UNITED STATES TAX COURT
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T.C. Memo. 1999-334
UNITED STATES TAX COURT
H GROUP HOLDING, INC. AND SUBSIDIARIES, FORMERLY HG, INC. AND
SUBSIDIARIES, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos.
616-91, 2012-92,
7994-93, 2423-95,
8532-95.
Filed October 5, 1999.
Harold J. Lipsitz, Robert A. Bedore, and Stephen Fedo, for
petitioners.
Pamela V. Gibson, Donna C. Hansberry, and Steven W.
LaBounty, for respondent.
1
The following cases are consolidated for purposes of
trial, briefing, and opinion: H Group Holding, Inc. and
Subsidiaries, formerly HG, Inc. and Subsidiaries, docket Nos.
2012-92 and 7994-93; and AIC Holding Co. and Subsidiaries,
formerly Anartic Investment Co. and Subsidiaries, docket Nos.
2423-95 and 8532-95.
- 2 MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Judge:2
Respondent determined deficiencies in, and
additions to, Federal income tax and penalties as follows:
H Group Holding Inc. and Subsidiaries
2
Taxable year
ending
Deficiency
Jan. 31, 1980
Jan. 31, 1981
Jan. 31, 1982
Jan. 31, 1983
Jan. 31, 1984
Jan. 31, 1985
Jan. 31, 1986
Jan. 31, 1987
Jan. 31, 1988
$7,681,409
5,658,067
6,677,731
40,311
6,768,120
799,024
19,397,355
9,153,141
13,176,113
These consolidated cases were reassigned to Judge Joel
Gerber by a Feb. 25, 1999, order, following the death of Judge
Theodore Tannenwald, Jr. The parties agreed that the issues
tried to the Court in the trials conducted by Judge Tannenwald
could be reassigned to another Judge without the need for a
retrial or the presentation of additional evidence.
- 3 AIC Holding Co. and Subsidiaries
Taxable year
ending
Deficiency
Penalty
sec. 6689
Dec. 31, 1976
Dec. 31, 1977
Dec. 31, 1978
Dec. 31, 1979
Dec. 31, 1980
Dec. 31, 1981
Dec. 31, 1982
Dec. 31, 1983
$659,483
1,798,443
1,420,787
3,160,729
12,418,363
10,660,213
3,885,657
4,024,241
--------$23,145
5,227
-----
The issues relating to section 482,3 the subject of this
opinion, have been severed from the other issues in these cases.
The issues presented for our consideration are:
(1)
Whether respondent’s allocations of income (a) for the
use of the Hyatt trade name and marks by Hyatt International
Corp. (HIC) and its subsidiaries, and (b) for management services
HIC provided to its subsidiaries were arbitrary, capricious, or
unreasonable; and
(2) the amount of arm’s-length consideration, if any, for
such transactions.
3
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.
- 4 FINDINGS OF FACT4
I.
Historical Background
Hyatt Corp. (Hyatt Domestic) is a wholly owned subsidiary of
petitioner H Group Holding, Inc. and Subsidiaries (HGH).
HIC is
a wholly owned subsidiary of petitioner AIC Holding, Inc. and
Subsidiaries (AIC).
All of these entities were organized under
the laws of the State of Delaware, and their principal offices at
all pertinent times were located in Chicago, Illinois.
The
relevant consolidated corporate Federal income tax returns of HGH
and AIC (or their respective predecessors) were timely filed with
the Internal Revenue Service Center at Kansas City, Missouri.5
For the taxable periods in issue, Hyatt Domestic and HIC were
owned or controlled directly or indirectly by the same interests,
and said control satisfies the threshold for application of
section 482.6
Hyatt Domestic was organized in 1957.
As of 1968, Hyatt
Domestic operated seven hotels in the United States with 2,431
rooms, collectively.
About one-half of the hotels and rooms were
4
The parties’ stipulations of facts and the attached
exhibits are incorporated by this reference.
5
The issues considered involve petitioners’ subsidiaries,
Hyatt Domestic and Hyatt International Inc. (HIC) (and its
subsidiaries).
6
Attached as an appendix is a diagram reflecting the
relationships of some of the more significant entities addressed
in this opinion.
- 5 in California.
At the end of 1968, Hyatt Domestic operated 11
hotels with 3,376 rooms, collectively.
As of January 1976, Hyatt
Domestic’s operation had grown to 45 hotels with approximately
20,000 rooms, collectively, and 14 motels, with approximately
1,500 rooms, collectively.
HIC was established August 19, 1968, with the principal
purpose of owning and/or operating hotel properties outside the
continental United States under the Hyatt name.
HIC’s initial
shareholders were the same as the shareholders of Hyatt Domestic.
A. Peter di Tullio, (Mr. di Tullio), HIC’s first employee, was
hired as executive vice president to guide the international
venture.
Mr. di Tullio had experience as an international
hotelier and had spent the majority of his career with Hilton
International Hotels (Hilton International).
At the time he
started with HIC, Mr. di Tullio had been serving as a vice
president of Hilton International.
He had worked in Europe, the
Middle East, and, to a lesser extent, Asia, and as an area
director for Southern Europe, Africa, the Middle East, and
Southeast Asia.
By July 31, 1969, Mr. di Tullio, who remained an employee,
had hired an assistant and an architect, and he focused on
establishing a European base of operations, with an office in
Rome.
Around 1971, however, HIC established its headquarters in
Chicago, and its three employees were moved from Rome.
By the
- 6 end of 1971, the Hyatt International group7 managed seven hotels
located in Hong Kong; Singapore; Manila, the Philippines;
Colombo, Ceylon (Sri Lanka); Acapulco, Mexico; Colon, Panama; and
Toronto, Canada.
Early in the 1970’s, Mr. di Tullio hired
Moustaffa Bakry, a former vice president of Hilton International
in Cairo, to assist in developing the Middle East.
By late 1972,
the Hyatt International group had executed nine management
contracts, and additional management contract negotiations were
in process.
By 1973, Mr. di Tullio had become president of HIC.
From 1969 through 1975, the number of hotels managed by the Hyatt
International group grew from a single property in Hong Kong to
19 hotels located on 4 continents.
As of the end of 1979, the
Hyatt International group managed 28 hotels in 19 different
countries.
Mr. di Tullio recruited Roland McCann, another former
Hilton colleague, to head the Hyatt International group’s efforts
in the Caribbean and Latin America.
During the period from 1976
through 1984, the Hyatt International group added 51 properties
in Europe, Africa and the Middle East, Mexico and Central
America, and Asia, in addition to those already managed.
On November 29, 1968, Hyatt Domestic and HIC entered into a
licensing agreement for use of certain “Licensed Marks” owned by
7
We use the term “the Hyatt International group” to refer
to HIC and its subsidiaries collectively or some combination
thereof. That term is in contrast to “HIC” or other instances
where we have referred to a specific entity.
- 7 Hyatt Domestic.
These licensed marks were:
“Hyatt House
Hotels”, “H. H. & Designs”, and “Hyatt Lodges & Design”.
Hyatt
Domestic granted to HIC the exclusive license to use the marks
outside the United States and its territories and possessions,
the nonexclusive license to use the marks in Hawaii, Alaska, and
the U.S. territories and possessions, and the nonexclusive
license to use the marks on printed matter, brochures, and
similar products throughout the world.
The agreement also
allowed HIC to grant sublicenses to any entity in which it owned
at least a 50-percent interest.
HIC agreed that the standards of
services and the quality of products bearing a mark would be at
least equivalent to those adopted or used by Hyatt Domestic.
HIC
agreed to pay Hyatt Domestic $10,000 upon execution of the
agreement, plus $10,000 for each new hotel operated under the
name “Hyatt”.
The expenses of trademark and name registration in
foreign jurisdictions were the responsibility of HIC as were the
costs of any foreign trademark infringement litigation.
The
agreement was signed twice by Jay Pritzker, once as president of
Hyatt Domestic and a second time as president of HIC.
On October 22, 1971, Hyatt Domestic authorized HIC to use
the “Regency” name in addition to the “Hyatt” name licensed under
the 1968 agreement.
The previously established $10,000 fee per
hotel, however, was not changed.
On September 24, 1976, the list
- 8 of marks licensed was expanded to include various logo designs,
advertising slogans, restaurants, and other “Hyatt” names.
II.
Organizational Structure8
The first international hotel property managed by the Hyatt
International group was an entity that became known as the Hyatt
Regency Hong Kong.
The owners and HIC entered into a management
agreement dated June 7, 1969.
Generally, the agreement followed
the form used by Hilton International, and the name “Hyatt” was
substituted for the name “Hilton”.
On October 28, 1969, Hyatt of
Hong Kong (HHK) was incorporated in Hong Kong as a wholly owned
subsidiary of HIC, and on October 30, 1969, HIC assigned its
interest in the management agreement for the Hyatt Regency Hong
Kong to HHK.
Mr. di Tullio hired Brian Bryce from Hilton
International to be the Hyatt Regency Hong Kong’s general manager
and the senior vice president of HHK.
The Hyatt Regency Hong
Kong began operations in November 1969, using the Hilton
International registration forms as a model.
Other members of
the Hyatt Regency Hong Kong executive committee staff were hired
from Hilton International, including Ken Mullins, Bernd
Chorengel, Larry Tchou, and David Chan.
8
Although the Hyatt International group consisted of
numerous legal entities, we limit our description to a sufficient
number of representative examples in order to provide an
understanding of the group structure.
- 9 Generally, separate corporations were formed to execute
and/or hold each management contract.
Some of the more
significant purposes for forming separate entities were to limit
liability and take advantage of possible local tax benefits.
The
separate hotel management companies were usually made wholly
owned subsidiaries of either HIC or HHK, and most were
incorporated either in the country where the hotel was located or
in Hong Kong.
Generally, no consideration was paid when
management contracts were assigned from a signing entity to a
hotel operating entity.
On one occasion, however, Hyatt of
Singapore (HS) paid HIC $500,000 for the assignment of the
management agreement for the operation of the Hyatt Regency
Singapore.
In numerous instances, HIC guaranteed the performance
of the signing subsidiary.
HIC was involved in the development
of contract opportunities primarily in Central America, Europe,
Africa, and the Middle East, whereas HHK was active in the AsiaPacific area.
Ultimately, HHK evolved into a master hotel
management subsidiary responsible for the entire Asia-Pacific
region.
Hyatt International Canada Ltd. was established in August
1969, as HIC’s Canadian subsidiary, and three ground-up hotels
were opened, two of which closed by 1979, and the remaining hotel
was transferred in exchange for consideration to Hyatt Domestic
in 1984.
- 10 HS was incorporated in Singapore on August 14, 1970, as a
wholly owned subsidiary of HIC for the purpose of holding the
Hyatt Regency Singapore management contract.
The first
management agreement for the Hyatt Regency Singapore, dated May
27, 1970, was executed by HIC and contained a financial guaranty
regarding the amount of the hotel owner’s share of the gross
operating profits.
HS has been responsible for the operation of
hotels in Malaysia, Indonesia, and Thailand.
Although HS is a
subsidiary of HIC, it has always reported to HHK.
On the advice
of tax counsel, HS was assigned the Sydney, Australia, Kingsgate
management contract by Hyatt Regency Corp. Pty. Ltd., a wholly
owned subsidiary of HHK.
The Hyatt Regency Acapulco (opened in Mexico in October
1971) was the first hotel outside of Asia managed by the Hyatt
International group.
Ken Mullins transferred from the Hyatt
Regency Hong Kong to become the Hyatt Regency Acapulco’s first
general manager.
HIC formed a local management company,
Servicios Internacionales Administrativos, S.A. de C.V. (SIASA),
a wholly owned subsidiary of HIC, to manage the hotel.
Mullins
was succeeded as the Hyatt Regency Acapulco general manager by
Fred Lederer, and both had been Hilton employees.
On October 24, 1979, the Hyatt International group entered
into a joint venture with Valores Industriales S.A. (VIS),
Mexico’s largest brewer of beer, which already owned and operated
- 11 five hotels under its Exelaris banner.
The joint venture was
called Hoteles Exelaris, S.A. (HESA), and was owned 51 percent by
VIS and 49 percent by HIC (Mexico), a wholly owned subsidiary of
HIC.
HIC’s 49-percent ownership was, to some extent
unrepresentative in that HIC had contributed about 75 percent of
the value and was entitled to about 25 percent of economic
returns.
After 2 years the profit split was changed to 65
percent for HIC and 35 percent for VIS.
Mexican law did not
permit greater than 49-percent ownership by a foreign
corporation.
HESA was established and operated in Mexico; it was
a VIS-oriented chain, and it was VIS’ intention to exploit the
Exelaris name in the marketplace.
On each HESA hotel was the
name Exelaris, and underneath was the name Hyatt and the name of
the city.
VIS established an HESA office in Mexico City with
approximately 70 to 80 employees.
Fred Lederer, then general
manager at Hyatt Regency Acapulco, was named as the first
director general of HESA.
According to the agreement between VIS
and HIC (Mexico), Fred Lederer would continue serving as general
manager for 18 months, and, thereafter, he would work exclusively
for HESA.
The Hyatt International group formed certain companies to
provide services that supported its hotel management activities,
to wit:
Support services companies, hotel consulting and project
development companies, and special purposes companies.
Support
- 12 service companies are principally involved in marketing, sales,
reservations, and computer support.
In most instances, these
support services were provided by staff at the local hotel level;
however, the Hyatt International group also provided support
services through separate entities; the most prominent of these
was Hyatt Chain Services, Ltd. (HCS).
On January 19, 1971, HCS was incorporated in Hong Kong as a
wholly owned subsidiary of HHK.
Essentially a marketing
cooperative, HCS provided marketing, sales, and reservation
services to the hotels under contract to the Hyatt International
group.
HCS also provided guidance to the hotels regarding the
development of their own individual marketing programs.
The
services provided by HCS are commonly called “chain services” in
the hotel industry.
It is understood that chain services also
promote a particular hotel chain.
In keeping with industry
practice and pursuant to contractual agreements with hotel
owners, HCS provided its services at cost.
The costs for HCS
were totaled annually and shared pro rata by each hotel based on
its room revenue and total number of rooms, subject to
limitations based on a certain percentage of revenue.
Such
amounts were not considered as income or expense to HCS.
HCS’
total annual costs were as follows:9
9
Beginning with 1984, the totals are derived from
(continued...)
- 13 Year
Amount
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
HK$
285,595
HK$
372,290
HK$
363,948
HK$
448,656
HK$ 2,532,531
HK$ 2,752,146
HK$ 2,361,955
HK$ 2,177,055
US$ 1,921,907
US$ 2,300,788
US$ 2,990,913
US$ 3,227,881
US$ 4,681,778
US$ 4,309,759
US$ 5,934,852
US$ 6,519,779
HCS maintained sales and marketing offices in several major
cities, including Frankfurt, London, New York, Chicago, Los
Angeles, Tokyo, Hong Kong, and Singapore.
Hyatt Domestic and the Hyatt International group provided
chain services (i.e., marketing, sales, and reservations) for the
benefit of each other’s hotels.
On or about January 25, 1974,
Hyatt Domestic and HIC agreed to charging for the chain services
between domestic and international Hyatt hotels.
Hyatt Domestic
was to provide a certain amount of chain services for the Hyatt
International, to be negotiated annually.
9
For the services it
(...continued)
consolidated financial statements of HCS and its subsidiaries,
HCS GmbH and Hyatt Reservations SARL. The certified public
accountants who prepared the first consolidated statement
indicated that prior years’ comparative statements were
unnecessary because “The effect * * * is not material”.
- 14 provided, Hyatt Domestic would charge the Hyatt International
group a prorated chain allocation10 on a per room basis as
follows:
Non-North American hotels to pay 50 percent of the
usual chain allocation; Canadian hotels to pay 75 percent; United
States hotels to pay 100 percent.
These percentages were based
on the perceived relative benefit received by each group of
hotels.
Effective February 1, 1980, HIC and Hyatt Domestic
agreed to represent each other in their respective geographical
markets and to separately control and account for their
respective expenses.
As of 1980, Hyatt Domestic concluded that
the exchanged benefits had equalized, so that no further charges
were allocated for chain expenses to Hyatt International hotels.
Pursuant to the 1974 agreement, HIC charged Hyatt Domestic
the following amounts:
Taxable year
ending
Amount
Dec. 31, 1975
Dec. 31, 1976
Dec. 31, 1977
Dec. 31, 1978
Dec. 31, 1979
Dec. 31, 1980
$296,250
368,746
489,591
568,750
666,080
56,250
HIC’s charges for chain-type services were included in Hyatt
Domestic’s total chain expenses.
The total of chain services
expense was billed by Hyatt Domestic directly to Hyatt
10
“Chain allocation” refers to the amount determined by
the cost-sharing formula applied to chain services.
- 15 International group and domestic hotels based on their individual
chain allocations.
For 1978, 1979, and 1980, Hyatt Domestic
charged the Hyatt International group hotels approximately
$1,050,000, $1,200,000, and $1,375,000, respectively.
During 1981, HCS contracted for the development of a
computerized reservation system to be called “IMAGE”.
David
Cook, an HIC employee, spent about a year and a half in Germany
training to become the systems manager for IMAGE.
During 1983,
Mr. Cook returned from Germany, and IMAGE was installed at Hyatt
Domestic’s information services headquarters.
Mr. Cook traveled
to various cities implementing the IMAGE system.
employee trained reservations personnel.
system was not fully implemented.
Another HIC
The IMAGE reservations
From 1981 through 1985, HCS
expended more than $4 million on the IMAGE system with funds that
had been advanced by HHK for the IMAGE system development.
When the Hyatt International group executed a management
contract for a hotel that was to be constructed or when a hotel
under contract underwent a major renovation, the Hyatt
International group frequently provided design consulting
services, also known as technical services, to the hotel owners
in exchange for a fee.
The Hyatt International group was not
prohibited from supplying these services to hotels outside the
Hyatt chain.
These fees were earned by and payable to
International Project Systems, Inc. (IPS), which was incorporated
- 16 in Delaware on February 27, 1974, as a wholly owned subsidiary of
HIC.
IPS could provide either full or partial technical
assistance.
Full technical assistance involved comprehensive
support of the hotel owner’s designers and engineers from the
first architectural drawing to the last day of construction,
including writing specifications, reviewing internal documents,
and reviewing and critiquing back room operational designs.
In
contrast, partial technical assistance involved taking over a
project that is either under construction or fully built and
operating.
IPS offered consulting services on a hotel’s design (by
approving or recommending the architect’s drawings), but it was
not responsible for overall design.
It also could recommend
sources for the wide range of items--from structural building
members to bedding--that a hotel might need.
Occasionally, IPS
subcontracted aspects of the project to other companies.
In most
cases, however, IPS established a flat fee for the specific
technical services it would provide to a hotel, purportedly based
on the Hyatt International group’s experience with the
anticipated expenses.
During most of the years at issue, IPS’
expenses exceeded its revenues.
The Hyatt International group maintained an operational
structure allowing for general strategies to be created and
organized at the top corporate level.
The choice to implement
- 17 general strategy remained with the individual hotel’s management.
Rather than strive for uniformity of appearance and
accommodations in its properties, the Hyatt International group
was able to develop and manage unique hotel properties.
Each
property was fashioned to be culturally correct and
geographically distinct within a particular country.
Guests were
thereby permitted to recognize or appreciate a local character
while enjoying a high level of service.
In spite of that
flexibility, the Hyatt International group, in substantially all
cases, has used the name Hyatt in the hotel names and used the
Hyatt logos and slogans, such as
“Don’t you WISH YOU WERE HERESM”
and “touch of Hyatt”.
III.
Modus Operandi of Hyatt International Group
While the Hyatt International group has taken some equity
positions and in limited circumstances has been involved in
hotel leases, its modus operandi has, generally, been to pursue
management contracts as a means to expand the Hyatt chain and to
increase profitability.
In the international hotel business, the
management contract approach places much of the operating risk on
the owner, not the manager.
Consequently, the owners’ rewards
are also greater, and they generally receive the larger share of
the hotel operating profits and the benefit from appreciation in
capital value.
- 18 Basically, the hotels connected with the Hyatt International
group’s business can be classified in three general categories:
“takeover[s]”, “shell[s]”, and “new hotel[s]”.
Takeovers involve
hotels where one management company succeeds another in managing
a property that is fully operational.
When a management company
becomes involved during hotel construction, it is called a shell.
Because the shell’s building is partially constructed, the
fundamental design is incomplete, and the opportunity remains for
design revisions.
Through the mid-1980’s, the majority of the
Hyatt International hotels were either takeovers or shells,
leaving the Hyatt International group with little or no influence
over the design of the hotels.
In the case of “new or ground-up”
hotels the management company is involved from the start of the
hotel project design and prior to any construction.
Most of the
Hyatt International hotels opened after 1985 have been ground-up
properties where there was involvement in the design of the
hotel.
To be effectively involved in the design, a hotel management
company must work closely with the hotel owner or its
representative, the architects, and the project manager.
The
hotel owner or its representative is the primary force behind the
hotel development, making the choice of architect, project
manager, and the type of property to be built.
For example, the
owner may choose a luxury, business, or economy-type hotel.
The
- 19 owner also chooses the basic image that the hotel property will
project.
The hotel architects receive design manuals and an area
program describing in great detail how the Hyatt International
group believes the hotel layout should blend with the management
agreement.
The architects, however, are generally free to design
the hotel according to their experience and imagination, combined
with the focus and intent of the owner.
The project manager is
the hotel owner’s on-site construction liaison, serving as the
link between the owner and the Hyatt International group.
It takes about 3 to 4 years to develop a hotel.
The amount
of design consulting provided by the Hyatt International group
varied depending on the particular hotel, the nature of the Hyatt
International group’s relationship with the hotel owner, and the
owner’s requirements, and budget.
Though not all hotels choose
to utilize IPS’ consulting services in the facility design, the
Hyatt International group generally provided guidelines,
concepts, and recommendations throughout the process; it
established performance criteria and minimum requirements for
each hotel.
The design manuals provided to each hotel
owner/developer outlined the standards established by the Hyatt
International group for the property.
The standards were based
on service characteristics and the scope of operations of each
hotel; that is, the number of food and beverage outlets and
rooms.
- 20 HIC issued a pro forma letter stating that the manuals are
guidelines and that the standards are not intended to be rigidly
applied by every hotel in every instance.
These guidelines
served as minimum specifications, essentially providing the Hyatt
International group with a way to withdraw from a project without
liability if the specifications are not met.
The guidelines were
developed over a period of years and contain a compendium of
Hyatt institutional experience.
HIC also provided hotel
equipment standards books containing the detail of the items
needed to stock and furnish the hotel exclusive of the guest
rooms, public areas, and major kitchen equipment.
At least one
volume of the three-volume book of equipment standards had to be
customized for a particular hotel.
A significant strength of the Hyatt International group was
its capability to provide the hotel owner with an assembled work
force, including senior management, general managers, and behind
the scenes or back room service hotel personnel.
Hyatt
International group’s senior management consisted of HIC’s senior
executives, including the president and chief executive officer
as well as a number of vice presidents with functional
responsibilities for legal matters, finances, marketing,
technical services, and human resources.
It also included HIC
executives in charge of geographic regions, such as senior vice
presidents and their directors with functional responsibilities.
- 21 These executives, organized by geographic regions, either worked
for one of HIC’s master hotel management subsidiaries or for HCS.
Hyatt International group’s senior management assumed primary
responsibility for developing relationships with hotel owners and
maintaining their trust.
Generally, management contracts were
sourced in personal relationships with owners, and those
relationships were important to the success of the Hyatt
International group’s management and operational systems.
The general manager, in effect, operated as the chief
executive officer of the hotel.
Each general manager had the
power to make day-to-day decisions, interact with the owner, and
generally run the hotel as an autonomous business.
Offers of
employment for general managers were prepared and executed by
authorized Hyatt International divisional or regional personnel
on divisional or regional letterhead.
Owners generally
recognized the general manager’s importance and tended to rely on
the Hyatt International group to provide personnel who would be
key to the hotel’s success.
The owners worked with the hotel’s
general manager to ensure that their interests were being pursued
and generally looked to the general manager when they had any
operational questions.
In general, the owner’s involvement was
limited to participation in general management activities, such
as budgeting and finances; original, amended, or renewed
management contracts; hotel design and renovations; general
- 22 manager appointments; and legal, economic, and political risks.
Owners relinquished day-to-day operations of the hotel to the
general manager and other members of the hotel’s executive
committee.
While the general manager was principally responsible for
hotel management, the general manager relied upon the hotel
executive committee for operational and strategic support.
The
executive committee typically consisted of five to eight people:
Including the key department heads in the hotel, including the
resident manager; directors of rooms, food and beverage, human
resources, engineering, and sales/marketing; the executive chef;
and the financial controller.
The general manager was responsible for recruiting
personnel, setting pay rates, labor union negotiations, and
conducting the initial training.
The general manager was
assisted in these matters by the Hyatt International group
management subsidiaries.
The hotel’s director of human resources
was responsible for the actual hiring of the operational
personnel and had to be aware of and sensitive to local working
conditions, labor laws, religious and cultural mores, which
differ from hotel to hotel.
The director of human resource
positions were filled through the coordinated efforts of the
general manager and the divisional director of human resources.
- 23 The director of sales and/or marketing was responsible for
bringing in customers to the hotel, and was usually engaged about
6 to 9 months prior to a hotel’s opening in order to analyze the
business traveling pattern of the city and locate likely sources
of business.
Room revenues were usually derived from independent
travelers, tourists, incentive groups and tours, corporate rate
guests, and special rate guests, such as airline crews.
The
hotel had to find the appropriate market mix and aggressively
pursue new guest and customer markets in order to be successful,
remaining flexible and responding to any market shifts.
Some of
the business was generated locally from companies and local
travel agents.
The director of sales/marketing and the general
manager were responsible for negotiating with local companies and
travel agents and qualifying them for special rates in exchange
for the guaranty of a certain number of room nights.
Marketing performed by individual hotels differs from chainservice marketing.
For chain marketing, the strengths of a
particular property may be featured, but the overall purpose is
to promote the global chain.
For example, Hyatt International
group’s brochures may focus on a single hotel, but also provide
reservation information for other Hyatt International hotels and
publicize one or more Hyatt International hotels in the same
area.
Establishing a local presence was the general manager’s
- 24 responsibility with the assistance of the other members of the
executive committee.
For the Hyatt International group, the food and beverage
revenue was as integral to a hotel’s success as the room revenue.
Decisions about what type of food and beverage service to offer
were made by the general manager and area directors; HIC did not
provide a master plan or instruct hotels as to the kind of
restaurant, bar, or cafe services to offer.
“Back-of-the-house” operations refers to support services
that are performed behind the scenes in a hotel, including
engineering, maintenance, accounting, and management information
systems.
Back-of-the-house operations were within the exclusive
purview of the general manager and executive committee.
The
general manager and executive committee were also responsible for
managing other hotel departments, including telephones, foreign
exchange, laundry, and membership clubs such as fitness and/or
golf.
The engineering or technical services departments of hotels
were responsible for hotel maintenance and safety.
That job is
basically standard from hotel to hotel, but may vary according to
local government rules, regulations, and license requirements.
The hotel controller is responsible for the books and
accounts of the hotel operation and for maintaining the
accounting records of the hotel.
A uniform system of accounts
- 25 for hotels was used by all Hyatt International hotels.
of transactions can take place during any given day.
Thousands
For
example, if a 500-room hotel is 80 percent occupied with an
average of two occupants per room and each occupant purchases one
meal in the hotel per day, a total of 1,200 transactions takes
place during the day (400 rooms plus 800 food and beverage
transactions).
Each guest can generate additional transactions
by using the laundry, making purchases at the sundry store, and
using the business center, telephone, or health club.
Financial
controls at the local hotel level and its effect on the chain
operation are extremely important.
The operational personnel consisted of individuals who
worked in nonexecutive hotel positions and reported to executive
committee members; e.g., front desk clerks, banquet captains,
restaurant waiters, bartenders, and maintenance personnel.
The
operational personnel represented the largest human resource
group in the Hyatt International group.
Recommendations
regarding the compensation of staff were made by the executive
committee and approved by the general manager.
The hotel general manager and executive committee were
largely responsible for preopening activities, although certain
preopening responsibilities were undertaken at the divisional
level.
Included in successful preopening management activities
were:
Overall planning, staffing, setting up the physical plant,
- 26 and marketing.
Preopening activities were more important and
more elaborate for new hotels than for takeovers, although
takeovers did require some preopening preparation.
For a new
hotel, a general manager was generally designated and assigned 12
to 18 months prior to opening.
The owner was responsible for paying preopening expenses,
including the cost of training.
After the opening, the owner was
responsible for paying management fees and hotel operating
expenses.
The Hyatt International group’s management fees
generally were expressed as a percentage of revenue and/or gross
operating profits.
To avoid certain countries’ local withholding
taxes, the management fees were characterized or described in a
few contracts as royalties.
Each hotel’s revenues, expenses
(including payroll), and assets were carried on its own books and
were not recorded by or shown in the books of any Hyatt
International entity.
The Hyatt International group, however,
was responsible for managing the employees and the assets and for
generating each hotel’s revenues.
Hyatt International’s ability to retain management contracts
was dependent upon two factors:
(1) Satisfying hotel owners and
(2) generating sufficient revenue to ensure a successful
arrangement for both the owners and the Hyatt International
group.
For both of these factors, the hotel general manager
played a significant role.
Occasionally, management contracts or
- 27 leases were terminated for various reasons, including the
following:
(1) An owner might become dissatisfied with Hyatt
International’s management.
For example, the contracts for the
Hyatt Regency Toronto and Hyatt Vancouver Airport, two of the
three Canadian Hyatt International hotels, terminated due to the
owners’ dissatisfaction with the operating results and failure to
meet the contractual profit targets, respectively.
(2)
Conversely, the Hyatt International group might become
dissatisfied with the owner, including the owner’s unwillingness
to renovate the property.
(3) Forces of nature or the effect of
politics can be the cause of involuntary termination.
A strong owner-management relationship is essential to
implement necessary improvements to hotels because owners are not
usually eager to bear the high costs of improvements.
By the
mid-1980’s, the Hyatt International group’s growth enabled it to
be more selective in its management relationships.
At that time,
the group began eliminating poor performing and below-standard
properties.
The Hyatt International group played an important role in
the careers of the people hired and was responsible for
determining hotel employees’ compensation.
Employees hired for
management positions were subject to being reassigned to other
hotels.
The Hyatt International group identified promising hotel
staff members and positioned them for promotion at their current
- 28 or another hotel.
When planning a new hotel location, the Hyatt
International group looked for experienced chain employees for
the general manager and executive committee for the new hotel.
Generally, the general manager and area directors recommend
executive committee staff for transfer and promotion.
The
selection and transfer of general managers and certain executive
staff, however, required HIC’s approval.
Similarly, senior staff
recommendations for the general manager’s and executive committee
member’s compensation was also subject to HIC’s approval.
From
their first position, employees knew their career would be
determined by the Hyatt International group, not the hotel owner.
The general manager and executive committee staff at certain
Asian flagship hotels, such as the Hyatt Regency Hong Kong and
the Hyatt Singapore, served concurrently in senior executive
positions with HHK and HS.
Initially, the salaries of HHK and HS
employees and related overhead expenses were paid entirely by the
hotels.
Later, a portion of those salaries was paid by the Hyatt
International master hotel management subsidiaries, after they
assumed increased responsibility for new hotels.
In the early
1980’s, HHK began to hire and pay full-time clerical staff and
specialists in positions such as marketing, food and beverage,
engineering, and finance.
For certain hotels, the executive
staff (usually general managers and controllers) continued to
have dual roles.
For example, Brian Bryce, the first general
- 29 manager at the Hyatt Regency Hong Kong, was also a vice president
for HIC; David Chan was controller at Hyatt Regency Hong Kong and
area controller for HHK; Bernd Chorengel was general manager at
Hyatt Regency Singapore at the same time that he was area
director, and then senior vice president, for Southeast Asia at
HS.
IV.
HIC’s Role Within the Hyatt International Group
An attempt was made to insulate the Hyatt International
group from day-to-day hotel operations and from legal issues such
as guest complaints or injuries.
These matters were primarily
dealt with at the local hotel level by the general manager, the
owner’s representative, and/or the hotel’s counsel.
HIC rarely
became involved in these matters, although it was made aware of
significant developments by its master management subsidiaries
and/or the general managers.
“Slip-and-fall” personal injury
cases were handled at the hotel level and monitored by the
relevant management subsidiary or HIC.
The management
subsidiaries engaged their own legal counsel for employment
matters.
HHK used Hong Kong lawyers for tax advice and legal
liability concerns.
The subsidiary companies, therefore, while
relying on local counsel, involved HIC whenever there was a
question of exposure to liability for the subsidiary or the
entire Hyatt International group.
HIC coordinated the purchase
of business liability and other types of hotel operating
- 30 insurance for individual hotels, charging each hotel an allocated
portion of the cost.
Prior to 1984, HIC’s senior vice president for development
reviewed management contracts because HIC did not have in-house
counsel.
For later years, when HIC had equity participation in a
hotel and/or Hyatt ’s money was at risk, HIC’s legal department
played an integral role in the legal aspects of the transaction.
Legal counsel promoted the formation of separate corporations
within the Hyatt International group so that the risk of legal
liability would fall on individual hotels instead of the group.
The legal department tracked the registration of the Hyatt trade
names and marks in foreign jurisdictions, employing a U.S. law
firm, which in turn contracted with a foreign law firm to perform
the work.
The tracking was primarily for cost containment of
registration expenses.
HIC’s chief financial officer was responsible for
maintaining the financial accounting records of HIC and its U.S.
subsidiaries within the consolidated group.
He was also
responsible for preparing consolidated financial statements for
use by HIC’s board and during the annual audit, preparing
Federal and State tax returns and meeting other governmental
filing requirements, and managing the annual certified audit
process.
HIC’s staff internal auditor was sent to review books
and records of hotels and subsidiaries.
- 31 HIC coordinated the sales and marketing activities of its
subsidiaries, including the worldwide sales and reservations
offices, which fall under the responsibilities of the area
marketing directors.
The marketing vice president coordinated
the consistency of hotel advertising and graphic design and
conducted third-party marketing efforts with major airlines,
credit card companies, and travel consortia.
Hotel marketing
staff, however, wrote the advertising text, and individual local
hotels paid for advertising costs out of their own budgets.
The hotel operations vice president supervised HIC office
functions, including marketing, personnel, food and beverage
planning, and systems analysis.
It was this vice president’s
responsibility, and that of HIC generally, to set standards of
service, but not to manage the hotels.
This vice president
received and reviewed the various hotel reports, including
budgets and monthly reports of activity.
He reviewed, discussed,
and made suggestions concerning these reports throughout all
organizational levels of the Hyatt International group.
In
accord with Hyatt International group operations, hotel and area
staff initiated and implemented the management plans, with HIC
providing final approval or mediating differences between hotels
or geographical areas on various topics, such as staff transfers.
HIC also maintained a food and beverage department that
- 32 coordinated and exchanged information throughout the chain
regarding that subject matter.
HIC’s human resources vice president acted as the
clearinghouse for human resources policies and procedures,
personnel director for the HIC corporate office and the Hyatt
International sales offices located in the United States, and as
liaison to the third-party administrator for worldwide benefits
and retirement plans.
HIC instructed its hotels to buy life
insurance for the hotels' employees and arranged for a life
insurance provider.
HIC also arranged a provider for employee
medical insurance.
The hotel owners, however, paid the insurance
premiums.
As of January 1, 1975, HIC established the “Hyatt
International Salaried Employees’ Retirement Plan”.
On or about
February 26, 1981, HIC initiated “The Money Accumulation Pension
Plan for Third Country National Employees of Hyatt International
Corporation”, effective January 1, 1980.
Contributions to the
plan were funded by the owners of the hotels at which the plan
participants were employed.
In 1981, HIC inaugurated the HIC Incentive Compensation
Program for the general managers of Hyatt International hotels.
Under the program, a general manager could qualify for a monetary
award, which was paid by the employing hotel.
General manager
- 33 incentive compensation was measured by objective (operational
performance) and subjective evaluation by HIC personnel.
The performance of general managers and executive committees
was considered to be good for most local personnel matters in the
Hyatt International group.
Training, on the other hand, was an
area in which they did not perform as well.
General managers and
executive committees did not have access to effective “off-theshelf” training material, and they did not have sufficient
resources or time to develop adequate in-house local personnel
training programs.
To remedy this, Hyatt International provided
the “Training for your future” program that was offered to hotel
employees worldwide beginning in 1985.
Hyatt International group developed hotel management and
operation policy and procedures manuals.
HIC acted as a
clearinghouse for the preparation of the manuals, and portions
were written by area specialists and hotel staff.
HIC was
responsible for the distribution of manuals to new hotels and for
asking the field for updates.
After updates were prepared, HIC
coordinated the updates and distributed them to the appropriate
hotels.
General managers were responsible for their respective
hotel’s operating manuals, the food and beverage directors were
responsible for their departmental manuals, and the chefs were
responsible for their own menus and recipes.
- 34 As early as March 1975, HIC distributed a controller’s
checklist for reports.
In 1981, HIC copyrighted a manual
entitled “Accounting and Internal Control Systems and
Procedures”.
This manual was written at the request of the area
and hotel accounting staff and was provided to hotel controllers
who also assisted in its review.
The manual provided
standardized reporting and accounting controls, facilitating a
uniform budget process and the ability to move accounting
personnel between hotels.
accountants in Mexico.
It was also used to train the
Effective March 1, 1983, HIC promulgated
materials describing specialized policies and procedures for the
areas of law and insurance, administrative/general, and finance/
accounting.
Some of the topics included:
Technical assistance
agreements, management agreement obligations, area vice president
hotel visits, annual business plan, reports schedules, and interhotel financial transactions.
HIC vice presidents would occasionally visit the hotels,
generally accompanied by the area vice presidents, to make
inspections and recommendations.
Periodically, the Hyatt
International group would hold meetings of general managers.
At
these meetings, general managers met with HIC and senior
executives of management subsidiaries to review the growth and
development of the Hyatt International group.
The general
managers also exchanged ideas and information on what made their
- 35 hotels successful.
Data were also exchanged on candidates for
promotion to various positions.
V. Agreements Between Hyatt International Group Entities and
Hotel Owners11
A.
Hyatt Aryaduta Jakarta Agreement
On December 18, 1975, the owners of the Aryaduta
(Ambassador) Hotel located in Jakarta, Indonesia, and HHK entered
into a 10-year management agreement.
The owners agreed to
refurbish the existing hotel and to complete certain unfinished
floors.
The parties agreed that the hotel name would be changed
to the “Hyatt Aryaduta Hotel”.
In the early 1980’s, Andre Pury,
the Hyatt International regional director for Indonesia,
initiated negotiations with the Hyatt Aryaduta Hotel owners for
further renovations and an extension of the management contract.
On October 16, 1981, the owners entered into an agreement with
IPS for the renovation, but the work was delayed for several
years.
Around the same time, Mr. Pury located a group of investors
interested in constructing a new hotel in Jakarta to be known as
the Grand Hyatt Jakarta.
Included in the investor group was the
son of Indonesia’s President Suharto.
The new hotel was intended
to be at the top end of the Jakarta hotel market, in contrast to
11
Only selected agreements have been addressed in the
findings of fact to show patterns or the types of contractual
relationships that were utilized.
- 36 the Hyatt Aryaduta which was ranked fifth or sixth.
Near the
conclusion of the negotiations, the investor group demanded that
the Grand Hyatt Jakarta be the only Jakarta hotel to display the
Hyatt name.
Mr. Pury conveyed this demand to the Hyatt Aryaduta
owners, who were aware that President Suharto’s son was involved
in the new hotel.
On January 1, 1986, the Hyatt Aryaduta Hotel
owners agreed to permit HHK, at its election, to remove the Hyatt
name in exchange for a reduction in management fees from 3 to 2.5
percent and a reduction in incentive fees from 10 to 5 percent.
In addition, the Hyatt Aryaduta Hotel owners also agreed to
construct, furnish, and equip a 132-room extension.
On January 14, 1986, HHK entered into a management agreement
for the Grand Hyatt Jakarta, which opened in March 1991.
Around
the same time, the Hyatt Aryaduta’s name was changed to The
Aryaduta.
B.
Both hotels were very successful operations for HHK.
Century Hyatt Tokyo Agreements
Odakyu, a Japanese conglomerate of public and private
companies, among its other business activities, provides travel
and construction services and owns real estate, department
stores, railway lines, and hotels.
Odakyu owned three hotels and
a national travel agency in Japan.
The hotels were operated
under the Century Hotel name and logo, which was registered by
Odakyu in Japan.
Typical of Japanese hotel owners, Odakyu did
not wish a management contract relationship and preferred a
- 37 franchise agreement.
The Hyatt International group, on the other
hand, was opposed to franchising.
As a result, on March 16, 1979, a compromise agreement was
signed, under which Odakyu would operate the hotel, and the Hyatt
International group would provide sales, reservations and
information services, manuals, policies and training materials,
and related materials, all of which are made available to hotels
involved with the Hyatt International group.
In exchange, Odakyu
agreed to pay $300,000 per year for 3 years and the greater of
$300,000 per year or 10 percent of gross room revenues received
from non-Japanese guests thereafter.
In addition, at Odakyu’s
request, Hyatt International would make available numerous
optional services, including purchasing, operational management
services, and technical assistance for these services; generally,
Odakyu would pay at cost.
Odakyu was allowed the use of the
Hyatt names, with Hyatt International’s written approval prior to
using the Hyatt name on the hotel.
Odakyu agreed to promote
Hyatt International hotels by including the display of materials
in the rooms and lobby areas of its hotels and making
reservations for other Hyatt International hotels.
An August 22, 1979, amendment replaced the $300,000/10percent terms with a fixed $100,000 annual royalty for a 10-year
term in exchange for Odakyu’s use of the Hyatt name.
In
addition, the amendment provided for Hyatt International to
- 38 receive, in return for performance of sales and reservation
services and information services outside Japan, $200,000 per
year for the first 3 years and thereafter the greater of $200,000
per year or 10 percent of annual gross room revenue of nonJapanese guests.
After 3 years, the annual amount for services
was reduced to $100,000.
In this amendment, Hyatt International,
S.A., assigned the rights to the agreement to HHK, as permitted
by the original agreement terms.
In an October 1, 1984,
amendment, the fee for services was changed to a fixed fee of
Yen68,301,156 for the period September 15, 1983, to March 31,
1984, and the greater of $200,000 per year or 8 percent of annual
gross room revenue from nationals of countries other than Japan.
Here again the annual amount was reduced to $100,000 after March
31, 1984.
C.
HESA Agreements
On October 24, 1979, in conjunction with the establishment
of HESA by VIS and HIC (Mexico), HESA and HHK entered into a
consultancy agreement under which HHK was to provide management
services and preopening support.
HESA and HHK also entered into
an agreement for the use of the Hyatt names and marks and the
provision of chain services.
HESA agreed to pay HHK an amount
equal to 75 percent of the management fees received, less
administrative expenses incurred in the supervision of hotel
operations.
This agreement included a royalty of 2 percent of
- 39 the gross income for each HESA hotel that used the Hyatt names
and marks and for chain services.
In the case of the Hyatt
Regency Acapulco, however, which was already a Hyatt
International hotel, HIC (Mexico) would receive 90 percent of the
fees (including 15 percent for SIASA), without regard to the
administrative expenses incurred in connection with that hotel.
During 1982, due to the increased number of hotels under
HESA management, the agreement between HESA and HHK was amended,
reducing the percentage HESA was to pay HHK as a fee for services
and reducing the royalty for the trade names and chain services
from 2 to 1 percent of hotel gross income.
D.
Atrium Hyatt Budapest Agreements
The Atrium Hyatt Budapest opened during June 1982.
The
agreement concerning this hotel was in the nature of a franchise.
The Hyatt International group agreed to provide technical
services, preopening services, management expertise, and chain
services, in addition to allowing the use of the Hyatt trade
names and marks.
The parties agreed that the general manager was
to be chosen by the hotel and trained by the Hyatt International
group.
The Hyatt International group agreed to provide training
at its existing hotels for other key personnel.
For 3 years, the
hotel agreed to pay $1.50 per day for each occupied room, plus a
percentage of room revenue for reservations booked through Hyatt
International services, and a percentage of revenue from room,
- 40 food and beverage, and incidentals for guest groups booked
through the Hyatt International group.
Effective July 1, 1985,
the parties amended the remuneration for another 3-year period at
a rate of $200,000 annually in exchange for management expertise
and chain services, including reservations.
E.
Hyatt Regency Brussels Agreement
On January 12, 1973, HIC entered into an agreement to manage
and lease a hotel that was to be constructed and would be known
as the Hyatt Regency Brussels.
The terms of the lease provisions
included a guaranteed rental to be paid to the hotel owner.
The
owner, Belgium Hotels Leasing Partnership, was owned by the
principal stockholders of HIC (95 percent) and Mr. di Tullio (5
percent).
The agreement was assigned by HIC to Hyatt Management,
Inc., a Delaware corporation wholly owned by HIC.
The hotel
operated at a loss from its 1976 opening through 1986.
F.
Hyatt Regency Nice Agreement
The Hyatt Regency Nice opened during July 1979 and closed
during November 1983.
Hyatt International (France) was created
in France in 1976 to hold the management contract for the Hyatt
Regency Nice.
Hyatt International (France) was owned 90 percent
by HIC and 10 percent by HHK.
The management agreement included
a minimum annual payment to the hotel owner from Hyatt
International (France) that was guaranteed by HIC.
The hotel,
Société d’Exploitation Niçoise, was owned 39.6 percent by the
- 41 principal stockholders of HIC, 10 percent by an HIC subsidiary,
and 50.4 percent by unrelated parties.
VI.
Financial Information
The consolidated financial statements of HIC and its
subsidiaries reflect the following revenue and expenses:
- 42 Domestic1
Foreign
Total
Revenue
Expenses
$1,624,803
2,623,993
(999,190)
$4,382,067
423,064
3,959,003
$6,006,870
3,047,057
2,959,813
Revenue
Expenses
2,783,886
4,209,828
(1,425,942)
4,815,825
229,254
4,586,571
7,599,711
4,439,082
3,160,629
Revenue
Expenses
4,580,779
5,231,623
(650,844)
6,363,780
719,237
5,644,543
10,944,559
5,950,860
4,993,699
Revenue
Expenses
1,791,770
5,478,207
(3,686,437)
$8,665,739
552,785
8,112,954
10,457,509
6,030,992
4,426,517
Revenue
Expenses
2,085,787
7,777,161
(5,691,374)
11,948,337
712,218
11,236,119
14,034,124
8,489,379
5,544,745
Revenue
Expenses
3,324,344
7,079,795
(3,755,451)
13,434,924
1,285,992
12,148,932
16,759,268
8,365,787
8,393,481
Revenue
Expenses
2,447,592
8,481,592
(6,034,000)
13,491,587
3,289,469
10,202,118
15,939,179
11,771,061
4,168,118
1976
1977
1978
1979
1980
1981
1982
1
The category “Domestic” includes those Hyatt International
entities incorporated in the United States, including HIC, IPS,
and the management subsidiaries for hotels in Canada, Brussels,
and Central America.
Included in the above expenses are losses on leased
operations and on guaranties for hotels in Brussels and Nice, as
follows:
- 43 -
Year
Amount
1976
1977
1978
1979
1980
1981
1982
$648,604
1,841,960
2,269,444
2,075,582
3,749,346
2,600,408
1,343,006
As percentage of expenses
Domestic
Consolidated
25
44
43
38
48
37
16
21
41
38
34
44
31
11
The financial statements of HHK and its subsidiaries and of
HS reflect the following revenue and expenses:
HHK and subs.
HS
Total
Revenue
Expenses
$2,812,771
156,727
2,656,044
$668,338
88,478
579,860
$3,481,109
245,205
3,235,904
Revenue
Expenses
2,899,989
136,544
2,763,445
1,211,452
142,185
1,069,267
4,111,441
278,729
3,832,712
Revenue
Expenses
3,490,563
473,222
3,017,341
1,739,405
187,634
1,551,771
5,229,968
660,856
4,569,112
Revenue
Expenses
5,119,704
448,755
4,670,949
2,174,035
205,822
1,968,213
7,293,739
654,577
6,639,162
Revenue
Expenses
8,962,047
909,374
8,052,673
2,769,148
171,175
2,597,973
11,731,195
1,080,549
10,650,646
Revenue
Expenses
10,684,784
937,873
9,746,911
2,832,835
283,106
2,549,729
13,517,619
1,220,979
12,296,640
1976
1977
1978
1979
1980
1981
- 44 1982
Revenue
Expenses
10,413,189
2,834,416
7,578,773
2,294,179
272,547
2,021,632
12,707,368
3,106,963
9,600,405
Beginning with 1983, HHK’s financial statements contained
the amount of overhead expenses allocated to HHK from HIC for
services performed on behalf of HHK.
The 1983 allocation
included payment for services performed in prior years and was
the result of an Internal Revenue Service audit.
The overhead
expenses allocated to HHK from HIC for services performed on
behalf of HHK were reflected as follows:
Year
Amount
1983
1984
1985
1986
1987
1988
$2,503,692
198,422
228,740
249,872
261,361
326,512
HHK and HS had retained earnings before and after payment of
dividends to HIC.
The amount of the dividends and retained
earnings after dividend payments for the years 1976 through 1987
were as follows:
- 45 -
Year
Hyatt of Hong Kong
Retained
Dividends
earnings
Hyatt of Singapore
Retained
Dividends
earnings
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
--$921,000
2,100,000
3,520,000
11,099,930
5,050,000
--2,038,283
16,325,000
--9,000,000
10,150,000
$1,181,383
359,161
1,288,798
954,103
1,481,926
------------1
91,000
$8,598,528
10,018,226
10,521,245
10,974,344
6,477,453
10,660,914
17,783,063
18,926,781
9,723,525
6,267,334
5,063,406
9,206,112
$1,245,134
702,308
1,248,311
1,056,059
1,624,401
1,625,955
2,823,777
1
7,791,000
1
9,275,000
1
9,606,000
1
11,666,000
1
11,853,000
1
Figures denominated in Singapore dollars.
For most of the taxable years under consideration, the
majority of HIC’s income consisted of dividends and the remainder
of HIC’s income consisted of operating income or interest.
For
most of the years, the reported expenses of IPS’ and HIC’s U.S.
hotel management subsidiaries exceeded their revenues.
VII.
Respondent’s Determinations
Respondent determined, in the notices of deficiency sent to
HGH, increased income for Hyatt Domestic as follows:
- 46 -
Taxable year
Trade name
adjustment
Jan. 31, 1980
Jan. 31, 1981
Jan. 31, 1982
Jan. 31, 1983
Jan. 31, 1984
Jan. 31, 1985
Jan. 31, 1986
Jan. 31, 1987
Jan. 31, 1988
Total
$2,159,000
3,266,000
4,603,000
5,279,000
5,548,000
6,070,000
5,735,687
5,935,143
7,333,495
45,929,325
The October 12, 1990, notice of deficiency contained the
following explanation for the 1983 through 1985 tax years:
It has been determined that an adjustment be made in
accordance with the provisions of Internal Revenue Code
Section 482 and the regulations thereinafter to
increase your income for the value of the trade name
“Hyatt”. Accordingly, your taxable income for year
ended January 31, 1983; January 31, 1984 and January
31, 1985 have been increased in the amounts of
$5,279,000; $5,548,000 and $6,070,000 respectively.
The Explanation of Items in the October 28, 1991, notice of
deficiency for HGH’s taxable years 1980 through 1982 states:
Hyatt Corporation (HC) engaged in transactions with
Hyatt International Corporation (HIC), relating to
HIC’s use of “Hyatt” trade names, trademarks, and other
intangible assets, which were not at arm’s-length
terms. Pursuant to section 482 of the Internal Revenue
Code and Treas. Reg. §1.482-2(d), it is determined that
an arm’s-length royalty or license fee for these
transactions equals 1.5% of the gross revenues of each
hotel operated under the “Hyatt” name by HIC or any of
its subsidiaries. * * *
The January 27, 1993, notice of deficiency for HGH’s 1986 through
1988 tax years contained the same above-quoted explanation.
- 47 Respondent, in the notices of deficiency addressed to
petitioner AIC, determined that the income of its subsidiary HIC
income should be increased as follows:
Taxable year
ending
Trade name
Management
fees
Total of
these items
Dec. 31, 1976
Dec. 31, 1977
Dec. 31, 1978
Dec. 31, 1979
Dec. 31, 1980
Dec. 31, 1981
Dec. 31, 1982
Dec. 31, 1983
Total
$982,000
1,086,000
1,495,000
1,877,010
3,094,935
4,157,250
4,838,580
5,046,810
22,577,585
$1,601,467
2,048,740
2,296,218
3,300,716
5,070,618
4,852,581
4,946,904
2,642,440
26,759,684
$2,583,467
3,134,740
3,791,218
5,177,726
8,165,553
9,009,831
9,785,484
7,689,250
49,337,269
The November 18, 1994, notice of deficiency reflecting AIC’s 1976
through 1978 taxable years contains the following explanation for
the above-scheduled adjustments:
Royalty Income-Trade Name
You engaged in transactions with your subsidiaries,
Hyatt of Hong Kong, Ltd. (HHK), Hyatt of Singapore, Ltd
(HS), and Hyatt of Panama (HP) under which the
operating subsidiaries were permitted to use the
“Hyatt” trademarks and trade names, to which you held
an exclusive license outside the territorial United
States. Under section 482 of the Internal Revenue Code
and Treasury Regulation section 1.482-2(d), it is
determined that an arms’-length royalty equals 1.5% of
gross revenues of HHK, HS and HP for each of the years
1976, 1977 and 1978. * * *
Management Fee
It is determined that your attribution of substantially
all management fees for the operations and management
of foreign Hyatt hotels to Hyatt-Hong Kong, HyattSingapore and Hyatt of Panama, respectively, fails to
clearly reflect Hyatt International Corporation (HIC)
income for 1976, 1977 and 1978. Pursuant to Internal
- 48 Revenue Code section 482 and Treasury regulation
section 1.482(d), it is determined that an arm’s-length
charge for management services performed by Hyatt-Hong
Kong, Hyatt-Singapore and Hyatt-Panama equals
$73,200.00 per hotel managed in 1976 through 1978.
* * *
The management fees adjustments generally represent all of the
net income of the named subsidiaries in excess of respondent’s
determined per-hotel allowance, less the amount already
determined as trade name royalty.
The February 28, 1995, notice
for AIC’s 1979 through 1983 taxable years contained the same
explanations for these adjustments as the November 18, 1994,
notice, except that the per-hotel arm’s-length charges determined
by respondent were as follows:
Year
Amount
1979
1980
1981
1982
1983
$75,000
87,500
100,000
62,000
62,000
The number of hotels respondent used to compute the fee
adjustments were as follows:
Year
HHK
HS
HP
1976
1977
1978
1979
1980
1981
1982
1983
6
6
7
9
20
28
14
17
2
2
2
3
3
2
2
2
1
1
1
1
1
1
1
1
- 49 These numbers were described in the explanation of items as
“counts any hotels actually managed by” the respective entity;
i.e., HHK, HS, or HP.
OPINION
I.
Preliminary Matters--Evidentiary Objections
A. Documents Executed During or Pertaining to Taxable Years
Subsequent to Those in Issue
Respondent objected, on the grounds of relevance, to the
admission into evidence of certain documents executed during
and/or pertaining to periods subsequent to the taxable years in
issue.
Alternatively, respondent objected on the grounds that
any probative value of such documents is outweighed by prejudice
or considerations of undue delay, waste of time, or the needless
presentation of cumulative evidence.
The documents in question
primarily include management agreements and financial statements
of Hyatt International hotels.
Respondent’s objections, in essence, bear more heavily on
the probative weight of the documents than on their
admissibility.
It is noted that respondent did not object to
documents concerning subsequent periods when the documents
supported or were helpful to respondent’s expert’s opinion.
Respondent relies on rules 401, 402, and 403 of the Federal
Rules of Evidence.
Under the circumstances here, we hold that
the documents to which respondent objected are relevant and
- 50 reflect a continuing pattern of activity.
Further, respondent
has not shown that the probative value of said documents “is
substantially outweighed by the danger of unfair prejudice,
confusion of the issues, * * * or by considerations of * * *
needless presentation of cumulative evidence.”
Fed. R. Evid.
403.
Respondent’s objections are overruled, and the exhibits to
which respondent objected on relevance and related grounds are
part of the record in these cases.
B.
Foreign Language Documents That Have Not Been Translated
Respondent objected to certain foreign language documents
for which no English translation had been provided.
Respondent
contends that such documents could have no probative value to the
trier of fact.
This group of documents consists of financial
statements, management agreements, and preopening and technical
agreements.
Although the contents of these documents have not
been translated, the names of the parties involved and the place
and date of execution are discernible.
That information tends to
corroborate that the Hyatt International group entered into
certain agreements and/or operated certain hotels during the
years to which the documents pertain.
In addition, some of the
documents containing financial information are readily
discernible without the need for translation, but tend to be of
less value where the amounts have not been converted into U.S.
- 51 dollars.
Here, again, relying on rules 401 and 402 of the
Federal Rules of Evidence, respondent’s objections appear to go
more to the probative weight than the admissibility of these
documents.
C.
Therefore, respondent’s objections are overruled.
Documents Prepared for Litigation
Respondent objects to certain documents prepared for
purposes of this litigation on the grounds that they are hearsay
and irrelevant.
These documents consist of materials prepared
and supplied to petitioners’ expert Ernst & Young LLP (Ernst &
Young) to assist in the preparation of its expert report.
The
documents in question consist of various summaries of the Hyatt
International group data including expenses, sales, guests, and
employees.
One of the significant distinctions between expert and fact
witnesses is that experts are permitted to rely on evidence
outside the trial record.
The evidence outside the record may be
hearsay and need not be otherwise admissible, but they may be
used by the expert to formulate an opinion.
See Fed. R. Evid.
703.
Rules 702 and 703 [Fed. R. Evid.] do not, however,
permit the admission of materials, relied on by an
expert witness, for the truth of the matters they
contain if the materials are otherwise inadmissible.
See Paddack v. Dave Christensen, Inc., 745 F.2d 1254,
1261-62 (9th Cir. 1984). Rather, “Rule 703 [Fed. R.
Evid.] merely permits such hearsay, or other
inadmissible evidence, upon which an expert properly
- 52 relies, to be admitted to explain the basis of the
expert’s opinion.” * * *
Engebretsen, et al. v. Fairchild Aircraft Corp., 21 F.3d 721,
728-729 (6th Cir. 1994).
Accordingly, respondent’s objection is sustained in that such
documents are not received in evidence for the truth of their
contents.
Such documents, however, may be considered for
purposes of understanding or explaining the basis for the
expert’s opinion.
D.
Revenue Agent's and Economists’ Reports
Respondent objects to the admission of respondent’s in-house
economists’ reports and international examiner’s reports.
Respondent points out that these reports were prepared prior to
the issuance of the notices of deficiency and, further, that the
reports do not represent respondent’s final determination.
In
the vast majority of cases, we would agree that reports and
opinions of respondent’s employees prior to the issuance of the
deficiency notice are irrelevant to the proceeding.
In cases
involving respondent’s determinations under section 482, however,
taxpayers must establish that the Commissioner’s determinations
were arbitrary, capricious, or unreasonable.
That burden has
often been described as more difficult or heavier (than a mere
preponderance of the evidence) to carry.
- 53 In cases where we have considered whether there has been an
abuse of the Commissioner’s discretion, we have occasionally
received pre-deficiency notice matter into evidence and looked
behind the notice.
See Capitol Fed. Sav. & Loan Association &
Sub. v. Commissioner, 96 T.C. 204, 214 (1991); Branerton Corp. v.
Commissioner, 64 T.C. 191, 200-201 (1975).
In this case, it is
appropriate to include in the record such evidence to enable
petitioners to have a fair opportunity to meet their burden.
Accordingly, respondent’s objection to these exhibits is
overruled.
II.
Factual Overview
These cases present complex factually oriented section 482
reallocation and arm’s-length pricing issues.
The parties did
not detail, and we have not attempted to detail every aspect of
petitioners’ operations; i.e., HIC’s numerous second- and thirdtier subsidiaries, and the myriad individual hotel entities.
We
have found the essential and suitable representative facts to
explain and identify the entities and their practices and other
foundational facts to support our ultimate findings and holdings
on the issues.
For trial purposes, the parties have generally focused on
the issues without attempting to distinguish one taxable year
- 54 from another.12
We have followed the parties’ lead and addressed
the Hyatt International group’s patterns of operation as carried
out by HIC, HHK, HS, and certain other master hotel management
and support services subsidiaries.
The Hyatt International group consists of numerous related
companies engaged in the business of hotel management.
Hyatt
Domestic’s principal shareholders established HIC and started the
Hyatt International group operations by hiring an experienced
hotelier from the Hilton hotel chain, who in turn hired other
experienced individuals, many of whom were also from the Hilton
hotel chain.
HIC entered into an agreement with Hyatt Domestic
providing for the licensing of the Hyatt trade names and marks to
HIC.
Under the agreement, HIC was to pay Hyatt Domestic $10,000
for each Hyatt International hotel that HIC opened.
The Hyatt
International group and Hyatt Domestic exchanged reservations and
marketing services for their mutual benefit.
The Hyatt International group established separate legal
entities for the management of and/or the provision of various
services to hotels.
Foremost among the hotel management
subsidiaries were HHK and HS.
12
HESA, another management entity,
Although respondent’s deficiency notice determinations
utilized different amounts for each year in computing the perhotel allowances for petitioner AIC’s management fee adjustment,
for purposes of trial, respondent’s methodology no longer relies
on differing annual amounts.
- 55 was established by means of a joint venture agreement with an
unrelated company, VIS, and was owned 49 percent by HIC (Mexico).
Service subsidiaries included HCS, a Hong Kong corporation, which
provided sales, marketing, and reservation services to all Hyatt
International hotels, and IPS, a U.S. corporation, which provided
technical assistance, also known as design services.
As a management/services organization, the Hyatt
International group’s success was heavily dependent on its
employees.
Initially, the Hyatt International group’s size and
the volume of hotels managed increased because of employees’
efforts in cultivating relationships with hotel owners.
In the
beginning, staff was hired from other hotel chains and groomed
for advancement within the Hyatt International group.
As time
progressed and the new hotels were opened, expanding the Hyatt
group, executive staff could be chosen from within the ranks of
Hyatt International hotel personnel.
Executive committees ran each hotel’s day-to-day operations.
The executive staff at the flagship hotels of the Hyatt Regency
Hong Kong and the Hyatt Regency Singapore also concurrently
served as area directors and as staff of the master hotel
management subsidiaries HHK and HS, respectively.
This
duplication of responsibilities was thought to lower operating
costs.
At first, employees received their salaries directly from
the hotels.
In time, the salaries were paid by HHK or HS for
- 56 their area work.
Generally, HHK, HS, HESA, and HIC supervised
hotels within their respective geographic regions--i.e., AsiaPacific, Southeast Asia, Mexico, and Central America, and Europe.
Each management subsidiary maintained staff specialists/employees
in the functional hotel management areas, including finance, food
and beverage, human resources, and clerical.
Unlike management
staff working for HHK and HS, HESA and HIC management staff did
not have dual roles and did not also serve as hotel staff.
In addition to the direct supervision of particular hotels,
HIC provided all of the international group’s hotels with certain
services.
HIC was involved in coordinating insurance and
employee benefits and disseminating training materials.
It also
acted as a clearinghouse for the production, maintenance, and
distribution of the operations manuals.
HIC staff acted as
liaison to outside agencies, such as travel associations and
airlines, for the purpose of worldwide marketing.
HIC conducted
internal audits, budget and contract reviews, and made staffing
recommendations for its subsidiaries.
HIC set the service
standards for the Hyatt International group and, along with its
master hotel management subsidiaries, monitored the performance
of the Hyatt International hotels.
Preopening and operating expenses of hotels were charged to
the hotel owners, including:
Hotel staff salaries and benefits;
marketing and sales expenses; and office, rooms, and restaurant
- 57 expenses.
Hotel owners were each apportioned an amount of HCS’s
expenses that were incurred in connection with the marketing and
reservations service.
Owners who chose to use the IPS’ design
services paid IPS a fee for the services.
IPS’ fees were set
based on estimated costs and, for most of the taxable years in
issue, IPS’ expenses exceeded its revenues.
Accordingly, the
preopening and operating expenses and IPS fees were not borne by
the Hyatt International hotel management subsidiaries.
The hotel
owners paid management fees directly to the hotel management
subsidiaries.
We consider four categories of section 482 income
allocations:
(1)
Management fee revenues from one subsidiary of the
Hyatt International group to another or, most commonly, to HIC,
based on respondent’s postulation that the latter entity was
wholly or partially “responsible for” the management or operation
of the hotel that generated management fees;
(2)
Royalties from HIC to Hyatt Domestic for the use of the
Hyatt trade names, marks, and intangibles;
(3)
Royalties from HHK and HS to HIC for the use of the
Hyatt trade names and marks; and
- 58 (4) Net management income from HHK and HS to HIC for
services provided by HIC.13
In controversy are Hyatt Domestic’s taxable years ending
January 31, 1980, through January 31, 1988, and HIC’s taxable
years ending December 31, 1976, through December 31, 1983.
III.
Section 482--Background
Under section 482, the Commissioner has broad authority to
prevent the artificial shifting of income and to allocate income
among commonly controlled corporations in order to place them on
a parity with uncontrolled, unrelated taxpayers.
See Seagate
Tech., Inc., & Consol. Subs. v. Commissioner, 102 T.C. 149, 163
(1994); Sundstrand Corp. v. Commissioner, 96 T.C. 226, 352-353
(1991); see also Bausch & Lomb, Inc. v. Commissioner, 92 T.C.
525, 581 (1989), affd. 933 F.2d 1084 (2d Cir. 1991); Edwards v.
Commissioner, 67 T.C. 224, 230 (1976); sec. 1.482-1(b)(1), Income
Tax Regs.
A business purpose for an arrangement or a set of
transactions does not by itself insulate a taxpayer from a
section 482 allocation.
See Sundstrand Corp. v. Commissioner,
supra at 353.
13
In the deficiency notices, respondent determined
allocations from Hyatt of Panama to HIC for both trade names and
marks and management services. Respondent’s trial position
included only allocations from the HHK and HS. Because
respondent no longer relies on or advocates the notice
determination on this aspect, we treat respondent’s abandonment
of the allocations from Hyatt of Panama as a concession of these
adjustments.
- 59 Section 482 determinations are to be sustained absent a
showing that the Commissioner’s discretion was abused.
See
Paccar, Inc. v. Commissioner, 85 T.C. 754, 787 (1985), affd. 849
F.2d 393 (9th Cir. 1988).
Consequently, taxpayers bear a heavier
than normal burden of proving that the Commissioner’s section 482
allocations are arbitrary, capricious, or unreasonable.
See Your
Host, Inc. v. Commissioner, 489 F.2d 957, 960 (2d Cir. 1973),
affg. 58 T.C. 10, 23 (1972); Seagate Tech., Inc. & Consol. Subs.
v. Commissioner, supra at 164; G.D. Searle & Co. v. Commissioner,
88 T.C. 252, 359 (1987).
Whether the Commissioner’s discretion
has been abused is a question of fact.
See American Terrazzo
Strip Co. v. Commissioner, 56 T.C. 961, 971 (1971).
In reviewing
the reasonableness of the Commissioner’s allocation under section
482, we focus on the reasonableness of the result, not the
details of the methodology employed.
See Bausch & Lomb, Inc. v.
Commissioner, supra at 582; see also Eli Lilly & Co. v. United
States, 178 Ct. Cl. 666, 676, 372 F.2d 990, 997 (1967).
The
applicable standard is arm’s-length dealing between taxpayers
unrelated either by ownership or control.
1(b)(1), Income Tax Regs.14
See sec. 1.482-
Taxpayers bear the burden of showing
that the standard they used or that they proposed is arm’s
14
References to the income tax regulations under sec. 482
are to the 1968 regulations as amended and in effect for the tax
years under consideration.
- 60 length.
See Seagate Tech., Inc., & Consol. Subs. v.
Commissioner, supra at 164.
If it is established that there was an abuse of the
Commissioner’s discretion and a taxpayer fails to show that
questioned transactions met an arm’s-length standard, then the
Court must decide the amount of an arm’s-length allocation.
See
Sundstrand Corp. v. Commissioner, supra at 354.
IV. Was the Commissioner’s Determination Arbitrary, Capricious,
or Unreasonable?
A.
In General
Petitioners argue that respondent has abandoned the grounds
for the determinations in the deficiency notice and, in effect,
conceded that the determinations are arbitrary, capricious, or
unreasonable.
Petitioners also argue that respondent’s
determinations were in other respects arbitrary, capricious, and
unreasonable.
Respondent disagrees and contends that no
abandonment of theory or methodology occurred and that the trial
position of respondent is compatible with the determinations in
the deficiency notice.
We consider this portion of the
controversy from two different perspectives.
First, we consider
the effect, if any, of respondent’s substitution of different
experts, for trial purposes, from those whose reports were used
for the bases of the determinations in the deficiency notice.
Then, we consider, generally, whether respondent’s determination
- 61 was an abuse of discretion (arbitrary, capricious, or
unreasonable).
B.
Substitution of Experts’ Opinions
Hyatt Domestic and HIC are subsidiaries of different parent
corporations, petitioners HGH and AIC, respectively.
Each
petitioner filed consolidated Federal income tax returns with its
U.S. subsidiaries.
In the notices of deficiency, respondent
determined that, for the taxable years ending January 31, 1980
through January 31, 1988, the income of Hyatt Domestic should be
increased to reflect royalties from HIC for the use of the Hyatt
trade names and marks.
The amount of the determined royalty was
equal to 1.5 percent of the gross revenues of each hotel operated
or managed by Hyatt International group.
Similarly, respondent
also determined that HIC’s income for its taxable years ending
December 31, 1976 through December 31, 1983, should be increased
by the same 1.5 percent of the gross revenues and that amount
should be allocated from HIC’s subsidiaries.
Respondent also determined that HIC’s income should be
increased by allocating a certain portion of the management fee
income of its subsidiaries (HHK, HS, and HP).
The allocated
portion was the excess of the amount respondent determined as the
arm’s-length charge for management services performed by the
subsidiary, less the amount that was determined to be a royalty.
Respondent calculated arm’s-length charges for management
- 62 services that respondent allowed on a per-hotel basis times the
number of hotels managed.
The determinations of the per-hotel
amounts were based on the reports of respondent’s prenotice
economists, Dr. Joseph Mooney (Dr. Mooney) and David Burt (Mr.
Burt).
In addition, respondent determined that the subsidiaries
did not manage all of the hotels that remitted fees to them, and,
therefore, the number of hotel allowances was limited
accordingly.
At trial, the reports of the above-referenced in-house
economists were not offered or relied on by respondent.
Instead,
respondent relied on Business Valuation Services’ (BVS) opinion,
in which a profit-split method15 of determining allocations was
utilized to produce an arm’s-length royalty for use of the trade
names and marks and arm’s-length fees for services performed.
The total allocations, as recommended in the BVS report, are as
follows:
15
“The profit split approach divides the related parties’
combined revenues based on an ad hoc assessment of the
contributions of the assets and activities of the commonly
controlled enterprises.” Eli Lilly & Co. v. Commissioner, 856
F.2d 855, 871 (7th Cir. 1988), affg. in part, revg. in part on
other issues and remanding 84 T.C. 996 (1985).
- 63 Taxable year
ending1
From HIC to
Hyatt Domestic
From HHK/HS
to HIC
Dec. 31, 1976
Dec. 31, 1977
Dec. 31, 1978
Dec. 31, 1979
Dec. 31, 1980
Dec. 31, 1981
Dec. 31, 1982
Dec. 31, 1983
Dec. 31, 1984
Dec. 31, 1985
Dec. 31, 1986
Dec. 31, 1987
Dec. 31, 1988
Total
$791,103
954,126
1,092,387
1,302,797
1,731,902
1,985,825
1,750,500
1,832,550
1,926,900
1,889,100
2,218,500
2,712,150
3,488,100
23,675,940
$2,164,604
2,501,906
2,992,556
4,316,952
7,565,475
9,054,035
7,377,525
6,150,778
7,781,600
1,536,910
8,703,363
9,573,138
11,759,205
69,718,842
1
Taxable year is that of HIC/AIC.
taxable year ends Jan. 31.
Hyatt Domestic/HGH’s
Respondent’s notice determinations attributable to the
trademarks were as follows:
Taxable year
ending1
From HIC to
Hyatt Domestic
From HHK/HS
to HIC
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
--------$2,159,000
3,266,000
4,603,000
5,279,000
5,548,000
6,070,000
5,735,687
5,935,143
7,333,495
45,929,325
$982,000
2,048,740
2,296,218
1,877,010
3,094,935
4,157,250
4,838,580
5,046,810
----------24,341,543
Total
1
Hyatt Domestic’s fiscal year ends Jan. 31, and HIC was on a
Dec. 31 calendar year.
- 64 Petitioners argue that respondent has, therefore, abandoned
the grounds for the section 482 allocations that were set forth
in the notices of deficiency.
Petitioners also argue that, by
abandoning the deficiency notice grounds, respondent has conceded
that the original determinations were arbitrary, capricious, or
unreasonable.
Respondent counters that the grounds for the
allocations have not been abandoned, that the underlying theories
are the same, and that the substitution of new expert reports,
per se, does not establish that the notice determinations were
arbitrary.
Respondent also points out that his trial experts’
report or opinion was affected by the acquisition of information
that was acquired after the issuance of the notice of deficiency
and therefore not available to the prenotice experts.16
Prior to issuing the deficiency notices, respondent assigned
Dr. Mooney the task of analyzing whether and to what extent
section 482 allocations of income or deductions are warranted
between HIC and certain of its subsidiaries involving the
management of foreign hotels.
Dr. Mooney prepared a report
(Mooney report) dated February 15, 1986, entitled “Economic
Evaluation of the Performance of Hyatt of Hong Kong, Ltd.”
The
Mooney report was included as part of the revised International
16
In this regard, no claim is made here that respondent
was systematically kept from the information that would have had
an effect on the deficiency notice determinations. See, e.g.,
DHL Corp. v. Commissioner, T.C. Memo. 1998-461.
- 65 Examiner’s Report for the taxable years 1976 through 1981.
The
Mooney report served as one of the bases for respondent’s
deficiency notice determinations (addressed to petitioner AIC)
that HIC’s income be increased by allocations of income from
certain of its subsidiaries.
The Mooney report, for the 1979 through 1981 tax years,
credited HIC with the development, implementation, and monitoring
of the Hyatt International management system (policies and
procedures) and of a set of standards for the operations of its
hotels.
It contained the statement that “Without these efforts
and intangible assets developed by HIC, HHK could not operate as
a hotel management firm.”
In deciding how to allocate income
between HHK and HIC, Dr. Mooney also determined a “normal return”
amount.
He further opined that amounts in excess of his
determined “normal return” should be attributed to the intangible
assets and services provided by HIC.
To compute the “normal return”, Dr. Mooney first reviewed a
1980 study by James J. Eyster (Eyster study) containing the
information that chain operators generally require a per-hotel
management fee ranging from $65,000 to $120,000.
Dr. Mooney,
however, relied on two Hyatt International contracts that
specified minimum management fees:
one dated August 24, 1979,
providing for a $75,000 minimum annual fee per hotel in the
Philippines, and the other dated April 24, 1981, providing for a
- 66 $100,000 annual fee for a Saudi Arabian hotel.
Dr. Mooney,
considering these contracts with unrelated parties as the best
evidence of a normal return for HHK, set the allowable fees at
$75,000 per hotel for 1979, $87,500 for 1980, and $100,000 for
1981.
He recommended that any income above the allowable fees be
allocated from HHK to HIC.
Mr. Burt, an industry economist employed by the IRS, was
assigned the task of analyzing whether and the extent to which
section 482 allocations of income or deductions should be made
among and between Hyatt Domestic, HIC, and certain subsidiaries
of HIC, attributable to the use of the Hyatt trade names,
trademarks, and/or other intangibles.
Mr. Burt prepared two
reports that were included as part of the revised International
Examiner’s Report for the taxable years at issue.
Mr. Burt’s
reports served as one of the bases for respondent’s deficiency
notice determinations allocating income from HIC to Hyatt
Domestic and from certain subsidiaries of HIC to HIC as a result
of the use of the Hyatt trade names, trademarks, and/or other
intangibles.
In the first undated report (Burt report one), for the 1979
through 1981 tax years, Mr. Burt opined that 1.5 percent of gross
hotel revenue was an arm’s-length royalty for the use of the
Hyatt trade names and marks.
Mr. Burt’s use of the 1.5-percent
rate derived from franchise royalties rates charged by four
- 67 international hotel chains, as adjusted to eliminate inclusion of
advertising or reservations fees.
Mr. Burt located the rates he
thought to be comparable in a 1984 publication.
Franchise rates
were expressed as a percentage of room revenues; however,
available data suggested that room revenues for international
hotels were equal to half of total hotel revenues.
The other
half was attributable to food and beverage revenues.
Mr. Burt’s second report (Burt report two), dated November
11, 1989, covered the 1982 through 1984 tax years.
Mr. Burt had
visited hotels in Hong Kong and Singapore during November 1988.
He observed that day-to-day operations were conducted under the
supervision of the general manager and staff, who made reports to
area and/or HIC personnel, but that “every Hyatt [sic] property
uses operating policies and procedures originally developed, or
modified and adapted, and then implemented by the Chicago-based
corporate parent and its staff.”
Mr. Burt observed:
“to the
extent management is exercised over hotel operations by HHK
and/or HS, it usually takes the form of ensuring correct
application of, or adherence to, HIC overall corporate philosophy
rather than direct management of each hotel’s day-to-day
operations.”
Mr. Burt concluded that each Asian Hyatt
International hotel be allowed “remuneration equivalent to that
received by an independent (rather than chain) hotel management
company”, which he suggested was $62,000 per hotel per year, due
- 68 to Hyatt International hotels’ status as luxury or resort hotels.
Mr. Burt located the $62,000 figure in the same Eyster study used
by Dr. Mooney.
The Eyster study provided information that
independent operators required $24,000 to $62,000 in annual
earnings based on a survey of 29 independent hotel operating
companies.
If fees exceeded $62,000, Mr. Burt advised that the
excess be allocated to HIC.
Mr. Burt also repeated his earlier
opinion that 1.5 percent of hotel gross revenue is an arm’slength royalty and would have been paid to Hyatt Domestic out of
this excess.
For purposes of trial, however, respondent relied on the BVS
report/opinion.
step process.
That opinion was formulated by means of a fourFirst, and prior to determining allocations for
royalties or management services income, BVS reassigned the
management fee income of certain hotels from one subsidiary to
another or to HIC based on BVS’ perceptions of the roles played
in developing the contract or in managing the hotel.
Second, BVS
employed a royalty equal to 15 percent of HIC’s revenues
(calculated after adjustments for all of the other types of
allocations) due from HIC to Hyatt Domestic.
The resulting
figure was thought to represent a profit split between HIC and
Hyatt Domestic.
The split was intended to account for Hyatt
Domestic’s contribution of its investment in chain services and
its position as the originator of the Hyatt trade name and marks
- 69 and the Hyatt International group’s contribution of capital and
personnel.
Third, BVS employed a royalty equal to 33 percent17
of management fees (after the first above-described adjustment)
that was to be allocated from HHK and HS to HIC.
This royalty is
for trade names and marks and to “provide a profit for the
reservations activities, cover corporate overhead and subsidize
the development activities.”
In addition, the royalty from HHK
and HS was also intended to fund or pass on the cost of the
royalties that would be due from HIC to Hyatt Domestic.
Fourth,
BVS concluded there should be an allocation from HHK and HS to
HIC, described as a profit split, of generally 50 or 65 percent
(depending on the year) of the operating income remaining after
expenses and the above royalties are deducted.
BVS intended the
profit split to cover the financial guaranties and differences in
assets, with HIC being considered the owner of the intangibles
and the financial capital.
In deciding whether the Commissioner’s determination is
reasonable, courts focus on the reasonableness of the result, not
on the details of the methodology used.
See Seagate Tech., Inc.,
& Consol. Subs. v. Commissioner, 102 T.C. at 164.
In a
particular case, the Commissioner’s deficiency notice
17
It was contended that the 33 percent of the management
fee rate was the equivalent of 1 percent of gross hotel revenues
in comparison to Mr. Burt’s 1.5 percent rate.
- 70 determination was based upon one method and an amendment to
answer contained another method that resulted in an increased
deficiency from that determined in the deficiency notice.
See
Eli Lilly & Co. v. Commissioner, 84 T.C. 996, 1132 (1985), affd.
in part, revd. in part on other issues and remanded 856 F.2d 855
(7th Cir. 1988).
The Commissioner’s trial expert in that case
did not opine about either of these methods and, instead, relied
on two other methods to allocate income.
The taxpayer in Eli
Lilly & Co., similarly to petitioners here, argued that the
difference between the trial position and the deficiency notice
determinations caused the Commissioner’s determinations to be
arbitrary, capricious, and unreasonable.
As a result, the
taxpayer contended that the Commissioner’s determination should
not be entitled to the presumption of correctness.
The Court
disagreed, holding that the presumption of correctness afforded
to the Commissioner’s section 482 determinations is not to be
lost solely because of the use of differing methodologies.
The
Court reasoned that to hold otherwise would preclude the
Commissioner from using outside experts or making alternative
determinations.
In some circumstances, however, an abandonment
of methodology may support a finding in part or whole, that the
Commissioner’s determination was unreasonable, arbitrary, or
capricious.
See, e.g., National Semiconductor Corp. v.
Commissioner, T.C. Memo. 1994-195.
- 71 Under the circumstances of this case, respondent’s
substitution or change of methodology, alone, does not result in
our finding or holding that respondent’s determinations are
arbitrary, capricious, or unreasonable.
There were certain
similarities in the approaches and methodologies used to
formulate respondent’s deficiency notice and those used by
respondent’s trial experts.
C. Is Respondent's Determination in Other Respects
Arbitrary, Capricious, and Unreasonable?
Background
Next, we consider petitioners’ contentions that respondent’s
determinations were, considering all the circumstances, an abuse
of respondent’s discretion.
It appears that a primary basis for
respondent’s section 482 deficiency notice allocations was the
belief that HIC bore the majority of the consolidated expenses of
the Hyatt International group and that HHK and HS received the
majority of the revenue.
Respondent compared petitioners’
profitability ratios to those of other hotel companies.
In that
regard, the Hyatt International group’s accounting system does
not include expenses paid by the owner, whereas other hotel
companies that respondent treated as comparable, used
combinations of franchise, lease, and management contracts.
- 72 Another variable here is that HIC acted as both management
entity and parent (individually), so that some of its expenses
were related to its activity as a parent company.
In addition,
HIC incurred expenses with respect to its involvement with hotels
in Brussels and Nice.
Respondent’s experts generally did not
recognize the contributions made by HHK and HS, because their
efforts were not evidenced by expenditures recorded on those
management subsidiaries’ books.
On those occasions where the
efforts of HHK and HS personnel were recognized, respondent’s
experts considered them to be performed on HIC’s behalf.
We now
consider, in particular, whether any of respondent’s
determinations were arbitrary, capricious, or unreasonable.
1.
Allocations Between HIC and Hyatt Domestic
HIC and Hyatt Domestic entered into a 1974 agreement for the
purpose of sharing the services of each other’s sales offices.
HIC billed Hyatt Domestic for a contractually agreed level of
support from the Hyatt International sales offices.
Hyatt
Domestic included these costs as part of its chain expenses and
billed each of its hotels and those of the Hyatt International
group for a share of the overall chain expenses.
The chain
allocation formula was based on the number of guest rooms.
In
accordance with the 1974 chain services sharing agreement, Hyatt
International hotels paid either 50, 75, or 100 percent of a full
chain allocation depending on the hotel’s geographical location.
- 73 This approach was used because it was thought that a hotel’s
geographical distance from Hyatt Domestic’s U.S. sales offices
would affect the benefits; i.e., the greater the distance, the
less the benefit.
Respondent, however, concluded that the
possibility for tax avoidance was lurking in these circumstances
under which many hotels were being charged less than an equally
apportioned share of the chain service allocation.
The use of
total rooms per hotel adjusted for the distance of a hotel from
the U.S. sales offices, to some extent, appears to reasonably
account for the circumstances.
Beginning February 1, 1980, cross-billing and reimbursement
were discontinued under the assumption that the benefits
exchanged were equal, although both organizations continued to
share chain services.
Both Hyatt Domestic and the Hyatt
International group invested in establishing chain services and
made a business decision to share those services.
To the extent
that they exchanged services of equal value, we hold that no
allocation between HIC and Hyatt Domestic is warranted.
To the
extent that respondent’s determinations included allocations of
income between Hyatt Domestic and HIC for chain services it was
an abuse of discretion.
We note that any income allocation
between HIC and Hyatt Domestic would have been made under the 1.5
percent royalty adjustment.
- 74 Respondent, in making the deficiency notice allocations,
relied on the fact that Hyatt International group hired staff
trained by Hyatt Domestic.
Due to differences in their
respective operations, however, HIC did not gain by hiring HyattDomestic trained staff rather than experienced staff from other
similarly situated hotels.
In other respects, the record does
not support a finding that the Hyatt International group received
anything else for which compensation would have been due to Hyatt
Domestic; e.g., training programs, innovative atrium and
restaurant designs, or manuals.
In addition none of the parties'
trial experts focused on these specific items.
Accordingly, we
find that respondent's determination with respect to these items
is arbitrary, capricious, and unreasonable.
2. Notice Determinations for Hyatt Domestic’s Income
Allocations Attributable to Royalties for Trade Names and Marks
For each of Hyatt Domestic’s taxable years, respondent
determined that 1.5 percent of the gross receipts each hotel
operated in the Hyatt International group be allocated to Hyatt
Domestic.
Two of the notices contain explanations that the
adjustment is a royalty for the use of Hyatt trademarks and other
intangibles.
One notice (for 1983, 1984, and 1985 taxable years)
contains the 1.5 percent adjustment, but states that it for use
of the trademark, without any reference to other intangibles.
For purposes of trial, respondent’s expert concluded that a
- 75 royalty of 15 percent of the net revenues should be allocated to
Hyatt Domestic.
Respondent’s expert concluded that the royalty
was an equivalent of a profit split accounting for HIC’s capital
and personnel to build an international chain and Hyatt Domestic
contributing chain services and its intangibles, including the
trademarks.
The 1974 licensing agreement between HIC and Hyatt Domestic
was for the use of the various Hyatt trade names and marks.
agreed:
HIC
To pay Hyatt Domestic a one-time payment of $10,000 per
hotel opened; to pay the costs of registering the trade names and
marks; and that the standards of services and the quality of
products bearing a mark would, at very least, be equivalent to
those adopted or maintained by Hyatt Domestic.
For $10,000 per
hotel, HIC received a license to use Hyatt trade names and marks
in perpetuity from Hyatt Domestic.
Beyond that, however, the
Hyatt International group received relatively nominal amounts of
chain services from Hyatt Domestic in excess of services provided
for Hyatt Domestic.
Respondent’s deficiency notice determination that Hyatt
Domestic and HIC’s income be increased by a royalty of 1.5
percent of the gross hotel revenues of the Hyatt International
group18 was based on hotel franchise rates.
18
Respondent’s
The amount of royalty determined to be included in HIC’s
(continued...)
- 76 prenotice expert adjusted these franchise rates to make them
exclusive of marketing and reservation charges, and ultimately we
have decided that the franchise rates respondent used in the
notice were overstated.
A franchisee, in exchange for a royalty,
receives trade names and marks, business systems and expertise,
and for additional fees may receive reservations and marketing
services.19
Hotel franchisors generally offer preopening
assistance with site selection and feasibility, design, obtaining
financing, and the hiring and training of staff.
The
consultation and technical services and training provided by the
franchisor continue after the opening of the hotel.
Neither HIC
nor the Hyatt International group as a whole, received the level
of intangibles and services from Hyatt Domestic that would
warrant the full charge for a franchise relationship.
Considering the relationship between the Hyatt International
group and Hyatt Domestic, it was unreasonable for respondent to
allocate income based on 100 percent of the hotel franchise
royalty rate.
Respondent’s trial position relied on the BVS' allocation of
less than $24 million for use of the Hyatt trade names and marks
18
(...continued)
income would, in turn, be paid by HIC to Hyatt Domestic.
19
See Canterbury v. Commissioner, 99 T.C. 223 (1992), for
a description of franchising in the restaurant industry.
- 77 for Hyatt Domestic’s 9 taxable years.
This contrasts with the
nearly $46 million 9-year total set forth in the deficiency
notices.
Respondent’s trial position represents less than 40
percent of the original deficiency notice determinations.
Those
factors, coupled with the change of methodology and experts
supports our holding that respondent’s deficiency notice
determinations for the Hyatt trade names and marks were
unreasonable and an abuse of discretion as to respondent’s
determinations regarding royalty allocation to Hyatt Domestic.
See National Semiconductor Corp. v. Commissioner, T.C. Memo.
1994-195.
3.
Allocations to HIC from Its Subsidiaries
We next consider whether there was an abuse of discretion in
respondent’s royalty income allocations to HIC for its
subsidiaries’ use of the Hyatt trade names or marks.
HIC did not
receive any portion of the management fee income from the hotels
as operating revenue.20
Beyond expenses related to chain
services that were charged to the hotels through HCS, HIC did not
charge its subsidiaries for services provided.
During 1983,
however, there was a one-time “catch-up” charge on HHK’s books
for HIC’s overhead expenses from prior years.
20
HIC did, however, receive dividends from HHK and HS.
- 78 Respondent’s adjustments to HIC’s income involve three types
of allocations:
(1) Royalty to HIC for its subsidiaries’ use of
trade names and marks, (2) allocation to HIC of its subsidiaries’
management fee revenues, and (3) allocation of management income
to reflect HIC’s relative contribution vis-a-vis the subsidiary
in operating the individual hotels.
Respondent’s royalty income
allocations for trade names and marks from HIC’s subsidiaries to
HIC are based on the same reasoning and were at the same
percentage as allocated from HIC to Hyatt Domestic.
Our
reasoning for the Hyatt Domestic/HIC royalty allocation also
applies to HIC and its subsidiaries.
Accordingly, we hold that
respondent’s determinations involving royalty income allocations
to HIC from its subsidiaries were an abuse of discretion.
Respondent also determined that the management fee income
reported by HHK, HS, and HP above a “normal return” per hotel,
should be allocated to HIC.
In computing the subsidiary income
allowed, only those hotels respondent determined to be actually
managed by the respective subsidiary received an allowance.
Accordingly, some portion of the allocations represented income
from HIC’s subsidiaries with respect to those hotels that
respondent decided were not managed by the subsidiary.
Due to
respondent’s selectivity and the use of average allowances rather
than actual hotel revenues, there is no way accurately to
- 79 ascertain the portion of the adjustment for hotels not managed
from the “excess” income attributable to those respondent
determined were actually managed.
After computing the total
income to be allocated from the subsidiaries, respondent
subtracted the royalty for the use of the trade names and marks
to arrive at the amount allocated for services.
In the reports that predated the deficiency notice, Mr. Burt
and Dr. Mooney opined that the amount earned by a hotel in excess
of the “normal return” was allocated to HIC in recognition of
HIC’s contribution of intangibles and services.
The theory
advanced for those allocations was that the excess over a “normal
return” was due to the benefit and advantages of being a part of
the chain, which were contributed by HIC.
In establishing a
“normal return”, both Mr. Burt and Dr. Mooney used amounts
reported by others as the minimum acceptable earnings.
One used
the independent hotel operator figure of $62,000, and the other
considered the chain operator’s figures ranging from $65,000 to
$120,000, but ultimately used the amounts reflected in two Hyatt
International contracts.
Mr. Burt used $62,000 for the years
1982 and 1983 (the latest years in issue) and increasing amounts
ranging from $73,200 for 1976 to $100,000 for 1980.
The use of
the $62,000 figure resulted in losses for the subsidiaries.
There was no apparent consideration of the sizes or locations of
the hotels used in the Eyster study, or of the hotels involved in
- 80 the Hyatt International contracts, relied upon by Dr. Mooney and
Mr. Burt.
Mr. Burt and Dr. Mooney did not give consideration to
the role played by HHK or HS in the development, implementation,
and monitoring of the Hyatt International group policies and
standards or in otherwise enhancing the performance of the hotels
they supervised.
Overall, by means of the deficiency notices, respondent
determined $49,337,269 of allocations attributable to HIC.
Comparatively, BVS’s opinion recommends just over $30 million
attributable to HIC.
BVS analyzed the relationship between HIC
and its management subsidiaries and concluded that a profit-split
methodology should be used in constructing its recommendations.
Petitioners’ expert, Ernst & Young, concluded that management
fees were earned by the subsidiary that received them.
Because
of the approximate $2.5 million catchup overhead charge in 1983,
they recommended that no allocations were needed for support
services from HIC.
Ernst & Young also concluded that allocations
were unnecessary for IPS’s services, due to its limited influence
in the years involved, or for chain services, as costs were
covered and any profit on chain services should accrue to HCS, a
subsidiary of HHK.
Ultimately, we hold that HHK and HS received the benefit of
certain services from HIC (as discussed infra) and that
allocation of income is necessary.
The reports, prior to the
- 81 issuances of the deficiency notices, were confronted with a
compelling financial picture.
For 1976 Hyatt’s domestic
(including HIC) operations reflected revenues somewhat over $1.5
million with expenses somewhat over $2.5 million, whereas the
amounts reflected for foreign operations income approached $4.5
million with expenses approaching $.5 million.
Accordingly
domestic operations had almost a $1 million loss and foreign
operations had almost a $4 million gain.
These differences
increased throughout the period, and in the 1982 year domestic
operations had about $2.5 million income and $8.5 million
expenses for about a $6 million loss.
The foreign operations,
for 1982, had about $13.5 million income and $3.3 million
expenses for about a $10 million gain.
Roughly, domestic
operation expenses averaged about double the amount of receipts
and foreign operation expenses were only about 50 percent of
their receipts.
During the period under consideration, the foreign operation
receipts and profit was, in general, steadily increasing.
During
that same period, the domestic operation expenses were steadily
increasing in tandem with foreign receipts and profit, but
domestic receipts tended to be more static.
These circumstances
resulted in generally increasing losses for domestic operations
and generally increasing gains for foreign operations.
Throughout the period, HIC was involved in the management of its
- 82 subsidiaries and in the overall management of the Hyatt
International group.
Significantly, to the extent that services
were charged, they were at cost.
Under that combination of
circumstances these financial trends appear to be incongruent.
Confronted with that information and data gathered from other
hotel chains, respondent’s employees' evaluations and,
ultimately, respondent’s determinations were based on reasonable
assumptions and fell within reasonable limits.
After trial, we
were able to discern nuances and differences in petitioners'
operations that caused us not to sustain fully respondent's
notice or trial positions; however, we generally did not accept
petitioners' reporting or trial positions either.
Accordingly, we do not find respondent’s determination with
respect to these allocations to be arbitrary, capricious, or
unreasonable.
Having decided that some of respondent’s determinations were
arbitrary and capricious, petitioners are left with the burden of
showing that the amounts in question were for an arm’s-length
consideration.
If petitioners fail to show that their
transactions met the arm’s-length standard, then we must decide
the appropriate consideration; i.e., an arm’s-length rate between
unrelated parties.
Concerning the remainder of respondent's
- 83 section 482 determinations, petitioners must show an abuse of
respondent's discretion.21
V.
Arm’s-Length Consideration
A. Respondent’s Allocations of Management Fee Revenue for
HHK, HS, and HIC
HHK and HS received management fee revenue from hotels for
which HHK or HS did not provide services.
In this regard,
petitioners acknowledge that HIC was responsible for European and
Central American hotels throughout the years in issue (1976
through 1983).
Accordingly, we sustain respondent’s allocation
of income for these hotels to HIC.22
HHK received consulting fees and royalties from HESA without
performing services for HESA or the Mexican hotels.
HESA managed
the hotels in Mexico and earned the management fees, and the
consulting agreement was merely a mechanism to reduce local
21
In the final analysis, it did not make a difference that
petitioner was unable to show that all of respondent's
determinations were arbitrary, capricious, or unreasonable. That
is so because, in those instances where we redetermined an arm’slength consideration, petitioners were not able to meet the
lesser standard of showing that their reporting or trial position
was for an arm’s-length consideration.
22
BVS recommended allocation of revenue from certain
hotels in the Middle East and North Africa. These particular
hotels were not in operation during the years affecting the
allocations to HIC (1976 through 1983), and allocation in the
later years that involve only Hyatt Domestic’s allocations
(through 1988) would not change the result because, ultimately,
the royalties were computed as a percentage of gross hotel
revenues rather than being based on HIC’s revenues. Thus, it is
not necessary to analyze the particulars of hotels managed in
those regions.
- 84 taxes.
Regardless of whether the income is HESA’s or HHK’s, it
is not HIC’s income.23
See Columbian Rope v. Commissioner, 42
T.C. 800, 812-813 (1964).
Accordingly, respondent’s allocation
concerning the Mexican hotels is an abuse of discretion and is
not sustained.
BVS opined that the revenue for the Hyatt Kingsgate Sydney
should be allocated from HS to HHK.
Due to favorable tax
treaties, the Hyatt Kingsgate Sydney’s fees were assigned to HS,
although the hotel was supervised by HHK.
While this allocation
may have been part of the BVS profit-split analysis, it has no
impact on and is neutralized by our holdings concerning HIC’s
income.
See National Semiconductor Corp. v. Commissioner, supra.
In addition to those hotels for which BVS recommended 100percent revenue allocation, smaller percentages were recommended
where some other entity was the contract source or provided some
small service.
This appears to be a new matter that was not
addressed in the deficiency notices.
The parties’ broad-based
approaches failed to address the specific details concerning each
hotel involved in these smaller allocations.
Irrespective of the
parties’ approach, allocations from one to another foreign entity
would not directly or adversely affect HIC’s U.S. income.
23
As for
HIC (Mexico) was, at that time, a 49-percent owner of
HESA. Any amount that would be paid from HESA as dividend income
to HIC (Mexico), a U.S. subsidiary of HIC, would be included in
the U.S. consolidated return with HIC.
- 85 those allocations that involve HIC, as discussed infra, we find
that the business development type activity constituted HIC’s
activity as a parent company.
Accordingly, these allocations
either are not in issue or have no effect on the outcome.
B. Royalties Allocated to Hyatt Domestic for HIC’s Use of
the Hyatt Trade Names and Marks and Other Intangibles
Hyatt Domestic, beginning in 1968, provided HIC with a
license to use the Hyatt trade names and marks.
In its 1980
taxable year, Hyatt Domestic provided more chain services to the
Hyatt International hotels than Hyatt Domestic had received.
Respondent, relying on the BVS report, contends that a 15-percent
royalty should be allocated from HIC to Hyatt Domestic based on
HIC’s revenues.
The proposed allocation, according to
respondent, represents a profit split between HIC and Hyatt
Domestic reflecting Hyatt Domestic’s contribution of its
investment in chain services, Hyatt Domestic’s originator status
regarding the Hyatt trade name and marks, and HIC’s contribution
of capital and personnel.
Petitioners, relying on the Mercer Management Consulting
(Mercer) report, contend that the Hyatt name had little or no
value and did not increase the Hyatt International group’s
income-generating capability.
The parties and their experts did
not focus on the specific factors that might influence the
amounts or the operation of the royalties.
Instead, in a broad-
- 86 brushed manner, each side generally sought to convince us that
there should or should not be a royalty allocation.
In that
setting, we undertake our analysis of the value of royalties
attributable to the names and marks.
In a recent Memorandum Opinion of this Court, a trademark
was described as:
a marketplace device by which consumers identify goods
and services and their source. In the context of
trademark nomenclature, a trademark symbolizes
“goodwill” or the likelihood that consumers will make
future purchases of the same goods and services. In a
licensing arrangement, the goodwill symbolized by the
trademark is owned by the licensor, even though created
by the licensee’s efforts. See, e.g., Cotton Ginny,
Ltd. v. Cotton Gin, Inc., 691 F. Supp. 1347 (S.D. Fla.
1988).
DHL Corp. v. Commissioner, T.C. Memo. 1998-461.
In another Memorandum Opinion, it was explained that:
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.
Nestle Holdings, Inc. v. Commissioner, T.C. Memo. 1995-441, revd.
and remanded on other grounds 152 F.3d 83 (2d Cir. 1998).
Petitioners’ expert (Mercer) found little evidence of any
value of the Hyatt trade names and marks when used by Hyatt
International hotels.
This conclusion was based on Mercer’s
- 87 postulations:
that, generally, brand name is a less significant
factor to hotel guests than location; chain hotels constitute a
much smaller percentage of the international market than that of
the U.S. hotel market; smaller hotel chains have lower brand
awareness; there was no premium paid for Hyatt International
hotel rooms over competitors’ rooms; there was a small number of
guests from the United States (who would be familiar with the
Hyatt name) traveling to the Asia-Pacific area where most Hyatt
International hotels were located; the percentage of U.S. guests
in most Hyatt International hotels was below market average; and
the Hyatt International group management fees were lower than
average.
We do not accept the Mercer conclusion that the Hyatt name
has no value in the context of international operations.
Hotel
location may be an important or possibly even a primary factor in
a guest’s hotel selection; however, it has been shown that brand
name is an important factor in attracting certain categories of
guests.
BVS found that trade names are important for incremental
business, even where most of the reservations were secured
through local contacts.
Petitioners argued that Hyatt
International hotels earned no premium on the rates they charged
as compared to other competing hotels.
Hyatt International
hotels, however, competed favorably with luxury hotels, including
those run by Hilton International, reflecting that the Hyatt
- 88 brand was valuable and, to some extent, was a drawing factor for
potential customers.
The affiliation with a major chain also has
a beneficial effect on Hyatt hotel owners’ attempts to secure
financing.
Petitioners’ experts minimized and attempted to play
down the fact that some Hyatt International hotel guests were
from the United States.24
Hyatt Domestic’s promotion of the
Hyatt name and referral of guests to Hyatt International
contributed some value to the Hyatt trade names and marks to
Hyatt International, especially when viewed 10 years out and
later.25
Overall, we disagree with petitioners and hold that the
Hyatt trade names and marks had some importance or value to the
Hyatt International group.
In the event that we might decide the Hyatt names and marks
had value, petitioners advanced the alternative argument that the
Hyatt International group’s use of the names and marks represents
the arm’s-length consideration and provides reciprocal benefits
to Hyatt Domestic.
While it is possible that a similar benefit
24
As would be expected, the percentage varied from
location to location, particularly in Mexico, Puerto Rico, and
Central America.
25
We reiterate that $10,000 was paid for each hotel
without regard for the time value of money or the passage of
time. As of the years under consideration, when the number of
hotels had increased and the name use and recognition must have
increased, the $10,000 was the standard, unchanged from 1968. In
1975 there were 19 hotels, and by 1988 about 40 (without
considering those in Mexico). From 1975 to 1988 HIC's gross
management revenue increased fivefold.
- 89 could have enured from Hyatt International’s use of the name
(i.e., where guests staying at Hyatt Domestic hotels were
familiar with Hyatt International hotels), petitioners have
presented no evidence, one way or the other, on the origin of
guests staying at Hyatt Domestic hotels or any other measure of
any such benefit from the Hyatt International group’s operations
to Hyatt Domestic.26
As a second alternative, petitioners argue
that the Hyatt International group assisted in the development of
the trade names and is entitled to a setoff for that under
section 1.482-2(d)(1)(ii)(b), Income Tax Regs.
Petitioners,
however, have presented no evidence of the costs or outlays that
may have been incurred in order to measure and reach such a
determination.
See sec. 1.482-2(d)(1)(ii)(c), Income Tax Regs.
Respondent relies on the fact that Hyatt Domestic initiated
lawsuits to protect its trade name.
Respondent argued that such
action is evidence that the Hyatt name had great value.
Instituting suits, however, does not automatically reflect that
the name or mark has great value.
Such suits may be brought to
protect marginal values, because failure to act against
infringements could lead to loss of the trade name protection.
26
Nor did petitioners present evidence showing that the
$10,000 amount per hotel provided for in the licensing agreement
was an arm’s-length consideration within the meaning of sec.
1.482-2(d)(2), Income Tax Regs.
- 90 Winget Kickernick Co. v. La Mode Garment Co., 42 F.2d 513, 514
(N.D. Ill. 1930).
Having held that the Hyatt trade names and marks do have
value in the context of the international operations, we now turn
to evaluating the amount of arm’s-length consideration that
should have passed from HIC to Hyatt Domestic for the use of the
Hyatt names and marks.
The parties placed heavy reliance on
their respective expert witnesses in arguing what is the correct
amount of arm’s-length consideration for use of the names and
marks.
In reaching our holding:
We weigh expert testimony in light of the expert’s
qualifications as well as all the other credible
evidence in the record. Estate of Newhouse v.
Commissioner, 94 T.C. 193, 217 (1990). We are not
bound by the opinion of any expert witness, and we will
accept or reject that expert testimony when, in our
best judgment, based on the record, it is appropriate
to do so. Estate of Newhouse v. Commissioner, supra;
Chiu v. Commissioner, 84 T.C. 722, 734 (1985). While
we may choose to accept the opinion of one expert in
its entirety, Buffalo Tool & Die Mfg. Co. v.
Commissioner, 74 T.C. 441, 452 (1980), we may also be
selective in the use of any portion of that opinion.
Parker v. Commissioner, 86 T.C. 547, 562 (1986).
Sundstrand Corp. v. Commissioner, 96 T.C. at 359.
A review of
the royalty, marketing, and reservations charges of U.S.-based
hotel franchises by respondent’s expert (BVS) resulted in
combined average rates ranging from 3 to 7 percent of gross room
revenue.
Generally, as a percentage of gross room revenues,
royalties ranged from 4 to 5 percent, typical marketing fees
- 91 ranged from 1 to 3 percent, and reservations fees ranged from 1
to 2 percent.
Finding no completely comparable transaction, BVS
used the royalty of 1 percent of gross hotel revenue that HESA
paid HHK.
BVS then calculated that 15 percent of HIC’s net
adjusted revenues (after all other allocations) approximated the
1 percent of gross hotel income HESA paid as a royalty.
That
amount and most of respondent’s notice determinations included
within the royalty the use of the trademarks/trade names and
other intangibles.
The original HESA agreement provided for royalties of 2
percent of hotel gross income within the context of a consulting
fee in the amount of 75 percent of HESA’s management fee revenue.
As more hotels were added to the venture, royalties were reduced
to 1 percent.
Although petitioners have put their spin on the
reasons for the rate reduction, it is not entirely clear why BVS
chose the 1-percent, rather than the 2-percent, rate.
The HESA
royalty included use of the trade names and marks and all Hyatt
chain services.
We note that Hyatt Domestic licensed the use of
its names and marks but provided only a portion of the Hyatt
International group’s chain services, and the latter was, to some
extent, balanced by the Hyatt International group’s reciprocation
of similar services.
Importantly, the HESA agreements reflect a relationship that
is quite different from the relationship between Hyatt Domestic
- 92 and HIC.
The HESA royalty agreement was part of a group of
simultaneously executed contracts establishing a joint venture
relationship between HIC and VIS.
We also note that although 15
percent of HIC’s adjusted net revenues, as calculated by BVS,
might have been equivalent to 1 percent of hotel gross income, we
do not accept all of the management fee allocations BVS made, and
therefore the use of BVS’s 15-percent equivalence does not have
adequate support in the record.
With the parties going off in opposite directions and
reaching diametrically opposed positions, neither of which is
wholly supportable, we do not place complete reliance on either
party’s expert.
Petitioners’ expert denies any but a de minimis
value, a position we have rejected.
In that same vein, we have
found respondent’s expert’s premises to be only partially
acceptable.
Section 1.482-2(d), Income Tax Regs., provides a framework
for determining an arm’s-length consideration for the transfer,
sale, assignment, loan, or other use of intangible property or an
interest therein between related entities.
An arm’s-length
consideration for intangible property is defined as “the amount
that would have been paid by an unrelated party for the same
intangible property under the same circumstances.”
2(d)(2)(ii), Income Tax Regs.
Sec. 1.482-
The best indication of such arm’s-
length consideration generally is the amount of consideration
- 93 paid for transfers by the same transferor to unrelated parties
involving the same or similar intangible property under the same
or similar circumstances.
See id.
If no sufficiently similar
transfers can be found, section 1.482-2(d)(2)(iii), Income Tax
Regs., sets forth a list of factors that may be considered in
arriving at the amount of the arm’s-length consideration.
The
arm’s-length nature of an agreement is determined by reference
only to facts in existence at the time of the agreement.
See
Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 601 (1989),
affd. 933 F.2d 1084 (2d Cir. 1991).
No evidence of similar intangibles being transferred to an
unrelated party was produced.
Hyatt Domestic’s transaction with
HIC and HIC’s with its subsidiaries concerned services and other
aspects, in addition to the names and marks.
In each instance,
the names and marks were part of a larger package including the
provision of various services.
Accordingly, we utilize the
factors specified in section 1.482-2(d)(2)(iii), Income Tax
Regs., to formulate our holding, noting that the parties’ experts
have not specifically addressed those factors.
One significant factor to consider would be the prevailing
rates in the industry.
Ideally, the 1968 rates for trade names
and marks in the hotel industry would be a starting point.
The
hotel franchise rates presented in the record, however, cover the
period 1979 through 1988.
The licensing agreement here was
- 94 granted in perpetuity in exchange for a $10,000 flat fee payable
for each new hotel.
The terms of the licensing agreement do not
include a consideration of time factors, such as the amount of
time the hotel was to be operated.
The license transferred was
for exclusive use outside the United States.
The Hyatt
International group was required to pay for the registration of
the trade names and marks in the countries of its operation, a
factor that may be considered.
See sec. 1.482-2(d)(2)(iii),
Income Tax Regs.
Petitioners dispute the appropriateness of the use of
comparables based on franchise rates principally because the
Hyatt International group operated under management agreements,
not franchise agreements.
Although a franchise analogy does not
present a completely suitable comparison with the existing
relationship between the Hyatt International group and the hotel
owners, a franchise analogy does more accurately fit the
relationship between HIC and its hotel management subsidiaries.
A franchise relationship normally includes a license to use the
franchisor’s name and marks.
That type of license was provided
by Hyatt Domestic to HIC, which in turn provided it to HIC’s
subsidiaries.
Franchise rates, however, normally include much
more than the rights or licenses transferred by Hyatt Domestic;
e.g., providing business systems and expertise and providing
reservations, marketing, and technical services.
Thus, we must
- 95 separate the value attributable to trade names and marks from the
other items normally included in a franchise rate or agreement.
The parties’ experts appear to agree that the franchise
rates for luxury hotels charged by U.S.-based hotel chains were
the equivalent of about 2 percent of gross hotel revenue.27
In
determining the arm’s-length charge for the Hyatt trade names and
marks, we begin with a franchise rate of 2 percent of gross hotel
revenues.
The Mercer report included a presentation of Hilton
franchise revenue and expenses from 1987 through 1990.
Approximately one-half of the Hilton franchise revenues were used
for expenses, exclusive of taxes.
If approximately one-half of
franchise revenues represent expenses, the other half, or 1
percent of gross hotel revenues, remains for allocation to profit
on reservations, marketing, expertise, and other services, as
well as a royalty for trade names and marks.
Of the 1 percent
representing profit, we attribute .5 percent to royalties and .5
percent to other items.
Based on the information available, we hold that the
appropriate arm’s-length charge for the Hyatt trade names and
marks and the chain services provided by Hyatt Domestic is two-
27
Accepting the premise that room revenues and food
revenues each comprise, on average, half of an international
hotel’s gross revenue, a franchise rate of 4 percent of room
revenues translates to a rate of 2 percent of hotel gross
revenues.
- 96 fifths of 1 percent (.4 percent) of the gross revenue of each
Hyatt International hotel.28
The .4 percent franchise rate, in
addition to accounting for an approximate division of the
elements in the franchise rate including use of the marks and
other intangibles, favors petitioners’ position in one important
respect.
In particular, our allocation or reduction of the
franchise rate recognizes, to some extent, that marks and names
are less important in the international hotel marketplace.
C. Allocations of Royalty Income for Trade Names and Marks
to HIC From Its Subsidiaries
HIC’s subsidiaries did not pay HIC royalties for the use of
the Hyatt trade names and marks.
In the notices of deficiency,
respondent determined that HIC’s income should be increased for
royalties from HHK, HS, and HP of 1.5 percent of their gross
revenues, the same rate as respondent’s determined royalties from
HIC to Hyatt Domestic.
At trial, respondent relied on the BVS
recommendation that a royalty of 33 percent of management fees,
as adjusted, should be allocated from HHK and HS to HIC.
The
proposed royalty is to account for trade names and marks and to
“provide a profit for the reservations activities, cover
corporate overhead and subsidize the development activities.”
28
It
The royalty allocations should be offset by the $10,000
per hotel license fees that HIC paid to Hyatt Domestic during the
years in issue.
- 97 also was intended to cover the cost of royalties from HIC to
Hyatt Domestic.
Mirroring their argument with respect to respondent’s
royalty determination between HIC and Hyatt Domestic, petitioners
argue that these intangibles have no value, or that it was the
subsidiaries (HHK and HS) that created the value.
In this
setting, however, petitioners also rely on Your Host, Inc. v.
Commissioner, 58 T.C. 10, 27-28 (1972), affd. on other issues 489
F.2d 957 (2d Cir. 1973), for the proposition that, even in a
chain operation, a trade name may have little value.
Your Host, Inc. v. Commissioner, supra, involved 11
restaurant corporations with common ownership and senior
management that operated a total of 40 restaurants with the name
of Your Host Restaurant.
All but three of the restaurants were
located in the Buffalo, New York, area, with the remainder in
Rochester, New York.
Two of the three Rochester restaurants
closed after 6 years.
All of the restaurants were similar in
appearance, served identical menus at the same prices, and were
open 24 hours a day.
They advertised as being part of a chain
under the same management.
For economy of scale, a master policy
for liability insurance and workmen’s compensation was obtained
for all the corporations.
The premium for the coverage was
advanced by Your Host corporation and was reimbursed by the other
corporations in apportioned amounts based on each corporation’s
- 98 payroll.
All employees were paid from a special payroll account
maintained by the Your Host corporation.
The individual
corporate entities would deposit the funds needed to pay the net
wages of their respective employees and then Your Host
corporation paid out the wages, leaving a zero balance in the
payroll account.
Each restaurant had a manager; however, the
manager could not change the menu or hours of business, nor
purchase supplies from other than the related supplier.
The
costs of the administrative staff, insurance premiums,
administrative office expenses, advertising, and maintenance and
supervisory staff generally were allocated among the corporations
according to gross sales, except the Rochester corporation did
not share in advertising costs because its restaurants did not
benefit from Buffalo area advertisements.
The Commissioner
allocated all of the income and deductions of all 11 corporations
to the Your Host corporation pursuant to section 482.
In Your Host, Inc. v. Commissioner, supra, we held that each
of the corporations was a viable business entity that paid its
own expenses.
Although the restaurants opened over a 25-year
period, with the openings of the first restaurant for each
corporation over a 13-year period, we found that the restaurants
operated by the Your Host corporation were, on average, no older
and no better established than those operated by the other
corporations.
Thus, the later-established restaurants were not
- 99 found to have traded upon the goodwill generated by the Your Host
corporation’s restaurants; all of them generated goodwill that
they shared equally.
We found that the advantage of being a Your
Host Restaurant flowed primarily from the local advertising and
shared management.
This was supported by the fact that the
Rochester restaurants nearly failed due to absentee management
problems.
The Tax Court concluded that the Your Host corporation
provided no service or benefit to the other 10 corporations for
which it was not already adequately compensated.29
Here, the hotels operated by the Hyatt International group
have only a limited amount of similarity to the restaurants in
Your Host, Inc. v. Commissioner, supra and the same result does
not obtain.
HHK and HS through management and local advertising
generated goodwill that benefited Hyatt International hotels and
entities in their regions and beyond.
We have held that the
arm’s-length royalty for the Hyatt trade names and marks from HIC
to Hyatt Domestic is .4 percent of the Hyatt International
group’s total hotel gross revenues.
As the holder of the
international license to the Hyatt trade names and marks, HIC’s
income should be increased by two-fifth of 1 percent of the gross
revenues of those hotels whose management fees, taking into
29
As previously noted, the parties posed an all-or-nothing
type question to the Court on the sec. 482 issues. See Your
Host, Inc. v. Commissioner, 58 T.C. 10, 29 n.4 (1972), affd. 489
F.2d 957 (2d Cir. 1973).
- 100 consideration the adjustments for the allocation of fees, were
remitted to HHK and HS.30
D.
Allocation to HIC for Management Services
Beyond limited expense allocations, HIC’s subsidiaries did
not pay for services provided by HIC.
Respondent determined that
income should be allocated to HIC from its subsidiaries for
management services.
Respondent relies on the provision of the
following services in support of allocations:
Manuals, training,
human resource development, employee benefits, contract review,
financial systems and advice, business development assistance,
preopening services, owner relations, marketing, and HIC's
efforts at building the IMAGE reservations system.
Petitioners contend that, for the most part, all management
fees were reported by the entity that earned them.
Petitioners
also argue that what HIC did for its subsidiaries was stewardship
or duplication and as such is not subject to section 482
allocations.
Petitioners assert that the design and chain
services were provided to and paid for separately by the hotel
owners, not the subsidiaries, and thus were by definition arm’slength transactions not subject to section 482.
30
Petitioners also
This allocation is for the Hyatt trade names and marks.
We consider the other items proposed by respondent, through his
expert BVS, in the royalty--i.e., corporate overhead and
development activities--under the topic of management services,
below.
- 101 allege that there was little IPS activity during the years in
issue.
Allocations may be made where one member of a controlled
group performs services for the benefit of, or on behalf of,
another member of the group.
Regs.
See sec. 1.482-2(b)(1), Income Tax
“Allocations will generally not be made if the service is
merely a duplication of a service which the related party has
independently performed or is performing for itself.”
Sec.
1.482-2(b)(2)(ii), Income Tax Regs.; see Young & Rubicam, Inc. v.
Commissioner, 187 Ct. Cl. 635, 410 F.2d 1233 (1969).
In
addition, section 482 allocations are inappropriate for
stewardship activities because the benefit is to the parent
entity.
See Young & Rubicam, Inc. v. United States, 410 F.2d at
1245-1247; Eli Lilly & Co. v. Commissioner, 84 T.C. at 1154;
Columbian Rope Co. v. Commissioner, 42 T.C. at 813-814.
We find
that items such as HIC’s audits, reporting requirements,
reviewing contracts, and providing for consistency of accounting
systems are supervisory functions that benefited the parent
company and are not management services.
See Young & Rubicam,
Inc. v. United States, 410 F.2d at 1245-1247.
Likewise, business
development activities, financial guaranties, and owner relations
are to the benefit of the parent company and not subject to
allocation.
See id.
However, we are, likewise, not persuaded by
petitioners’ argument that chain and design services should not
- 102 be subject to section 482 allocation because they were provided
to the owners, who are unrelated parties.
Although the charges
for these services were billed to the owners, the services were
provided as part of the Hyatt International group’s hotel
management business.
However, any allocation must take into
account the costs that have already been paid.
Accordingly, the
remaining arm’s-length issues for our consideration involve:
The
services HIC performed with respect to worldwide marketing, chain
and design services, and coordination of human resources,
insurance, and employee benefits.
First, however, we consider petitioners’ assertion that the
appropriate measure of arm’s-length consideration for the
services provided by HIC is cost.
Section 1.482-2(b)(3), Income
Tax Regs., defines an arm’s-length charge for services rendered
as:
the amount which was charged or would have been charged
for the same or similar services in independent
transactions with or between unrelated parties under
similar circumstances considering all relevant facts.
However, except in the case of services which are an
integral part of the business activity of either the
member rendering the services or the member receiving
the benefit of the services (as described in
subparagraph (7) of this paragraph), the arm’s length
charge shall be deemed equal to the costs or deductions
incurred with respect to such services by the member or
members rendering such services unless the taxpayer
establishes a more appropriate charge under the
standards set forth in the first sentence of this
subparagraph. * * * [Emphasis added.]
- 103 Thus, petitioners are correct that, under certain circumstances,
the cost of providing the services may be treated as the arm’slength consideration in lieu of the amount that an unrelated
party would charge.
This is permitted where the services are not
an integral part of the business of either the renderer or the
recipient of the services.
Respondent argues that all of the
services provided by HIC were integral to its business.
Conversely, petitioners argue that none of the services were
integral to the business.
Section 1.482-2(b)(7)(i) through (iv), Income Tax Regs.,
describes situations in which services shall be considered an
integral part of the business activity of a member of a group of
controlled entities.31
31
In pertinent part, the section 1.482-2(b)(7)(i) through
(iv), Income Tax Regs. provides:
(i) Services are an integral part of the business
activity of a member of a controlled group where either
the renderer or the recipient is engaged in the trade
or business of rendering similar services to one or
more unrelated parties.
(ii) Services are an integral part of the business
activity of a member of a controlled group where the
renderer renders services to one or more related
parties as one of its principal activities.
*
*
*
*
*
*
*
(iii) Services are an integral part of the
business activity of a member of a controlled group
where the renderer is peculiarly capable of rendering
the services and such services are a principal element
(continued...)
- 104 Petitioners’ expert conceded that the services of IPS were
integral in that those services were provided to unrelated
parties, although petitioner’s expert also concluded that IPS’
activities were minimal during the years in issue.
It appears
that IPS was uniquely capable of providing its services since the
design manuals and area programs, although tailored to suit a
particular hotel, were intended to exemplify how a Hyatt
International hotel should be constructed or operated.
No other
design company would have access to this information.
Thus, we
find the activities of IPS are integral.
Other services,
including marketing and coordination of insurance and benefits
were performed and may be integral, but there is no way to
distinguish the costs of the other services provided to HHK and
HS from the total costs to the Hyatt International group
entities.
The subsidiaries or the hotel owners paid the direct
costs; however, the indirect costs (i.e., overhead) were not
included.
Thus, whether we conclude that such services were or
were not integral, we are effectively unable to determine the
31
(...continued)
in the operations of the recipient.
(iv) Services are an integral part of the business
activity of a member of a controlled group where the
recipient has received the benefit of a substantial
amount of services from one or more related parties
during its taxable year. * * *
- 105 costs for the services rendered to HHK and HS.32
Accordingly, we
use a different approach in measuring arm’s-length consideration
for HIC’s services.
The BVS report contains the conclusion that a royalty
consisting of 33 percent of adjusted management fees be paid by
HHK and HS to HIC, plus a profit split of 50 or 65 percent
(depending on the year) of their operating income remaining after
expenses and the above royalties are deducted.
The royalty
allocation was for trade names and marks, profit on reservations,
and overhead.
BVS intended the profit split to cover the
financial guaranties and differences in assets, with HIC being
the owner of the intangibles and the financial capital.
A major impetus for BVS’ allocations appears to be the
opinion that HIC bore the majority of the consolidated expenses
of the Hyatt International group and that HHK and HS received
most of the revenue.
BVS’ choice of percentages appears to be
based on the above-stated premise.
In particular, the BVS report
contains the statement:
The reallocation process yields a much more balanced
distribution of operating income and adjusted operating
income. * * * It is only after the profit-sharing and
32
Although petitioners have argued that the one-time
overhead charge in 1983, as a result of challenged deductions, is
the appropriate amount, they have provided us with no factual
predicate for accepting this argument. Obviously, respondent’s
determinations reflect disagreement about the sufficiency of the
one-time charge.
- 106 royalties are adjusted for, that HIC, HHK and HS appear
to have the proper relationships in terms of adjusted
operating income. * * *
The perceived imbalance was due to the absence of hotel
expenses on the management subsidiaries’ books and the fact that
numerous HHK’s and HS’ expenses were absorbed by the flagship
hotel’s sharing of space and employees.
Some of HIC’s expenses,
however, were attributable to its role as a parent organization
and as the management entity for hotels in Europe, Central
America, and parts of the Middle East and would not be
attributable to HHK and HS.
BVS considered the expenses of HIC
and its U.S. subsidiaries but limited the comparison to the
operating revenues.33
BVS did not consider the fact that HIC
received dividends as a “parent” and that some of the dividend
income could be associated with the management relationship.
Significantly, BVS’ profit-split methodology was intended to
reflect the proportion of assets each entity had contributed.
That narrowly focused approach overlooks the contribution of
labor and expertise, which are the most important elements in a
service industry.
Although BVS' methodology was designed to rely
on asset proportioning, BVS’ conclusion essentially relies on
33
It appears that BVS’ analyses exclude the losses
incurred from the expenses of HIC for the hotels in Brussels and
Nice.
- 107 guideline transactions rather than on the entities’ comparative
asset holdings.
BVS selected certain Hyatt International agreements as
guideline transactions and concluded that there were implied
royalties of 33 percent in the Aryaduta agreement and 25 percent
in the HESA agreements.
The 33-percent royalty derives from the
potential decrease of revenue that would have occurred had the
name change negotiated in January of 1986 been implemented for
1988 and 1989.
The name, however, did not change until 1991 when
the second Hyatt International hotel opened in Jakarta.
Given
that the Hyatt International group needed the hotel owners of the
Aryaduta to agree to drop the name in order to secure the deal
for the newer and potentially more profitable Grand Hyatt, the
transaction should not be considered an arm’s-length transaction
with neutral parties who are under no compulsion to engage in the
transaction.
Further complicating the Aryaduta transaction, the
management fee rates were negotiated downward to reflect removal
of the Hyatt name, and the hotel owners agreed to add rooms to
their hotel, thus increasing the revenue base by the time the
name change occurred.
There were other similar instances where
fees, expressed in percentages, were scheduled to decrease when
the number of rooms managed increased; e.g., the HESA agreements
and agreements with owners of multiple hotels.
The BVS report
- 108 does not contain an explanation of the reason the implied 33percent royalty rate (for name only in the Aryaduta transaction)
was selected over the implied 25-percent rate for trade names,
marks, and chain services (HESA).
The BVS report merely contains
the statement that:
A royalty rate of 33% was found to have still allowed
both HHK and HS to produce a very high return on assets
and high overall profitability. A royalty rate as high
as 50% could have been supported in certain periods.
In support of its approach on the profit split, BVS stated
that:
The approximately 50% split in the net revenue of HESA
provides a guideline uncontrolled transaction that
suggests that, at most, HHK and HS would have been
entitled to half of the value of their respective
adjusted operating incomes after royalties. * * *
For HHK, BVS used a 65-percent split, to be allocated to HIC for
the years 1976 through 1981, with 50 percent for the remaining
years.
For HS, BVS used a 75-percent split for 1976, 65-percent
for 1977 through 1982, and 50-percent thereafter.
These profit splits, according to respondent’s expert,
recognized HIC’s contribution of intangibles.
We note that was
also one of the purposes of the 33-percent royalty.
BVS
references the split as being “approximately 50%,” but it
actually used 75, 65, and 50 percent (depending on the specific
year).
These percentages more closely resemble the consulting
fee paid by HESA to HHK, which we have found to be an arrangement
- 109 for the purpose of reducing foreign tax.
In connection with the
HESA joint venture, the Hyatt International group provided the
local staffing and management talent, while VIS provided the
hotel contracts.
We have found that HHK and HS played important
roles in both of these functions within their territories.
Thus,
the relationship between HIC and VIS does not resemble the
relationship between HIC and HHK or HS.
In addition, the
ownership share of HIC (Mexico) in HESA was 49 percent.
A
corporate shareholder/owner is entitled to a portion of any
dividends distributed.
As HHK and HS are wholly owned
subsidiaries of HIC, HIC would be entitled to 100 percent of
their dividends.
Those considerations, however, do not address
the share, if any, of operating income that HIC should receive.
In these respects, the BVS report was not helpful and did not
assist us in our consideration of an appropriate arm’s-length
consideration for the services provided by HIC.34
Once again, we are left stranded in a “sea of expertise” and
must navigate our own way through a complex record to decide what
constitutes an appropriate arm’s-length consideration.
For the
reasons we have explained, the parties' notice and trial
positions do not properly address the type of circumstances we
34
Since the parties have not provided adequate factual
basis for differentiation among the several years in issue, we
disregard BVS’ approach of allocating different percentages in
different years.
- 110 have found.
Accordingly, we looked for other alternatives.
The
Budapest agreement resembled the type of package that the Hyatt
International group provided to those hotels where local
management was not provided.
It included preopening and
technical services, management expertise, chain services, and the
trade names and marks.
The Odakyu agreement provided for the use
of the names and marks, chain services, manuals, among other
things, and provided us with some guidance.
The hotels involved
in that agreement used their Century names in conjunction with
the Hyatt names and also had the benefit of Hyatt chain services.
Unfortunately, there is insufficient information to enable the
fee structure for the Budapest or Odakyu agreement to be
translated, extrapolated, and applied to the other transactional
relationships in the Hyatt International group.
As we have already explained, the franchise relationship is
analogous to the relationship between HIC and its hotel
management subsidiaries.
HIC did not operate the hotel; it
provided services to the management companies.
Accordingly, we
see the franchise rates as the most indicative of arm’s-length
consideration for the services that HIC provided.
We also
recognize, however, that the master hotel management subsidiaries
such as HHK and HS worked in conjunction with HIC to provide
those franchise type intangibles and services to the hotel
operators under their supervision, assisting in the writing of
- 111 the manuals and consulting with the local hotel executive staff.
Yet petitioners have provided precious little guidance for us to
determine an appropriate offset for the services supplied by HHK
and HS.35
We are satisfied, however, that our holding allows HHK
and HS reasonably adequate compensation for their efforts as
hotel management companies, unlike respondent’s notice of
deficiency determinations.
As already discussed, franchise rates during the relevant
period were equivalent to about 2 percent of hotel gross
revenues.
We have held that the arm’s-length charge for the
Hyatt trade name and marks is .4 percent of hotel gross revenues.
That holding was based on a 2-percent franchise rate, with 1
percent being attributable to expenses and the other 1 percent to
profit on reservations, marketing, expertise, other services, and
a royalty for trade names and marks.
We considered one-half of
1 percent as the limit attributable to the royalties.
In
arriving at a two-fifths of 1-percent royalty rate we favored
petitioner’s position that trade names and marks are less
important in the international marketplace.
The reallocable
services provided by HIC coincide with those provided in a
35
Part of this is due to HHK and HS’s use of hotel staff
in dual capacities and their ability to pass on expenses to the
hotel owners in most of years in issue herein for which they
supplied no records of hours spent or costs incurred, leaving us
without the means to measure their contributions.
- 112 franchise arrangement.
Therefore, we hold that HIC’s income
should be increased by 1.5 percent of the gross revenues of those
hotels whose management fees were remitted to HHK and HS, taking
into consideration the adjustments already discussed.36
The 1.5-
percent rate consists of 1 percent for expenses and .5 percent
for profit based on a franchise model.
To reflect the foregoing and considering the parties’
stipulations of settled issues and the fact that additional
issues remain for resolution,
An appropriate order
will be issued.
36
This allocation should be offset by the overhead charges
already taken in 1983.
- 113 APPENDIX
AIC Holding (US)
(AIC)
H Group Holding
(US)
(HGH)
Hyatt Int’l.
Corp.(US)
Hyatt Corp.
(US)
(Hyatt Domestic)
HIC(Mexico)
Int’l.Proj.
Sys.(US)
(IPS)
Hyatt of
Singapore(Singapore)
(HS)
Hyatt of Hong Kong(Hong Kong)
(HHK)
HESA(Mexico)
49%
Hyatt Chain Services
(Hong Kong)
(HCS)
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.