UNITED STATES TAX COURT

T.C. Memo. 1999-377

UNITED STATES TAX COURT

BTR DUNLOP HOLDINGS, INC.

AND SUBSIDIARIES, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 24140-97.

Filed November 15, 1999.

Michael F. Solomon, Clifton B. Cates, III, Alan W. Granwell,

and Dirk J.J. Suringa, for petitioner.

Alan R. Peregoy, Gary D. Kallevang, and Judith C. Cohen, for

respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Chief Judge:

Respondent determined a deficiency of

$11,202,042 in petitioner's Federal income tax for 1989.

issues for decision are as follows:

The

- 2 (1) What was the value of Schlegel U.K. Holdings, Ltd.

(Schlegel UK), and Schlegel GmbH on July 1, 1989, and

November 30, 1989, respectively, for purposes of section 311(b)

and section 482 and

(2) what was the Schlegel Corporation’s adjusted tax basis

in Schlegel GmbH on November 30, 1989.

Unless otherwise indicated, all section references are to

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

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

Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated, and the facts set

forth in the stipulation are incorporated in our findings by this

reference.

Schlegel Corporation

Schlegel Corporation is a New York corporation that was

formed on August 10, 1900.

Its primary businesses were the

production of automotive, building, and industrial seals, and its

subsidiaries included Schlegel UK and Schlegel GmbH.

During the

relevant period, Schlegel Corporation had manufacturing

facilities in 12 countries; design centers in Bardon Hill,

England, and Detroit, Michigan; and technical centers in Bardon

Hill, England, and Rockford, Tennessee.

The technical centers

- 3 and design centers worked closely with each other, exchanging

ideas and information about new technology.

The most significant and profitable technology within

Schlegel Corporation was wire carrier, a wire-knitted textile

device for stiffening and giving shape to automotive seals.

Wire

carrier was a preferred attachment medium for automotive seals

and weather stripping throughout North America and Europe.

Wire

carrier was manufactured at the South Carolina division of

Schlegel Corporation and at Schlegel Ireland, and it was

protected by a number of patents, including the original patent

and several subsequent "enhancement patents".

Although the

original wire carrier patent had expired by 1989, the enhancement

patents were still in effect in that year.

All of the patents

including patents pertaining to wire carrier were owned by

Schlegel Corporation.

Schlegel UK

Schlegel Holding Company was a subsidiary of Schlegel

Corporation that owned all of the stock of Schlegel UK.

UK had two separately managed operating divisions:

and building products.

Schlegel

automotive

The automotive division had two

manufacturing plants, located in Leeds, England, and Coalville,

England, and both plants produced and supplied car manufacturers

with seals for car doors, trunks, and windows.

The Schlegel UK

building products division operated a single manufacturing plant

- 4 in Henlow, England, that produced seals for building windows and

doors.

Schlegel UK-Leeds was a relatively small facility that

produced only plastic automotive seals.

Schlegel UK-Coalville

was a much larger, more modern plant that produced both extruded

rubber and plastic automotive seals.

The primary customers of

Schlegel UK were Rover, Ford, and Jaguar, and the business with

Rover and Ford accounted for 60 to 70 percent of the business of

the automotive division.

In 1989, Schlegel UK-Coalville was

experiencing adequate growth, but there was concern about the

continued viability of Schlegel UK-Leeds.

Schlegel UK-Leeds was

later closed.

Schlegel UK-Coalville did, however, experience some problems

in 1989 finishing seals manufactured for Rover.

Rover required

Schlegel UK-Coalville to mold corners of the rubber seals in the

shape of apertures to which the seals would be affixed.

The

Rover contract also obligated Schlegel UK to provide a new kind

of window seal called "sprayed-on slip coat", which Schlegel UK

had no experience producing.

Schlegel UK-Coalville experienced

manufacturing problems with these processes, increasing labor

costs and capital expenditures for new injection molding presses.

Schlegel UK did not make wire carrier and had no direct or

indirect ownership interest in the divisions of Schlegel

Corporation that manufactured wire carrier.

Rather, Schlegel UK

- 5 purchased wire carrier from Schlegel Ireland and incorporated it

into the automotive seals it manufactured.

Schlegel UK purchased

approximately 35 to 40 percent of the wire carrier produced by

Schlegel Ireland, and those purchases accounted for approximately

25 to 30 percent of the total raw material costs in the Schlegel

UK automotive division.

Schlegel Corporation licensed to Schlegel UK additional

technology that was essential to the manufacture of most of the

products in the automotive and building products divisions, and

Schlegel UK paid royalties to Schlegel Corporation for the use of

this technology.

The standard royalty rate was 5 percent of the

selling price of products using the technology.

Schlegel GmbH

Schlegel GmbH was also a subsidiary of Schlegel Corporation.

It was formed under the laws of the former Federal Republic of

Germany and was acquired by Schlegel Corporation on August 22,

1972.

The business of Schlegel GmbH was divided into two

separate divisions:

75 percent automotive parts manufacturing

and 25 percent building products manufacturing.

The automotive

division of Schlegel GmbH had five main customers that were the

largest German automotive producers.

While most of the market

for German automotive seals in 1989 consisted of rubber-based

seals, Schlegel GmbH produced only plastic automotive seals.

- 6 Schlegel GmbH did not own any of the patents, processes, or other

intellectual property that it used to manufacture its products.

Schlegel GmbH entered into a silent partnership agreement

with Schlegel Corporation in December 1981.

The partnership

agreement provided terms for a contribution of 10 million

Deutsche marks from Schlegel Corporation to Schlegel GmbH.

Subsequent amendments were made to this agreement, extending it

through December 18, 1990.

Schlegel GmbH had its lone production facility in Hamburg,

Germany.

This factory was built in 1972, and Schlegel GmbH had

experienced problems with the foundation of the building since

the mid-1970's.

The floor on one end of the factory was sinking

due to the settling of the soil beneath.

This sinking occurred

at an approximate rate of 3 centimeters per year, resulting in an

approximate total sinkage for some parts of the floor of 50

centimeters by 1989.

The sloping floor posed potential

production problems in addition to safety concerns.

Environmental contamination was also discovered under the factory

in 1988.

Schlegel GmbH management was aware of these problems but did

not take significant steps to stop the floor from sinking until

1990 and 1991.

Those attempts were unsuccessful.

In addition,

an adjoining warehouse was subsequently built with an entirely

different support structure that required floor support pilings

- 7 to be inserted between 10 and 17 meters below ground.

It was

estimated that it would cost $1.4 million to level and

reconstruct the factory floor.

BTR Dunlop, Inc. (BTR Dunlop),

was not made aware of these problems before it purchased Schlegel

Corporation in 1989.

Economic Conditions

In mid-1989, the U.K. economy was slowing, following a long

period of growth that began in the early 1980's.

Gross National

Product growth peaked in 1987 at a rate of 4.7 percent and

declined to 4.3 percent in 1988.

This trend was expected to

continue for the following 2 years with a recovery anticipated in

1991 or 1992.

In 1989, the U.K. automotive industry was,

however, in a position to benefit from the impending European

community integration set to occur at the end of 1992.

There was

concern that the resurgence of automobile production might not

help automotive component producers because many automobile

manufacturers in the United Kingdom were using components from

abroad.

The U.K. construction industry had experienced

significant growth in the years leading up to 1989, but, due to a

rise in mortgage interest rates, this trend was expected to

decline.

The economic conditions in Germany in 1988 and 1989 were

good, with both the construction industry and automotive industry

expanding.

The automotive component industry was seeing signs of

- 8 a decrease in demand from domestic customers and only a small

increase in exports.

There was also a trend towards price

reduction that favored large suppliers.

In the construction

supply industry, prices were stable.

1989 Transaction

In 1988, Prudential-Bache Capital Funding Group was

authorized to solicit bids for the sale of Schlegel Corporation.

Schlegel Corporation was implementing new contracts and was in

need of additional capital to fund its business growth.

Accordingly, Schlegel Corporation wanted to sell its stock to a

company that could provide this additional capital.

There were

as many as six prospective buyers for Schlegel Corporation,

including BTR Plc, Draftex, Pirelli/Metzler, Diversitech,

Standard Products, and Continental.

At all relevant times, BTR Plc, a producer of a variety of

rubber products, owned all of the stock of BTR International,

Ltd. (BTR International), and BTR Secretaries, Ltd. (BTR

Secretaries).

All of these are U.K. companies.

BTR Dunlop was a

Delaware corporation wholly owned by BTR International, and, from

January 1, 1987, through December 29, 1989, BTR Dunlop was the

parent corporation of an affiliated group of corporations (the

BTR affiliated group) that joined in filing a consolidated

Federal income tax return.

- 9 BTR Dunlop was also interested in acquiring Schlegel

Corporation because BTR Dunlop had a small sealing systems

business that Schlegel Corporation fit into synergistically.

BTR

Dunlop submitted a bid to purchase Schlegel Corporation on

December 12, 1988.

BTRS Acquisition, a New York corporation, was

formed on December 20, 1988, as a wholly owned subsidiary of BTR

Dunlop, joining the BTR affiliated group.

BTRS Acquisition

subsequently purchased Schlegel Corporation on January 27, 1989,

for $200 million plus the assumption of $33,864,000 in debt.

Immediately thereafter, BTRS Acquisition merged into Schlegel

Corporation pursuant to a merger agreement dated December 22,

1988.

As a result, Schlegel Corporation became a wholly owned

subsidiary of BTR Dunlop.

In January 1989, James Thom (Thom), treasurer of BTR Plc,

contacted Robert Coyle (Coyle), director of taxation of BTR

Dunlop, concerning the potential transfer of Schlegel UK and

Schlegel GmbH to BTR Plc and BTR International.

Thom asked Coyle

to calculate the "tax cost" of the transfers, i.e., the Federal

capital gain tax that would have to be paid in the event of these

transfers.

Shortly thereafter, Schlegel Corporation hired

Valuation Research Corporation (VRC), an appraisal firm, to value

the stock of Schlegel UK and Schlegel GmbH.

Assisting in the VRC valuation, Schlegel Corporation

management prepared sales forecasts for the automotive and

- 10 building products divisions of Schlegel UK and provided them to

VRC along with expense forecasts and historical financial data.

From this information, VRC prepared a document entitled "Schlegel

UK Projections" that projected continued profit growth for

Schlegel UK.

VRC opined in a letter dated April 28, 1989, that the fair

market value of Schlegel UK was $32,363,000 with a bargain

purchase value of $21,846,000 and, in a separate letter dated

April 28, 1989, indicated that the value of Schlegel GmbH was

$3,777,000, exclusive of the silent partnership interest.

After

discovering certain clerical errors, VRC mailed a letter on

September 15, 1989, that confirmed that the correct bargain

purchase value of Schlegel UK was $21,846,000.

Accordingly, pursuant to a stock purchase agreement dated

July 1, 1989, Schlegel Holding Company sold all of the stock of

Schlegel UK to BTR Plc for $21,846,000.

As of the date of sale,

the Schlegel Holding Company’s adjusted basis in Schlegel UK was

$2,310,863.

On November 30, 1989, Schlegel Corporation sold

99.9 percent of Schlegel GmbH to BTR International, .1 percent of

Schlegel GmbH to BTR Secretaries, and its interest in the silent

partnership to BTR International.

Schlegel Corporation received

$9,400,000 in consideration for this transaction.

The adjusted

tax basis, book value, and fair market value of the Schlegel

Corporation’s interest in the silent partnership was $5,116,136.

- 11 BTR Dunlop Holdings, Inc. (BTR Dunlop Holdings), a Delaware

corporation, was formed on December 14, 1989, as a wholly owned

subsidiary of BTR International.

On December 30, 1989, BTR

Dunlop Holdings acquired all of the stock of BTR Dunlop from BTR

International and became the parent corporation of the BTR

affiliated group.

On its 1989 Federal income tax return, petitioner reported

the adjusted basis of Schlegel GmbH to be $9,400,000, including

the silent partnership agreement.

The Schlegel Corporation

general ledger account for the period ended December 31, 1988,

shows that Schlegel Corporation had a basis in Schlegel GmbH of

$4,074,993.

This amount did not include the $675,227 in

subpart F interest income that Schlegel Corporation recognized

from Schlegel GmbH in 1988.

Audit

On audit, respondent’s revenue agent, Zygmunt Rachwal

(Rachwal), reviewed the reported fair market values of Schlegel

UK and Schlegel GmbH using the management-prepared sales

projections for Schlegel UK from the VRC report and financial

statements of Schlegel UK and Schlegel GmbH.

Rachwal concluded

that Schlegel UK should be valued at $49,069,000 and that

Schlegel GmbH had a value of $13,246,000, including the silent

partnership of $5,623,000.

- 12 Petitioner challenged this valuation with an appraisal of

Schlegel UK prepared by Ernst & Young LLP (E&Y).

In preparing

its valuation report, E&Y used the management-prepared sales

projections for Schlegel UK, concluding that the value of

Schlegel UK was $15 million on a “stand-alone” basis.

Rachwal,

however, rejected the E&Y "stand-alone" valuation theory in favor

of a "highest and best use" valuation.

Rachwal did, however,

revise his final valuation of Schlegel UK from $49,069,000 to

$48,838,000 after adjusting for corporate overhead expenses and

revising the applicable exchange rate.

The notice of deficiency

calculated gain based on the values determined by Rachwal of

$48,838,000 for Schlegel UK and $13,246,000 for Schlegel GmbH.

ULTIMATE FINDINGS OF FACT

On June 30, 1989, the fair market value of Schlegel UK was

$31 million.

On November 30, 1989, the fair market value of Schlegel GmbH

was $3.777 million, exclusive of the silent partnership interest.

OPINION

Section 311(b) provides that, in the case of distributions

of appreciated property to a shareholder, a corporation

recognizes gain to the extent that the fair market value of the

distributed property exceeds its adjusted basis in the hands of

the distributing corporation.

See Martin Ice Cream Co. v.

Commissioner, 110 T.C. 189, 219-220 (1998).

In the alternative,

- 13 respondent relies on section 482, which gives respondent broad

discretion to allocate gross income, deductions, credits, or

allowances between two related corporations if the allocations

are necessary either to prevent evasion of taxes or to reflect

clearly the income.

See Seagate Tech., Inc. & Consol. Subs. v.

Commissioner, 102 T.C. 149, 163 (1994).

The applicable standard

for making these allocations with respect to fair market value is

arm’s-length dealing between taxpayers unrelated by ownership or

control.

See sec. 1.482-1A(b)(1), Income Tax Regs.

Accordingly,

we are called upon to decide the fair market value of Schlegel UK

and Schlegel GmbH on their respective valuation dates.

Respondent argues that, for purposes of section 311(b) and

section 482, the value of Schlegel UK on July 1, 1989, was

$49.8 million, that the value of Schlegel GmbH on November 30,

1989, was $8.4 million, exclusive of the silent partnership

interest, and that petitioner’s adjusted tax basis in Schlegel

GmbH was $4,074,993 on the valuation date.

Respondent also

argues that this determination is not arbitrary, capricious, or

unreasonable pursuant to section 482.

Petitioner argues that, based upon the fair market value of

the net assets of Schlegel UK, including goodwill and goingconcern value, the fair market value of the stock of Schlegel UK

on the valuation date was no more than $21,846,000, that the

opinions of petitioner's experts independently establish the fair

- 14 market value of Schlegel UK, and that respondent's experts failed

to analyze the facts and use the appropriate standard in

determining the value of Schlegel UK.

With respect to Schlegel

GmbH, petitioner argues that the value of Schlegel GmbH stock on

November 30, 1989, was $2.6 million because the company had no

goodwill, few assets of value, and no prospect of growing its

earnings in the period after the valuation date and that the

basis of Schlegel Corporation in Schlegel GmbH was $4,750,220.

Valuation is a question of fact, and the trier of fact must

weigh all relevant evidence on the date of valuation, without

regard to hindsight, to draw the appropriate inferences.

See

Estate of Jung v. Commissioner, 101 T.C. 412, 423-424 (1993);

Estate of Newhouse v. Commissioner, 94 T.C. 193, 217 (1990);

Estate of Andrews v. Commissioner, 79 T.C. 938, 940 (1982).

Future events foreseeable on the valuation date may be considered

in deciding fair market value.

See Estate of Newhouse v.

Commissioner, supra at 218.

For Federal tax purposes, fair market value is the price

that a willing buyer would pay a willing seller, both having

reasonable knowledge of all of the relevant facts and neither

being under compulsion to buy or to sell.

See United States v.

Cartwright, 411 U.S. 546, 551 (1973); 1.170A-1(c)(2), Income Tax

Regs.

The willing buyer and the willing seller are hypothetical

persons, rather than specific individuals or entities, and the

- 15 peculiar characteristics of these hypothetical persons are not

necessarily the same as the individual characteristics of an

actual seller or an actual buyer.

See Estate of Bright v. United

States, 658 F.2d 999, 1005-1006 (5th Cir. 1981).

The

hypothetical willing buyer and willing seller are presumed to be

dedicated to achieving the maximum economic advantage.

Estate of Newhouse v. Commissioner, supra at 218.

See

This advantage

must be achieved in the context of market and economic conditions

on the valuation date.

See id.

The hypothetical sale should not

be constructed in a vacuum isolated from actual facts that affect

value.

See Estate of Andrews v. Commissioner, supra at 956.

As is customary in valuation cases, the parties rely

primarily on expert opinion evidence to support their contrary

valuation positions.

Opinion testimony of an expert is

admissible if and because it will assist the trier of fact to

understand evidence that will determine a fact in issue.

Fed. R. Evid. 702.

See

We evaluate the opinions of experts in light

of the demonstrated qualifications of each expert and all other

evidence in the record.

561 (1986).

See Parker v. Commissioner, 86 T.C. 547,

We are not bound by the opinion of an expert

witness, especially when such opinion is contrary to our

conclusions.

See IT&S of Iowa, Inc. v. Commissioner, 97 T.C.

496, 508 (1991).

If experts offer divergent estimates of fair

market value, we decide what weight to give these estimates by

- 16 examining the factors they used in arriving at their conclusions.

See Casey v. Commissioner, 38 T.C. 357, 381 (1962).

While we may

accept an expert opinion in its entirety, Buffalo Tool & Die

Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980), we

may be selective in the use of any part of such opinion or reject

the opinion in its entirety.

561.

Parker v. Commissioner, supra at

We may also reach a determination of value based on our own

examination of the evidence in the record.

See Estate of Davis

v. Commissioner, 110 T.C. 530, 538 (1998).

Finally, because

valuation necessarily results in an approximation, the figure at

which we arrive need not be directly attributable to specific

testimony if it is within the range of value that may be properly

arrived at from consideration of the evidence.

See Silverman v.

Commissioner, 538 F.2d 927, 933 (2d Cir. 1976), affg. T.C. Memo.

1974-285.

Respondent relies on the expert report of Alan C. Shapiro

(Shapiro), a professor of banking and finance at the University

of Southern California, Marshall School of Business, in valuing

Schlegel UK and Schlegel GmbH.

Petitioner relies on the expert

reports of Lawrence B. Gooch (Gooch) of PricewaterhouseCoopers

LLP and Kenneth R. Button (Button) of Economic Consulting

Services, Inc., in valuing Schlegel UK and relies on the expert

report of Wilfried Lahmann (Lahmann) of Schitag Ernst & Young in

- 17 valuing Schlegel GmbH.

Herbert T. Spiro testified as a rebuttal

expert witness on behalf of petitioner.

Despite generally using the same methods of valuing the

subject companies, the experts reached fair market value

estimates that are extremely far apart.

The following chart

lists the values at which the experts arrived:

Shapiro

Button

Schlegel UK

$49.8 million

$20 million

Schlegel GmbH*

8.4 million

-–

*exclusive of the silent partnership interest.

Gooch

Lahmann

$21.7 million

--

-$2.6 million

Schlegel UK

Shapiro

Shapiro began his analysis by calculating the fair market

value of Schlegel UK using the discounted cash-flow (DCF) method.

The DCF method measures fair market value by calculating the

present value of the stream of future cash-flows of a company.

There are three components to the DCF method:

(1) The cash-flow

projections for a forecasted period; (2) the terminal value; and

(3) the appropriate discount rate.

Terminal value is calculated

by adjusting cash-flows in the final period to represent the

future cash-generating capability of the company.

This

“normalized” cash-flow figure is then capitalized as a perpetuity

by the previously determined discount rate, adjusted for some

level of growth that can be expected to continue into perpetuity.

The resulting terminal value is then discounted back to present

- 18 value using the discount rate.

Under the DCF method, the present

value of the cash-flow projections and the terminal value are

ascertained using the appropriate discount rate, and the sum of

those amounts is the fair market value of the company.

The discount rate is calculated using the weighted average

cost of capital (WACC) formula, which combines the after-tax

costs of debt and equity into a weighted average overall cost of

capital.

The cost-of-equity capital is equivalent to the long-

term expected annual rate of return an investor seeks on an

investment in stock.

It is calculated using the capital asset

pricing model (CAPM).

One of the variables in the CAPM formula is beta, which

measures the volatility in financial returns of a target firm.

Beta is calculated by comparing the movement in the returns of a

stock against the movement in the returns of the stock market as

a whole, which has a beta of 1.

For example, if a stock

generally increases 2 percent in price when the market increases

by 1 percent, the stock would have a beta of 2 (2 divided by 1).

Shapiro calculated beta for Schlegel UK using the average

beta from nine companies that he determined to be in a similar

business as Schlegel UK.

The average beta for the nine companies

was .87 with a range from .56 to 1.11.

Because Schlegel UK

maintains relatively little debt in its capital structure,

Shapiro then adjusted for the different degrees of debt leverage

- 19 associated with the guideline companies and Schlegel UK.

This

process, referred to as unlevering, separates out the effects of

debt financing and is necessary because higher debt levels

generally lead to higher betas.

Accordingly, beta is unlevered

to approximate the beta of a company that has no debt.

Shapiro

then relevered the beta to take into consideration a 35-percent

debt level based on VRC estimates of the Schlegel UK debt level

in Rachwal’s report.

Shapiro concluded that .84 was an

appropriate beta for the CAPM calculation.

He also estimated the risk-free rate and the market risk

premium using U.S. data, because he was of the opinion that a

U.S. buyer would purchase Schlegel UK.

Based on these estimates,

Shapiro concluded that a 13.8-percent WACC was an appropriate

discount rate.

In his rebuttal report, Shapiro adjusted his beta

to .5 based on calculations he made with petitioner’s beta

guideline companies.

He used that beta, the same risk-free rate,

and the U.K. market risk premium, concluding that the adjusted

WACC discount was 14.57 percent.

Shapiro used VRC sales forecasts as reproduced in the

Internal Revenue Service (IRS) engineer’s report to calculate

free cash-flows and the appropriate terminal value of Schlegel

UK.

For cash-flows, Shapiro calculated earnings before

depreciation, interest, and taxes (EBDIT), using the historic

rate of EBDIT from 1987 through June 30, 1989, and applied it to

- 20 the sales forecasts.

He then reduced EBDIT by a 1.3-percent

corporate overhead expense, the depreciation, and the capital

expenditures from the E&Y report. He also adjusted for the

corporate tax rate.

Shapiro calculated terminal value using a projected growth

rate in cash-flows of 6 percent, while also taking into

consideration expected inflation of approximately 4 percent and

economic growth of about 2 percent.

He arrived at a terminal

value of $88.26 million.

Applying the discount rate from his original report and his

rebuttal report to his cash-flow projections and terminal value,

Shapiro concluded that the fair market value of Schlegel UK under

the DCF method on the valuation date was $52.2 million and

$49.8 million, respectively.

As a “sanity check”, Shapiro also valued Schlegel UK using

several market multiple methods.

First, Shapiro selected seven

companies that manufactured rubber products for automobiles and

buildings and were involved in acquisitions in similar industries

around the same time as the sale of Schlegel UK.

Shapiro then

calculated market multiples from the available data of

purportedly comparable companies and applied those multiples to

the financial data of Schlegel UK, arriving at the following fair

market values:

- 21 -

Multiple

Market value/sales

Market value/book value

Market value/EBITDA*

Market value/EBIT*

Market value/EBI*

Average value

Comparable

Average

Schlegel UK

Value

1.03

1.68

9.73

13.48

18.17

$62,280,000

12,374,000

59,559,000

64,987,000

55,238,000

$50,888,000

*E=Earnings; I=Interest; T=Taxes; D=Depreciation; A=Amortization.

Shapiro then applied this same approach to eight publicly

traded companies.

The principal difference between the two

approaches is that comparison to publicly traded companies values

Schlegel UK as a stand-alone company, whereas the preceding

approach valued Schlegel UK as an acquisition target.

The

results from the publicly traded market multiple analysis are as

follows:

Multiple

Market value/sales

Market value/book value

Market value/EBITDA

Market value/EBIT

Market value/EBI

Average value

Comparable

Average

0.84

1.36

7.46

11.11

13.09

Schlegel UK

Value

$50,262,000

9,152,000

44,565,000

52,729,000

38,488,000

$39,039,000

Lastly, Shapiro used the sale of Schlegel Corporation for

$233.2 million as a market comparable applying the market

multiples from Schlegel Corporation to the financial data of

Schlegel UK in arriving at an average value of $41.338 million.

- 22 According to Shapiro, because the various comparable methods

ignore a variety of relevant economic factors, including asset

turnover, profit margins, sales growth, return on investment, and

working capital requirements, he assigned more weight to the DCF

method.

He concluded that the value of Schlegel UK was

$52.2 million in his original report but changed his conclusion

to $49.8 million based on adjustments made in his rebuttal

report.

Button

Button also used the DCF method to value Schlegel UK.

In

calculating the cost-of-equity capital, Button used five

guideline companies to calculate unlevered beta, and he relevered

beta based on the median debt-to-equity ratio of the guideline

companies, 24.8 percent, to reflect the debt-equity ratio that

Schlegel UK would have as an independent entity.

In arriving at his final cost-of-equity capital, Button also

applied a small company risk premium and company-specific risk

premium.

Button claimed that studies show that the CAPM does not

fully capture the risk associated with small companies.

Accordingly, he contends that it is appropriate to incorporate a

small company risk premium in the discount rate to reflect the

additional risk of small companies such as Schlegel UK.

Button

adjusted his CAPM analysis to include a small company risk

premium of 5.7 percent.

Button also maintained that a company-

- 23 specific risk premium adjusts the cost-of-equity capital for the

relative riskiness of the company compared to the guideline

companies in terms of either quantitative or qualitative factors.

Button opined that, based on aggressive sales projections,

operational problems, lack of diversity, inadequacy of management

resources, and lack of access to adequate capital, Schlegel UK

was more risky than the guideline companies that were used in the

valuation analysis.

Thus, he added a 1-percent company-specific

risk premium to the cost-of-equity capital in coming to a costof-equity capital of 28.77 percent.

Button concluded that the

appropriate WACC was 24.75 percent.

Button forecasted Schlegel UK cash-flows based on

information obtained from Schlegel UK documents and discussions

with management in 1998 or 1999 about expectations existing

during the first half of 1989 regarding the period after the

valuation date.

He prepared cash-flow projections for the

automotive division and the building materials division

separately, using the sales projections that were used by

Rachwal, E&Y, and Shapiro.

He stated that the building products

forecast was based on unrealistically optimistic assumptions

about sales growth because he anticipated a decline in housing

starts and other sales, but he concluded that the construction of

an alternative sales forecast was not feasible.

He viewed the

automobile division forecasts as reasonable, although management

- 24 stated 10 years later that little credibility was given to those

projections in 1989.

Button projected expenses, including materials, labor,

overhead, royalty, depreciation, taxes, capital expenditures, and

depreciation, based on historical ratios from January 1987 to

June 1989.

He also took into consideration change in working

capital in arriving at the cash-flow estimates.

The cash-flow

estimates for the building materials and automotive divisions

were ultimately combined.

He calculated terminal value using the

24.75-percent discount rate and a growth rate of 6.9 percent.

He

concluded that the terminal value of Schlegel UK was $33.554

million.

Applying the 24.75-percent discount rate to the projected

cash-flows and terminal value of the Schlegel UK automotive and

building products divisions, Button concluded that the

controlling interest value of Schlegel UK was $19 million;

however, Button also was of the opinion that a discount for lack

of marketability was necessary because the DCF method calculates

the value of a publicly traded company.

Thus, Button applied a

16.3-percent lack-of-marketability discount to value Schlegel UK

as a privately held company, concluding that the fair market

value was $16 million.

Button also used the market multiple approach to value

Schlegel UK; however, he relied only on the price/earnings and

- 25 price/cash-flow ratios.

He calculated these ratios using five

guideline companies and made adjustments similar to those made

under the DCF method for small company risks and company-specific

risks.

He arrived at the following market multiples:

Multiple

Price/earnings

Price/cash-flow

Most Recent

Year

3-year

Average

5.55

4.24

6.63

4.73

Button applied those multiples to Schlegel UK data from

1988, to the average of the Schlegel UK three most recent fiscal

years (1986-1988), and to a blend of one-half of 1988 and the

first half of 1989.

The results of these calculations valued

Schlegel UK from $14 million to $22 million.

Button then applied

a 16.3-percent discount for lack of marketability and a control

premium of 35 percent, arriving at a range of values from

$16 million to $25 million.

In light of all of the information

and specific circumstances of Schlegel UK, Button concluded that

the most appropriate value under the market approach was

$21 million.

Button indicated in his report that the asset

valuation approach was not appropriate and that Schlegel UK

should not be adjusted to take into consideration synergies.

Assessing the values determined under the DCF method and the

market multiple approach, Button concluded that both estimates

provided useful information in determining the value of the

company, but he placed greater emphasis on the market multiple

- 26 approach because the DCF method required a greater number of

estimates.

Accordingly, Button concluded that Schlegel UK had a

fair market value of $20 million as of July 1, 1989.

Gooch

Gooch also valued the Schlegel UK automotive and building

products groups separately, taking into consideration the

differences between the industries.

His valuation, however,

departed from Button’s approach in that Gooch valued Schlegel UK

on both a synergistic and stand-alone basis.

Applying the DCF method, Gooch calculated a WACC using an

industry-wide beta estimate for the automotive and building

products operations of Schlegel UK to calculate cost-of-equity

capital.

Gooch was of the opinion that the beta of individual

companies is often unreliable due to speculation, low trading

volume, or other factors affecting stock price besides earnings.

Based on his industrywide research, he concluded that the

appropriate beta for companies operating in the automotive sector

was in the range of 1.05 to 1.45 with an average of 1.2 and that

the appropriate beta for companies in the building products

sector ranged from 1.1 to 1.8 with an average of 1.3.

He

ultimately used 1.3 and 1.5, respectively.

Gooch applied a small company risk premium of 5 percent to

both the automotive and building products divisions when

calculating the cost-of-equity capital.

Gooch also perceived

- 27 there to be a greater risk in the Schlegel UK automotive segment

due to the competitive nature of winning business for new models

and Schlegel UK reliance on Rover and Ford for a majority of its

revenue.

Due to this concern, Gooch also chose to apply a

company-specific risk premium of 2 percent to the automotive

division.

No such adjustment was made with respect to the

building products division.

For the automotive group, Gooch calculated his projected

synergistic cash-flows from financial forecasts developed by the

managers of Schlegel UK.

He made adjustments to these

projections based on his 1998 or 1999 discussions with management

and his overall view of the automotive industry in the United

Kingdom during those years.

He also took into consideration the

potential close of the Leeds plant in early 1989.

Gooch

concluded that the stand-alone scenario was slightly less

profitable than the synergistic scenario.

With respect to the building products division, Gooch noted

that there had been rapid growth over the mid- to late 1980's in

the housing industry; however, Gooch found that there had been a

drop in house building starts in early 1989 and the likelihood of

reduced sales of other Schlegel UK building products.

Thus, he

reduced the building product projections for stand-alone

projects, while adjusting for higher sales under the synergistic

approach for economies achieved from synergies.

- 28 In estimating expenditures, Gooch analyzed historic

royalties, capital expenditures, and overhead and had some

discussions with Schlegel UK management.

Gooch determined from

this analysis that the royalty rate for the automotive group was

3 percent of sales, that the royalty rate for the building

products group was 3.2 percent of sales, and that capital

expenditures should be 4.5 percent and 2.3 percent for the

automotive and building products divisions, respectively.

also calculated a terminal value of $47.648 million.

He

Applying

the WACC discount rate to the sales projections and terminal

value, Gooch arrived at a synergistic value of $24.18 million and

a stand-alone value of $17.05 million.

Gooch also used the market multiple approach to value

Schlegel UK, focusing on the market value of invested capital

(MVIC) as the primary indicator of value.

MVIC is the sum of the

market value of the common stock of a comparable company, the

market value of the interest-bearing debt of the comparable

company, and the preferred stock.

Gooch calculated the following

market multiples using nine purportedly comparable companies:

Multiple

MVIC/sales

MVIC/EBITDA

Market value/EBIT

Price/adjusted

Net income

Comparable

Average

Comparable

Median

Selected

Multiple

0.70

5.50

7.05

0.62

5.42

7.13

0.65

5.50

7.00

10.33

10.78

10.50

- 29 Gooch adjusted Schlegel UK royalties, central management

overhead, and additional charges before applying the multiples to

Schlegel UK operating results.

He gave more weight to the

results from the EBITDA and EBIT multiples because he considered

them to be more stable.

He then applied a control premium to the

results of the market multiple comparison to take into

consideration synergies of a potential buyer, arriving at a value

of $23,870,000.

Gooch concluded that the stand-alone value of

Schlegel UK was $20,350,000, applying no control premium.

Finally, Gooch applied an underlying asset approach to

valuing Schlegel UK.

He indicated that the net working capital

as of June 30, 1989, was $6.82 million and that fixed assets had

a book value of approximately $10.85 million.

At the end of

1989, fixed assets were written up to $19.84 million.

After

adjustments for debt and timing issues, Gooch estimated that the

value was more likely to be restated to $19.22 million.

In view

of the values derived from the income and market approaches,

Gooch stated that the liquidation value was a less reliable

indicator because the other approaches seemed to produce higher

values.

Gooch gave equal weight to the synergistic and stand-

alone values from the various approaches set forth above,

concluding that the fair market value of Schlegel UK was

$21.7 million.

- 30 Schlegel GmbH

Shapiro

Shapiro used the same valuation methods set forth above in

valuing Schlegel GmbH.

He calculated a cost-of-equity capital of

11.21 percent and a WACC of 8.46 percent.

Applying this discount

rate to the IRS engineer cash-flow projections that were derived

from the VRC projections, Shapiro calculated a value for Schlegel

GmbH of $10 million, independent of the silent partnership.

Shapiro verified this amount using the market multiple

approaches described above.

Application of the comparable

company market multiple analysis to Schlegel GmbH resulted in an

estimated value of $10.4 million.

Shapiro noted, however, that

this valuation was more conjectural because the underlying data

were subject to some degree of error.

In particular, it was

necessary to translate German financial statements and discern

the meanings of various terms and accounts.

The market multiple

analysis from publicly traded comparables resulted in a value of

$7 million.

Shapiro’s ultimate conclusion was that Schlegel GmbH

had a value of $10 million, exclusive of the silent partnership;

however, he made adjustments in his rebuttal report, restating

the value to be $8.4 million.

- 31 Lahmann

Lahmann valued Schlegel GmbH, attempting unsuccessfully to

identify comparable third-party transactions.

Thus, he

determined the fair market value based on the sustainable profits

of the company at the valuation date.

He projected the

sustainable profits in perpetuity after November 30, 1989, by

adjusting the recorded annual profits by extraordinary expenses

and income relating to transactions that were not part of the

business of Schlegel GmbH at the valuation date.

German income

taxes (i.e., trade tax on income and corporation taxes) were

deducted from the adjusted profits as the final component of the

calculation.

Lahmann’s projections were then discounted to their

present value using a discount rate that was composed of the

long-term interest rate for risk-free Government bonds

(7.6 percent) reduced by the German corporation tax rate of

36 percent on distributed profits.

The resulting adjusted

discount rate of 4.86 percent was increased by the following risk

elements:

A market risk premium of 5.3 percent for general

business risk (based on empirical investigation in Germany), a

small company risk premium of 2 percent, and a 1-percent

specific-company risk premium because Schlegel GmbH could

potentially be held liable for soil contamination.

discount rate was 13.16 percent.

The overall

The application of this

- 32 discount rate to the sustainable profits resulted in a fair

market value for Schlegel GmbH of $2.6 million.

Valuation Analysis and Conclusions

Petitioner argues that we should value the subject companies

using an asset valuation method; however, in valuing the stock of

operating companies, primary consideration is generally given to

the earnings of the company.

See Estate of Huntsman v.

Commissioner, 66 T.C. 861, 876 (1976) (citing Levenson’s Estate

v. Commissioner, 282 F.2d 581, 586 (3d Cir. 1960), affg. on this

issue T.C. Memo. 1959-120); see also Rev. Rul. 59-60, 1959-1 C.B.

237, 242.

Asset valuation is accorded the greatest weight in

valuing the stock of a holding company.

Commissioner, supra at 586.

See Levenson’s Estate v.

Schlegel UK and Schlegel GmbH are

operating companies, and the experts in this case focused on the

earning potential in arriving at fair market value.

The experts

also indicated that the asset methodology is inappropriate

because it undervalues the subject companies.

Accordingly, we

focus on the earning power to arrive at fair market value, giving

little weight to the value of the assets of the companies.

We focus initially on whether Schlegel UK should be valued

as a stand-alone entity or as an entity likely to be acquired by

a company with synergies.

Button valued Schlegel UK on a stand-

alone basis because he was of the opinion that no synergistic

buyer was available for Schlegel UK.

Gooch considered the

- 33 potential for a synergistic buyer, concluding that synergies only

increased the value of Schlegel UK by a small amount.

Shapiro

was of the opinion that Schlegel UK should be valued as if it

would be purchased by a synergistic buyer.

The fair market value of property should reflect the highest

and best use to which the property could be put on the date of

valuation.

See Stanley Works & Subs. v. Commissioner, 87 T.C.

389, 400 (1986).

Petitioner, relying on the expert report of

Gooch, argues that the likelihood of a synergistic buyer’s

purchasing Schlegel UK was no greater than a stand-alone

scenario, but petitioner maintains that it considered both

scenarios in arriving at the fair market value for Schlegel UK.

We are not persuaded that petitioner adequately considered

the potential for synergies in valuing Schlegel UK.

six potential synergistic buyers of Schlegel UK.

There were

Yet,

petitioner’s application of the DCF method and market multiple

approach relied significantly on a small company risk premium, a

company-specific risk premium, and numerous cash-flow assumptions

more appropriate for a stand-alone valuation.

Button did not

value Schlegel UK with synergies, and, when Gooch purportedly

valued Schlegel UK with synergies, he used the same revenue

projections he used in the stand-alone analysis and did not make

the necessary adjustments to the discount rate to reflect the

benefits of synergies.

A synergistic buyer would not only

- 34 achieve cost savings but would also increase sales.

When asked

during trial if he would sell Schlegel UK at the value at which

he arrived from his calculations, Gooch responded:

“I probably

wouldn’t have sold it [for $21 million] because it was worth more

to me, the seller, yes.

that.”

I probably would not have sold it for

Accordingly, we reject petitioner’s proposed valuation of

Schlegel UK as not the value at which the company would have

changed hands between a willing seller and a willing buyer.

Reliance solely on a stand-alone value and application of the

small company risk premium and company-specific risk premium are

not justified by the evidence in this case.

We also disagree with respondent’s proposed valuation

because too much reliance is placed on the synergistic valuation

of Schlegel UK, resulting in an unrealistically high value.

In

selecting beta for the DCF calculation in his original report,

Shapiro selected a low beta, and, in his rebuttal report, he

actually used a beta of .5 that was below the range of betas for

purportedly comparable companies.

He also did not address the

appropriate royalty rates or properly consider the economic

conditions in the United Kingdom on the valuation date.

Just as

determination of fair market value requires assumption of a

willing seller, it does not assume hypothetical transactions that

are “unlikely and plainly contrary to the economic interests” of

a hypothetical buyer.

See Estate of Hall v. Commissioner, 92

- 35 T.C. 312, 337 (1989) (quoting Estate of Curry v. United States,

706 F.2d 1424, 1429 (7th Cir. 1983)); see also Estate of Newhouse

v. Commissioner, 94 T.C. 193, 232 (1990).

We are not persuaded

that buyers exist who would be willing to pay the value asserted

by Shapiro.

The experts’ selection of comparable companies with respect

to the market multiple estimates failed to consider objective

guideposts of comparability.

In addition, petitioner’s experts

made extensive adjustments based on hindsight as to matters

occurring subsequent to the valuation date.

Some of these

adjustments were based on interviews with petitioner’s employees

and representatives 10 years after the valuation date and in

anticipation of trial.

at trial.

Certain of the employees also testified

Their testimony was not corroborated by

contemporaneous records and thus appears to exaggerate 1989

adverse conditions and problems.

The adjustments made were

inconsistent with assumptions used at the time of the

transaction.

Such adjustments are susceptible to manipulation

for the purpose of achieving the result sought by the party, and

they are unreliable in this case.

Shapiro, on the other hand,

did not sufficiently investigate the specific circumstances of

the company in 1989.

Consequently, we do not rely completely on

the opinion of any of the experts and must do the best we can

- 36 with the compilations of data and explanations that each

provided.

In valuing Schlegel GmbH, Lahmann and Shapiro actually

calculated comparable discount rates.

The assumed cash-flows and

sustainable profits, however, varied to such an extent that the

resulting fair market value estimates differed by approximately

$5.8 million.

Evaluating the reports, we agree with respondent

that the contemporaneously prepared sales projections are the

most appropriate starting point for cash-flows, but Shapiro again

failed to investigate or to consider adequately specific facts

relating to Schlegel GmbH known at the valuation date.

When

asked at trial whether a prospective buyer would have used his

methodology or would have visited the facility and talked to the

people involved in the business, Shapiro stated that “they

would-–they would go-–they should certainly go out and talk to

the people there, try to uncover any hidden problems that might

exist.”

Shapiro and Button used the management-prepared sales

projections in making their cash-flow estimates for Schlegel UK,

and the results of their cash-flow analyses are comparable.

The

primary difference in their fair market value conclusions is

attributable to the discount rate and terminal value that each

calculated.

- 37 Shapiro used the WACC formula, concluding that the discount

rate was 14.57 percent.

Button used the same formula in arriving

at his discount rate estimate of 24.75 percent.

However, as we

indicated above, the beta that Shapiro used was too low, and

Button erroneously incorporated a small company risk premium and

a company-specific risk premium that elevated the discount rate

to an unreasonably high level.

Substituting a beta of 1.18 into

Shapiro’s calculation and subtracting out the small company risk

premium and company-specific risk premium used in Button’s

calculation, we arrive at a discount rate of approximately

20 percent.

Applying that discount rate to Button’s and

Shapiro’s cash-flow estimates and calculating terminal value for

each, fair market values of $31.577 million and $30.811 million,

respectively, are indicated.

Taking into consideration the

inherently imprecise nature of valuation, we conclude and find as

a fact that, based on all of the factors set forth herein and on

the entire record, the fair market value of Schlegel UK was

$31 million on the valuation date.

Petitioner reported a $9.4 million fair market value for

Schlegel GmbH on its 1989 Federal income tax return.

This amount

was the sum of the fair market value of the silent partnership,

$5.623 million, now stipulated to be $5,116,136, and the $3.777

million VRC fair market value estimate for Schlegel GmbH.

Petitioner now contends that the fair market value of Schlegel

- 38 GmbH was $2.6 million on the valuation date, relying on the

expert report of Lahmann.

The reported values in petitioner’s

return are admissions by petitioner.

A lower value cannot be

substituted at this point without cogent proof that the reported

values were erroneous.

at 337-338.

See Estate of Hall v. Commissioner, supra

For the reasons indicated above, we are not

persuaded by Lahmann’s use of hindsight, nor are we persuaded by

respondent that the fair market value should be increased.

Accordingly, the fair market value of Schlegel GmbH on the

valuation date, exclusive of the silent partnership interest, was

$3.777 million.

Adjusted Basis of Schlegel GmbH

The parties also disagree as to the adjusted basis of

Schlegel GmbH.

Respondent maintains that the adjusted basis is

$4,047,993, and petitioner argues that the adjusted basis should

also include interest income of $675,227 that Schlegel GmbH

reported on its 1988 tax return pursuant to section 951.

Section 961 provides that the basis of a U.S. shareholder’s

stock in a controlled foreign corporation is increased by the

amount included in the shareholder’s gross income under section

951.

Section 961(b), however, provides that the basis of such

stock shall be reduced by the amount actually received and

excluded from gross income of the U.S. shareholder under section

959.

Schlegel Corporation included $675,227 of interest income

- 39 from Schlegel GmbH in its gross income for 1988 pursuant to

section 951.

Basis, therefore, depends upon whether this amount

was actually distributed to Schlegel Corporation before

November 30, 1989.

The Schlegel Corporation general ledger reflected that

Schlegel Corporation had an adjusted basis in Schlegel GmbH of

$4,047,993 at the end of 1988.

This amount reflects a reduction

in basis under section 961(b) for the amount of the interest

income reported in 1988, which in turn assumes that the

distribution was made prior to November 30, 1989, and excluded

from Schlegel Corporation income under section 959.

Petitioner

challenges the account balance shown on the ledger, claiming that

the distribution of interest income was not made, but then

petitioner relies on the absence of a ledger entry recording the

distribution and vague testimony suggesting, but not

establishing, that no distribution in fact was made.

Due to the

ambiguous and unreliable nature of the books and testimonial

evidence, petitioner has failed to prove that it is entitled to

additional basis in Schlegel GmbH over that reflected in the

general ledger account of Schlegel Corporation at the end of

1988.

- 40 We have considered the other arguments of the parties.

Our

resolution of the valuation issues renders discussion of

alternative arguments unnecessary.

Decision will be entered

under Rule 155.