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ADM.

RECOEDED

sumo

T.C

Memo . 1996-131

UN TÉD STA"ES TAX COURT

COMPUTERVISION INTERNAT ONAL CORP. , Petitioner

COMMISSIONER OF ÍNTERNAL REVENUE, Respondent

COMPUTERVISION CORPORATION AND SUBSIDIARIES, Petitioners1 y.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 25134-93, 2513

93.

Filed March 18,

1996.

. John S.- Brown, George P. Mair, Donald-Bruce Abrams, Jody E.

Forchheimer, for petitioners.

Charles W. Maurer, Jr. and John C. Galluzzo

re spondent .3

Jr. , . for

These cases have been consolidated for purposes of trial,

briefing, and opinion and shall hereinafter be referred to as the

instant case.

SERVED

MAR 1 8 199

- 2 -

MEMORANDUM FINDINGS OF FACT AND OPINION

WELLS, Judge:

Respondent determined a deficiency of

$9,460,419 in the Federal income tax of petitioner Computervision

International Corp.

(CVI) for its taxable year ended January 31,

1984.

Respondent determined the following deficiencies in the

Federal income tax of .petitioners Computervision Corp.

(CV) and

subsidiaries for the following years:

Taxable Year Ended

Deficiency

Dec.

Feb.

$25,226

32,279

4,720,840

570,819

31, 1983

31, 1984

31, 1987

5, 1988

After concessions, the following issues remain for decision:

(1)

Whether CVI qualifies as a domestic international sales

corporation (DISC) for its taxable years ended January 31, 1983

and 1984;

·(2)^

whether petitioners are ent-itled to net inter'est income

against interest expense in calculating CV's deduction for

commissions payable to CVI with -respect to each of. CVI's taxable

years ending January 31, 1983 and 1984, and December 31, =1984;and,

(3)

whether the net proceeds of the sale of a certain stock

warrant held by CV are long-term capital gain, ordinary income,

or a reduction in CV's cost of goods sold.

3 FINDINGS OF FACT

Unless othérwiselindicated, all Rule references are to the

Tax Coûrt Rules of Practice and Procedure, and all sect~ion

references are to the Internal

years in issue.

evenue Code iñ*effect for the

Some of the fabts have been stipulated for trial

pursuant 'to Rule 91.

The Jparties' stipulatiions are incorporated

in this Memorandum Opinion by refe ence and are found accordingly

except as noted below with respect to àertain stipulations to

which objections were reserved.

General Background

The principal place of business of both CV and CVI was

.Bedford, ·Massachusetts, at the time each fïled its petitiion in

the instant case.

CV, a Delawa è corporation, designs,

manufactures,+ and sells compute -aided design, computer-aided

manufacturing, and computer-aid d engineering (CAD/CAM/CAE)

products.

CV maintains its bo >ks and records on an accrual

accounting; basis using a calend r year

During'relevant

periods, CVI,- a Massachusetts c rporation, maintained its books

and records on an accrual accounting basis using a fiscal year

ending January 31.3

During CV'

and CVI's taxable years ending

in 1983 and 1984, CVI was a who Lly owned subsidiary of CV.

In 1988, however, CV, toge her with at least certain of its

subsidiaries, filed a' consolidated Federal income tax return for

the period beginning Jan.. 1, 1988, and ending Feb.. 5, 1988.

In 1985, however, CVI, fil d a Form 1120-DISC for the period

beginning Feb. 1, 1984, .and end ng Dec. 31, 1984.

DISC Qualification Issue

CVI was organized in 1972. to serve as a sales agent for CV

with respect to CV's sales of its products to customers located

outside the.United States.

CVI qualified as a DISC for each of

its taxable years ending prior to the taxable years for which its

DISC status is in issue in the instant case (viz, its taxable

years ending January 31, 1983 and 1984

(relevant taxable years)).

Throughout the periods relevant to the instant case, . Martin Allen

was CVI's president, Richard Krieger was its treasurer, and James

Spindler was its clerk.

They were also the directors of CVI.

CV and CVI entered into a series of agreements with respect

to their export sales activities.

entitled "Commission Agreement"

Under a written agreement

(commission agreement) dated as

of March 22, 1972, that was in effect during the periods relevant

to the instant case, CVI was appointed CV's sales agent with

respect to CV's sales of CV's products to customers located

outside the United States.

that,

.The commission agreement provided

in exchange for services provided under the agreement, CVI

would receive a commission equal to the maximum amount allowable

pursuant to section 994.

Pursuant to a written agreement entitled "Agreement

Designating Foreign Marketing Departments and Related

Intercompany Accounts" (export promotion agreement) dated as of

February 1, 1980, that wa.s also in effect during the periods

relevant to the instant case, certain departments within CV were

designated foreign marketing departments of CVI for purposes of

accounting -for export promotion expenses within the. meaning of

sectiong994 (c) to,be incurred by CVIsand certain accounts were.

designated as export-promotion expense accounts.

Pursuant to the

export promotion agreement,. CVI obligated itself to reimburse CV

annually for

042 exportk promotion expenses accounted for .in: the

designated -accounts that were -to be paid byt CV in the first

instance.

The.export promotiòn agreement.provided'thát CV would

bill the expenses to CVI.at the close of CVI's fiscal-year and

that the amount due -was:payable within 60 days after billing.2

Pursuant to a written agre ment entitled"'!Accounts

Receivable Purchase Agreement"

(master receivables,purchase

agreement) dated as of January 3J, 1981, CVI wasvauthorized to

purchase from time to time lm undivided interest in CV's accounts

receivable arising from certain of the types of transactions that

give rise to qualified export receipts pursuant to ,section

993 (a ) (1,) and on which CVI. was

ntitled to ireceive à cotùmission

(qualified export receivables).

.Pursuant to the'master

receivables purchase.agreement, the purchase price toybe paid for

the undivided interest in.the: qualified export receivablès was to

be determiried at the.. time of purchase and was ito reflect a

reasonable discount on the amount of.the receivables purchased.

The agreement also.provided that CV would produce, upon demand by

CVI, a list of- the qualified export receivables:in which- CVI had

än interest, including the iden ity of the- accou'nt debtor, 'the

amount of, each receivable, and

he date on which it arose:

was required to bill and, collect áll payments on:the qualified

export receivables in which CVI had an interest on CVI's behalf

and, unless requested to remit the proceeds to CVI, to substitute

an undivided interest in additional receivables for those

discharged.

Using the commissions paid it by CV, CVI, pursuant·to the

master receivables purchase agreement, periodically purchased at

a discount interests in CV's qualified export receivables that

were qualified export·assets within the meaning of section

993(b).

During its 1981 taxable year, CV entered into the

following sales of.qualified export receivables to CVI at a

discount under the master receivables purchase agreement:

Date of Sale

Receivables Face Amount

Oct. 1, 1981

Oct. 15, 1981

Dec. 1, 1981.

$23,345,288

1,874,000

4,028,369

Under the terms of the sales, CV was obligated to pay to CVI all

proceeds collected with respect to CVI's interest in the

qualified export.receivables on September 30, 1982.

During 1982, CV made an election to use the installment

method to report its income with respect to domestic and foreign

sales.

Because CV believed.that further purchases of qualified

export receivables by CVI would result in recognition of income

by CV at the time of the purchases, a plan was developed.during

September 1982 by CV's tax department and its outside

accountants, Price Waterhouse, both to avoid recognition of

income from the purchase of qualified export receivables and to

maintain CVI's ·status as a DISC (the plan).

Under the plan, when

CV became obligated to páy CVI

he proceeds åollected with

respect. to CVI's intérest in the qualified.export recëivables'on

September 30,? 1982, CVI would usé the proceeds of the investméñt

to fund demand loáns to CV that would not be"" Iualified -exportassets" within the meaning of section.993 (b) . ?CVI would cáll

those loans prior to the 'end of its taxable year ;and use their

proceeds to (1) purchase ·qualif ..ed export receivables;

(2)

reimburse CV for- export promo'ti n exþenses "incufred on behalf· of

CVI, and (3) pay a dividend tò¤CV.

It cwas expected that "the -

execution of the plan would cause CV1 to satisfy the 95 pèrcents

of assets test- provided by-sect:on 992 (a) (1) (B) at 'the close of

its taxable year.

Spindler.

The 41an was approved by Mr:·.Krieger and'Mr.

By purchasing CV's 'qualified eicport receivables at the

end of January of 1983, CVI sought. to minimize - the amount of the

receivables that might be paid before the end,o'f its'taxable yèar

because- the' conversion of the

eceivableá tö cash could have

cáùsed CVI to fail the 95 percertt *of assets test .

The following series of ^ev 254áts

óccùrred pùrsuánt tó the

plan.

First, CVI made demand loans. to CV on the followincj clates

in .1982 in' the . following amoùrit

Date

Amount' of Loan

Sept . 30

Oct. 29

Nov. 1

Nov. 16

Dec. 1

$2 7+, 272, 888 . 00

1,142,311.00

1,135,689..50

1,046,278.76

1,099,944:32

Then) on Januarf 27, 1983, CVI

ade 'written demand for lpayment bf

both the principal amounts of the loans (viz;- $311,697,111.58)· and

_ 8 -

accrued interest thereon (viz, $1,386,326.55), which totaled

$33,083,438.13.

On January 31, 1983, the following occurred:

(1)

CV wired the sum to CVI in full payment of the principal amounts

and interest, and the sum was deposited in CVI's account with the

First National Bank of Boston;

(2) CVI received the proceeds of

two maturing time deposits, totaling $5,663,970.38, that were

also deposited on that date in.the account;

(3) CVI wired both

the payment it had received from CV and the proceeds of the

maturing time deposits to CV, transferring a total of

$38,747,408.51.

The receipt by CVI of the proceeds of its maturing time

deposits was recorded in its general ledger by entries recorded

and approved between January 20, 1983, and January 25, 1983.

The

repayment by CV of CVI's demand loans and the subsequent transfer

of funds by CVI to CV described above were recorded in CVI's

general ledger by entries prepared and approved on January 31,

1983.

For accounting purposes, the transfers between CV and CVI

were recorded as passing through an account designated

"intercompany account".

On January 31, 1983, and prior to the application of the

above-described payment by CVI to CV, CV held qualified export

receivables as described in the master receivables purchase

agreement and CVI was indebted to CV (1) pursuant to the export

promotion agreement for expenses that previously had been paid by

CV but had not yet been reimbursed by CVI and (2) for accrued

State taxes that would be paid by CV in the first instance.

the time .CVI wired the payment to CV, bothsCVrandi CVI intended:

that CVI would (1) purchase from CV the receivables of CV' that

were outstanding at the close of business on January 31, 1983

(2)-.reimburse' CV for the aforementioned experises,

(3) pay CV an

amount equal to the 042

accrued Stat e taxes, and (4) pay a dividend

to CV from a portion of the transférred funds.^

All events necessary*to determine 'the'total amount of the

receivables, . expenses, and taxed hád taken pYace by) the close óf

business on that date; however

the information necessary .to ^

compute the total amount of the ritems"was not1available to CV and

CVI's tax and accounting .departm!ents on thatvdate.

In prior

years, CVI regularly had reimbugsed CV for export promötion

expenses pursuant to 'the export promotionvagreement ©and -for State

tax payment s .

-Additionally, ¿CVI ' s wand, CV' s tax and account ing

departments. did not ha've available to them on January 31, 1983,

the information snecessary,to com ute .the amount of the dividend

CVI intended to pay CV.

Ät the

imë CVL made the foregoing

transfers to CV,c neither CVI nor CV intended that any portion- of

the funds transferred would be repaid to' CVI;3

By February 23, 1983, CV's and CVI's tåx ånd accounting

departments had, received the' inf rmation necéssary to compute the

outstanding balance of CV' s qualified export receivables and the

amount of unreimbursed export promotioni expenses as of January

31, 1983 / and to prepare the doc ments memorializing the

transactions . "On .or , about that date, an 'agreement entitled

"Purchase of .Qualified Accounts Recéivable Ac)reement",- dated

- 10 -

effective as of January 31, 1983, provided for CVI's purchase

from CV of qualified export receivables in.the aggregate face

amount of $24,027,770. at a discount of $1,541,782, resulting in a

purchase price of $22,485,988.

All of the receivables purchased

thereby were qualified export assets within the meaning of

section 993(b).

The amount CVI owed CV as expense reimbursements

under the export promotion agreement was $2,570,631, and the

amount of accrued State tax CVI owed CV was $228.

A portion of

the funds CVI transferred to CV on January 31, 1983, was applied

to reimburse CV for the expenses and taxes.

Also on or about February 23, 1983, an "Action of Directors

,In Lieu of a Meeting" was signed by the directors of CVI.in which

it was voted as of January 31, 1983, to pay CV a dividend of

$13,690,561, the difference between (1) the amount of funds CVI

wired to CV on January 31, ,1983

(viz, $38,'747,408), and (2) the

sum of (a) the aggregate purchase price of the receivables

purchased by CVI (viz, $22,485,988),

(b) the amount CVI owed CV

as expense reimbursements under the export promotion agreemeht

(viz, $2,570,631) and accrued State. tax.

The foregoing transactions were recorded in CVI's general

ledger by entries that were prepared and approved after January

31,.1983, but prior to the time CV and CVI closed their books in

accordance with their usual accounting practice.

With respect to.CVI's taxable year ending January 31, 1984,

the following series of events occurred pursuant to the plan that

had been developed in September 1982.

CVI made demand loans to

- 11 -

CV .on the following dates in 1933 in ,the following amounts:

Date

Mar. , 31

Aug. 29

Oct . 31

Amount of Loan

$4;694., 145

28 , 552, 907

3, 365, 590

Subse;quently, non January 27, 1984, the folloWing occurred:

(1)

CVI made written,demand fór payment of both:the principal amounts

of the foregoing loans (viz

$36,612,642) and accrued interest

thereon . (viz, . $1, 797, 153) ,. whicE 3totaled $38, 409, 795;

(2)

wired $38 409, 795 to CVI in full payment of the principal amouñts

and interest on the fforegoing loans, and the payment was *

deposited in CVI's. account with the iFirst National Bank of

Boston; and (3)

CVI wired i$38, 409,1795 to CV.

, . The foregoing transfers were.. recorded in CVI's general

ledger by. entries that were. pr.epared and approved on or before ..

February 15, 19.84, but before. CV and CVI closed their lbooks for

the month of January 1984 in accordance with their usual

accounting practice.

For, accounting purposes~, not all^of the

sums transferred. between CV and CVI were recorded -as- passing

through the "intercompany accoun " bècause the eritries used to

record the foregoing transactiona Were more simplified than those

used to record the corresponding tránsfers that had occürred in

January 1983

On January. 27, 1984, and prior to. the application of the

above-described payment, by CVI to CV, CV held qualified 'export

·receivables as described in the' master~receivables purchase

agreement and CVI was indebted to CV (1) pursuant to the export

- 12 promotion agreement for expenses that previously had been paid by

CV but had not ÿet been reimbursed by CVI and (2) for accrued

State taxes that would be paid by CV in the first instance.

the time CVI wired the payment to CV, CV and CVI intended that

CVI would (1) purchase from CV receivables that were outstanding

at the close of business on January 31, 1984,

for the aforementioned expenses,

(2) reimburse CV

(3) pay CV an amount equal to

the accrued State taxes, and (4) pay a dividend to CV from a

portion of the transferred funds. .All events necessary to

determine the total amount of the receivables, expenses and taxes

as of that date had taken place by the close of business on that

date; however, the information necessary to compute the total

amount of the items was not available to CV's or CVI's tax and

accounting departments by the close of business.on January 31,

1984.

Additionally, CVI's and CV's tax and accounting

departments did not have available to them on January 31, 1984,

the information necessary to compute the amount of the dividend

CVI intended to pay CV.

At the time CVI made the foregoing

transfers to CV, neither CVI nor CV intended that any portion of

the transfers would be repaid to CVI.

By February 15,

1984, CVI's and CV's tax and accounting

departments had received the information necessary to compute the

outstanding balance of qualified export receivables.and the

. amount of unreimbursed export promotion expenses as of January

31, 1984.

On or about February 15, 1984, an agreement entitled

"Purchase of Accounts Receivable Agreement" was executed and

dated as of January 31, 1984 .

The;agréemeht. þrovided fór - CVI ' s

' purchases from CV÷of qualified*expört receivábles having an

aggregate face amount of $33,517,418bat a discount of $2,151,817,

for =an aggregate purchase sprice of $31, 365, 601..

All. of 'the

receivables purchased pursuant to the .agreement were qualified

export assets within the meaning of section 993 (b)

Also on or about February J5, T984; an' "Äction of Directors

in Lieu of a Meeting":wäs signed by each .of CVI's directors in

which it was voted to pay as of January 31, 1984, a dividend of

$5 million to CV. . The amount of the dividend is equal'to the

difference. between (1). the amourit of· funds 'CVI wired to 1CV on

January ,27,

1984,

(viz / .$38, 409, 795)

and (2), the súm of E (a)

the

. aggregate purchase price for theP receivables purchased by CVI

(viz, $31, 365, 60.1) ,

(b) (i) the amount of expense reimbursement s

CVI owed CV,,under the export ÷pronotion agreement as of that datë,

and (ii) .accrued State taxes a(vir, .$228) , and (c) can unapplied

balance of $228. .

The foregoing transactionswere recorded in CVI's general

ledger by entries that· were pfepared and approved after January

317 1984, but prior ' to the time CVI land CV dlosed their books for

the month of January in accordañce with their usual account'ing

practice.

For the period January 31, :.982, through January 31, 1984,

no security agreement was executed with respect to the qualified

export receivables sold

nor was any financing statement filed.

- 14 Computation of DISC Commission

For each of CVI's taxable years ending'January 31, 1983 and

1984, and December 31, 1984

(taxable years in question),

.petitioners computed the commission payable to CVI using the 50

percent of·combined taxable income method (50 percent of CTI

method) provided pursuant to section 994(a) (2), allocating a

ratable·portion of gross interest expense to qualified,export

receipts by product line for purposes of the method.

Stock Warrant Issue

Background

Prior to May 1983, CV decided that, in order to meet its.

customers' needs, it required a new, more advanced computer

workstation4 on which to run its CAD/CAM software.

Its customers

desired a computer workstation with an "open system environment"

that would enable its user to run software other than CV's.

CV, the change to such a system was a significant strategic

change because CV previously had sold products based only upon

its own closed proprietary operating systems.

An additional

significant strategic change for CV was the decision to purchase

its workstations from a vendor, rather than to manufacture them

itself, because manufact.uring workstations had been its primary

activity up to such time.

Due to its large investment in

A computer workstation is a desktop computer utilized by

scientists or engineers that performs complex computing tasks

using its own computing power rather than that of a central

computer shared with other users. Workstations, however, may be

linked together to form a network.

manufacturing assets, however,

manufacturing.

V needed be able to continue

CV sought to est ablish a long-term relationship

with a supplier for the design and- manufacture of its new

workstation.

Two manufacturers, Apollo Computer, Inc.

(Apollo), an

established firm .in the computer workstation. industry, and Sun

Microsystems, Inc.

(Sun) , a smaller competitor, submitted bids to

CV for such a workstation in. res onse to a solicitation by CV.

In a May 9, 1983, letter to CV, Sun acknowledged that it might

not be able to produce workstations in quantities sufficient to

meetaCV's demands, and indicated that it would becwilling to

grant CV the right to manufacture the workstations were Sun.'s

capacity insufficient.

Sun also set forth its method of

discounting purchases, which was to allow a»36·-to 40-percent

discount from the list price of

product for purchases of

between $10 million and $30 mill on, and.a 40-percent discount

for purchases above $30 million:

In a May, 11, 1983, letter to

CV, Sun made reference to, a ;"max mum Computervision discount" of

45 percent.

Neither letter .discussed stock warrants.

Although CV made a preliminary decision to select Apollo as

its vendor, CV continued to consider Sun because (1) Sun

possessed valuable technology and know-how. with respect to UNIX,

a nonproprietary, open computer operating system- that CV believed

Such .discount -apparently represented the: sum of the maximum

quantity discount from list price offered by Sun (viz, 40

percent) and the discount allowed for early payment. (viz, 5

percent) .

- 16 -

was best·suited to provide the open system environment desired by

its customers, but with which CV did not have experience, and (2)

Sun aggressively pursued the business.

CV decided to,propose to

Sun a technology sharing arrangement under which CV and.Sun would

jointly develop a workstation using Sun's technology and the UNIX

operating system.

Also, in order to both allow CV to manufacture

workstations and assure Sun that CV would purchase workstation

manufactured by Sun and would not manufacture all the

workstations itself, CV decided to propose~ to Sun a "reverse

royalty" arrangement under which CV'could manufacture

workstations but would be discouraged from being its primary

manufacturer because the "royalty" paid Sun with respect to the

workstations would increase as the number of workstations

manufactured by CV increased.

During June.1983, representatives of CV and Sun met to

discuss the proposals and to develop the framework for their

business relationship.

During the negotiations, CV.sought to

minimize the price at which it would purchase workstations by

maximizing the discount from Sun's list price for Sun's products,

and Sun sought to maximize the selling price of the workstations,

and sought to minimize the discount from its list price.

pressed for a higher discount although.it was aware that, in the

computer industry, a 45-percent discount was on the high end of

normal purchase discounts given by suppliers to original

equipment manufacturers (OEM's).

Near the conclusion of the June

1983 meeting, CV and Sun discussed giving CV warrants to purchase

- 1-7 -

Sun stock eas means tof' reducing. the cost io CV of the transaction

with iSun!

The Preliminary .Agreement e

The . negotiations culminated- in an agreement that was signed

on · or about June 17, 1983 ('June 17, . 1983, agreement ) , , and that

established guidelines for the

oint-development andimanufacture

of workstations by CV. and Sun

The June 17-, 1983, agreement

providedsthat the relationship

etween »CV and Sun was to

encompass : . (1) . An exchange of current i product . technologies ;

cooperation on· future product d velopment;

support services and facilities

(2)

(3) sharing of field

(4) investment participation in

Sun by CV; and (5) the basis for use of mutually owned designs

and manufacturing implementatio1 s.

The terms regarding the

purchase of workstations themselves were "subject to the terms

and conditions of a separate OE

between the parties".

contract to be negotiated

Consummation of the transactions outlined

in the agreement was subject to a number of conditions, including

the signing of definitive agreements implementing the basic

unders'tanding set forth in the

ne 17, 1983, agreement.

The June 17, 1983, a reeme t contempÊated tha

Sun would

grant to CV two stock warrants and a convertible debenture

(debenture) .

The first warrant was to be .exèrcisable iff within

a 36-inonth period, CV had transacted $20 million iof busi-ness with

Sun, consisting cf purchasês of Sun-'mariufactured products and

royalties paid by CV

The secon

stock warrante (second narrant)

was to be exercisable if CV's business with Sun (computed on the

18 -

same basis) reached a level of·$30 million within the same 36month period.'

Sun regarded the warrants as an incentive for CV

to purchase workstations from Sun:

Sun believed that it was

unlikely that the parties would have agreed on the June 17, 1983,

agreement, or that the transactions outlined therein would have

been consummated, without the warrants.

Additionally, concern1ng a $2.5 million loan made to Sun by

CV, the June 17, 1983, agreement provided for the issuance of a

5-year, 8-percent, $1.5 million debenture convertible into

100, 000 shares of . Sun common stock, and a $1 million

The June 17, 1983, agreement provided in relevant part:

(E) Investment Participation in Sun by CV

--Warrants

(5 Year)

(a)

On 100,000 shares of common stock at $12.00/share,

exercisable after CV has received $20 million of Sunmanufactured product plus royalties paid by CV within 36

months after 1st production CV delivery for revenue.

(b)

On 100, 000. share [s] of common stock at

$15.00/share exercisable. after CV has received $30 million

of Sun-manufactured product plus royalties paid by CV within

36 months of 1st production CV delivery for revenue.

- 19 -

nonconvertible note.

The Definitive Agreements

On or aboutvNovember 22,1 1 83, CV and Sun executed the

following three agreementss (agreements) :

(purchase agreement)-, pursuant

A purchase agreement

o which Sun agreed, inter. alia,

to sell CV certain workstations on certain terms and conditions

and CV agreed, inter alia, to abidec by the terms and conditions

in the event it purchased ,any w rkstations, from 'Sun; an Agreement

Relating to Investments by Computervision Corporation in -Sun

Microsystems=,, Inc.

(investment

greement), which related, inter

alia, to the warrants and the d benture eto be issued by Sun to

CV; and a joint. development agr ement (joint development

agreement) , which related, inte

alia,1 to the

of certain computer products an

provided for the $1 million loan

referred to in the June 1 , 1983,. agreement .

oint development

The division of the

respective undertakings of CV and Sun into separate agreements

had no particular sign fi ance, and the parties viewed the

agreements as a single inteÚrated agreement .

Ihe - June 17, 1983, agreemen

--Debenture

provided in relevant part :

A $1. 5 million debenture (5* year 8%) convertible into

100,000 shares of common std>ck, in conjunction with a $1.0

million loan~ at 8%,

042 such . lodn to: be repaid quarterly at the

rate of 10% of the previous three months invoices to CV

until.the loan-is repaid in full.

(i.e., after $10-million

in invoices)

- 20 -

Pursuant to the terms of the purchase agreement, as set

forth in the exhibit entitled "Volume Pricing Terms", CV was

allowed an "across the board" discount of 40 percent on all

purchase orders for the first 6 months, and after that, a maximum.

volume discount of 40 percent' off list price.

The purchase

agreement, which ran for a period of approximately 3 years,

contained no reference to the warrants.

It also provided the

"The Joint Development Agreement shall prevail over this

Agreement."

The purchase agreement also stated that

[CV] shall get the benefit of lower prices that

are given to other customers.of * * * [Sun] for current

and future products that are sold on terms and .

conditions that are the same as the terms and

conditions offered to * * * [CV].

If * * * [Sun] does

not offer * * * [CV] a price equal to the lowest price

being offered to such other customer of * * * [Sun]

because the terms and conditions being offered to that

customer are different from those offered to * * *

[CV], * * * [CV] shall have the option to accept the

lower price on the same terms and conditions as are

being offered to the other customer. Terms and

conditions shall include, but not be limited to, such

items as payment terms, manufacturing rights,

quantities, .technology exchanges, warranties and upfront investment by a purchaser.

Pursuant to the investment agreement, Sun agreed to issue

two stock warrants to CV to provide a further "incentive for an

ongoing business.relationship."

The exercise of the first stock

warrant was contingent upon CV's purchase of $20 million of

products (including royalties paid by CV to Sun pursuant to the

joint development agreement) within 36 months of the first

shipment by Sun to CV; the exercise of the second warrant

required $30 million of purchases within the same 36-month

period.

The stock warrants were exercisable in whole or in part

at any time:within 5 years-after theyùfirst became exercisable.

The investment

greement p ovided in relevant part :

Sun and CV have enter d into ar Joint Development

Agreement of ·even date * * * providing for the sharing

by the parties of certain t echnologies, for the

manufacture by CV of certain reasonable workstation

configurations ("RWCs") and for the purchase by CV from

Sun of RWCs.. In recognitidn of their mutual

expectation of a continuinÙ business relationship of

value to both parties, CV has indicated its willingness

to make certain loans .to Si n and Sun has indicated its

willingness to grant to CV an equity participation in

Sun.

The Warrants

As addìtional incentive for an

ongoing business relationsh p Sun .is .issuing to CV (a)

a warrant to purchase 10,.00 shares of Su 576i'

s Series F

Preferred Stock.at a price f $120.00 per share, such

warrant to become. exercisable on -the -day af ter the

Cumulative Sun +Business with CV (referred to below)

exceeds $20 million if suchi figure is reached within 36

months of the date of the first shipment by, CV of a

First Generation RWC (as defined in the Joint

. Development~.Agreement) for Ëevenue tand (b) a warrant to

purchase 10,000 shares of SÄn's Series G Preferred

Stock at a-price of -$150.00]per share, such warrant to

become exercisable on+the .day "after the Cumulative Sun

Business with CV exceeds $30 million . if such f igure is

reached-within the 36 month period mentioned "in (a) above. * * * Definitions of "Cumulative Sun Business

with CV" and of the first sliipment by CV of a uhit for

revenue appear- below.

Cumulative Sun Business.with CV. The Cumulative

Sun, Business with CV, which determines the .i

exercisability of the Warrants as provided above, shall

be the aggregate cumulative sum of (i) the amount of

Sun's invoices (net of freight, insurance, duty, taxes

and returned products) to CV for Sun. products purchased

by CV under the Purchase Agreement (as defined below),

and (ii) royalties payable by CV to Sun pursuant to

Section 5 of the Joint Devel pment Agreement.

(b)

The shÍ.pme

by CV of a First Generation RWC for

reveriuee refers to the first bona' fide regular way

placement of such a unit by CV with an independent

- 22 -

customer, whether such unit be placed on sale or lease

terms. The use by CV of units internally, including

units used by its subsidiaries, shall not be regarded

as shipments for revenue. CV will give Sun written

notice of the date of the first shipment of such First . .

Generation RWC for revenue within 30 days after such

shipment .

ANNEX I I

10,000 Shares Series F/G Preferred Stock

Preferred Stock Purchase Warrant

SUN MICROSYSTEMS,

INC.

("Sun"), a California

corporation, hereby certifies that, for value received,

COMPUTERVISION CORPORATION ("CV") , or permitted assigns,

entitled, subject to the terms set forth below, to purchase from

Sun at any time or from time to time after the Initial Exercise

Date and before * * * the Expiration Date, 10, 000 fully paid and

nonassessable shares of Series F/G Preferred Stock of Sun, at the

purchase price per share of [$120/150] * * * The number and

character .of such shares of Preferred Stock and the purchase

price per share are subject to adjustment as provided herein.

This Warrant is one of the Preferred Stock Purchase

Warrants (the "Warrants") issued in connection with an

Agreement Relating to Investments by Computervision

Corporation in Sun Microsystems, Inc. dated November

21, 1983, (the "Investment Agreement") . The Warrants

evidence rights to purchase an aggregate of 10,000

shares of Series F Preferred Stock and 10,000 shares of

Series G Preferred Stock of Sun * * *

CV had not invested in a supplier prior to the transaction

with Sun described above.

CV did not make a practice of

investing in its suppliers and did not view the warrants as an

investment in Sun.

The linking of CV's ability to exercise the warrants to the

dollar volume of business CV transacted with Sun served as an

incentive for CV to do business with Sun.

The warrants served as

- 23 -

an incentive to -CV to^ purchase

orkstations manufactured by ;Sun,

rather than to manufacture the workstations itself, during the

initial -phase?of the atransaction . bétween CV and Sun

For

workstations manufactured 3by ·Sun, the purchase >agreement provided

a higher price .to be paid by . CV to Sun than the royalties that CV

was obligated to pay .Sun for wo kstations manufactured by CV. .

Consequently, the volume purchase levels at . which .the warrants'

became exercisable would be rea hed more quickly were CV . to

purchase _workstations manufactu ed by Sun than would be the case

if CV were to manufacture them itself and pay Jroyalties to iSun.

The dollar volume Aof business at which the warrants became

exercisable was ·within the expected dol'lar volume: of business to

be transacted between- CV and Sun.

Although TCV did not commit to

buying the volume specified -in the investment agreement for

exercisability of the warrants,

ts projections- furnished to Sur

indicated th t CV believed it wo ld be able to éffect purchases

at those volume, levels.

The joint development agreement contained provisions

implementing the objectives of CV and Sun with respect to the

development of future products.

As noted above, Sun possessed

valuable technology and know-how with respect to the operation of

UNIX, an open computer operating system compatible with hardware

and software developed by compan es besides CV and with which CV

did not have experience.

CV int nded to develop software for

future products, and it was nece sary for CV to coordinate such

advanc ment with the development of the workstations by Sun.

- 24 Further, the parties had to develop an appropriate interface

between the systems in order to facilitate the use of Sun's

workstations with CV'.s existing product line.

They al.so agreed

. to contribute mutually to the design of new workstation products.

The parties agreed to broadly share all current product

information and knowledge relating to development of future

products and to exchange specific items such as hardware and

software.

The joint development agreement also specified the

royalties to be paid by CV for Sun's technology.

It also·gave CV

the right to manufacture workstations if Sun did not supply them

under the purchase agreement.

Finally, although there was no

.commitment to purchase any minimum volume of workstations, CV.

agreed to purchase 50 percent of its workstation requirement from.

Sun during the 3-year term of the purchase agreement.

The joint

development agreement also stated that

. 9.

CV Investment in Sun. The parties are entering

into a separate Agreement Relating to Investments by

* * * [CV) in Sun Microsystems, Inc. which provides for

loans. by CV to Sun and investments by CV in Sun.

The Warrants and the Debt Financing

Both at the time of the negotiations and when the agreements

were entered into, neither CV nor Sun knew the extent, if any, to

which the stock warrants would appreciate in value, although CV

hoped that Sun would be successful and believed that Sun had the

potential to be successful.

Sun obtained an independent

appraisal of the fair market value, as of November 21, 1983, of

the stock warrants.

The appraisal estimated the fair market

value of the warrant to purchase series F preferred stock to be

- 25 $146, 000 and the fair market value of the warrant to purchase

series G preferred stock to be

58,000.

The,apprai

1 was made

by the investment banking firms of Robertson, Colman & Stephens

and Alex, Brown & Sons,

March 28, 1984 .

nc. an

forth in a letter dated

CV did not acquire Sun stock pursuant to the

warrants, but instead

ltimately sold the warrants in 1986 and

1987 to underwriters.

During i s 1984 fi cal year, Sun had an unsecured working

line of credit pursuant to whic

it could borrow up to $8 million

at a rate of interest equal to prime plus .75 percent.

Sun also

had a $3 million loan commitment from banks that provided for

interest equal to the prime rate plus

percent .

The prime rate

in May and June 1983 was 10.5 percent, and, on December 2, 1983,

it was 11 percent .

During its negotiations with CV, Sun tried to obtain $5

million of financing from CV.

, which had a large cash

reserve, would only agree to loah $2.5 million to Sun; the

financing consisted of the $1.5 million debenture that was

convertible and was subordinated to the extent and in the manner

set forth therein to "all Sun s Senior Indebtedness"

tiherein), and a $1 million note.

(as defined

The form of the debenture

attached to tlié Investment Agree ent as Annex I def ined "Senior

Indebtedness" as:

the principal of (and premium, if any) and unpaid

interest on, (i) indebtedneds of ·Sun, whether

outstanding on the date hereof ór hereafter created, -to

banks, leasing companies, ir surance companies or ·other

lending . institutions, regularly engaged .in the business

of lending money, which is for money borrowe'd by Sun or

- 26 -

a subsidiary of Sun, whether or not secured, or

equipment leased by Sun or a subsidiary of Sun and (ii)

any deferrals, renewals or extensions of any such

indebtedness.

The debenture was also not entitled to a sinking fund.

The

terms of the debenture, issued on December 1, 1983, required Sun

to pay $1.5 million to CV on or before December 1, 1988, with

interest accruing on the unpaid balance at the rate of 8 percent

per year.

The principal amount of the debenture was convertible

into Sun's series G preferred stock at a price equal to $150 per

share.

CV acquired common stock.in Sun in conversion of the

debenture and recognized gain on the sale of that stock in 1986

and 1987.8

Sale of the Warrants

On March 4, 1986, Sun made its initial public offering of

its common stock.

Subsequently, pursuant to the agreements, each

share of the Sun preferred stock covered by the stock warrants

issued to CV was converted into 15 shares of Sun common stock.

Cons.equently, for each of the two stock warrants, CV had the

contingent right to purchase 150,000 shares of Sun common stock.

The first warrant to purchase Sun common stock (at a price

of $8 per share, derived by dividing the original exercise price

of $120 per share of series F preferred stock by 15,

corresponding to the 15-to-1 conversion ratio referred to above)

It appears that the preferred stock that CV was entitled to

receive pursuant to the debenture was converted into common

stock, as was the case with the stock CV became entitled to

receive pursuant to the warrants as discussed below.

- 27 -

became7exercisable in the fourth quarter of-Sun·'s 1986 fiscal

year (i.e. µ April through June

November 24, 1986.

986). and was exercised on

On thatn dat , CV sold :its. rights ^to the first

warrant ·to an underwriter, who- hen exercised; the first warrant. .

The closing sale price of .Sun còmmon stock as reported in the

NASDAQ National Market System on November 24,1 1986, was^$19.375

per share, or $11.375.per share greater than the $8-per-share

exercise price.

During January 1987, the s cond warrant became exercisable

by CV (at a price of $103 per share, derived by dividing the

original exercise price of $150

r share of series F preferred

stock by 15, corresponding to the 15-to-1 conversion^ ratio

r'eferred to aböire) .

CV sold its rights to the rsecond warrant

(the "second warrant") to an.und rwriter on March 12, 1987.

cloÁing sa e

>ric

of S n cc mon stock

National Market System on March

The

s reported in t e NASDAQ

1, 1987, was $31.375 per share,

$21. 375 greater than CV' s $10 -pe -share

xercise price .

received a net amount of $3, 002, 750 in proceeds from sale of the

secon2d 'w rrant, a t r

aking intò account underwriting costs and

other expenses of the sale.

Tax Return and Financial Reporting Treatment of the Sale of

the Warrants

On its Federal income tax r turn for its 1987 taxable year,

CV reported part of the gain on disposition of ther secònd warrant

as q reduction in~its cost of go ds sold: andopart as a91ong-term

capital gain.

CV computed a capital gain from the sale of the

second warrant of $1,179,578 by subtracting from the $3,002,750

- 28 -

net sale proceeds an "adjusted basis" of $1,823,172.-

The

"adjusted·basis" represented the amount that CV would have

realized had it disposed of the second warrant whén the warrant

first became exercisable and which CV treated in its tax return

as a reduction in CV's cost of goods sold (i.e., as a discount in

the price paid by CV for goods purchased from Sun).

On its Form 10=Q for the quarter.ended March 31, 1987, filed

with the Securities and Exchange Commission (SEC), CV reported a

$4.7 million gain

from the sale of stock and warrants that had been received

in conjunction with a convertible loan and a volume purchase

agreement. The portion of the gain attributable to the

volume purchase rebate ($1.4 million) was accounted for as a

favorable purchase price variance and included in the costof goods sold. The remaining $3.3 million gain on the sale

of stock. and warrants has been reflected in other income

(net).

On its Form.10-Q for the quarter ended June 30, 1987, filed

with the SEC, CV also reported that it had received during the

first quarter of the year gain from the sale. of common stock and

warrants that had been received in conjunction with a convertible

loan and volume purchase agreement.

The Form 10-Q reported that

the portion of the gain attributable to the volume purchase

agreement ($1.4.million) had been accounted for as a favorable

purchase price variance and included in cost of goods sold.

OPINION

DISC Qualification Issue

The first issue that we address is whether CVI qualifies as

- - 29 a DISC pursuant to section-992 ( ) (1)

for each of its relevant

taxable years.

In Computervision Corp. v. Commissioner,

96 T.C. 652, 656

(1991) , we stated :

. 042

In general, a corporation that qualifies as a DISC

is not taxable on its prof ts . * * * Instead, the

DISC's shareholder is taxe each year, on a specified

portion of the DISC's earnings and profits as deemed

distributions,' while -the r maining portion of profits

is not taxed until actually withdrawn from the DISC or

until the- erstwhile.DISC c ases-,to qualify as a DISC.

To: ensure .that a DISC's tax-deferred profits are

used for export activities, Congress provided strict

requirements for qualification as a DISC.

* * *

Becausesof »minimal capitalization and

organizational requirements a DISC may be no more than

Sec. 992 (a) (1) provides as

ollows:

DISC.--For purposes of this title, the term "DISC" means,

with respect to any taxable year a corporation which is

incorporated under the laws of a ly State and satisfies the

following conditions - for the taxáble year:

(A) 95'percent or more of the gross9recèipts (as

defined in section 993 (f) ) of such corporation consist of

qualified exportireceipts ( s defined in- section 993(a)),

(B)o the adjusted basis of the qdalifiedfexport assets

(as defined in section 993( )) of the corporation at the

close of the taxable year equals or exceeds 95 percenè of

the sum of the adjusted basis .of all assets of the

corporation at the close of the taxable yeãr,

of stock and the par or stated value of its outstanding

stock ,is at least $2, 500 on each day of the taxable year,

and

(D) the corporation has made an election pursuant to

subsection (b) to be :treate as a DISC and such election is

in effect for the taxable ye r.

- 30 -

a corporation that serves primarily as a bookkeeping

device to measure ·the amount of export earnings that

are subject to tax deferral.

[Citation omitted.]

In that case, we 'concluded that CVI was organized and

operated solely as an accounting device for computing income

subject to deferral under the DISC provisions.

·Id. at.670.

Based on the record in the instant case, we similarly conclude

that CVI was merely an accounting device to defer taxation of

income during the taxable years in.issue by qualifying as a DISC.

The parties agree that the only question in dispute

concerning CVI's qualification as a DISC for its relevant taxable

years.is whether the adjusted basis of CVI's qualified export

assets exceeded 95 percent of all of its assets at the close of

those taxable years (95 percent of assets test).

992(a) (1) (B).

Sec.

The parties further agree that resolution of that

question depends solely upon whether CVI's transfers of funds to

CV prior to the close of each of those years were effective to

complete (1) the purchase from CV of qualified export

receivables,

(2) the reimbursement of CV for certain expenses,

and (3).the.payment of a dividend to CV prior to the close of

those taxable years.

The parties agree that, in the event the

transfers were effective to complete the foregoing, CVI satisfied

the 95 percent of assets test as of the close of each of its

relevant taxable years.

Petitioners contend that the transfers in issue effected the

purchase of qualified export receivables and the transfer of

ownership of the cash used to reimburse CV for certain expenses

31 -

and to pay dividends to CV, so that CVI's .assets' as of the close

of its relevant taxable yeàrs' did not include the funds

transferred to CV but. did include the receivables purchased with

a portion of the funds . P Pet-iti ners further contend that the

actions taken subsequent to the end of each of CVI's relevant

taxable years, when the iinformation ñecessary to ascertain the

amount of receivables, purchased becamé available, nierély

memorialized òr documented the

ransactions that had taken place

before the end of-eäch year.

Respondent, however, contedds that the actions taken before

the close'of each of CVI's relevant taxable ye'ars were nót

.sufficient.to effect thé purchase of CV's qualified export

receivables, the reimbursement

f 'expenses' incurred by CVi and·

payment of- dividends to CV, but that CV and CVI merely had an

intention to. do such *things àt

he close of eadh of CVi's

relevant taxable years which was not''carried out -until àfter the

close of each of those years, wlden -therfinal steps of 'each

transaction were carried out .

C nsequéntly, respondent inaintains

that CVI's assets as of the close of each year·included an open

account of, or loan to, CV, equal to the amount of fiinds

transferred, which was not a qualified export asset of CVI and

that, therefore, CVI failed to satisfy the 95 percerit 'of assets

test as ~of -the close of each of its relevant taxable years .

We consider whether? 1for pui^póses o

the 95 percent of

assets test for each of CVI's relevant taxable years, CVI's

assets inc"luded qualified accounts, réceivable purchased fröm CV

- 32 -

or an open account equal to the amount of funds transferred from

CVI to CV on each of January 31, 1983, and January 27, 1984.

Resolution of that question depends upon whether a completed sale

of the receivables occurred prior to the close of each.of CVI's

relevant taxable years.

Petitioners contend that so-called "relaxed ownership

requirements" with respect to the acquisition by a DISC of an

interest in its parent's accounts receivable, such as were

announced by the Commissioner in Rev. Rul. 75-430, 1975-2 C.B.

313, means that arrangements less formal than may be customary

are sufficient to effect the purchase of receivables for purposes

of the 95 percent of assets test.

We, however, do not find the

ruling on point because it concerns only the question of whether

a DISC's interest in receivables is sufficient for the

receivables to be considered qualified export assets of the DISC

for purposes of the 95 percent of assets test; it does not

address the time at which a transfer of ownership occurs.

In Derr v. Commissioner, 77 T.C. 708, 723-724

(1981), we set

forth the following approach to resolve the issue of when a sale

is complete:

For purposes of Federal income taxation, a sale

occurs upon the transfer of the benefits and burdens of

ownership rather than upon the satisfaction of the

technical requirements for the passage of title under

State law. The question of when a sale is complete for

Federal tax purposes is essentially one of fact. The

applicable test is a practical one which considers all

the facts and circumstances, with no single factor

controlling the outcome.

{Citations omitted.]

See also J.B.N. Tel. Co., Inc. v. United States, 638 F.2d 227,

232

(10th-Cir.g1981); Rich Lumber Co. v. United States, 237 F.2d

424, 427 (1st Cir. 1956) ; Guardian Indus.' Corp. v. Commissioner,

97 T.C.

308, 318

(1991), affd.

ithout published opinion 21 F.3d

427

(6th .Cir. 1994); Yelencsics v. Commissioner,

1527

(1980) .

74 T.C.

1513,.

Respondent contends that tl e sale~of CV's igualified export

receivables could not have occurred prior to the close of CVL' s

relevant taxable years becauseuthe. requirements for. the transfer

of accounts receivable. prescribe

by. Article 9 of the .Uniform

Commercial Code (U. C. C. ) as .adop ed by Massachuset ts were not

satisfied.

We do not agree-.

Generally, State-law is not

dispositive of whether or when a sale or :transfert of, property

occurs for Federal tax purposes .

110

Burnet v. Harmel, : 287 U. S. 103,

(1932); Snyder v.-Commissioner, 66 T.C

7852992

(1976).

the Supreme ,Court has stated

the revenue laws are to be construed, in the light of

their general purpose to est!ablish a nationwide scheme

of ;taxation uniform in its Application.. Hence their

. provisions are not to be taNen as subject to state

control or limitation unless the language or necessary

implication of the section :i]nvolved makes its

application, dependent on state law. * * *

[United 042

States v.

Peltzer,

312 U.S.

399,

402-403

(1941) .]

Respondent does not point to any circumstance showing that

Congress intended that a DISC's ability to satisfy the 95 percent

of assets test depends solely upon State law governing the

passage of title,- and we are unab e to discern any such intent on

the part of Congress.