioner to redeem the bonds at par if NSA reduced its direct or indirect shareholdings in petitioner below 51 percent before maturity of the bonds. NSA did not provide a legal guarantee or enter into a purchase agreement for the extendible bonds. The extendible bonds were not supported by any swing line of credit.
Petitioner believed that interest rates were going to decrease and, thus, entered into interest rate swap transactions to obtain floating rates. Such swap transactions enabled petitioner to reduce the effective interest rate on the $ 200 million of unrelated-party debt from 9-7/8 percent to approximately 7 percent.
In 1987 and 1988, petitioner issued commercial paper in the European bond market (Eurobonds). One of the terms of the Eurobonds was that the bondholders had the option to require petitioner to redeem the bonds at par if NSA reduced its direct or indirect shareholding in petitioner *470 below 51 percent before maturity of the bonds. NSA did not provide a legal guarantee or enter into a purchase agreement for the Eurobonds. The Eurobonds were not supported by any swing line of credit.
E. Subsequent Related-Party Advances
During 1985, NSA provided petitioner with additional advances of $ 960 million (NSA subsequent advances) as follows: Date Amount
June 26, 1985 $ 90,000,000
June 26, 1985 150,000,000
July 29, 1985 120,000,000
Nov. 14, 1985
through
Dec. 3, 1985 600,000,000
$ 960,000,000
Some of the NSA subsequent advances were used to retire maturing 4(2) notes. For each of the NSA subsequent advances, NSA sent confirmation letters signed by Regolatti that provided payment terms for the advances and an interest rate calculated as LIBOR plus 3/8 percent. None of the NSA subsequent advances were subordinated to any other debt of petitioner. There were no closing binders for the NSA subsequent advances.
On its audited financial statements for the taxable year ended December 28, 1985, petitioner reported a total of $ 1,740 million in long-term notes payable to affiliates.
F. Repayments on the Related-Party Financing
1. NSA Advance
Petitioner *471 repaid the NSA advance during its taxable year ended December 28, 1985, through a series of asset transfers that involved petitioner, NSA, and Carnation. Pursuant to an agreement dated April 30, 1985, Carnation sold its trademarks, trade names, and patented and unpatented technology and know-how to NSA for $ 423,100,000, which was based on a preliminary independent appraisal by American Appraisal Associates (AAA), discussed in detail below. The final FMV of these assets determined by AAA was subsequently increased to $ 425,630,700. Carnation also sold its foreign subsidiaries to NSA pursuant to several agreements for an aggregate price of $ 235,827,071.
NSA paid for the Carnation assets (other than foreign subsidiaries) through several transactions. As a result of the sale, NSA recorded an account payable to Carnation of $ 423,100,000, and Carnation recorded an account receivable of the same amount. Carnation recorded an additional account receivable from NSA of $ 2,531,000 to reflect the increase in the AAA final appraisal. Petitioner paid $ 123,100,000 in cash to Carnation to reduce the Carnation NSA account receivable from $ 423,100,000 to $ 300 million, which in turn reduced *472 petitioner's indebtedness to NSA. Carnation issued a dividend of the remaining $ 300 million NSA account receivable to petitioner; petitioner recorded the $ 300 million as dividend income and reduced its indebtedness to NSA by the same amount.
Through the sale of the Carnation assets, the amount outstanding on the NSA advance was reduced as follows: Date Amount Balance as of 12/31/85
Apr. 30, 1985 $ 423,100,000
May 22, 1985 81,859,714
June 14, 1985 11,542,144
July 3, 1985 62,667,146
Sept. 6, 1985 10,470,669
Sept. 20, 1985 10,360,327
$ 600,000,000 0
Petitioner made interest payments to NSA on the NSA advance primarily through the Nestle netting system, which was an automated system that accounted for transactions among various Nestle entities, as follows: Date Amount
Apr. 18, 1985 $ 12,450,000
July 15, 1985 6,512,271
Oct. 15, 1985 400,939
$ 19,363,210
Petitioner withheld 5 percent in withholding taxes from each of the interest payments made on the NSA advance and paid such amounts to the IRS.
2. NSA Subsequent Advances
The additional amount of $ 58,927,071 that remained from the sale of the foreign subsidiaries, after reduction of the NSA *473 advance, was used to reduce the balance of the June 26, 1985, NSA subsequent advance of $ 90 million.
The following schedule reflects the payments made by petitioner to NSA on the June 26, 1985, NSA subsequent advance of $ 150 million: Year Amount Balance as of 12/31/89
1987 $ 10,000,000
1988 7,000,000
1989 7,000,000
$ 24,000,000 $ 126,000,000
The following schedule reflects the payments made by petitioner to NSA on the July 29, 1985, NSA subsequent advance of $ 120 million: Year Amount Balance as of 12/31/88
1987 $ 12,000,000
1988 108,000,000
$ 120,000,000 0
The following schedule reflects the payments made by petitioner to NSA on the November 14 through December 3, 1985, NSA subsequent advances of $ 600 million: Year Amount Balance as of 12/31/89
1986 $ 30,000,000
1987 30,000,000
1988 30,000,000
1989 30,000,000
$ 120,000,000 $ 480,000,000
On October 15, 1985, petitioner made a quarterly interest payment of $ 6,956,209 to NSA through the Nestle netting system. During the taxable year ended December 28, 1985, petitioner accrued total interest expense attributable to the NSA subsequent advances of $ 18,713,731. After *474 1985, petitioner made interest payments to NSA for the NSA subsequent advances through the Nestle netting system in the following aggregate amounts: Year Amount
1986 $ 65,964,255
1987 62,078,854
1988 69,369,961
1989 82,350,746
Petitioner withheld 5 percent in U.S. withholding taxes from all of the interest payments made with respect to the NSA subsequent advances and paid the withholding taxes to the IRS.
3. Maggi Advance
During the taxable year ended December 28, 1985, petitioner made interest payments of $ 47,443,446 to Maggi for the Maggi advance. In subsequent years, petitioner made the following interest payments to Maggi on the Maggi advance: Year Amount
1986 $ 59,020,790
1987 50,983,508
1988 63,447,405
1989 34,659,235
These interest payments were made primarily through the Nestle netting system. Petitioner withheld 5 percent in U.S. withholding taxes from each of the interest payments made with respect to the Maggi advance and paid the withholding taxes to the IRS.
Petitioner paid the first installment repayment of $ 25 million to Maggi in 1987 and paid the $ 35 million installment in 1988. In November 1988, when the outstanding *475 balance was $ 665 million, petitioner notified Maggi that it was able to secure more favorable financing and that, on December 14, 1988, it would prepay 11 annual payments of $ 35 million each ($ 385 million). Petitioner paid the $ 385 million prepayment in 1988. The remaining balance of $ 280 million was scheduled to be repaid in 8 annual payments of $ 35 million each, with the first installment to be paid on March 31, 2000, and the last payment due on March 31, 2007.
G. NCC-Carnation Loans
Nestle Capital Corp. (NCC) was a wholly owned U.S. subsidiary of NSA until December 27, 1985, when NSA contributed the shares of NCC to petitioner. NCC was made a part of petitioner's consolidated group on December 28, 1985. For the period ended December 27, 1985, NCC filed a Federal income tax return marked "final" and was not a part of petitioner's consolidated group.
NCC was engaged primarily in the business of borrowing funds to be used as working capital for petitioner-related or Nestle-related entities in the United States. NCC acted as a source for short-term and medium-term funds by borrowing money via the commercial market, mostly through the section 3-A-3 commercial paper exemption *476 of the Securities Act of 1933, 15 U.S.C. secs. 77a-77aa (1982) , and lending money to the U.S. operating companies of Nestle. NSA supported the commercial paper issued by NCC with a note purchase agreement and a 30-day swing line of credit.
On September 10, 1984, privately placed unsecured medium-term promissory notes of NCC and $ 24.7 million of Carnation senior debt were placed on Standard & Poor's Corp. CreditWatch due to concerns over the size of the financing required for the Carnation acquisition. The NCC commercial paper program was not placed on CreditWatch. On December 12, 1984, Standard & Poor's Corp. removed the NCC and Carnation debt from CreditWatch.
During the taxable year ended December 28, 1985, NCC made approximately 450 loans to Carnation (NCC-Carnation loans). During 1985, Carnation accrued $ 26,222,874 of interest expense associated with the NCC-Carnation loans. In 1985, NCC reported taxable interest income of $ 26,222,874 from payments made by Carnation on the NCC-Carnation loans. As of December 28, 1985, 36 of the NCC-Carnation loans were outstanding.
H. Petitioner's Financial Statements
The audited financial statements *477 of petitioner reported the following: Sales Net Income Interest Royalties
Date ($ 000) ($ 000) ($ 000) ($ 000)
12/28/85 $ 5,698,625 $ (6,015) $ 275,437 $ 54,712
1/3/87 5,959,483 39,267 213,242 85,976
1/2/88 5,951,412 (28,446) 189,104 106,621
12/31/88 6,089,141 13,663 220,616 110,366
12/30/89 6,969,281 59,476 288,589 121,236
Dividends Dividends
Cash ($ 000) In Kind ($ 000)
12/28/85 $ 150 0
1/3/87 0 0
1/2/88 0 0
12/31/88 0 0
12/30/89 - $ 49,468
The audited financial statements of petitioner further reported the following amounts of debt payable to affiliated companies: Year Ended Notes Payable to Affiliates
12/29/84 $ 156,000,000
12/28/85 1,740,000,000
1/3/87 1,718,000,000
1/2/88 1,640,500,000
12/31/88 1,081,500,000
12/30/89 1,035,500,000
I. Summary of Disallowed Interest Expense
In the notice of deficiency, respondent disallowed the following amounts of interest expense associated with the advances from related entities to petitioner and Carnation: Preacquisition Loans to Petitioner
Interest
Date Lender Amount Expense
10/18/82 Maggi $ 15,000,000 $ 1,785,205
2/10/84 Maggi 25,000,000 2,209,375
Acquisition Related Advances to Petitioner
Interest
Date Lender Amount Expense
1/8/85 NSA $ 600,000,000 $ 19,363,211
1/8/85 Maggi 725,000,000 62,849,696
Postacquisition Advances to Petitioner
Interest
Date Lender Amount Expense
6/26/85 NSA $ 90,000,000 $ 2,505,259
6/26/85 NSA 150,000,000 6,487,500
7/29/85 NSA 120,000,000 4,361,250
11/14/85 NSA 600,000,000 5,359,722
Subtotal-advances to petitioner $ 104,921,218
Financing to Carnation
Interest
Date Lender Amount Expense
12/9/85 Maggi $ 100,000,000 $ 424,542
3/85-12/85 NCC -- 26,394,031
Subtotal-Carnation loans $ 26,818,573
Total disallowed interest expense $ 131,739,791
*478 In the notice of deficiency, respondent disallowed interest deductions of petitioner on the grounds that petitioner's acquisition of Carnation lacked economic substance and that, in substance, NSA acquired Carnation. Alternatively, respondent asserted that the interest expense deductions should be reallocated to NSA and/or its affiliates pursuant to section 482 in order clearly to reflect income.
IV. Section 338 Election: Valuation of Carnation Assets
A. Background
On November 7, 1984, PMM sent a letter to Green, treasurer of petitioner, discussing the feasibility of petitioner's making an election under section 338 .
Green asked PMM to provide assistance in hiring an appraisal firm to value the assets of Carnation for the section 338 election. In November 1984, petitioner retained AAA, an unrelated appraiser, to appraise certain assets of Carnation and certain domestic subsidiaries primarily for purposes of petitioner's section 338 election. In a presentation to Nestle, AAA stated that the objective of the valuation was to "Allocate Maximum Part of Purchase Price to Depreciable and Amortizable Assets". An internal "Order For Service" form prepared by AAA representatives *479 recorded: "It is the intention and recommendation of PMM to take a very aggressive posture on the valuation of the intangible assets and to maximize the write-up of these assets." That AAA document also stated: It is PMM's opinion, supported by that of Neil Green of Nestle that our best approach with IRS in this particular negotiation is to provide a fully detailed, comprehensive appraisal report that will provide a backup to all of the data provided in the development of the valuation. * * *
A letter dated November 30, 1984, from AAA to Green stated: Events concerning the appraisal of certain assets of Carnation Company have moved so fast that I find myself confirming our understanding of your requirements as we prepare to provide you our preliminary totals.
* * * It is our understanding that the preliminary phase was to provide you with our opinion of the fair market value in continued use of certain intangible assets in order that you can make decisions concerning the divestiture of these assets in 1984.
Petitioner filed an election under section 338 with respect to its acquisition of Carnation stock. This election was effective as of January 10, 1985. With respect *480 to its section 338 election, petitioner made a transitional allocation election pursuant to section 1.338(b)-4T , Temporary Income Tax Reg., 51 Fed. Reg. 23737 (July 1, 1986). As a result, petitioner determined the tax basis of the assets of Carnation pursuant to section 1.338(b)-4T , which, because of a "second tier step-up", resulted in an increase in the tax basis above FMV for some of the assets of Carnation. The return position of petitioner with respect to the value of Carnation assets was based on the valuation report of AAA.
In the notice of deficiency, respondent determined that petitioner had not properly allocated the tax basis to the assets of Carnation. Respondent's allocation of tax basis under section 1.338(b)-4T , resulted in a tax basis of Carnation assets that was lower than the FMV for those assets as determined by respondent. Respondent's allocation was based on the premise that the "adjusted grossed-up" basis of the assets was less than their FMV.
B. Carnation Inventory
As of January 10, 1985, the operations of Carnation included divisions that were referred to as Grocery Products Divisions and included: Contadina, Evaporated Milk, *481 Instant, Pet Foods, Processed Potatoes, Swift, and Trenton. In addition, the Carnation operations included other divisions and subsidiaries (other divisions) that were engaged in various other lines of business and included: Can; Carnation International Division -- Los Angeles (CILA); Dayton Reliable Tool & Manufacturing Co. (Dayton Reliable); Fresh Milk and Ice Cream; General Office; Genetics; Health & Nutrition; Herff Jones, which included Camera Art School Photographers (Camera Art) and Princeton Industries Corp. (Princeton); Milling, which included the Hawaiian Grain subsidiary; Research Farm; and Seaboard Carton (Seaboard).
The Grocery Products Divisions manufactured raw foodstuffs into highly processed, consumer-ready food products. Many of the other divisions also carried on manufacturing operations.
Carnation had a goal of maintaining a 98-percent customer service level, or "fill rate", which would mean that, out of 100 customer orders, 98 would be shipped on time, as ordered. Carnation sought to achieve this goal by maintaining finished goods inventory at 11 distribution centers and a number of third-party warehouses throughout the United States.
The following Carnation *482 divisions had finished goods inventory on hand as of January 10, 1985: Can; CILA; Contadina; Evaporated; Fresh Milk and Ice Cream; General Office; Genetics; Health & Nutrition; Herff Jones, which included the Camera Art and Princeton subsidiaries; Instant; Milling, which included the Hawaiian Grain subsidiary; Pet Foods; Processed Potatoes; Seaboard; Swift; and Trenton.
The following Carnation divisions had raw materials inventory on hand as of January 10, 1985: Can; CILA; Contadina; Dayton Reliable; Evaporated; Fresh Milk and Ice Cream; General Office; Health & Nutrition; Herff Jones; Instant; Milling, which included Hawaiian Grain; Pet Foods; Processed Potatoes; Research Farm; Seaboard; and Trenton.
For financial and tax accounting purposes in 1984, Carnation inventory was reported at the lower of cost or market. All Carnation divisions kept inventories on a first in, first out basis, except for gold inventories at Herff Jones, which were kept on a last in, first out basis.
Carnation maintained an on-line inventory management system for the Grocery Products Divisions called the IC system. The IC system was updated daily, incorporating production from the prior day and sales from *483 the current day. Based on the information contained in the IC system, Carnation regularly prepared a report entitled "IC19" that provided a listing of the inventory quantity (at the product code level) at each company location. An IC19 report was created on December 31, 1984, and an IC19 report for January 10, 1985, could have been printed on or about January 11, 1985. This report would have provided the number of units in inventory on January 10, 1985, for the Grocery Products Divisions.
Carnation closed its books on December 31, 1984, and the closing of its books was based on physical inventories taken in the latter part of 1984 that were rolled forward to the yearend. This is the period for which PW performed its annual audit of Carnation. Carnation did not close its books on January 10, 1985, nor did it take a physical inventory on January 10, 1985. The book inventory of Carnation as of December 31, 1984, was $ 413,564,000.
Among the assets appraised by AAA were the inventories of Carnation and certain subsidiaries. In appraising the inventory of Carnation, AAA used the Carnation December 31, 1984, inventory count, determining that it was not necessary to perform a "rollforward" *484 from December 31, 1984, to January 10, 1985. AAA determined that the FMV of the inventory of Carnation was $ 487 million as of January 10, 1985, under the comparative sales method.
In the notice of deficiency, respondent determined that the basis in the Carnation inventory was less than the basis ascribed by petitioner pursuant to its section 338 election; however, respondent did not raise the issue of use by petitioner of the December 31, 1984, inventory count for the determination of FMV on January 10, 1985. As a result of respondent's reduction of inventory, respondent decreased the Carnation cost of goods sold and increased the taxable income of petitioner for the taxable year ended December 28, 1985.
C. Trademarks and Trade Names
Carnation owned more than 3,000 trademarks and trade names worldwide. The Carnation trademarks and trade names that are in dispute are from the following divisions of Carnation: Contadina, Dairies, Evaporated, Instant, Pet Food, Processed Potatoes, Trenton/Swift (Food Service). These trademarks and trade names include: Coffee-mate, Mighty Dog, Instant Breakfast, Processed Potatoes, Buffet Cat Food, Fresh Milk/Ice Cream, Trenton Foods, Fancy Feast, *485 Contadina, Friskies Dry, Coffee-mate FS, Hot Cocoa-Sugar Free, Hot Cocoa Mix FS, Contadina FS, Breakfast Bar, Malted Milk, Canadian TM, Instant Breakfast FS, Evaporated Milk, Bright Eyes, Nonfat Dry Milk, Hot Cocoa Mix, Slender/DIY Diet, Chef's Blend, Come N Get It, and Bon Bon's.
A known trademark has implicit value in that it relieves its owner of the cost to develop consumer awareness and promotes a predisposition towards the product. Trademark recognition develops from years of advertising, consistent packaging, promotional campaigns, customer service, and quality control. Depending on the strength of a trademark, the maintenance of the desired consumer awareness level generally requires significant, continuing advertising investment and product renovation. Trademarks lose substantial value without adequate investment, management, marketing, advertising, and sales organization.
Consumers purchased Carnation products for many reasons, including the trademarks, advertising, price, promotions, coupons, effective distribution systems, and shelf location. Historically, and particularly during 1980 through 1985, Carnation engaged in a "push" marketing strategy, under which Carnation *486 "pushed" products into the marketplace by offering lower prices, promotions, coupons, and trade deals, rather than through advertising. The reduction in advertising resulted in a reduced Carnation brand awareness at the consumer level. In its Long Term Plan for 1986-1988 (long-term plan), prepared on June 14, 1985, Carnation management viewed the reduced brand awareness as a weakness. In that long-term plan, Carnation management indicated that it planned "to establish stronger consumer pull with existing and new products through increased advertising and consumer effort, while we reduce dollars that go into trade deals." Carnation management viewed its close relationship with the trade and excellent distribution system as strengths but noted, in the long-term plan, that "The major risk Carnation faces is the lack of portfolio diversification in profitable branded products. We are vulnerable in some areas (Coffee-mate, some pet foods) to a competitor entering the market with a perceived uniqueness."
On its income tax return, petitioner valued the trademarks and trade names in dispute at $ 315 million. Respondent, in the statutory notice of deficiency, determined that these trademarks *487 and trade names had a value of $ 139,429,000.
D. Unpatented Technology
On its tax return, Carnation reported that the value of its unpatented technology as of January 10, 1985, was $ 106,018,700. In the statutory notice of deficiency, respondent alleged that the value of the Carnation unpatented technology was $ 55,947,000. By Amendment to Answer, respondent alleged that the value of the unpatented technology was $ 21,204,000. The technologies that remain in dispute are described below.
1. Flash-18
Flash-18 is a unique food processing system that is particularly suited to the institutional food market and involves canning heavy viscous products that contain large particles and products in large (No. 10) cans. Flash-18 is a unique version of the "hot fill and hold" type of food processing system; Flash-18 was designed to handle low acid foods that conventional hot fill and hold systems could not process.
In general, Flash-18 is a continuous process that involves heating a product to sterilizing temperature under pressure and filling the product into a precleaned can at the sterilizing temperature and pressure. The sterility of the can and its contents is then further ensured *488 by sealing and holding the can at high temperature and under pressure for a short time. The Flash-18 process also requires workers to enter the pressurized chamber in which the sterilization takes place. The employees who work in the pressurized chamber experience pressure similar to that of divers in 30 feet of water and are limited to 4 hours in the pressurized tank.
Flash-18 was developed by Swift & Co. (Swift) in the early 1960's; Swift filed several patents relative to the Flash-18 process, all but one of which expired in 1983. Trenton Foods acquired the Flash-18 process from Swift; Carnation acquired Trenton Foods in 1966. Carnation made several modifications to the Flash-18 process and also developed formulas and process instructions for its Flash-18 products. The Flash-18 process had a production rate of 90 cans per minute.
Although Flash-18 was considered to be a unique technology when it was developed, it was also considered to be more expensive to operate than other canning processes. A plant in Trenton, Missouri, was the only Carnation food processing facility to use Flash-18 to process food products on a commercial scale; no other canning facility in the world used *489 a pressurized tank like the Carnation Trenton facility. Other companies considered using a process like Flash-18 but never adopted it as a commercial process. One of the reasons that Flash-18 was not used by other companies was because Flash-18 products were sold in a narrow market, which was dominated by the Flash-18 products that Carnation produced; the companies that investigated the filling and sterilization process concluded that they did not need, or want, such a process. Carnation investigated the possibility of, but decided against, building a second Flash-18 line at Trenton because the market was not large enough to justify the cost.
With respect to the Food Service Division long-term plan, Carnation management recognized, in its 1985 report, that packaging innovation was occurring in the industry that might replace the No. 10 can. However, one of the strategies of Carnation management was to utilize the Flash-18 process to increase volume. In the long-term report, Carnation management determined that the strengths of the Food Service Division included quality products, outstanding direct sales organization, modern distribution centers, excellent reputation in the market, *490 and low cost manufacturing centers. In that report, Carnation management also stated that one of the key factors that contributed to the success of the division was the introduction of new cheese items from the Trenton facility; Trenton production of the Que Bueno Nacho Cheese product reached a 500,000-case sales rate.
As of January 10, 1985, there were other sterilizing processes that were available, including Aseptic, retort, and Orbitort systems. The Aseptic process was a continuous process that was best suited for light- to medium-viscosity products like puddings and sauces. The Aseptic process was only used commercially to sterilize products with particulates no larger than a grain of rice. Carnation considered using an Aseptic process for its nonparticulate cheese sauces but determined that such a process was not viable; at the cheese levels of the Carnation products, the Aseptic process caused "burn-on" in the processing equipment that resulted in dark particles flaking off into the cheese sauce. Moreover, the Aseptic process omitted a step of the Flash-18 process that Carnation thought added better flavor. The retort systems were best suited for small-diameter cans. The Orbitort *491 system, a variant of the retort systems, was a batch system that was designed for medium viscous products in large can sizes; the Orbitort system was not suited for heavy viscous products such as pumpkin or corned beef hash. The Orbitort system could produce about 10 cans per minute.
2. Drying/Instantizing
The drying and instantizing processes were used in the Carnation Instant Division to produce products such as Coffee-mate, Instant Breakfast, and Hot Cocoa. Drying is the process of removing water from a liquid mixture to form a powder. Instantizing is the process of rewetting the powder to form an agglomerate that can be readily dispersed in liquids.
Instantizing was developed in the 1950's by David D. Peebles (Peebles), an employee of Western Condensing Co. (Western Condensing). Peebles filed several patents on his instantizing process, the last of which expired in 1976. Peebles assigned all of his rights to his instantizing technology to Western Condensing. Carnation developed its initial applications of Peebles' instantizing technology for milk products in a joint venture with Western Condensing in the 1950's. Subsequent to the joint venture, Carnation acquired Western *492 Condensing and all of its rights to the instantizing technology.
The Peebles instantizing process was first used by Carnation to produce instant skim milk around 1955. With additional research and development efforts, Carnation further developed the instantizing technology, which it applied to the production of other products such as nondairy coffee creamer and instant breakfast products.
Carnation installed the drying and instantizing process at its plant in Jacksonville, Illinois, in 1970 to process Coffee-mate. The Jacksonville plant had a six-story spray dryer. The spray-drying process removed water from a liquid feed containing corn syrup, water, and vegetable or tropical oil to form a powder. The spray-drying process was not contained in the Peebles patents. The Jacksonville plant had a capacity of 22,000 pounds per hour, and the process parameters there were specifically designed for this high output.
A certain amount of information regarding the formulation of nondairy creamers was commercially available in the food industry. As of 1985, several private label and generic nondairy creamers were produced. A March 1983 article in Consumer Reports rated several private label *493 brands above Coffee-mate and stated that, although Coffee-mate was the biggest-selling brand of creamer, in its opinion, there were less expensive brands that tasted better. Coffee-mate sold at a premium price and had a high market share; however, Carnation management stated, in their 1985 long-term report: Coffee-mate is monolithic -- the product has only one form and is relatively undifferentiated from competitors. This means that the Brand (at a 39% share) is highly vulnerable to head-on assault by a competitor offering a meaningful technological advantage (such as zero calorie fat). * * *
Carnation management also stated that one of the primary vulnerabilities in the Instant Division was the lack of proprietary technologies.
Carnation also used its drying and instantizing process at other plants to produce hot cocoa mixes, Instant Breakfast, Instant Slender, and instant and malted milk. The equipment and processes at these plants differed from that at the Jacksonville plant depending upon the type of product being manufactured. For example, chocolate-flavored Instant Breakfast was difficult to instantize because of its fat content. On October 18, 1984, NSA and Carnation *494 made the following joint statement before the FTC in support of the Nestle acquisition of Carnation: Not only is there enormous supply substitutability and excess capacity in hot cocoa mix production, but it is exceedingly easy to enter into the business of manufacturing and selling the product. A potential manufacturer can enter into the hot cocoa mix business simply by producing the product on its existing equipment, often even without modification, or by constructing, purchasing, leasing or modifying existing manufacturing facilities. The equipment needed to produce hot cocoa mix is relatively inexpensive and is available for delivery in a modest amount of time. * * *
3. Coating
As of 1985, Carnation used a multiple-coating process in the production of its dry cat food brands, Little Friskies and Chef's Blend. This process originated in 1977 when Carnation was making improvements to products that it was marketing in Europe. Carnation incorporated this coating process into its production of dry cat food for the United States in 1983 as part of an effort to make a more competitive product. Around that time, Carnation also made other changes to Little Friskies, including *495 changes in the base product mixture. During 1981 through 1984, Carnation increased advertising spending for Little Friskies.
The market leader in the dry cat food industry was Ralston Purina, which produced Cat Chow and Meow Mix and through those products controlled about 53 percent of the dry cat food market; Carnation was a distant second. The Carnation market share increased between 1982 and 1985; however, it did not overtake the Ralston Purina brands.
Carnation conducted palatability tests comparing Little Friskies to Cat Chow and determined that, in 1982 through 1984, Cat Chow had a higher palatability rating than Little Friskies but that Little Friskies exceeded Cat Chow in palatability in 1985. Nevertheless, in its 1985 long-term plan, Carnation management recognized that there was little product difference between its dry cat food products and those of Ralston Purina and the other competitors. In that report, Carnation management stated: There is very little brand loyalty in the dry cat food category, presumably because no brand has a meaningful, differentiated position. The average consumer uses 2.7 brands within a three month period, with no brand accounting for more *496 than 40% of an average consumer's usage of dry cat food. The lack of brand loyalty causes a heavy dependency on deal incentives in the category, with 50% of pounds being sold on some form of deal.
4. Mibolerone Dog Food
On September 12, 1967, The Upjohn Co. (Upjohn) was issued a patent for a compound 7-Methyltestosterones (mibolerone), which was an antigenic anabolic steroid. Upjohn's mibolerone patent expired on September 12, 1984.
On May 1, 1972, Carnation and Upjohn entered into an agreement (1972 agreement) for the joint development of a pet food product containing mibolerone to suppress estrus in female dogs, which would provide temporary, reversible birth control for dogs. Under the 1972 agreement, Carnation and Upjohn agreed to share the expense for conducting field testing and other studies on mibolerone and Upjohn granted Carnation the exclusive right to use mibolerone in over-the-counter pet food. Carnation and Upjohn communicated on a regular basis concerning developments in the effort to market an over-the-counter mibolerone product. Although the 1972 agreement contemplated a product for dogs and cats, later work revealed an inadequate margin of safety for cats, *497 and the effort for cats was dropped.
In 1972, Carnation and Upjohn began a "Lifetime Study" to determine the safety and efficacy of a pet food containing mibolerone. In the lifetime study, the mibolerone compound was fed to a number of dogs of a variety of breeds for approximately 9 years. An Upjohn internal memorandum of November 9, 1982, reported that long-term feeding of mibolerone was associated with an increased incidence of chronic liver disease and changes in the reproductive tract. An Upjohn internal memorandum dated April 21, 1982, stated that "the chances of mibolerone being approved by FDA [Food and Drug Administration] for OTC [over-the-counter] use is essentially nil." From 1974 through 1976, Carnation conducted a "Home Placement Protocol Study" to evaluate the completeness and clarity of the labeling instructions for pet food containing mibolerone.
On November 17, 1975, Upjohn requested approval from the Food and Drug Administration (FDA) for sale of mibolerone in a drop form. On October 5, 1976, Upjohn requested approval from the FDA for sale of a dog food containing mibolerone. On April 14, 1978, the FDA granted Upjohn approval to sell mibolerone in drop form through *498 veterinarians by prescription only. After responding to five "incomplete" letters from the FDA (requesting further study and information), on February 16, 1982, Upjohn received FDA approval to sell dog food containing mibolerone through veterinarians by prescription only, with a 24-month usage limitation. Upjohn was aware that the 24-month limitation was due to adverse effects caused by long-term usage. Carnation was aware that dosage restrictions would present problems for over-the-counter sales. Upjohn never marketed the mibolerone dog food as a prescription product; Upjohn and Carnation were aware that the FDA would likely require prescription marketing before it would consider approval for over-the-counter sale.
On November 17, 1983, Upjohn filed a request with the FDA for change in status for the mibolerone dog food from sale by prescription to over-the-counter sale. On May 16, 1984, the FDA issued an incomplete letter that denied regulatory approval for over-the-counter sale because of the adverse effects of mibolerone, which required veterinary intervention for monitoring, diagnosis, and treatment. The FDA letter also stated: "Adequate directions for safe use of the product *499 cannot be written in a manner that would be easily comprehended and executed by a lay person in the absence of a veterinarian's guidance."
On May 1, 1982, the 1972 agreement expired; thus, on January 10, 1985, there was no agreement between Carnation and Upjohn for the development of an over-the-counter mibolerone product. On February 19, 1985, Carnation and Upjohn entered into a new agreement (1985 agreement), under which Carnation would have exclusive rights to use mibolerone in dog food on a national mass market, over-the-counter basis. On August 2, 1985, the FDA issued a second letter to Upjohn denying over-the-counter status because the range and severity of symptoms from mibolerone required the supervision of a veterinarian.
5. Low-pH/Hot-Fill-and-Hold
"Low-pH/hot-fill-and-hold" technology is a food preservation process. Carnation used the low-pH/hot-fill-and-hold process for processing products with high acid content.
Processes for safe sterilization of acidified foods and of naturally acid foods are well known in the food industry and are specified in regulations promulgated by the FDA and many States, including California.
V. Sale of Trademarks and Technology
*500 It was the general policy of NSA to have the intellectual intangible assets of an acquired company transferred for FMV to NSA in order to centralize ownership of all brands and technology. Such transfers were made for FMV in order to avoid challenges from the local tax administrators. Prior to the execution of the merger agreement, it was understood that these intangible assets would be transferred from Carnation to NSA at FMV.
An agreement dated April 30, 1985 (sales agreement), between Carnation and NSA stated: CARNATION hereby sells, transfers and assigns to NESTLE and NESTLE hereby purchases and acquires from CARNATION as of the date of this agreement all of CARNATION's rights, title and interest in:
any and all registered and/or used trademarks, trademark applications, designs, copyrights, patents, patent applications, manufacturing processes, formulae, know-how and any other industrial property rights * * *
The sales agreement provided that the sales price was $ 423,100,000 "subject to any changes which may result from the final findings as to the fair market value assessment currently being carried out by American Appraisal Associates." Carnation and NSA *501 intended for the sales agreement to fix the purchase price at the FMV of those assets. In its final report, AAA increased its determination of the FMV of the trademarks and technology by $ 2,531,000 to $ 425,630,700.
The Carnation 1985 certified financial statements stated that Carnation sold certain intangible assets to Nestle based on the appraised value of such assets at January 10, 1985, for an aggregate amount of $ 425,630,000. These statements did not report a change in capital structure, a reserve account, or a contingency for modification of the $ 425,630,700 sales price.
On its income tax return, Carnation reported sales proceeds of $ 425,630,700 and an adjusted basis in the trademarks and technology of $ 435,837,000, which included a claimed second tier step-up under section 338 ; as a result, Carnation claimed a loss on the sale, which it reported as a deferred loss.
The NSA 1985 annual report listed the trademarks and technology as an asset valued at SwF (Swiss franc) 900 million and stated that that amount "reflects the capitalisation at the end of 1985 of the balance of the amount paid to acquire the trademarks and other industrial property rights of Carnation, of *502 which a first tranche has already been written off against the profits of the year 1985".
In the notice of deficiency, respondent adjusted Carnation's basis in the trademarks and technology as a result of revisions to petitioner's section 338 computation. Respondent determined that the FMV, and thus basis, of the trademarks and technology was $ 196,022,000 and, as a result, determined that Carnation had a short-term capital gain in the amount of the difference between the amount realized and the redetermined adjusted basis.
OPINION
I. Introduction
The issues presented to the Court relate to the acquisition of Carnation by petitioner. Both parties presented a number of experts to support their positions, all of whom were qualified in different respects. We have closely examined each expert report and the clarifying testimony given at trial. We are not bound by the opinion of any expert when the opinion is contrary to our own judgment. Bausch & Lomb, Inc. v. Commissioner , 92 T.C. 525 , 597 (1989) , affd. 933 F.2d 1084 (2d Cir. 1991) . We may embrace or reject expert testimony, whichever in our judgment is most appropriate. *503 Helvering v. National Grocery Co. , 304 U.S. 282 , 295 (1938) ; Silverman v. Commissioner , 538 F.2d 927 , 933 (2d Cir. 1976) , affg. T.C. Memo. 1974-285 . Moreover, we are not restricted to choosing the opinion of one expert over another but may extract relevant findings from each in drawing our own conclusions. Chiu v. Commissioner , 84 T.C. 722 , 734 (1985) .
To the extent that we rely on experts, our reliance is based, not on credentials, but on the degree to which their opinions are supported by the evidence and by consistent reasoning. We do not list or discuss the qualifications of the experts; our decision in this case is not based on comparing qualifications, and our listing them would unduly burden this opinion. Similarly, we do not use titles, such as "Doctor" and "Professor", in this opinion because we do not wish to imply any greater deference to the academic experts than to the industry experts.
II. Interest Deduction
Respondent's statutory notice determination that, in substance, NSA acquired Carnation was contradicted by respondent's subsequent responses *504 to discovery and to a motion for summary judgment on the interest issue filed by petitioner. In an amended answer, respondent pleaded and now contends that petitioner and Carnation are not entitled to interest deductions totaling $ 131,739,791 on related-party borrowings because such payments, in substance, related to nondeductible capital contributions instead of bona fide loans. Respondent bears the burden of proof on this issue. Rule 142(a).
In resolving questions of debt versus equity, courts have identified and considered various factors. See Dixie Dairies Corp. v. Commissioner , 74 T.C. 476 , 493 (1980) ; see also Anchor National Life v. Commissioner , 93 T.C. 382 , 400 (1989) . Some of those factors include: Presence of a written agreement demonstrating indebtedness, presence of a fixed maturity date, right to enforce payment, intent of the parties, identity of interest between creditor and stockholder, thinness of capital structure in relation to debt, ability of corporation to obtain credit from outside sources, failure of debtor to repay, and risk involved in making advances. No single factor is determinative or relevant *505 in each case. Dixie Dairies Corp. v. Commissioner , supra at 493-494 . "The various factors * * * are only aids in answering the ultimate question whether the investment, analyzed in terms of its economic reality, constitutes risk capital entirely subject to the fortunes of the corporate venture or represents a strict debtor-creditor relationship." Fin Hay Realty Co. v. United States , 398 F.2d 694 , 697 (3d Cir. 1968) . We have stated that the ultimate question is: "Was there a genuine intention to create a debt, with a reasonable expectation of repayment, and did that intention comport with the economic reality of creating a debtor-creditor relationship?" Litton Business Sys., Inc. v. Commissioner , 61 T.C. 367 , 377 (1973) .
Respondent argues that, where, as is the case here, the financing arrangements are between a U.S. subsidiary and a foreign parent, the foreign parent has an incentive to capitalize inadequately the U.S. subsidiary through debt and, thus, that such arrangements should be closely scrutinized because the subsidiary receives a U.S. tax deduction but the foreign parent does *506 not have ordinary income taxable by the United States at the marginal rate. Throughout her brief, respondent applies the relationship between NSA and petitioner to the various factors to justify her position that the advances constitute capital contributions and not loans.
The form of the transaction and the labels that the parties place on the transaction may have little significance when the purported debtor and creditor are related parties, and arrangements between a parent corporation and its wholly owned subsidiary invite close scrutiny. Calumet Indus., Inc. v. Commissioner , 95 T.C. 257 , 286 (1990) ; Malone & Hyde, Inc. v. Commissioner , 49 T.C. 575 , 578 (1968) . Nevertheless, the existence of a bona fide debt is not precluded merely because the debtor and creditor are related parties. Kraft Foods Co. v. Commissioner , 232 F.2d 118 (2d Cir. 1956) , revg. 21 T.C. 513 (1954) . The Court of Appeals for the Second Circuit has stated: it is one thing to say that transactions between affiliates should be carefully scrutinized and sham transactions disregarded, and *507 quite a different thing to say that a genuine transaction affecting legal relations should be disregarded for tax purposes merely because it is a transaction between affiliated corporations. * * * [ Id. at 124 .]
Our focus is therefore directed toward a determination of the true nature of the advances at issue.
A. Intention to Create Debt
Respondent contends that NSA intended to make a capital contribution to petitioner but characterized its investment as debt so as to obtain tax benefits. In support of its contention that NSA intended to make an equity contribution, respondent argues that NSA stated in SEC filings that it would make a capital contribution to petitioner; that analyses of the financial structure of the Carnation acquisition prepared in July and August 1984 projected capital contributions of between 25 and 50 percent of the projected acquisition price; and that PMM considered only the tax ramifications of debt classification and not the financial implications. Respondent implies that these facts demonstrate that Nestle had tax-avoidance motives, which, under Gilbert v. Commissioner , 248 F.2d 399 (2d Cir. 1957) , revg. and *508 remanding T.C. Memo. 1956-137 , indicate that the related-party advances were equity. As recognized in Gilbert , however, petitioner's desire to minimize taxes is not conclusive of characterization of the advances. Id. at 406 (quoting Kraft Foods Co. v. Commissioner , 232 F.2d 118 , 128 (2d. Cir. 1956)) .
Here, the evidence is persuasive that NSA and petitioner had a genuine intention that the advances create a debt obligation. The revised financing structure that did not include a capital contribution was the result of additional time for planning and was supported by valid business reasons. As early as October 1984, Nestle contemplated a financing structure consisting of over $ 3 billion of debt, which exceeded the amount of total debt ultimately used. Thus, the ultimate amount of debt was not out of line with earlier financing plans.
Moreover, the record contains substantial objective evidence of an intent to create a debtor-creditor relationship. The advances had many of the formalities of a debtor-creditor relationship. See Litton Business Sys., Inc. v. Commissioner , supra at 377-378 . *509 The confirmation letters and other correspondence provided documentation of a stated interest rate and a specified repayment schedule, maturity date, or that the loan was revolving. None of the debt was subordinated to the claims of any creditor or shareholder, and petitioner consistently recorded all of the intercompany advances in dispute as loans on its books and records. Further, prior to the Carnation acquisition, petitioner's filings with the SEC represented that the funds obtained from affiliates would be in the form of loans.
In addition to the evidence indicating that the advances were loans, there is evidence negating a capital contribution intent. Because of the anticipated fall of the dollar against the Swiss franc and the hedging policy of NSA, NSA had business reasons for not making an equity investment in petitioner. See Irbco Corp. v. Commissioner , T.C. Memo. 1966-67 .
B. Reasonable Expectation of Repayment
Respondent implies that NSA had no reasonable expectation of repayment on the advances because payment on the advances depended solely upon the success of Carnation. Respondent cites several cases to support its position that *510 an expectation of repayment from corporate earnings is not indicative of bona fide debt. Roth Steel Tube Co. v. Commissioner , 800 F.2d 625 (6th Cir. 1986) , affg. T.C. Memo. 1985-58 ; In re Lane , 742 F.2d 1311 (11th Cir. 1984) ; Fin Hay Realty Co. v. United States , 398 F.2d 694 (3d Cir. 1968) ; Segel v. Commissioner , 89 T.C. 816 (1987) .
The cited cases indicate that the more the advances "are at the risk of and subject to the vagaries of the business, the more they are indicative of equity." Id. at 830 . However, the facts that led to equity classification in those cases are distinguishable from the circumstances here. For example, in Roth Steel , repayment was completely dependent on the prospective financial success of the corporation because all of the existing assets of the corporation were subject to security interests and thus were not available as a source of repayment. Roth Steel Tube Co. v. Commissioner , T.C. Memo. 1985-58 . In Lane , advances were considered to *511 be equity because many of the advances contained no provisions for interest and the purported creditor sought repayment only when it was beneficial to the corporation. In re Lane , supra at 1317 . In Fin Hay Realty and Segel , the payments were made to finance the development of newly established corporations and, at the time of the advances involved there, it could not be projected that repayment could be made out of assets or soundly anticipated cash-flow.
Here, Nestle anticipated that the combined petitioner-Carnation entities would have a high level of cash and investments on hand that could be used to pay down debt; that divestiture of assets would be used to pay debt; and also the cash-flow from the combined entities would be adequate for debt service. The advances in this case contained interest and payment provisions, and timely principal and interest payments were made. Moreover, the advances were made as part of an acquisition of a complete, existing enterprise that had valuable assets and an established market position. Such factors indicate that the advances were not solely dependent on the risk of the business. Litton Business Sys., Inc. v. Commissioner , 61 T.C. at 378 ; *512 see also Malone & Hyde, Inc. v. Commissioner , 49 T.C. at 578 (expansion of nucleus involves minimal business risk).
C. Economic Reality
Respondent makes several arguments as to why the advances, in terms of economic reality, were capital contributions. First, respondent contends that petitioner could not have obtained financing from outside sources without the financial backing and guarantees of NSA and that this factor indicates that the related-party advances were capital contributions. The question of whether petitioner could have obtained comparable debt financing from independent sources is a relevant factor in measuring the economic reality of the debt in question. Estate of Mixon v. United States , 464 F.2d 394 , 410 (5th Cir. 1972) ; Nassau Lens Co. v. Commissioner , 308 F.2d 39 , 47 (2d Cir. 1962) , remanding 35 T.C. 268 (1960) . Evidence that a taxpayer could not obtain loans from independent sources indicates that the related-party advance was in substance a capital contribution. Calumet Indus., Inc. v. Commissioner , 95 T.C. 257 , 287 (1990) . *513
Respondent emphasizes that petitioner attempted to borrow from independent creditors but was unable to obtain loans without a guarantee by NSA. Respondent contends that Citibank required a guarantee by NSA and that Citibank involved a bank syndicate to make the loan to petitioner because it did not want to bear the risk of lending $ 2.5 billion to one company. Respondent further contends that the outside financing element of the Carnation acquisition loans required a guarantee by NSA. Respondent also argues that the NSA note purchase agreement for the 4(2) note program constituted a guarantee by NSA.
With respect to the Citibank arrangement, the record indicates that the NSA guarantee enabled the bridge financing to be arranged in a matter of hours, in response to a perceived urgency related to the acquisition process. The NSA note purchase agreement may have influenced the investment grade rating and presumably lowered the interest cost of the 4(2) notes, without necessarily being an absolute requirement for independent financing. Petitioner placed debt in the European financial market, without any guarantee or purchase agreement by NSA, in 1985, 1987, and 1988. Petitioner may *514 not have been able to borrow the entire amount of the advances at issue directly from a single bank without the NSA guarantee; however, on this record, we are satisfied that petitioner, as a separate entity, could have obtained the full amount from some combination of private lenders and commercial banking sources. See Litton Business Sys., Inc. v. Commissioner , 61 T.C. at 379 .
Respondent also contends that the interest rate charged on the related-party advances was an exceptionally low rate and that petitioner could not have obtained a LIBOR-plus-3/8-percent rate from independent lenders. Respondent submitted the expert report of Jacob R. Brandzel (Brandzel). In his report, Brandzel opined that the credit ratings of petitioner's long-term borrowings would have been "non-investment grade" in the absence of the NSA support agreements and that petitioner would not have been able to service noninvestment grade debt. Brandzel stated that the applicable noninvestment grade debt interest rate would be 16.6 percent.
Brandzel's opinion that petitioner could not obtain independent debt financing at a rate below 16 percent is not supported by the record. During *515 1985, petitioner obtained medium-term financing from independent parties at a rate of 9-7/8 percent, without guarantees by NSA, despite the amount of the outstanding acquisition debt. At trial, Brandzel admitted that he was not familiar with, and that his analysis did not consider, petitioner's European debt offerings. Further, in his rebuttal report, Brandzel inaccurately states that petitioner believed that interest rates were going to increase and thus that petitioner entered into interest rate swaps to fix its interest rate. To the contrary, the record indicates that petitioner believed that interest rates would decrease and entered into interest rate swap transactions to obtain floating rates. Such swap transactions enabled petitioner to reduce the effective interest rate on the $ 200 million of unrelated-party debt to approximately 7 percent. We conclude that Brandzel's opinion as to the interest rate available on independent-party financing is not reliable.
As a further argument that the LIBOR-plus-3/8-percent interest rate was low, respondent notes that the Kidder Carnation LBO analysis used interest rates of 15 through 17 percent as of August 1984. Respondent also cites *516 interest rates, including LIBOR plus 2 percent and LIBOR plus 2-1/4 percent, incurred by several corporations in other leveraged transactions that were listed in Brandzel's report.
We are not persuaded that these rates indicate that LIBOR plus 3/8 percent was unreasonably low. The Kidder analysis is a series of computations analyzing the feasibility of an LBO at various stock prices, assuming interest rates from 15 to 17 percent. Nothing in that analysis asserts that those interest rates were the only possibilities. Nothing in that analysis addressed the interest rates that could be obtained by a purchaser such as petitioner, who, through a combination with Carnation, could potentially generate synergies and additional cash-flow. Furthermore, the Kidder analysis does not address the possibility of using interest rate swaps to take advantage of the anticipated decline in interest rates.
The rates incurred by corporations in other leveraged transactions that were cited by respondent are also not determinative here. Because of the infinite number of factors that may affect the interest rates incurred on the debt in those transactions, which differ in each particular situation, we cannot *517 compare the rates on the debt there to the rates on the debt here. We do however note that, in his report, Brandzel stated that the debt used in the Esmark, Inc., acquisition of Norton Simon was at "prime, LIBOR plus 3/8 percent, CD plus 1/2 percent or any rate mutually agreed" by Esmark, Inc., and the bank.
Respondent also contends that the repayment terms of the related-party advances were lenient and could not have been obtained from outside lenders. Respondent argues that some of the advances had maturities of over 20 years and that, in most cases, the long-term advances deferred repayment for 2 years. Respondent contends that these long maturity periods reflect equity, not debt, and that the deferred maturities indicate that NSA knew that it had overloaded petitioner with debt and that petitioner lacked the cash-flow to reduce its debt obligation. Respondent also argues that independent creditors would have imposed nonfinancial covenants that would place restrictions on the declaration of dividends, asset sales, and incurring additional debt.
At trial, Regolatti testified that petitioner could have borrowed the necessary acquisition funds, without NSA guarantees, but that such *518 loans would have been at a higher interest rate (i.e., LIBOR plus 1 to 1-1/4 percent) and would have contained certain conditions such as maintenance of working capital, restrictions on sales of assets, and declaration of dividends.
In evaluating the terms of related-party debt, we do not apply a mechanical test of absolute identity between the related-party advances and the debt that actually or hypothetically would have been available to petitioner, but, instead, we seek to determine whether the terms of the advances were a "patent distortion of what would normally have been available" to petitioner. Litton Business Sys., Inc. v. Commissioner , 61 T.C. 367 , 379 (1973) . We have recognized that "different creditors invariably undertake different degrees of risk and that, where debtor and creditor are related, the lender might understandably offer more lenient terms than could be secured elsewhere." G.M. Gooch Lumber Sales Co. v. Commissioner , 49 T.C. 649 , 659 (1968) , remanded on a different issue 406 F.2d 290 (6th Cir. 1969) . The terms of the related-party advances here cannot be characterized *519 as a "patent distortion" of what would normally have been available to petitioner as independent-debt financing. Cf. Segel v. Commissioner , 89 T.C. 816 , 832-834 (1987) (purported loans that contained no written agreement, security interest, provision for the payment of interest, or a schedule for repayment justified a conclusion that no outside lender would have made loans on the "anywhere near the same" terms).
Respondent also contends that the financial ratios of petitioner demonstrate that the capital structure of petitioner was inadequate. Thin or inadequate capitalization is strong evidence that advances are capital contributions because "Any 'loan' to the corporation in such circumstances would necessarily be venture capital in reality, for any business loss by the corporation would be reflected in an inability to repay the 'loan'". Gilbert v. Commissioner , 248 F.2d 399 , 407 (2d Cir. 1957) .
Respondent's inadequate capitalization argument is based mainly on the contention that petitioner did not have adequate cash-flow from its operations to cover its debt obligations. Respondent relies heavily on the expert report *520 of Brandzel. In his report, Brandzel computed the interest coverage ratio (ICR) of petitioner in an attempt to quantify the ability of petitioner to service interest expense with income from operations. Brandzel computed the ICR as earnings before interest and taxes divided by interest expense. Brandzel reported that, as of December 28, 1985, the ICR of petitioner was 1.2 and that the average ICR of 13 comparable corporations was 3.6. Brandzel also computed the ICR of Beatrice Foods Co. after its acquisition of Esmark, Inc., as 1.9. Citing cases in which we considered industry debt/equity ratios in evaluating whether a particular taxpayer was undercapitalized, respondent contends that the low ICR of petitioner demonstrates that it had an inadequate capital structure.
Petitioner contends that Brandzel's methodology for computing ICR does not reflect the ability of petitioner to service the debt, because Brandzel's calculations understated petitioner's cash-flow by excluding the cash-flow associated with amortization and depreciation of petitioner's assets and the sales of Carnation assets to NSA and also because Brandzel overstated petitioner's interest expense. Further, petitioner *521 contends that Brandzel did not consider the high level of existing liquidity on petitioner's balance sheet.
We need not determine whether the ICR computations of Brandzel accurately reflect whether petitioner had excessive debt because we are not satisfied that such a ratio is determinative here. At trial, Regolatti testified that Nestle did not calculate the ICR for petitioner because such a calculation was not significant to Nestle. Regolatti explained that Nestle did not maintain a high amount of liquidity in petitioner because, from a foreign exchange risk standpoint, it was more prudent to maintain debt in the currency of the foreign subsidiaries and liquidities in the holding company in the currency of which dividends had to be paid. As an example of this financing principle, Regolatti testified that, before its acquisition, Carnation had debt in its foreign subsidiaries and liquidity in dollars in the U.S. holding company because it had to pay its shareholders in dollars. Regolatti further testified that Nestle's interest was whether, after the acquisition and subsequent sale of certain Carnation assets, petitioner would be able to meet its debt obligations.
The record here *522 establishes that petitioner satisfied its debt obligations, and we believe that the evidence of actual repayment is better proof of ability to repay than the calculation of an ICR. Respondent, however, contends that, after the acquisition, petitioner did not have sufficient funds to repay its third-party obligations without subsequent advances from NSA.
In Litton Business Sys. , we held that an advance from a parent corporation to a subsidiary was debt even though the parent had to make subsequent advances to the subsidiary in order to cover interest payments on the advance account because, despite the additional advances, there was an annual net reduction in the balance of the advance from its inception through the years in issue. Litton Business Sys., Inc. v. Commissioner , 61 T.C. at 380 -381 . The facts are similar here. Although NSA made subsequent advances to petitioner in 1985, some of which were used to retire maturing 4(2) notes, petitioner reported a net reduction of related-party debt each year after 1985, in addition to making timely interest payments. As we held in Litton Business Sys. , such repayment resulting in net reduction "is *523 significant evidence that the parties' substantive actions complied with the form of the transaction as establishing a debtor-creditor relationship." Id. at 381 .
Respondent also contends that, even when petitioner made repayments to NSA, it did not reduce its overall debt because such repayments were merely a result of refinancing petitioner's debt by the issuance of Eurobonds in 1987 and 1988. The ability of petitioner to issue debt to unrelated parties during this period, however, indicates that petitioner was not overcapitalized and that NSA expected repayment pursuant to the terms of the confirmation letters.
Petitioner submitted the expert report and testimony of Daniel P. Broadhurst (Broadhurst), in which Broadhurst computed the total debt/equity ratios of petitioner as follows: Year Ended 12/85 1/87 1/88 12/88 12/89
Total debt/equity 4.46 4.47 4.35 4.57 3.73
Related-party debt 2.98 3.04 2.69 1.71 1.29
Third-party debt 1.48 1.44 1.67 2.86 2.45
Respondent contends that Broadhurst's calculations are misleading in that the financial statements from which Broadhurst made his computations used a pooling method of *524 accounting that resulted in Carnation's obligations to NCC being treated as unrelated-party debt. Respondent's objection to Broadhurst's calculations is not compelling as the majority of the NCC loans were no longer outstanding as of December 28, 1985. Broadhurst's debt/equity calculations, however, provide a general indication that, overall, after the acquisition, petitioner reduced its debt.
Petitioner also submitted the expert report and testimony of J. Gregory Ballentine (Ballentine). Ballentine compared the leverage ratios of petitioner to the leverage ratios of independent firms that made large acquisitions from 1981 through 1992. Ballentine determined that the extent of petitioner's debt was not extreme compared to similarly situated independent firms. There is no evidence that the debt/equity or leverage ratios of petitioner were out of line with other companies. To the contrary, respondent's expert, Brandzel, seemed to agree with Ballentine's conclusion by stating in his report that petitioner's "leverage is identical to the average leverage ratio of manufacturing companies making substantial acquisitions".
Although the debt/equity and leverage ratios as determined by petitioner's *525 experts do not provide a safe harbor for petitioner, they do counter respondent's allegation of inadequate capitalization. Litton Business Sys., Inc. v. Commissioner , 61 T.C. at 379 ; see also Kraft Foods Co. v. Commissioner , 232 F.2d 118 , 127 (2d Cir. 1956) , revg. 21 T.C. 513 (1954) .
Respondent further contends that the sale of trademarks, patents, unpatented technology, and foreign subsidiaries of Carnation to NSA indicates that NSA had an ownership interest. Citing Segel v. Commissioner , 89 T.C. 816 (1987) , respondent argues that the disposal of material assets in order to pay shareholder "debt" is indicative of equity.
The facts here are materially distinguishable from those in Segel . There, the "borrower"-corporation experienced financial difficulty and made distributions on the purported loans out of proceeds from the sale of major operating assets as the business was "winding down". Here, petitioner and Carnation were viable entities and did not transfer the assets to unrelated parties as part of a liquidation or cessation of business. Carnation licensed *526 back some of the transferred assets, and petitioner/Carnation reported royalty expenses on its audited financial statements.
Respondent argues that petitioner/Carnation "paid a hefty price for the debt reduction by taking on a permanent liability in the form of a royalty obligation". The market, however, apparently disagreed. The royalty obligation did not prevent petitioner from obtaining debt financing from unrelated parties in subsequent years.
Noting the disparity in dividends and interest paid from petitioner to NSA during 1984 through 1986, respondent also argues that petitioner's putative "debt" repayments substituted for dividend payments. The Carnation acquisition was a leveraged transaction; interest payments would necessarily reduce the amount available for dividends. This factor is merely another way of stating the debt-equity issue and adds nothing to the analysis.
Here, prior to the acquisition, petitioner had over $ 650 million in equity and very little leverage. Petitioner leveraged itself to acquire Carnation, an established entity with an established cash-flow and valuable assets. See Tomlinson v. 1661 Corp. , 377 F.2d 291 , 299 n.18 (5th Cir. 1967) ("Leverage *527 is the aim of many entrepreneurs, many of whom are quite successful in securing financing on high ratios."). After the acquisition, petitioner was able to obtain financing from unrelated parties. In sum, as we said in Malone & Hyde, Inc. v. Commissioner , 49 T.C. 575 , 578 (1968) : "we think it unwarranted to apply legalistic and mechanical tests, in the area of parent-subsidiary relationships, without regard to the realities of the business world and the manner in which transactions are handled in the normal and ordinary course of doing business."
The notice of deficiency disallowed interest deductions on related-party loans made to both petitioner and Carnation. Respondent has not made any specific arguments with respect to the Carnation loans, other than to argue that the "all debt scheme seems almost preposterous" and that Carnation needed "a massive debt infusion" because of the acquisition debt. The majority of the related-party loans provided to Carnation in 1985 consisted of loans from NCC, which provided working capital loans for Nestle-related entities. Carnation made interest payments, and NCC reported such payments as interest income; as of *528 December 28, 1985, the vast majority of those loans were no longer outstanding.
The preponderance of the evidence shows that the related-party loans to petitioner and Carnation were, in substance, debt and not capital contributions. Regardless of the burden of proof, we hold that petitioner and Carnation are entitled to deduct the disallowed interest of $ 131,739,791.
III. Valuation Under Section 338 Election
An election under section 338 permits a corporate taxpayer that acquires another corporation (target) in a "qualified stock purchase" to step up the basis of all of the target's assets (other than cash and cash equivalents) to reflect the acquisition cost. This step-up is accomplished through a taxable deemed sale in which the (1) "old target" is treated as if it sold all of its assets at FMV in a complete liquidation on the acquisition date and (2) "new target" is treated as if it purchased all of the assets of the old target. Sec. 338(a) .
Section 338(b) provides that the basis of the assets after the deemed purchase consist of four elements, which the regulations call "adjusted grossed-up basis" (AGUB). Sec. 1.338- 4T(j)(1) , Temporary Income Tax Regs., 50 Fed. Reg. 16402 *529 (Apr. 25, 1985). The rules for allocating AGUB to individual assets are contained in section 1.338(b)-2T , Temporary Income Tax Regs., 51 Fed. Reg. 3583 (Jan. 29, 1986); however, because of the date on which the Carnation acquisition occurred, petitioner was permitted to make a transitional election under section 1.338(b)-4T , Temporary Income Tax Regs., 51 Fed. Reg. 23737 (July 1, 1986), to use the allocation rules for lump-sum purchases. In general, lump-sum purchase prices are allocated by reference to the FMV of the individual assets. See Victor Meat Co. v. Commissioner , 52 T.C. 929 (1969) ; C.D. Johnson Lumber Corp. v. Commissioner , 12 T.C. 348 (1949) .
The dispute here concerns the valuation of, and thus the allocation of basis to, the inventory of Carnation, trademarks and trade names, unpatented technology, and goodwill and going concern.
A. Inventory
For purposes of its December 28, 1985, income tax return, petitioner allocated $ 487 million to inventory based on the AAA appraisal. Based on the expert report and testimony of Stamos C. Nicholas (Nicholas), *530 petitioner now maintains that the FMV of the Carnation inventory as of January 10, 1985, was $ 509,837,000. In his report, Nicholas used the comparative sales method to value the inventory, because, pursuant to Rev. Proc. 77-12 , 77- 1 C.B. 569 , which sets forth guidelines for lump-sum purchase price allocations, the comparative sales method is authorized for manufacturing operations.
Respondent submitted the expert report and testimony of George H. Sorter (Sorter), in which Sorter, using the cost of reproduction method, determined that the value of the Carnation inventory was $ 413,564,000. Sorter also determined that, under the comparative sales method, the valuation of the inventory would not exceed $ 441,497,000. However, Sorter opined that the cost of reproduction method was a more appropriate method of valuation for the inventory than the comparative sales method because Carnation was not the type of manufacturing company that was described in Rev. Proc. 77-12 , supra . Sorter maintained that Carnation was a material-intensive, rather than a conversion-intensive, *531 company because the merchandise bought for manufacture or sale component of cost of goods sold (ratio of purchases to cost of goods sold) was 76 percent in 1984 and 78 percent in 1983.
Sorter's opinion is contrary to the record, which justifies treating Carnation as a manufacturer for purposes of valuing inventory. The record indicates that Carnation was primarily a manufacturing company. The Carnation Grocery Products Divisions manufactured raw foodstuffs into highly processed, consumer-ready food products. Other divisions of Carnation also carried on manufacturing operations. In addition, petitioner submitted the expert report and testimony of Irving H. Plotkin (Plotkin), in which Plotkin compared the Sorter ratio of purchases to cost of goods sold percentages of 76 and 78 percent to other manufacturing companies and determined that the Carnation ratios of purchases to cost of goods sold were similar to other manufacturing companies. Because we are satisfied that Carnation was a manufacturing company, we conclude that the comparative sales method is the appropriate method to value the Carnation inventory.
Rev. Proc. 77-12 , *532 supra at 569 , states: The comparative sales method utilizes the actual or expected selling prices of finished goods to customers as a basis of determining fair market values of those finished goods. When the expected selling price is used as a basis for valuing finished goods inventory, consideration should be given to the time that would be required to dispose of this inventory, the expenses that would be expected to be incurred in such disposition, for example, all costs of disposition, applicable discounts (including those for quantity), sales commissions, and freight and shipping charges, and a profit commensurate with the amount of investment and degree of risk. * * *
Pursuant to Rev. Proc. 77-12 , supra , Nicholas calculated the value of Carnation inventory as follows: Gross expected selling price $ 586,765,000
Cash discounts, price reductions,
and spoils (61,711,000)
Disposal costs (98,058,000)
Holding costs (6,381,000)
Purchaser-reseller's profit (12,091,000)
FMV of finished goods 408,524,000
Finished goods valued at book 5,039,000
Total finished goods 413,563,000
FMV of raw material 101,461,000
Significant adjustments (5,187,000)
FMV $ 509,837,000
*533 Nicholas relied on the expert report of Gary E. Holdren (Holdren) for accounting and financial data that were necessary for purposes of determining the FMV of the inventory. Based on Carnation records and discussions with Carnation personnel, Nicholas and Holdren determined that, except for Contadina, Processed Potatoes Division, and Herff Jones, the number of units in the Carnation inventory on December 31, 1984, did not differ substantially from the number of units on January 10, 1985. The $ 5,187,000 negative adjustment in Nicholas' calculation includes an adjustment to reflect changes in inventory quantities between December 31, 1984, and January 10, 1985, for Contadina, Processed Potatoes Division, and Herff Jones.
Nicholas attempted to determine the gross expected selling price at the product level. Holdren determined that there were no price lists and that there were insufficient company records to determine the prices for all products in inventory at the product level based solely on the company records. As a result, some of the product-level prices were based on a multiple-regression analysis of a sample of Carnation invoices.
Respondent disputes several aspects of Nicholas' *534 report. In general, respondent contends that Nicholas' report, and thus petitioner's position, is inaccurate because it relies on estimates. Specifically, respondent contends that Nicholas' determination of inventory value is based on the December 31, 1984, inventory count, with some "adjustments" for certain divisions between December 31, 1984, and January 10, 1985. Respondent contends that petitioner cannot meet its burden of proof because it cannot document the number of units, or their prices, on hand on January 10, 1985. Respondent cites Curtis Noll Corp. v. Commissioner , T.C. Memo. 1982-363 , affd. without published opinion 734 F.2d 13 (6th Cir. 1984) , in which the taxpayer was attempting to establish the value of inventory acquired on September 30, 1973, based on a physical count made on May 19, 1973. There, we held that the calculations were "fraught with too many uncertainties, estimations and inaccuracies to be accepted by us". Id. Here, in contrast, the gap is only 10 days, which includes at least 3 nonbusiness days, and it is unlikely that significant changes in inventory occurred during these 10 days. Moreover, *535 the notice of deficiency did not raise the 10-day gap issue. We conclude that the 10-day gap is not fatal to petitioner's satisfying its burden of proof.
The calculations contained in the Nicholas report are based on a detailed analysis conducted at the product level. Because of the level of the analysis in the Nicholas report, we conclude that it, in contrast to the Sorter report, is an appropriate starting point from which to determine the FMV of the inventory as of January 10, 1985.
At trial, the parties attempted to narrow the issues in dispute; in furtherance of this objective, respondent submitted a schedule prepared by Sorter that made adjustments to Nicholas' calculation of inventory value as follows: FMV per Nicholas $ 509,837,000
1. Correct disposal costs (37,303,000)
2. Holding costs on accounts receivable ( 4,726,000)
3. W.I.P-Gross margin on assumed cost
to complete ( 6,224,000)
4. Remove Herff Jones sample rings ( 866,000)
5. Health and nutrition finished goods ( 1,612,000)
6. Profit to purchaser-reseller (12,091,000)
Corrected FMV $ 447,015,000
At oral argument on the inventory issue, respondent stated to the Court that Sorter's schedule "lays *536 out the differences for * * * [the Court] to decide basically. You just have to go down the line and decide what you are going to do with the issues. We think they are relatively fairly presented." We informed the parties as to our thoughts and concerns as to each point in respondent's schedule, and the parties were directed to focus their arguments in the briefs on such concerns. Nevertheless, in her briefs, respondent ignores the prior schedule and proposes the following adjustments to the Nicholas schedule: FMV per Nicholas $ 509,837,000
Less: Expected selling price (21,651,000)
Holding costs ( 4,726,000)
Intangibles' cost (19,480,000)
SG&A costs ( 22,782,000)
Return on investment ( 4,601,000)
Corrected FMV $ 436,597,000
Because of the inherent uncertainties in this process and the necessity of narrowing the areas of dispute, we conclude that it is fair to treat the schedule presented at trial by respondent as an admission and to use $ 447 million as the minimum value of the inventory.
Respondent's "expected selling price" adjustment of $ 21,651,000 is the difference between Nicholas' expected selling price of $ 586,765,000 and *537 gross sales of $ 565,114,000 computed by AAA and used for petitioner's return position. While Nicholas' use of estimates is not fatal to petitioner's position, they are subject to particular scrutiny here. The computed FMV of the inventory at trial exceeded the FMV reported on the return by over $ 22 million. The return is an admission that can be overcome only by cogent proof. Estate of Hall v. Commissioner , 92 T.C. 312 , 337-338 (1989) . In our view, the use of estimates in this case is inadequate to overcome the admission. We conclude that Nicholas' calculation must be reduced in order to reflect petitioner's return position. Respondent's proposed "expected selling price" adjustment approximates this reduction, and we therefore adopt it.
The parties appear to agree that, under the comparative sales method, it is assumed that both the buyer and seller remain a going concern and that the inventory is valued under "the theory that it may be sold to a hypothetical willing buyer having facilities equal to that of the seller for distributing it at retail." Knapp King-Size Corp. v. United States , 208 Ct. Cl. 533 , 527 F.2d 1392 , 1402 (1975) . *538 Under that theory: Such a willing buyer would not be agreeable to paying the full retail price if he knew that he must incur a loss because there had been no allowance for his cost of disposition. Nor would he be willing to pay a price that would merely return his investment without compensating him for the risks which he must incur during the time it took to make the retail sale and for his loss of opportunity to make profits in other ways during the same period on the amount of his investment. Conversely, the willing seller of inventory for a lump sum could hardly expect to receive as much as the aggregate retail price if he was thereby enabled to shift the burden of the disposition costs and risks which would exist during the period of retail sale and if he could invest the proceeds in equally profitable investment or activities elsewhere. [ Id. ]
The parties also agree that, to compute the FMV of the inventory under the comparative sales method, the expected sales price should be reduced by disposal costs, holding costs, and a profit allowance; however, the parties dispute the correct amounts of those reductions.
1. Disposal Costs
The main item disputed by the *539 parties accounting for over $ 42 million is the calculation of the disposal costs that the willing buyer of the inventory would incur. Nicholas uses $ 98,058,000. Respondent includes in its adjustment of Nicholas' disposal costs certain selling, general, and administrative expenses of $ 22,782,000 (SG&A expenses) and an intangibles' charge of $ 19,480,000.
a. SG&A Expenses
In general, the dispute on disposal costs relates to whether disposition costs include all selling-related costs that would be incurred by the buyer during the disposition period or a lesser amount based on the specific selling-related functions remaining to be performed with respect to the acquired inventory.
Nicholas and Holdren determined that the costs that should be treated as disposal costs include only those costs that the purchaser-reseller would expect to incur with respect to the individual units of acquired inventory. As a result, Nicholas did not include all of the Carnation historic

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Source: Frix Law Library, https://www.frixlaw.com/law-library/cases/4624723. Public record. Not legal advice.