# UNITED STATES TAX COURT > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3Ab96f54577e66543e ## Record - **Collection:** Agency decision - **Document type:** Agency decision ## Text T.C. Memo. 1998-461 UNITED STATES TAX COURT DHL CORPORATION AND SUBSIDIARIES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos. 19570-95, 26103-95. Filed December 30, 1998. Lawrence L. Hoenig, Frank E. Sieglitz, William E. Bonano, Sarah G. Flanagan, John M. Grenfell, Roderick M. Thompson, Debra L. Zumwalt, Richard E. Nielsen, Greg L. Johnson, Andrew D. Mastin,and Susan T. Brown, for petitioners. Mary E. Wynne, Erin M. Collins, Cynthia K. Hustad, Michael J. Cooper, Kevin G. Croke, Kimberley J. Peterson, and James R. Robb, for respondent. -2CONTENTS Findings of Fact . . . . . . . . . . . . . . . . . . . . . . 4 I. Background . . . . . . . . . . . . . . . . . . . . . 4 II. Stock Ownership and Control . . . . . . . . . . . . . 13 III. Operating Agreements Between DHL and DHLI and Related Entities . . . . . . . . . . 21 IV. Development and Use of the DHL Trademark and Logo . . . . . . . . . . . . . . . . . 26 V. Financial Condition of DHL . . . . . . . . . . . . . 33 VI. Negotiations with UPS . . . . . . . . . . . . . . . . 37 VII. 1990-92 Transaction With Foreign Investors . . . . . . . . . . . . . . . . . . . . . . 37 VIII. The Imbalance and Transfer Fees . . . . . . . . . . . 61 IX. Technology and Systems . . . . . . . . . . . . . . 66 X. Respondent’s Determination . . . . . . . . . . . . . 68 Opinion . . . . . . . . . . . . . . . . . . . . . . . . . . 71 I. Background . . . . . . . . . . . . . . . . . . . . . 71 II. Were Respondent’s Determinations in the Notices of Deficiency Arbitrary, Capricious, or Unreasonable? . . . . . . . . . . . . . . . . . . . . 73 III. The Question of Control . . . . . . . . . . . . . . . 81 A. Was There Common Control After December 7, 1990? . . . . . . . . . . . . . 82 B. Effect of the Trademark Transfer After the Foreign Investors Attained Their Collective Shareholding Majority of the New DHLI/MNV Entity . . . . . . . . . . . . . . . . . . . . . 85 IV. Ownership and Value of the DHL Trademark . . . . . . . . . . . . . . . . . . . . . . 87 A. Ownership . . . . . . . . . . . . . . . . . . . . 87 B. Value of the DHL Trademark . . . . . . . . . . . 99 1. Effect of Section 482 Regulations on Allocation of Value. . . . . . . . . . . . 125 2. Respondent’s Alternative Argument--The Alstores Doctrine . . . . . . . . . . . . . . . . . . 131 V. Allocation of DHLI Income to DHL From Imputed Royalties, Imbalance, Transfer, and Network Fees for the Period 1974 Through 1992 . . . . . . . . . . . . . . 133 A. Background . . . . . . . . . . . . . . . . . . . 133 B. Royalties . . . . . . . . . . . . . . . . . . . . 135 C. Imbalance and Transfer Fees . . . . . . . . . . . 141 D. Network Fee . . . . . . . . . . . . . . . . . . . 155 -3VI. Are Petitioners Entitled to Setoffs to Any of the Section 482 Allocations That Have Been Sustained? . . . . . . . . . . . . . . 159 VII. Section 6662 Penalties . . . . . . . . . . . . . . . 163 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . 171 MEMORANDUM FINDINGS OF FACT AND OPINION GERBER, Judge: Respondent determined deficiencies in income tax and penalties for petitioners’ 1990, 1991, and 1992 taxable years as follows: Year 1990 1991 1992 Deficiency $194,534,167 13,912,891 216,139,109 Additions to Tax Sec. Sec. 6662(a) 6662(h) $3,036,446.00 $71,740,776 1,599,675.20 2,365,806 1,835,598.00 82,784,448 In addition, respondent denied timely filed claims for refund by petitioners with respect to the taxable years ended December 31, 1990, 1991, and 1992, in the amounts of $62,851, $920,991, and $3,208,934, plus interest thereon, respectively. The following issues remain for our consideration: (1) Whether respondent’s determinations in the statutory notices of deficiency were arbitrary, capricious, or unreasonable; (2) whether petitioners and certain other entities were commonly controlled, for purposes of section 482,1 on or after December 7, 1990; (3) whether petitioners realized additional capital gain on the sale of the DHL trademark; (4) whether petitioners’ postsale 1 Unless otherwise stated, section references are to the Internal Revenue Code as amended and in effect for the periods under consideration. Rule references are to this Court's Rules of Practice and Procedure. -4retention of a 15-year free domestic use of the DHL trademark results in capital gain income; (5) whether petitioners, under section 482, had additional income from forgone royalties; (6) whether petitioners, under section 482, had additional income attributable to imbalance and transfer fees; (7) whether petitioners, under section 482, had additional income from network fees; (8) whether petitioners correctly computed their net operating loss carryover deductions for 1990 and 1991;2 (9) whether petitioners are entitled to setoffs in any year in which additional section 482 income is finally determined; and (10) whether petitioners are liable for penalties under section 6662(a) and/or section 6662(h) for taxable years 1990, 1991, and/or 1992. FINDINGS OF FACT I. Background Petitioners are DHL Corp. (DHL or petitioner), formed in 1969 in California, and affiliated subsidiaries. At the time of the filing of the petitions in these cases, petitioners’ principal place of business was Redwood City, California. Petitioner was formed by Adrian Dalsey (Dalsey), Larry Hillblom (Hillblom), and Robert Lynn, and the first initial of each last name was used to form the “DHL” name. 2 Lynn transferred his Within the context of this issue, petitioners argued that for purposes of sec. 382 net operating loss limitations, the ownership of DHL changed on Dec. 7, 1990. On brief, respondent conceded this point. -5interest to Hillblom and Dalsey, each of whom owned 50 percent of petitioner as of November 1972, and Dalsey retired in 1984, and his shares were redeemed or transferred to other shareholders. Petitioner’s initial business activity was to pick up and deliver time-sensitive documents and small packages by means of regularly scheduled domestic airline flights between Hawaii and California. During 1970, a California corporation was formed to handle documents and packages between Los Angeles and San Francisco. Hillblom recruited John T. Atwood (Atwood) and William A. Robinson (Robinson) from another courier service to operate the Los Angeles to San Francisco business, which was merged with DHL on November 11, 1972, at which time Robinson and Atwood were each given a 7-percent stockholding interest in DHL. During 1972, a station was established in Hong Kong and incorporated there under the name Document Handling Limited, International (DHLI). DHLI was incorporated in Hong Kong on March 14, 1972, and its stock was owned 99 percent by DHL and 1 percent by Dalsey. Po Chung, a Hong Kong resident, was recruited by Dalsey to act as DHLI’s first manager. By late 1972 or early 1973, DHL was also offering service through a variety of entities to Guam, Hong Kong, the Philippines, Japan, Thailand, Australia, and New Zealand. The national and international expansion of DHL’s activity was accomplished by employees and/or stockholders going to a new -6location to establish an operational system/entity to facilitate pickup and delivery of documents and small packages to and from the United States and other locations. During 1972, Robinson traveled to Sydney, Australia, and met David Allen (Allen), and they began a pickup and delivery service there. Early on, employees who established the service in some locations accepted equity interests because of insufficient funds to pay them. Setting up an international station generally involved the obtaining of space at the local airport, making arrangements with the local government customs officials, setting up an office location, acquiring vehicles, and hiring and training local managers. Within a relatively short time, operations were established in Auckland, New Zealand; Fiji; Jakarta, Indonesia; Singapore; Kuala Lumpur, Malaysia; Caracas, Venezuela; Johannesburg, South Africa; and Sao Paulo, Brazil. The growth of the DHL network, especially in the earlier years, was attributed to a free-form approach to expansion. Although a regimen eventually developed, the business expanded and grew because of the flexibility and freedom of the management and employees to provide service to customers that comported with their customs and locality. After some problems involving the Civil Aeronautics Board (CAB), operations were divided between U.S. and international locations. Even though there was common shareholder ownership of the U.S. and international corporate -7entities, the two operations were allowed to develop separately in a manner that best suited local expansion and success. Although DHL and DHLI generally operated separately, certain physical facilities were operated for their joint benefit, and, occasionally, the companies used networkwide compensation incentive plans for their executives. At executive levels, there was commonality and “secunding” (sharing) of employees by and between DHL and DHLI. At the shareholder levels, there was common control of DHL and DHLI. The companies making up the DHL worldwide network cooperated through the Network Steering Committee (NSC), composed of DHL shareholders, senior management, and representatives of the three principal corporations, DHL, DHLI, and Middlestown, N.V. The NSC’s purposes were to establish network policies and strategies, address each company’s network rights and obligations, and present a uniform organizational image to DHL customers worldwide. One of the things that led to the success of the DHL network was the use of a flat-rate pricing structure, where the customer was charged a monthly rate for all shipments. Under this approach, profit was sought on the consolidation or volume strategy. DHL also developed color-coded pouches with distinctive markings that were known to customers and made package handling easier and more efficient. -8In the early 1970’s, one of petitioner’s competitors filed a complaint with the CAB, alleging that petitioner was not just a courier but also operated as an international air freight forwarder. The competitor complained that, as a result of the international freight forwarding, petitioner was required to have CAB operating authorization, which it did not have at that time. On April 11, 1972, petitioner filed for CAB interstate and international operating authorization, and the complaining competitor objected. CAB regulations prohibited individuals who were not U.S. citizens from owning more than 25 percent of a U.S. air freight forwarder. On May 24, 1973, DHL and Dalsey transferred their DHLI shares to nominees, ostensibly foreign, of Po Chung for little or no consideration. After that transfer of the DHLI stock, the CAB, on December 19, 1973, authorized DHL’s status as an interstate and international air freight forwarder. Thereafter, the CAB prohibition on foreign “control” of DHL was a significant factor in corporate and shareholder decisions to attempt to keep foreign and domestic activities separate. Operationally, DHL and DHLI, with limited exceptions, were autonomously managed by their respective officers, but with a common commitment to the DHL network. The exceptions involved DHL’s chief executive officer’s responsibilities over DHLI’s Canadian, Mexican, and Latin American operations. The common commitment to the network was nurtured by the NSC, consisting of -9senior managers representing DHLI and DHL, who met three or four times a year to exchange information and discuss operational issues of common interest. The companies that made up the entire DHL network were at all times, through September 1992, controlled by common interests. In 1974, Hillblom hired Peter J. Donnici (Donnici), a lawyer and law professor, to represent DHL in the CAB matter. About that time, Hillblom asked Donnici to establish a law office in Donnici’s name and to continue to represent DHL. L. Patrick Lupo (Lupo), a law student of Donnici’s, was employed to assist in the CAB litigation. After graduation from law school, Lupo was named general counsel of DHL. A few years later, Donnici and Lupo formed a law partnership that eventually became known as Donnici, Kerwin & Donnici. DHL was the firm’s primary client, and it also did legal work for DHLI and DHL shareholders. Donnici became Hillblom’s business and general legal adviser and consultant on major business decisions. personal friends. Donnici and Hillblom were also DHL, and at one point DHLI, paid expenses of the Donnici law firm, including rent, overhead, and all salaries. In the early 1980’s, Donnici received DHL shares for his past work for DHL, a third of which he gave to Lupo for work he had done. Donnici was also a director of DHL from the early 1980’s until the early 1990’s. While a director of DHL, Donnici received a retainer from DHLI in the amount of $48,000 per year. - 10 After the transfer of DHLI stock to Po Chung and nominees, DHLI was used for foreign operations and DHL for domestic. DHL Operations B.V. (Ops B.V.) was incorporated in the Netherlands on August 13, 1979, as a wholly owned subsidiary of DHLI. When Robinson and Allen formed the Australia station under the name Document Handling Limited, Australia, Robinson was a DHL employee who had invested his own funds in this business. The business founded by Robinson and Allen eventually became known as Middlestown, N.V., a Netherlands Antilles company (MNV) incorporated on June 26, 1979. For most of the period 1974 through September 1992, DHLI, its subsidiary, Ops B.V., and MNV were the controlling and operational entities of the international portion of the DHL delivery network. For the period beginning in 1972 and extending into 1992, DHL was responsible for handling the courier business inside the United States, and DHLI was responsible for handling the courier business outside the United States. shipments that were: Each company serviced Solely within its jurisdiction; from its jurisdiction that were bound for destinations outside its jurisdiction; and received from outside its jurisdiction with destination points inside its jurisdiction. DHL would also handle shipments from outside its jurisdiction that were merely passing through DHL’s jurisdiction on the way to another destination that was outside DHL’s jurisdiction. - 11 For shipments to locations outside DHL’s or DHLI’s territory or jurisdiction, the documents or packages would be sent to a “foreign” clearing point of the other company, and they would then be completely processed by the receiving company. For example, if DHL picked up a package in San Francisco that was bound for a location in Southeast Asia, it would be transferred to DHLI at one of DHLI’s foreign points of entry, and then DHLI would take responsibility for customs clearance, further transportation (frequently across international borders), and delivery to the foreign consignee. The entity to whom the customer first submitted the package was paid by the customer and retained the payment even though another entity delivered the package. Accordingly, in the above example, DHL would retain the customer’s payment even though a DHLI/MNV company completed the delivery. The worldwide air express service operated by DHL and DHLI was generally represented as, and perceived to be, a single worldwide delivery system (DHL network). In the foreign portion of the DHL network, local operating companies and independent agents operated under agreements with DHLI and related companies. Normally, local operating companies or agents billed customers an all-inclusive price for shipments to other service areas. The local operating companies or agents normally retained a percentage or predetermined portion of the revenue received from their customers and remitted the remainder - 12 to the DHLI corporate entities as a “network fee”. Although DHL was DHLI’s pickup and delivery agent in the United States and vice versa, neither paid a fee to the other, and each was allowed to retain the full amount charged to the initiating customer until 1987. The only exception to this reciprocal arrangement was the on-forwarding fee that DHLI charged to DHL through the 1986 year for some 10 destinations in the Middle East and Southeast Asia because of the great distances from the entry gateways to those destinations. The reciprocal no-fee arrangement was allowed to exist during the 1970’s and until 1986. No specific method had been developed to account for each shipment during that time. As of 1992, the DHL network extended to approximately 195 countries. In each of those countries (other than the United States), pickup and delivery functions were performed either by a local operating company that was a corporate affiliate of DHLI or MNV, or by an independent agent. Most of the local operating companies were subsidiaries of MNV. Thus, MNV (through its subsidiaries) provided pickup and delivery services in many countries, while DHLI operated the network that linked those countries together. As of 1988 the DHL network was, internationally, the third largest air courier company, with a global market share of about 8 percent, of which somewhat less than 40 percent arose from - 13 outbound shipments from the United States. Around 1985, a study reflected that DHL ranked first for international service in the user samples, and its customer awareness was highest among large shippers who shipped packages both domestically and internationally. A 1986 report explained that DHL had a high name awareness even though the amount spent to advertise the name at the time was low. Although DHLI/MNV (international business) was growing faster and was more successful during the 1980’s, as of the time of the transactions in question, DHL remained a important part of the worldwide delivery network. DHL was valuable to DHLI/MNV by delivering packages in the United States and by providing shipments originating in the United States to the international portion of the network for delivery. Without DHL, the DHL network would have had to obtain a delivery agent to deliver international-origin shipments in the United States and find new sources of outbound shipments from the United States. As of the time of the transactions in question, over 20 percent of the total third-party revenues earned by the DHL network outside the United States was estimated to be attributable to DHL. II. Stock Ownership and Control As of December 1, 1989, 77.61 percent of DHL’s outstanding stock was owned as follows: Hillblom, 46.75 percent; Cheiro’s Consultancy Services Ltd. (Cheiro), 21.59 percent; and W. - 14 Robinson, 9.27 percent. The remaining 22.39 percent of DHL’s outstanding stock was owned by others--one of them owning 9.27 percent, and the remainder each owning less than 5 percent. Cheiro was a Hong Kong corporation, the stock of which was held 50 percent by Allen and 50 percent by Po Chung, from 1977 through September 1981. After that time, Cheiro stock was held by Allen or for his benefit through various entities. As of the time of the transactions in question, DHLI’s stock was held through Mattawan Ltd. (Mattawan), a Hong Kong corporation, which served as an intermediate entity. It was owned 49 percent each by Po Chung and Hillblom, and the remaining 2 percent was held by the Mattawan Employees Trust. MNV’s stock was held 49 percent by Robinson and 51 percent by Allen through several intermediate entities. From the relatively early foundations of DHL, DHLI, and MNV, through the time when the foreign investors became involved in the DHL network, Hillblom, Po Chung, Allen, and Robinson, collectively and functionally, were the controlling shareholders of the DHL network entities and the DHL network. Amongst the four controlling shareholders, Hillblom was the most influential. In the mid-1970’s Donnici introduced Allen to Stephen J. Schwartz (Schwartz), a tax attorney, who began representing some of the DHL shareholders and their related entities. Schwartz’ focus was on the minimization of tax, which, among other methods, - 15 was saved by placing corporate entities in low-tax jurisdictions. DHLI/MNV, the foreign entities, grew faster than DHL during the 15-year period preceding the 1990 transaction. Schwartz formed Management Resources International Ltd. (MRI) in Hong Kong on January 27, 1981, largely for tax reasons. William Walden, who was hired by and connected to Hillblom, was placed as head of MRI. MRI contracted with DHLI, MNV, and DHL to supervise and coordinate the DHL network, including “(i) the development of information and advice, (ii) direction and implementation of policies relating to marketing, advertising, operations, electronic data processing, accounting, legal issues and insurance, (iii) project research and development, and (iv) strategic planning.” Before 1989, DHL, DHLI, and MNV used MRI to enhance the commercial benefits derived from the DHL network. The NSC also had oversight of MRI and, in 1989, agreed to its legal reorganization. DHL, DHLI, and MNV management reported through their regions to the NSC’s chief executive officer. By 1988, more than half of MRI’s employees worked in the United States, and they were covered under DHL’s employee benefits package. DHL and DHLI periodically advanced funds to MRI to enable it to meet its costs. MRI’s stock. Bedford Management Group, Inc., held 49 percent of At the behest of the DHL shareholders, Schwartz, - 16 Donnici, Lupo, and Charles Lane (Schwartz’s law partner) held equal shares of the stock of Bedford Management Group, Inc. During 1987, the central management organization was reappraised, and it was decided that the considerable growth in the business and increasing competition intensified the need for a coordinating body that could continue to project and maintain the DHL worldwide network with uniform operational and service standards. In 1988, DHL established the Worldwide Coordination Center (WHQ) in Belgium. Three superregions were established, each with its own chief executive officer (CEO). Po Chung was CEO for the Asia Pacific region; Patrick Foley, DHL’s CEO, was CEO for North and South America; and Robert Kuijpers was CEO for Europe, the United Kingdom, and Africa. WHQ was to direct, support, and advise the regions, to supervise compliance with global policies, and to ensure that the regions adopted a consistent approach to key issues. It had responsibility for establishing strategy, coordinating resource allocation, and supporting and advising regional management, including coordinating with DHL, to ensure that operating procedures and service levels established centrally or recognized as best demonstrated practice were used throughout the DHL network. A Worldwide Services Department was also established to be responsible for directing and coordinating the integration of operations and marketing initiatives across regions; coordinating - 17 purchased air operations; advancing the worldwide implementation of best demonstrated practices in operations, sales, and marketing; and overseeing the global accounts program. Lupo was DHL’s general counsel from 1976 through December 1, 1984; CEO for part of 1986; a member of DHL’s board of directors from the early 1980’s until 1990 and chairman of its board of directors from 1985 through September 1986; and from the early 1980’s to the time of trial, a minority shareholder of DHL. In 1985, Lupo moved to England to coordinate the service requirements of DHL operations in Canada, Mexico, and Latin America with DHLI and MNV. Lupo continued in that role until 1988. From 1986 into 1988, at the request of Po Chung, Lupo coordinated the activities of DHL, MNV, and DHLI pursuant to an agreement with DHLI. Lupo also performed services for MRI. He was involved in MRI’s 1985 global strategic planning for DHL. From 1988 until 1992, DHL paid Lupo’s compensation and benefits, but permitted him to serve DHLI. He performed his coordination activities as CEO of WHQ beginning in 1988. In 1990, with the entry of the foreign investors, Lupo was placed on the boards of directors of DHLI and MNV. DHLI provided necessary capital to DHL through Nirada Corp. B.V., a Netherlands corporation formed for that purpose. DHL’s domestic expansion during the 1980’s was, in part, intended to - 18 increase and protect DHL’s international market share. Although the operating officers of DHLI were not in favor of the expansion, DHLI benefited because it was able to offer more U.S. delivery destinations to its customers. On December 7, 1982, Hillblom acquired 49 percent of the stock of Mattawan, for which he was to contribute $150,000. At that time, DHLI had retained earnings of HK$433,521,201 (approximately US$56 million). Around that time, Hillblom borrowed or withdrew several million dollars from DHLI, and through the 1990-92 transactions no interest or principal was repaid. Prior to his 1982 acquisition of Mattawan stock, it was understood that Hillblom had some form of interest in DHLI. Po Chung also acquired 49 percent of Mattawan’s stock, for which he was to contribute 70 percent of the DHLI stock. The employee trust of Mattawan held the remaining 2 percent of its stock. On December 20, 1982, Mattawan acquired 120,000 DHLI shares from DHLI, and on January 24, 1983, Mattawan acquired 49,900 DHLI shares from Po Chung and 99 from Helen Wong. After August 8, 1984, Mattawan held all but 1 of DHLI’s shares. In 1989, Schwartz structured a sale of Hillblom’s 49 percent Mattawan interest to Po Chung for US$226 million. documents were dated December 31, 1989. The sale During the transaction with the foreign investors, petitioner’s lawyers advised that the sale would not be respected for U.S. tax purposes. - 19 On January 15, 1982, the DHL shareholders entered into an agreement that provided that, in the event of the death of one or more of them, the deceased’s “entire interest in the DHL business” would be transferred to the surviving DHL shareholders with appropriate compensation to the deceased’s estate. The DHL shareholders apportioned the net proceeds from the sale of MNV and DHLI stock in 1990 and 1992, the assets of DHLI and MNV excluded from the sale, and other assets the DHL shareholders acquired with funds from DHLI or MNV as follows: Hillblom 55.4744 percent; Robinson 11.6788 percent; Allen 21.8694 percent; and Po Chung 10.9774 percent. The apportionment was not based on their respective stock ownership and the relative values of MNV and DHLI. Instead, it reflected the DHL shareholders’ true economic arrangement. The DHL shareholders’ negotiated apportionment of the proceeds was premised on the relative contribution each shareholder had made to the success of the DHL worldwide operation, although Robinson had made a concession to Allen to cause the deal to be consummated. This plan for apportioning the proceeds was based upon a longstanding agreement or understanding of the DHL shareholders. According to the DHLI/MNV shareholders’ agreement, Donnici, Lupo, and Schwartz were to receive $8,437,500, $8,437,500 and $2,953,125, respectively, from the proceeds of the 1990 and 1992 transactions. A portion of the DHL shareholders’ proceeds was - 20 used to purchase some of the DHL shares of DHL’s minority shareholders. The DHL shareholders agreed that, for purposes of determining the amount to be paid for the minority shareholders’ shares, DHL was worth one-third of the total offer for all three companies. During the December 1990 through August 1992 period, before the foreign investors exercised their option, the DHL shareholders, through and as DHL directors, had veto power over the following actions by the boards of DHLI and MNV: (1) Any change in the employment of Lupo, P. Y. Kuijpers, Robert Parker, and Errol Gates; (2) any issuance of DHL shares or other related securities; (3) any debt or lease financing by DHL, with certain exceptions for refinancings, lease financings below $3 million, and borrowings totaling less than $5 million; (4) any material change to the business of DHL, except for a reasonable commitment of DHL’s resources to development of heavy freight transportation capability; (5) any change in DHL’s auditors or accounting policy. During that same period, among others, the following actions were subject to supermajority (would require agreement of some board members controlled by the DHL shareholders) approval by the DHLI and MNV boards: (1) Any amendment to the bylaws and memorandum and articles of association; - 21 (2) entering into a new business other than one that was directly related to the principal business of DHL; (3) reappointment of the CEO; (4) any debt or lease financing by DHL if, as a result of such financing, the total amount of debt and lease financing by DHL would exceed 75 percent of the total capitalization of DHL. The limit was 50 percent if the new investors exercised the “Newco Share Alternative”; (5) any matters that exceeded a fair market value of $20 million, including purchases, sales, and leases, and excluding the exercise of the DHL trademark option. III. Operating Agreements Between DHL and DHLI and Related Entities The responsibilities of individual foreign operating companies were defined in network operating agreements with DHLI or Ops B.V, its subsidiary, and the responsibilities of the independent agents were defined in agency agreements with DHLI and related entities. In general, an individual operating company or agent would bill customers in its service area an allinclusive price for shipments to other service areas. For transactions emanating outside the United States, each service area’s operating company or agent typically retained a portion of the revenue received from its customers and remitted the remainder to the DHLI entities as a “network fee”. - 22 The network fee was intended to compensate DHLI for central facilities and services--including the air transportation network, clearinghouse hubs at air terminals, customs clearing services, know-how, insurance, and advertising--that DHLI provided for the benefit of the local operating companies and agents. Although DHL was DHLI’s pickup and delivery agent in the United States and DHLI was DHL’s pickup and delivery agent outside the United States, with extremely limited exceptions, no fees or costs were paid for those services exchanged between them until 1987. Foreign operating companies and independent agents were required to use the DHL trademark so as to be identified as part of the DHL network. A trademark license was included as part of the agreements with the local operating companies and agents. The agreements with foreign local operating companies and agents generally did not require a separate payment for royalties. On occasion, it was necessary to include nominal royalty provisions in agreements with local operating companies and agents in order to comply with local law. Sometimes the royalties were credited against the network fee. The network fee remitted to DHLI and related corporations included payment for the capital infrastructure, operating expense, know-how, and sometimes a nominal amount for use of the DHL name provided by the DHL network. - 23 A memorandum of oral agreement, dated March 15, 1974 (1974 MOA), reflected the agency agreement between DHL and DHLI. Under the 1974 MOA, DHLI acted as the foreign pickup and delivery agent for DHL, and DHL licensed the use of the name DHL to DHLI for the 5-year term of the 1974 MOA. The 5-year term of the 1974 MOA could be terminated by DHL on 90 days’ notice. Upon termination of DHL and DHLI’s relationship, under the 1974 MOA, DHLI could not use the name DHL or any similar name for a period of 5 years. Between 1974 and 1990, the 1974 MOA was amended on six occasions. The first amendment provided (retroactively to 1974) that DHL and DHLI were each entitled to the revenues and were responsible for the expenses related to shipments originating in their respective service areas. The first amendment provided a procedure for selecting an arbitrator to arbitrate any disagreement concerning the allocation of revenues and expenses. Both parties consented to the jurisdiction of the U.S. District Court in Guam to enforce the arbitrator’s decision. On October 12, 1975, DHL and DHLI entered into the second amendment to the 1974 MOA which, in part, provided that costs and revenues of the parties’ electronic data transmission business were to be shared as agreed or, if no agreement, based upon reasonable value of services, reasonable value of resources contributed, with the understanding that the customers DHLI served presently were the result of DHL’s goodwill. DHLI again agreed that it would not use the name DHL or compete with DHL for - 24 5 years after the termination of the agreement. The second amendment was for 5 years, and it incorporated and reaffirmed the terms of the 1974 MOA and the first amendment, including DHL’s right to terminate the 1974 MOA upon 90 days’ notice. The third, fourth, and sixth amendments extended the term of the 1974 MOA through February 15, 1997. None of the amendments changed DHL’s right (under the original 1974 MOA) to terminate on 90 days’ notice. The fifth amendment provided that the relationship or agreement would “remain in full force and effect unless and until * * * disapproved by the United States Department of Transportation.” Neither the 1974 MOA nor any of the six amendments provided for royalties for the use of the DHL trademark or the DHL name. In connection with the involvement of the foreign investors, a December 7, 1990, agency agreement (1990 agency agreement) was entered into so that the arrangements between DHLI and DHL would be set forth clearly and completely in one document. Under the 1990 agency agreement, DHL had the exclusive right to use and sublicense the DHL trademark in the United States, and DHLI had the exclusive right to use and sublicense the trademark outside the United States. The agreement established reciprocal performance standards and financial covenants. Under the 1990 agency agreement, DHL or DHLI would compensate the other, at cost plus 2 percent, for its shipments in excess of those performed for the other. The 1990 agency agreement was terminable only for - 25 cause and had a 15-year term, with an automatic 10-year renewal if the parties were reasonably satisfied. It did not contain DHL’s right to terminate the agreement upon 90 days’ notice and it did not provide for DHLI’s payment of a royalty for use of the DHL trademark. DHL, DHL Airways, and a newly created entity, on August 18, 1992, entered into an agreement paralleling and keeping in force the 1990 agency agreement, essentially substituting a newly created entity for DHLI. Upon termination of the 1990 agency agreement, DHLI would be prohibited from using the DHL trademark anywhere in the world for a period of 5 years. The 1990 agency agreement provided that the laws of New York governed its interpretation. It was signed by DHL and DHLI and filed with the U.S. Department of Transportation. In addition to the 1974 MOA and amendments, DHL and DHLI in their cooperative effort to operate a worldwide DHL network entered into numerous written and oral agreements. Some of these included operational standards such as uniform service criteria for network performance (percentage of deliveries within an established time period, data retrieval standards), establishment of quality of service reporting criteria (systems and measures for network product volumes, pickup performance, and delivery performance), service directory format and content, development of quality control criteria for the network, and development of global air freight methods for handling larger or traditional air - 26 cargo. There were also agreements concerning customer service procedures, methods for taking and handling customer calls, booking shipments, responding to service requests, dealing with standard inquiries, managing large accounts, responding to complaints, and tracking or tracing shipments. Similar operational standards existed for the network’s ground operations, gateway operations, and hub procedures. The 1990 agency agreement, in part, attempted to gather these procedures and agreements into a single document. IV. Development and Use of the DHL Trademark and Logo During the early development of the delivery network, the “DHL” name was generally used, but no standard trademark or logo was used. In the late 1970’s, DHLI commissioned and paid for the design of the first standardized DHL logo, which was then used by the entire DHL network. In later years, DHL and DHLI cooperated on a project to modernize the DHL logo and to develop a Corporate Identity Manual explaining the use of the redesigned logo, all of which was cooperatively funded. Beginning in 1977, DHL began the process of registering the DHL trademark. Several different trademarks or logos have been registered, including “DHL”, “DHL Flyer”, “DHL Worldwide Courier Express”, and “DHL Worldwide Package Express”. DHL bore the cost for registering the DHL trademark in the United States. Ops B.V. and DHLI entered into an agreement on August 13, 1979, stating: (1) DHL was the “registered proprietor” of the - 27 name “DHL” and used that name in its business in the United States; (2) DHLI licensed the name “DHL” from DHL and carried on business as a document courier on a worldwide basis; and (3) DHLI, with DHL’s consent, appointed Ops B.V. as its agent to establish and improve the network throughout the world, excluding the United States. On November 15, 1980, DHLI and Ops B.V. executed a “Variation Agreement” modifying the 1979 agreement with DHL’s consent. Geoffrey Cruikshanks (Cruikshanks) was hired in 1982 as legal counsel for the DHLI portion of the DHL network. On August 1, 1983, Cruikshanks asked Lupo if DHL would sell DHLI the rights to the DHL trademark outside the United States. Lupo responded that the worldwide rights to the trademark could not be sold without DHL board of directors and shareholder approval, but the rights for DHLI to use the trademark only in Central America could be transferred for $100,000. DHL transferred the Central America trademark rights to DHLI for $100,000. In 1983, Cruikshanks undertook a worldwide registration program of the DHL trademark. Although Cruikshanks had been advised in April 1983 by the DHL general counsel that the DHL name should be reflected in connection with the registrations worldwide, that was not done. Cruikshanks hired John Caisley (Caisley) to register the trademark. Caisley was not informed about the 1974 MOA and DHL’s agreement with DHLI concerning the DHL trademark, and he registered it in DHLI’s name in various - 28 foreign countries. Caisley rendered an opinion regarding DHLI’s ownership of the DHL trademark in December 1990 when he was not yet aware of the 1974 MOA and its amendments. trademark registrations was borne by DHLI. The cost of these DHLI protected the DHL trademark against infringement outside the United States. Outside the United States, DHLI also took responsibility and bore the cost of protecting the DHL trademark, including disputes with terminated agents relating to trademark usage. The DHL name had been protected under U.S. trademark law since 1969 and the DHL logo since 1977. From 1978 until 1992, DHL or its subsidiaries were the registered owners of the DHL trademark in the United States, and they bore the costs of obtaining those U.S. registrations. In July 1986, an employee in the Argentina office asked a DHL employee for permission to alter the design of the logo used in Argentina. An MRI employee was asked to handle the matter, with the request that he direct each country manager to place next to the DHL logo a registration symbol showing that the logo was a registered trademark of DHL. In August 1988, DHL learned that the registrations of the DHL trademark outside the United States failed to reflect DHL’s interest in the trademark and the agreement set forth in the 1974 MOA. Margaret Phillips, an attorney in the Donnici law firm, and Cruikshanks discussed a revised trademark license agreement between DHL and DHLI setting forth DHL’s ownership of the DHL - 29 trademark and the practices and intent of the parties. Margaret Phillips drafted an agreement in 1988 setting forth the understanding that DHL licensed to DHLI the right to use the DHL name and logo. The agreement, although unsigned, contains acknowledgment that DHL owned the worldwide rights to the trademark and that DHLI obtained trademark registrations to be held in trust for DHL that DHLI would surrender to DHL upon termination of the license. The unsigned 1988 agreement was provided to counsel for the foreign investors, with the statement that it represented the agreement of the parties during due diligence for the 1990-92 transaction. As of July 1990, intranetwork memoranda contained the acknowledgment that DHL owned the worldwide rights to the DHL name and globally used trademark and trade name. DHLI was exclusively licensed to use those marks outside the United States and, for the sole purpose of complying with trademark laws, could file trademark applications outside the United States as the “registered owner”. There was network-wide employee recognition that DHL was the source of DHLI’s use of the trademark rights. For some period of time prior to 1990, Cruikshanks held the personal view that DHLI owned the trademark outside the United States, even though he orally and in writing represented to the contrary. During the negotiations with the foreign investors, questions arose about the trademark ownership outside the United - 30 States because of DHLI’s registration of the trademark in numerous foreign countries. For purposes of the transactions between DHL shareholders and the foreign investors, the agreements reflected: [DHLI] obtains its rights to the DHL trademark from DHL Corp. and has obtained its registrations pursuant to such licence agreement. An unwritten agreement exists between * * * [DHLI] and DHL Corp. which provides that upon the termination of the agency agreement between them, * * * [DHLI] will procure DHL Operations B.V. to assign all trademark registrations to DHL Corp. without consideration and at its cost. The three companies, DHL, DHLI, and MNV, operated in harmony to protect and develop the DHL trademark. In the mid-1980’s, a Corporate Identity Manual was produced, setting forth standards for the DHL logo’s use, including the typeset, colors, and letter size for each type of use. DHL’s advertising represented to the public that it was one global delivery company worldwide, and customers were made aware that their documents could be delivered anywhere in the DHL worldwide network. Although advertising was accomplished separately for DHL and DHLI, in the mid-1980’s, DHL’s management specifically decided that brand awareness and marketing strategies should have local focus because the markets served were too dissimilar to support a global program. Generally, DHL or DHLI each bore the cost of advertising for its respective market. DHL and DHLI did not directly control the quality of the goods or services that the other provided. - 31 From 1982 through 1992, DHL spent approximately $150 million for advertising, publicity, and promotion within the United States as follows: 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 $6,896,000 12,363,000 14,473,000 9,509,000 11,870,000 9,796,302 11,474,000 22,771,452 19,880,000 19,460,000 15,740,000 From 1982 through 1992, DHLI, MNV, and subsidiaries spent approximately $380 million for advertising, publicity, and promotion outside the United States as follows: 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 $6,671,000 8,592,000 14,933,000 24,290,000 32,340,000 34,341,000 37,045,000 48,937,000 47,460,000 56,099,000 70,140,000 The air express business is highly competitive, and consistency and reliability of service, and to a lesser extent delivery speed and price, engender customer satisfaction and loyalty. In order to provide consistently reliable service, an air express company must possess and maintain an extensive pickup and delivery network; an infrastructure of shipment facilities, planes, vans, and computer systems; tracking technology; and a - 32 great deal of know-how and expertise. These components are of greater significance to customers than the name or trademark of the delivery entity. Generally, a delivery business’ trade name or trademark will have less value when separated from the delivery infrastructure. On occasion, an established delivery company acquires another operating delivery company solely for its operating infrastructure, and the acquired company’s name is phased out and/or discarded. As part of the first stage of the transaction with the foreign investors, the parties agreed to a reservation of rights agreement in which an intermediate entity was used to transfer the DHL trademark to Newco (or DHLI Bermuda) and Elan Operations B.V. (Dutchco). The reservation of rights agreement provided that nothing contained in it shall be construed as an assignment or grant to the intermediate entity of legal or beneficial ownership in or to the trademark, it being understood that Dutchco is the owner of all right, title, and interest in and to the trademark in the United States, and that Newco is the owner of all right, title, and interest in and to the trademark outside the United States, in each case subject only to the rights reserved to the intermediate entity during a so-called reservation period and thereafter under a license period. Use of the DHL trademark by petitioner and its related domestic entities inured to the benefit of Dutchco and Newco, and the validity of trademark ownership was incontestable worldwide. While the - 33 intermediate entity could grant DHL and DHL Airways the right to use the DHL trademark in the United States, it could not grant the right to use the DHL trademark to any other person or entity anywhere in the world. In July 1990, there was an agreement in place between DHL and DHLI providing that, if the transaction with the foreign investors were terminated, DHLI could not use the DHL name outside the United States for 5 years. V. Financial Condition of DHL During the 1980’s DHL’s principal competitors included Federal Express, United Parcel Service (UPS), and Airborne Express (Airborne), all of which were larger, had better economies of scale, and were in better financial condition than DHL. In the early 1980’s, Federal Express had an 80-percent share of the U.S. domestic overnight delivery market, and it did not regard DHL as a significant competitor. In the early 1980’s, however, DHL had 30-40 percent of the U.S. international outbound market. Federal Express, which did not have or offer its own international line of business at that time, decided to expand into the European market. Federal Express did regard the DHL network as the significant competitor in the European market because of DHL’s existing network and ability to clear customs. Federal Express failed to build a successful European delivery network and lost several hundred million dollars but continued to offer U.S. outbound service. - 34 In 1983, DHL decided to increase its domestic coverage, both to protect its share of the outbound market and to handle more domestic shipments that could improve profitability and provide more potential for foreign outbound customers. DHLI management, however, was not in favor of DHL’s domestic expansion plan. DHL’s domestic expansion included the establishment of its own airline (DHL Airways), which was a capital-intensive and expensive method to ensure expansion capacity and more individualized and reliable schedules. There were also additional capital expenditures for new locations, vans, couriers, and other equipment, which further strained DHL’s cash-flow in the mid-1980’s. Because Federal Express had an established comprehensive overnight delivery network, it had achieved the highest volumes and the lowest pershipment costs, and as a result, the DHL expansion was insufficient to effectively compete. A bigger company with large volume and existing ground network, such as UPS, was better equipped to challenge Federal Express. DHL bid low on a U.S. Government contract with the General Services Administration (GSA) to help fill its planes and help with the extra cost of expansion. Additional costs, however, were incurred under the GSA contract because the deliveries were not at consolidated locations but rather were to specific floors, offices, or desks. The low bid and added costs made the GSA - 35 contract an additional burden on DHL’s financial condition rather than helping to facilitate expansion. In addition, DHL embarked on its expansion at a time when the U.S. overnight delivery market was becoming more competitive, especially because UPS had entered that market. Federal Express responded to the market forces by cutting prices, and U.S. market prices fell steadily during the period when DHL was trying to expand. Because of its expansion and the market forces, DHL experienced increased financial strains and severe cash-flow problems during the mid-1980’s. From 1983 through 1988, DHL’s domestic volume increased sharply, and its domestic revenues also increased, although at a lower rate. Although DHL did achieve some reductions in its per- shipment costs, the cost of the expansion, price competition in the U.S. market, and DHL’s failure to achieve the same economies of scale as its larger competitors caused DHL to sustain heavy losses, ranging from $5 million to $25 million per year. Some of the reasons for DHL’s poor performance in its attempted domestic expansion were similar to Federal Express’ poor performance in its attempted foreign expansion in attempting to compete with DHLI. DHL’s losses from 1983 through 1988 were attributable to its domestic business, not to its outbound business. During the same period as the domestic expansion and losses, DHL’s outbound volume and revenues were steadily increasing. DHL experienced - 36 consistent losses on internal domestic shipments and profits on its outbound shipments that originated domestically. In 1986, DHL retained Bain & Co., Inc. (Bain), to advise it on how to return to profitability. Bain analyzed DHL’s cost structure and, in 1987, developed a cost model specifically for DHL. Before that time, DHL did not specifically account for cost data by product line. Bain demonstrated that DHL’s revenue from an outbound shipment was greater than that from a domestic shipment, and customer density in a coverage area was extremely important to profitability. Bain made recommendations based on these findings, many of which were implemented and had a positive impact on DHL’s financial performance. In order to deal with the increasing debt, financial difficulties, and inability to enlarge or compete domestically, Bain recommended that DHL consider a merger with a company in the same industry. DHL changed its business strategy during 1988, focusing more on outbound shipments and less on domestic expansion. The GSA contract was allowed to expire, more effective cost control programs were instituted, and by the late 1980’s to the early 1990’s, DHL started showing profits. The controlling shareholders began looking for a suitable company with which to arrange a merger. - 37 VI. Negotiations With UPS From late 1986 through early 1988, DHL and DHLI negotiated with UPS concerning a potential merger. UPS was seeking to gain access to the operational portion of the DHL network outside the United States. UPS sought to accomplish that by purchasing all of the stock; subsequently, however, it focused on a purchase of the assets of DHLI, MNV, and DHL. UPS showed little interest in the DHL trademark, and no attempt was made to value the DHL trademark for purposes of the negotiations. It was UPS’ intent to phase in its own name and phase out the DHL name over a transitional period extending about 1-3 years beyond acquisition. In 1987, UPS made a “final offer” of approximately $330 million for most of the assets of the DHL companies (excluding certain “carved out” assets that UPS did not wish to acquire). UPS did not agree to assume any liabilities in connection with this offer. The DHL trademark was included in the assets that UPS proposed to acquire. Including the carved- out assets, UPS’ offer would have been approximately in the $450 to $500 million range. The negotiations with UPS broke down and failed primarily because the parties could not agree on price. VII. 1990-92 Transaction With Foreign Investors On December 21, 1988, a group of foreign investors made their first generalized offer. Ultimately, the foreign investors were Japan Air Lines Co., Ltd. (JAL), Nissho Iwai Corp. (Nissho Iwai), and Deutsche Lufthansa Aktiengesellschaft (Lufthansa). - 38 JAL and Lufthansa are large, partly government-owned airlines. The foreign investors were interested in integrating their airline business with the DHL international delivery network. Initially, JAL and Nissho Iwai were interested in acquiring a stock and/or asset interest in the DHL network entities, including the DHL trademark. After extensive negotiations and the entry of Lufthansa into the dealings, on December 7, 1990, JAL, Lufthansa, and Nissho Iwai acquired a 12.5-percent stock interest in DHLI and MNV, an option to purchase an additional 45percent stock interest to achieve a collective controlling interest in those entities, and a 2.5-percent stock interest in DHL. As of August 18, 1992, the foreign investors exercised their stock purchase option. DHL, DHLI, their shareholders, and the foreign investors were represented in the negotiations by tax, merger and acquisition, corporate, and other specialized attorneys, investment bankers, accountants, and advisers. Hillblom was the principal shareholder who was most prominent in deciding the terms in the negotiations with the foreign investors. The foreign investors’ due diligence investigation was comprehensive and intensive with respect to the DHL companies’ finances, operations, and assets. The December 21, 1988, offer was made by two of the foreign investors (JAL and Nissho Iwai) to purchase up to 80 percent of the combined DHL network. The offer did not contain a purchase - 39 price and was conditioned on satisfying the U.S. Department of Transportation requirement that no more than 25 percent of DHL be foreign owned. Counsel for the foreign investors were also aware that a sale of DHL’s assets, including the trademark, for less than their fair market value could generate legal repercussions caused by minority shareholders or creditors. Allen, Po Chung, Robinson, and Hillblom did not want to divest 100 percent of their interest in the DHL entities. Hillblom, in particular, wanted to continue his interest in the resulting enterprise. JAL and Nissho Iwai concluded, before making an offer, that the combined value of DHLI and MNV was $450 million. Before determining that value, JAL and Nissho Iwai examined valuations by independent financial advisers and a market forecast by Arthur D. Little, Inc. On June 14, 1989, JAL and Nissho Iwai sent a letter of intent to the selling shareholders, offering to purchase not less than 60 percent of the stock or net assets of DHLI and MNV at a price based on the $450 million value for a 100-percent interest. The letter of intent indicated that the foreign investors would not acquire an interest in $80 million of DHL’s class B common stock held by DHLI. The foreign investors retained Coopers & Lybrand (Coopers) to prepare a report on the DHL operations, including DHL, MNV, and DHLI. The report, dated May 31, 1989, was based on information furnished by employees and representatives of the DHL entities, both through documents and in meetings and interviews. - 40 As part of the report, Coopers advised JAL that if common control of DHL, DHLI, and MNV existed, the Internal Revenue Service (IRS) might seek to impute a royalty for DHLI’s use of the DHL trademark. Also, because of concerns about DHL’s weak capitalization and lack of profits, Coopers recommended the infusion of equity capital into DHL while safeguarding it from transfer pricing problems. Coopers stated that no royalty should be charged DHL for continued use of the DHL trademark and that such a royalty would make it more difficult for DHL to achieve profitability. Coopers also noted that a 2-percent royalty might be imputed to DHL for its royalty-free license to DHLI. The foreign investors also wanted to ensure that DHL would continue to be a cooperating and effective component of the DHL network. They were also concerned about the possibility that DHL could experience financial difficulties or could be acquired by a competitor, and in that regard they wanted to control the DHL trademark, which they considered to be a valuable strategic asset. The DHL network was the main focus of the foreign investors. During May 1989, in accord with its advisers’ recommendation, JAL decided not to acquire more than a 20-percent equity interest in DHL to minimize JAL’s exposure to risks, including those that could occur with respect to U.S. taxation. The buyers’ and sellers’ representatives were aware of and discussed concerns that DHL could be exposed to liability, tax - 41 and otherwise, for royalties due from DHLI for prior use of the DHL trademark. It was estimated by the sellers’ representatives that the possibility of an imputed royalty could fall in the range of 4 to 6 percent of DHLI’s annual gross revenues. It was at a May 10, 1989, meeting that the sellers’ representatives proposed using the purchase of the DHL trademark as a vehicle for capitalizing DHL. It was proposed that any gain on the trademark sale could be offset by DHL’s net operating losses and that DHL could license the trademark from JAL and pay royalties, and DHL’s taxable income could thereby be reduced. The foreign investors retained the assistance of an investment banker, Robert Fleming & Co., Ltd. (Fleming), and in February 1989, Fleming prepared a preliminary draft report concerning valuation. Fleming placed a value ranging from $600 million to $1.3 billion on the global DHL business, depending on the methodology. Fleming also estimated that a prospective purchaser could expect to pay a premium of 40 to 45 percent to gain control. Fleming indicated that the DHL name, while intangible, does have a value that the vendors would expect to see reflected in the price. Fleming also suggested that the selling shareholders might demand additional consideration for the value of the DHL trademark in the range of 10 to 15 percent of the DHLI/MNV stock price. After a more complete due diligence, Fleming issued a second report dated June 9, 1989, which determined that DHLI and MNV had a value in a range from - 42 $392.2 to $680.4 million and that a control premium of 40 percent of the purchase price was appropriate. Peers & Co. (Peers), which advised JAL, produced its report dated June 9, 1989, determining that DHLI/MNV had a value ranging from $522 to $580.9 million and that a control premium of 40 to 60 percent of the purchase price was appropriate. During December 1989, the foreign investors’ objectives were to gain collective control of DHLI and MNV, recapitalize DHL, and insure DHL’s future financial viability. On June 14, 1989, the foreign investors sent letters of intent, offering to purchase the trademark for $50 million, subject to further evaluation by the parties, and not less than 60 percent of the stock in DHLI and MNV based on a $450 million value. JAL recognized that by owning the DHL trademark it could gain some control over DHL’s activities by including in any license agreement provisions preventing DHL from engaging in economically irrational conduct. DHLI would also be protected from DHL’s terminating the agency agreement. On June 21, 1989, the DHL shareholders advised JAL and Nissho Iwai, in writing, that although they did not agree to all the terms in the June 14, 1989, letter, they remained enthusiastic, and that further financial negotiations were necessary. The DHL shareholders’ main concern was price. JAL commissioned Arthur D. Little, Inc. (Little), a consulting firm, to conduct a market study for its negotiations. Little's March 31, 1989, report projected growth in the small - 43 package sector of the air cargo market between 1987 and 2000, depending on the geographical market. During June 1989, Nicholas Miller (Miller) of Coopers, who was assisting JAL and Nissho Iwai, prepared a rough estimate to illustrate a conceivable value for the DHL trademark outside the United States. Miller arrived at a $25 million estimate, which was provided to the foreign investors, who considered the information in their evaluation of the transaction. In reaching that estimate, Miller believed that the value of DHL’s trademark rights was diluted by the agreements between DHLI and DHL and DHLI’s rights and use. Miller’s $25 million estimate was based on the assumptions of $250 million of capital invested and pretax operating profits of $80 million. He then used a 30-percent return on capital, or $75 million, leaving a premium of $5 million, which he extended for 5 years to reach a $25 million estimate. The foreign investors viewed DHLI as having the right to use the DHL trademark during the current term of the mutual agency agreement without additional cost. In July 1989, Schwartz questioned the impact of the DHL trademark value on DHL’s tax position. DHL shareholders had proposed a $100 million value for the trademark. JAL and Nissho Iwai decided that they would offer $50 million to DHL for the dual purpose of purchasing DHL’s trademark rights and infusing capital into DHL. In their decision to make this offer, JAL and Nissho Iwai considered DHL’s need for capital and had considered - 44 their advisers’ reports and advice. The $50 million offer was part of a letter of intent to DHL, offering to purchase the worldwide DHL trademark. JAL and Nissho Iwai initially thought that the DHL trademark should be transferred to an entity owned by them, but they were also agreeable to the DHL trademark’s being owned by an entity in which the selling shareholders retained an interest, if the sellers bore a proportionate share of the $50 million purchase price. On June 21, 1989, the DHL shareholders advised the foreign investors of their disagreement with some of the terms of the letter of intent, and the price offered by the foreign investors was the key issue concerning the DHL shareholders. After that, the parties began negotiating a joint venture arrangement where the DHL shareholders would retain a 40-percent interest in DHLI and MNV. Additionally, Hillblom wanted to retain an interest in the DHL trademark if the joint venture arrangement were implemented, and he wanted to retain an interest in DHLI and MNV because of concern about future stock value if he relinquished control. During discussions of a joint venture between the DHL shareholders and the foreign investors in July 1989, the DHL shareholders advised that they wanted a put with a floor for their minority share, and they refused to grant JAL and Nissho Iwai a call on the remaining 40-percent interest, but they were - 45 willing to accept the initial price if they could share in the benefits of mutual affiliation by deferring the sale of a significant minority interest and enhance its value. In July 1989, JAL’s and Nissho Iwai’s advisers estimated that at least one-half of DHL’s value was attributable to the agency agreement and the goodwill of the DHL trademark. In late August 1989, JAL’s and Nissho Iwai’s advisers were advising that unless they increased the purchase price, the transaction would not be consummated. On September 14, 1989, Peers produced a revised report, valuing a 100-percent interest in DHLI/MNV at $625 to $700 million. In late September 1989, the parties discussed placing the foreign investors in a supermajority position on the boards of DHLI and MNV, and other provisions were devised to protect the DHL shareholders’ resulting minority interests against the foreign investors’ collective majority position. On September 28, 1989, JAL and Nissho Iwai extended an offer to acquire a 60-percent interest in DHLI/MNV based on a $450 million valuation of those companies, which was rejected by the DHL shareholders. During late September 1989, the DHL shareholders asked for a price based on values of at least $500 million for the DHLI and MNV stock and $100 million for the DHL trademark, which the foreign investors rejected. The DHL shareholders stated that the parties were so far apart that - 46 further negotiation at that time was useless, and the negotiations ceased. The negotiations resumed late in 1989. Nissho Iwai, without JAL, approached the DHL shareholders in October 1989 to see if they would sell control of DHLI/MNV for a purchase price based upon a total value for the entities of $670 million. The DHL shareholders reacted favorably. to Nissho Iwai’s actions. JAL objected Also in October 1989, Peers suggested to JAL that it purchase a 25-percent interest in DHLI/MNV. Peers advised that if JAL wanted a controlling interest, it would have to increase the purchase price to $650 million for DHLI/MNV and the DHL trademark with a 1-percent royalty. On October 19-20, 1989, Hillblom and Mitsuo Ando (a JAL principal) reached an understanding, which they recommended to their colleagues, under which JAL would purchase 50 percent of DHLI/MNV, Nissho Iwai would purchase 10 percent, and the DHL shareholders would retain 40 percent, based on a $450 million value of DHLI/MNV to determine the purchase price. JAL then advised that it would agree to the above terms only if it received control of the boards, and Hillblom rejected that offer. JAL then suggested buying, with Nissho Iwai, a 39-percent interest in DHLI/MNV. Hillblom believed that for control (51 percent or more) of DHLI/MNV, the purchase price had to be based on a valuation of $600 million or more; for less than control, the purchase price could be based on a valuation of $500 million. Allen strongly - 47 opposed the 39-percent offer. Historically, decisions were made by unanimous vote of the DHL shareholders. The DHL shareholders, especially Allen, were concerned that Hillblom was negotiating without their consent. On November 7, 1989, JAL and Nissho Iwai offered to purchase up to 40 percent of DHLI and MNV and the DHL trademark for a total price based on $500 million, with $50 million for the trademark. On November 20, 1989, the DHL shareholders advised that they would sell 30 percent of DHLI and MNV and the DHL trademark for a price based on a $500 million valuation. At that price, the DHL shareholders refused to grant JAL an option to acquire more shares, and JAL and Nissho Iwai would pay their pro rata share of the $50 million for the DHL trademark. Around December 1989, JAL informed the DHL shareholders that the DHL trademark could be sold for $50 million to an entity in which the selling shareholders could retain a majority interest. Another basic understanding was that the foreign investors could acquire an interest in DHLI and MNV, but no single investor could acquire more than 50 percent. About that time, Lufthansa entered the negotiations, and it was made aware that the price was not subject to change. Lufthansa was advised that the $50 million payment to DHL for the DHL trademark had been set based on DHL’s need for capital. Lufthansa’s counsel understood that the $50 million amount was not based on any appraisal or valuation of the DHL trademark. - 48 On December 1, 1989, the DHL shareholders made an offer by which JAL and Lufthansa could each purchase 25 percent of DHLI/MNV, Nissho Iwai could purchase 7.5 percent, and the DHL shareholders would retain 42.5 percent. Lufthansa accepted. JAL, Nissho Iwai, and The memorandum of understanding for the sale of DHLI/MNV shares to JAL and Nissho Iwai, executed in December 1989, provided for the purchase of shares as stated above (25 percent/25 percent/7.5 percent) at a price based upon a $450 million value of DHLI/MNV. DHL would sell the DHL trademark to the postalliance entity for $50 million, depending on the tax effect, and receive an exclusive royalty-free license for the use of the DHL trademark in the United States. The foreign investors were interested in an asset acquisition to minimize their exposure to liabilities from DHL’s past tax history. In a meeting with the DHL representatives during January 1990, JAL and Nissho Iwai representatives stated that one of their objectives was to establish a new structure for DHLI/MNV to minimize any such exposure. Also, in a January 1990 meeting among the parties’ representatives, the issue arose of whether the trademark sale could be considered a sale for $50 million plus the value of the 15-year royalty-free period, which could constitute additional income to DHL (the Alstores problem). On February 23, 1990, the parties drafted a supplement to reflect the addition of Lufthansa to the transaction. First Boston Corp., investment bankers retained by Lufthansa, valued - 49 DHLI/MNV at $400 to $600 million. It valued the DHL trademark at $100 to $200 million. The foreign investors initially understood that DHL owned all rights in the DHL trademark throughout the world. As their due diligence progressed, however, they became aware of certain inconsistencies, including the registrations of the DHL trademark in DHLI’s name throughout the world. The foreign investors never resolved these inconsistencies concerning the DHL trademark. Ultimately, it was agreed that, if the foreign investors exercised their stock purchase and trademark options, DHL would transfer all its rights in the trademark, including those it may have within and without the United States. DHL’s lenders consented to a trademark option agreement, but only on the conditions that: (1) DHL would “receive full value (as determined on an arms length-transaction basis) for the assets it transfers pursuant to * * * [that] Agreement”; (2) DHL would receive at least $50 million as consideration for the DHL trademark or as additional equity investments; and (3) DHL would receive a 15-year royalty-free license to use the DHL trademark. After the 15-year royalty-free period, DHL would have to pay .75 percent of its gross sales as a royalty for use of the DHL trademark. In a communication dated as late as May 10, 1990, DHL’s legal representative was representing to the lenders that DHL owned the trademark and licensed it to DHLI. - 50 At a time when the total price for the transaction had been fixed and the amounts to be allocated or assigned to various aspects were being negotiated, the foreign investors’ representatives were concerned about the bona fides of the transaction and that the amounts assigned to various assets were properly determined for tax purposes. There was concern that the focus had been on a $50 million cash infusion into DHL and not on the price, value, and/or tax attributes of the trademark aspect of the sale. The DHL shareholders and their representatives were concerned about the tax implications of selling the United States and worldwide rights to the DHL trademark. DHL’s representatives expressed the wish to the foreign investors’ representatives that the amount received for the trademark be minimized. One suggested approach to accomplish that was to form a Dutch holding company. The new entity would transfer the foreign DHL trademark rights to the holding company after purchasing them from DHL for $10 million in return for a majority interest in the holding company. DHL would also transfer the domestic DHL trademark rights to the holding company in return for a minority interest. The foreign investors did not agree to this approach, but they would consider a new or other proposals. Detailed and protracted negotiations ensued among the parties’ legal representatives, and several alternatives were proposed and discussed. - 51 On March 23, 1990, Hillblom met with JAL and Lufthansa principals to restructure the transaction into two steps. In the first step, JAL and Lufthansa would each purchase a 5-percent interest in DHLI/MNV, and Nissho Iwai would purchase a 2.5percent interest. JAL and Lufthansa would each be granted an option to purchase up to 25 percent of DHLI/MNV, and Nissho Iwai would be granted an option to purchase up to 5 percent. DHLI would be granted an option to purchase the DHL trademark, exercisable when the foreign investors exercised the option to purchase the additional DHLI/MNV shares. The foreign investors would receive current board representation based upon the number of shares they would own after the options were exercised. On April 20, 1990, DHL’s representative presented a structure to the foreign investors for the transfer of the DHL trademark in an attempt to minimize the tax effects. The original memorandum of understanding set a price of $50 million for the DHL trademark, and under the proposed structure the foreign investors would contribute $28.75 million and the DHL shareholders would contribute $21.25 million. DHL’s representative proposed the following structure: before the execution of a binding contract of sale between DHL and the foreign investors, the current agency agreement would be extended for 15 years, including the royalty-free license to DHLI; in the new agency agreement DHL’s right to terminate at will would be eliminated; and upon DHLI’s exercise of its trademark option, DHL - 52 would sell to DHLI an interest in the non-U.S. rights to the DHL trademark. DHL would also sell to DHLI the U.S. rights to the DHL trademark, to be encumbered by the 15-year royalty-free license to DHL. Both royalty-free licenses, as well as the elimination of DHL’s right to terminate the agreement at will, could reduce the value of the DHL trademark sold by DHL. The value of the rights sold was to be determined by an appraiser but would be valued as encumbered. The transfer of the DHL trademark from DHL to DHLI followed this basic structure. On April 27, 1990, DHL’s representative indicated that an appraisal of the DHL trademark would have to be obtained in order to set the exercise price. Because the transaction was taxable to DHL, the representative did not want the exercise price to exceed fair market value, and he noted that the DHL trademark would be encumbered at the time the option was granted by reciprocal long-term royalty-free licenses to DHLI and DHL, and the trademark should therefore be diminished in value. The July 9, 1990, trademark option agreement provided that, upon exercise of DHLI’s option to purchase DHL’s trademark rights, DHL would “retain an interest in the [DHL] Trademarks in the form of a fifteen-year royalty-free license to use the Trademarks in the United States”. At the time the trademark option agreement was signed, the parties were still working on a form of trademark license. Although there were drafts of a trademark license agreement and negotiations concerning a license - 53 agreement, no trademark license agreement was ever executed by the parties. Ultimately, the parties entered into a reservation of rights agreement, dated as of September 17, 1992, under which a DHL company ultimately conveyed: (1) The U.S. rights in the DHL trademark to Dutchco, a Dutch subsidiary of DHLI Bermuda; and (2) the non-U.S. rights in the DHL trademark, to the extent that DHL or DHL Airways owned any such rights, to DHLI Bermuda (Newco). Pursuant to that agreement, DHL retained the right to use the DHL trademark in the United States without payment of royalties until September 17, 2007, and if the 1992 agency agreement was renewed, Dutchco would give DHL an exclusive license to use the DHL trademark in the United States for 10 years, at a royalty of .75 percent of gross sales. The selling shareholders arrived at a $20 million value on DHL’s trademark rights. The parties agreed that Bain, who was familiar with DHL and DHLI from prior engagements, would do the appraisal. DHL’s legal representative in the transaction was responsible for obtaining the valuation of the DHL trademark from Bain. Bain stated that it was asked to value the DHL trademark on the assumption that it would be conveyed to Newco on a 10-year royalty-free basis. the value. On May 21, 1990, Bain began its analysis of On May 23, 1990, 2 days after Bain began its valuation of the DHL trademark, it sent a draft letter stating - 54 that Bain could provide some comfort on the issue before it and that the 1990 value of the right to the DHL trademark in the United States 15 years after the transaction was $20 million. DHL’s legal representative noted that Bain should value both U.S. and the foreign rights to the DHL trademark and that they should be valued currently but as encumbered by the 15-year royalty-free license of the international rights from DHL to DHLI and the 15year royalty-free license of the U.S. rights from DHLI to DHL. Petitioner’s representatives had some doubt about Cruikshanks’ view that DHLI owned the foreign rights to the DHL trademark. In a July 3, 1990, memorandum to Bain, DHL’s legal representatives explained DHLI’s potential ownership rights in the DHL trademark and Cruikshanks’ view that DHLI owned the foreign rights to the DHL trademark. Bain’s valuation took into consideration DHLI’s possible ownership rights. Bain appraised the trademark rights to be conveyed from DHL to DHLI at $20 million as of July 9, 1990. There is some confusion as to whether Bain’s valuation is a current value or a present value of a future interest. The trademark option agreement gave DHLI an option to purchase the trademark rights of DHL only if the foreign investors first acquired a controlling interest in DHLI. The final trademark purchase and sale agreement, dated as of September 17, 1992, allocated the $20 million option price at $17 million for the transfer of certain U.S. trademark rights to - 55 Dutchco, subject to the reservation of rights agreement, and $3 million to a quitclaim of DHL’s interest in the non-U.S. trademark rights in favor of Newco. The overall transaction with the foreign investors was to occur in two phases, so that the foreign investors would initially have a minority of the shares with control of 7 of the 13 seats on the boards of DHLI and MNV in order to learn more about the DHL network and consider the operational synergy before deciding to acquire majority interests in DHLI and MNV. JAL and Lufthansa could each appoint three board members, and Nissho Iwai was entitled to appoint one board member. The remaining six members of the board were to be appointed by the DHL shareholders. The number of board members to be appointed by the foreign investors was dependent upon whether each of them exercised its option to acquire additional ownership in DHLI/MNV in the second phase of the transaction. The foreign investors were also entitled to appoint 2 of the 11 board members of DHL, the remainder being appointed by the DHL shareholders. Under a share pledge agreement, dated December 7, 1990, Po Chung, Robinson, Hillblom, and Allen and/or their entities holding stock on their behalf, pledged their DHLI and MNV stock holdings to secure their obligations and liabilities to the foreign investors. On December 7, 1990, under the amended share purchase and option agreement, the foreign investors acquired 12.5 percent of - 56 the stock of DHLI and MNV for $53,125,000 in cash and 2.5 percent of the common stock of DHL for $3,125,000 in cash. The $56,250,000 combined purchase price represented 12.5 percent of $450 million, without considering the $3,125,000 allocated to the DHL stock. Of the 12.5-percent stock holdings in DHLI and MNV, JAL was to receive 5 percent, Nissho Iwai 2.5 percent, and Lufthansa 5 percent. There was no assurance in December 1990, however, that the foreign investors would exercise their options to acquire a controlling interest in DHLI when they acquired their initial 12.5-percent interest in DHLI and MNV. If the foreign investors had not been able to, or had chosen not to, exercise their option to acquire a controlling interest in DHLI and MNV, they would have had no right to recover the money they paid for their initial 12.5-percent interest in DHLI and MNV. In the second phase of the transaction, the foreign investors had an option to purchase, in similarly divided portions, an additional 45-percent interest of DHLI and MNV (for 45 percent of $450 million or $202,509,000). The foreign investors also had the Newco alternative, involving the reorganization of DHLI and MNV into a single entity. Under the Newco alternative, each of the foreign investors would contribute the difference between the amount already paid for the 12.5percent interest and an amount that would give JAL and Lufthansa a 25.001-percent interest and Nissho Iwai a 7.5-percent interest in Newco. DHLI would contribute, with certain exceptions, all - 57 its assets to Newco, the MNV shares would be contributed to Newco, and Newco would transfer its remaining 42.498 percent of its shares to the DHL participants, which included the controlling shareholders of the DHL network. The net economic result of the DHLI/MNV or Newco options was substantially identical, and in either event the foreign investors would provide $283,634,000 in cash and obtain a 57.502-percent interest in DHLI/MNV. Ultimately, the Newco approach was used, and its structure and the entities involved were changed several times before the transaction was consummated, but the net economic effect remained the same as outlined above. An August 18, 1992, agreement contained the final version of the Newco transaction, and its terms are outlined, along with a diagram to show the steps, in the appendix to this opinion. As of June 7, 1992, the foreign investors exercised their option to use the Newco alternative to acquire the assets of DHLI and MNV subject to the liabilities of each entity. Thereafter, the foreign investors, together, owned a majority (57.5 percent) of the stock of DHLI Bermuda (the successor to DHLI and MNV) and collectively appointed a majority of its board of directors, which governs by majority vote. On September 17, 1992, DHL’s assignee, conveyed to Newco DHLI’s interest in the non-U.S. DHL trademark. The board of directors of Newco was to be composed of six members, of whom one would be appointed by JAL, a second by Nissho Iwai, a third by Lufthansa, and a fourth by the DHL - 58 shareholders. The remaining two directors were to be appointed by vote of the other four directors. The JAL and Lufthansa directors were each entitled to three votes; the Nissho Iwai director, one vote; the DHL shareholders’ director, five votes; and the resident directors, one-half vote each. Around the time the second phase of the transaction was being completed, DHL’s representatives became concerned about a tax-related issue denominated the “Alstores problem” because of the holding in Alstores Realty Corp. v. Commissioner, 46 T.C. 363 (1966). To avoid the problem, DHL’s representatives proposed several alternative approaches to conveyance of the DHL trademark. Each alternative involved the present conveyance of non-U.S. rights and the retention of U.S. rights to the trademark by DHL for 15 years with a mechanism that permitted DHLI to obtain ownership of U.S. rights if DHL did not maintain certain minimum net worth requirements or on the happening of certain other events. Each alternative contemplated payment of $20 million, even though complete transfer of U.S. rights was not to be for 15 years. One of the foreign investor’s representatives, responding in the negative to the proposal, explained that the transfer of the trademark was to protect the right and interest of the foreign investors from unexpected situations, such as a takeover of DHL by its competitors. He further advised that the foreign investors had no inclination to accept any of the alternatives proposed unless it not only satisfied the DHL - 59 shareholders’ request to save taxes on DHL but also protected the foreign investors. Another representative of the foreign investors rejected the proposal and noted that the foreign investors expressed their willingness to be flexible in considering adjustments to the form of Newco’s ownership if such adjustments would assist DHL in its tax planning without sacrificing a key element of the business deal. During the period December 1990 to August 1992, the foreign investors occupied their positions on the boards of DHLI and MNV and acted in the roles of directors. The management of DHL, however, was maintained with the staffing that it had prior to the 1990 transaction. The foreign investors did not participate in the day-to-day management of DHLI and MNV in that period, although an employee of JAL and, on occasion, a few employees of Lufthansa worked in the Brussels office. There was also an Executive Committee of the board, consisting of one director appointed by each of the foreign investors and of the DHL and DHLI CEO’s. The Executive Committee's purpose, however, was to implement decisions of the board. The reservation of rights agreement (RORA) reserved to petitioners the exclusive right to use the trademark in the United States in the door-to-door package delivery business for 15 years, subject to: (1) Quality control provisions; (2) a termination clause that provided for termination if the agency - 60 agreement was terminated; (3) petitioners’ exercising reasonable diligence to prevent infringement; and (4) prompt notice of infringement. Petitioners had no right to decide whether to bring an infringement action. If an infringement action was brought, petitioners had to cooperate completely, had to prosecute the action, and had to bear the cost thereof unless Dutchco elected to control the action. Petitioners further covenanted that they would use their best efforts to promote the trademark, that they would not register any of the trademarks or any similar trademark in the United States or any other nation, and that they would not use the trademark of any competitor or use the DHL trademark in any way not authorized by the RORA. The RORA imposed quality controls on DHL’s manner and use of the trademark, and DHL could be required to change its manner and use. After the RORA was executed, DHLI decided issues relating to the use of the DHL trademark. The RORA granted petitioners a license to use the DHL trademark for 15 years royalty free. After the 15-year period, the RORA called for a royalty of .75 percent of DHL’s gross sales for its delivery business. Of the $20 million price for the DHL trademark, representatives for DHLI and DHL allocated $17 million to the U.S. rights and $3 million to the non-U.S. rights. - 61 VIII. The Imbalance and Transfer Fees DHL shipments of domestic origin to foreign destinations to be delivered through DHLI were termed “outbound” shipments. DHLI shipments of foreign origin to domestic destinations to be delivered by DHL were termed “inbound” shipments. Shipments of foreign origin with foreign destinations, but which passed through the United States and were handled by DHL, were termed “transfer” or “transit” shipments. Before 1983, actual imbalances of shipments were not tracked or reported by either DHL or DHLI/MNV. In December 1983, however, the DHL board recognized the need to examine the ratio of U.S. inbound to outbound deliveries, as well as the need for further study of the allocation of air transportation costs for on-forwarding of international shipments between U.S. points and a comparison of corresponding international on-forwarding of U.S. shipments. Before 1987, neither DHL nor DHLI was compensated if the outbound or inbound shipments exceeded one another. Likewise, before 1987, DHL received no compensation for handling transfer shipments. In a 1988 amendment to the 1974 MOA, provision was made for a cost plus 2 percent compensation on the imbalance of shipments (imbalance fee). DHL’s system of determining imbalance shipments and applying cost plus a percentage markup was modeled after the system used by postal authorities throughout the world. The imbalance fee was implemented for the taxable year 1987 and - 62 forward, although only costs were paid for 1987. The imbalance fee was calculated by netting the inbound and outbound shipments and applying the cost plus 2 percent markup to the difference. The imbalance cost factor was each company’s average cost of delivery of packages of any weight and size within its respective territories, determined annually. The imbalance fee was calculated using shipment units without considering the weight of any particular shipment. In 1987, the U.S. Department of Transportation (DOT) questioned whether the memorandum of agreement, as it existed before 1987, adequately compensated DHL for the services performed by DHL for DHLI/MNV. During due diligence for the 1990 and 1992 transactions, DHL management expressed doubt that the cost plus 2 percent markup adequately compensated DHL for its services to DHLI/MNV. Coopers also questioned whether the cost allocation system accurately reflected the costs incurred by DHL in delivering shipments for DHLI/MNV. On average, more than one-third of the DHL network’s international shipments emanated from or were delivered in the United States, not including shipments that DHL transferred for DHLI/MNV in transit from one foreign locale to another. The DHL cost information models used to calculate the imbalance fee and the transfer fee were developed by Bain in 1987 and were denominated “Product Line Profitability” (PLP) models. DHLI also employed a model that was developed by Bain in 1989. - 63 Based on available data for the years 1984 through 1986 (before development of PLP), it was determined that DHLI suffered an imbalance of 65,000 shipments in 1984, an imbalance of 496,000 shipments in 1985, and an imbalance of 333,000 shipments in 1986. The net imbalance of shipments for 1987 through 1992 was as follows: Year DHLI’s Shipments In Excess of DHL’s DHL’s Shipments In Excess Of DHLI’s 1987 1988 1989 1990 1991 1992 452,439 458,423 343,342 18,774 ----- --------162,746 212,127 For 1989 through 1992, the following table shows the reconciled shipment imbalances between DHL and DHLI: Year Shipments from DHL to DHLI Shipments from DHLI to DHL DHLI’s or (DHL’s) Net Imbalance 1989 1990 1991 1992 5,795,812 6,742,804 7,155,582 7,888,518 6,139,154 6,761,578 6,992,836 7,676,391 343,342 18,774 (162,746) (212,127) Shifts in the imbalance were expected at the time the imbalance fee formula was negotiated. The imbalance suffered by DHLI grew each year from 1991 through 1996. The imbalance fee negotiated between DHL and DHLI and included in the 1988 agency agreement was used in the 1990 - 64 and 1992 agency agreements, after the foreign investors became involved in DHLI, and continued through the time of trial. A costing model (with the acronym “PRISM”) developed by Bain for DHLI is used for pricing, budgeting, and planning purposes and is also used in the imbalance fee calculation between DHLI and DHL. For 1991, DHLI computed its per-unit cost of delivering documents and dutiable parcels from DHL at $10.59 and $30, respectively. For 1992, the document and dutiable parcel delivery costs were $10.49 and $28.70, respectively. The actual weighted average costs, including the 2-percent markup used by DHL for 1990 and DHLI for 1991 and 1992, were $10.19, $15.25, and $15.25, respectively. The 1988 amendment also provided for a cost plus 2 percent payment to DHL for its cost of handling transfer shipments. DHLI paid this transfer fee to DHL, and DHLI did not perform a similar function for DHL. Before 1987, DHL paid a fee to DHLI for delivery of outbound shipments to certain remote or higher cost destinations (onforwarding fee). The on-forwarding fee was charged to DHL to cover DHLI’s cost of delivering shipments from the first international gateway to approximately 10 remote or higher cost destinations. The transfer cost factor was computed annually as DHL’s average cost of handling a transfer shipment. For 1987, DHL received its costs without the 2-percent markup for the transfer shipments. The on-forwarding fee was eliminated after 1986. The - 65 transfer fee was determined by multiplying the estimated number of transfer shipments by DHL’s average cost of handling such a shipment, and (beginning in 1988) by adding a 2-percent markup to average cost. Before 1987, DHL and DHLI/MNV did not employ any method to determine the average cost per shipment or the volume of transfer shipments. From 1987 through 1990, the cost data used in the transfer fee formula were taken from the PLP model. The shipment volumes used in the transfer fee formula were not readily available when the transfer fee was instituted because DHL did not focus on how shipments were routed. To determine percentages of transfer shipments for 1987 and 1988, the number of transfer shipments was estimated by counting shipments originating in or destined for a Latin American country, Mexico, and/or Canada, with appropriate adjustments, and interviews with gateway managers. For 1989, the number of transfer shipments was estimated by taking a percentage (based on 1987 and 1988 data) of international inbound shipments. Annual transfer shipments for 1990 were estimated by sampling transfer shipments for 1 week, calculating a daily transfer shipment volume, and applying the percentage of daily transfer shipment volume to total annual Western Hemisphere shipments. The same procedure was used for 1991 as had been used in 1990, but using a 2-week sampling. A more refined transfer shipment cost calculation was devised for 1991. - 66 The transfer fee was carried forward in the 1990 and 1992 agency agreements after the foreign investors became involved in DHLI. IX. Technology and Systems Generally, DHL and DHLI each developed its own technology and systems. Several software applications, however, developed by or for DHLI were adapted and used by DHL, and DHL sold DHLI rights to certain laser technology in 1984. The sale price was $14.5 million, consisting of $10 million for the technology rights and $4.5 million for technical services. The technology had been developed between 1982 and 1984 by NetExpress, Inc. (NetExpress), with funding from DHL. DHLI did not use the laser system in its original form; instead, it was used after modifications. The major reason for the sale of the laser technology was to raise capital for DHL during a period of acute financial problems. In addition to the technology that DHL and DHLI each developed for its own use, certain shared technology was developed to enable DHL and DHLI to exchange information electronically. Beginning in 1987, DHL and DHLI each paid for this shared technology service on a cost plus 10 percent basis. This shared technology was developed during the period 1982-92 by three companies: NetExpress; MRI, which managed the “Global MIS” group; and DHL Systems, Inc. (DHL Systems). - 67 The Global MIS group of MRI was formed in 1986. In 1987 and 1988, MRI/Global MIS was paid for management information services by DHL and DHLI in proportion to DHL’s and DHLI’s respective gross revenues, except for certain communications and other costs, which were paid on the basis of actual services. The management information services and technology functions performed by MRI were taken over by DHL Systems in 1989. During the years 1989-92, DHL Systems was paid for its services pursuant to an agreement between DHL and DHLI whereby DHL Systems was reimbursed for its costs in amounts proportionate to DHL’s and DHLI’s respective gross revenues, except where the anticipated benefits from particular projects could be allocated according to specific anticipated usages. This method of cost allocation was not changed with the advent of the foreign investors in 1990 or 1992. From 1986 through 1992, $178 million was expended for shared technology, consisting of approximately $40.5 million by DHL and $137.5 million by DHLI, or in a 22.8 percent to 77.2 percent ratio. NetExpress was incorporated in 1982 as an 80-percent-owned subsidiary of DHL. NetExpress had operated at a deficit, and in 1985 DHL sold to DHLI 200,000 shares of NetExpress stock for $20 per share, an arm’s-length price. DHL realized a $3.9 million taxable gain from the 1985 sale of NetExpress stock to DHLI. In 1982, DHL provided the initial funding for the NetExpress tracing and tracking technology referred to as LaserNet. The - 68 amount of the funding was $290,000. In 1983 and 1984, DHL made additional equity investments in and loans to NetExpress totaling $3,783,000. In 1985 and 1986, DHL advanced loans to NetExpress in the amounts of $3,107,128 and $6,000,000, respectively. In 1986, those loans were assigned from DHL to DHLI in exchange for an interest-bearing promissory note in the amount of $9,107,128. The transfers of NetExpress stock and loans to DHLI benefited DHL by enabling it to raise cash. When DHL Systems took over the technology functions of MRI in 1989, it was owned 50 percent by DHL and 50 percent by DHLI. As part of this transition, MRI’s technology assets were sold to DHL Systems. The sale price was established by an independent third-party appraisal and was borne by DHL and DHLI in proportion to their ownership of DHL Systems; i.e., 50 percent by DHL and 50 percent by DHLI. X. Respondent’s Determination Before issuance of the notices of deficiency to petitioners, no revenue agent’s report was prepared and no international examiners’ reports were issued to petitioners. An economist’s report was prepared in connection with the examination, but was not provided to petitioners until a Court order compelled its production in pretrial discovery. The pre-notice audit process was protracted and did not operate on a free exchange of information basis. Respondent issued third-party summonses seeking information about petitioners, and petitioners would not - 69 agree to extend the assessment period, triggering the issuance of the notices of deficiency before respondent’s receipt of complete information. The pretrial and trial dialogue in these cases was contentious. The parties’ representatives gave no ground on any point and protracted the trial and pretrial activity. The trademark sale adjustments and royalty deficiency notice determinations were developed by respondent’s economist, Nicholas Baran (Baran). This was Baran’s first IRS examination, and he had never previously valued a trademark. His prior experience with discounted cash-flow analysis related to bank loan portfolios. Baran determined a worldwide value for the DHL trademark of $516,520,000 as of 1990 and $601,380,000 as of 1992. Baran valued the 1990 DHL trademark rights at $289,300,000 for domestic and $227,220,000 for foreign. Baran valued the 1992 DHL trademark rights at $350,870,000 for domestic and $250,510,000 for foreign. He valued the 1990 through 2004 DHL domestic trademark rights at $140,800,000, and valued those same rights beginning in the year 2005 at $148,500,000, as of 1990. Baran valued the 1992 through 2006 DHL domestic trademark rights at $170,370,000, and he valued those same rights beginning in the year 2007 at $180,500,000 as of 1992. Baran considered a royalty rate in a license agreement between DHLI and a controlled subsidiary as a standard for use in valuing the DHL trademark. He used a 3-percent royalty rate for - 70 his discounted cash-flow analyses and for his trademark royalty determinations. Baran relied upon a general industry survey of the licensing practices of unidentified companies. The trademark royalty adjustments proposed by respondent’s trial experts were less than the adjustments for the corresponding years in the deficiency notices. Walter Earl Huff (Huff) was used as an expert by respondent in connection with the determination of the imbalance fee, transfer fee, and network fee adjustments in the deficiency notices. Huff’s expertise is in the petroleum industry. Respondent acknowledged that the 1991 and 1992 deficiency notice determinations relating to the imbalance and transfer fees are incorrect because part of the amounts allocated to petitioners had already been reported on the 1991 and 1992 returns. Huff recommended a 15-percent cost plus markup method that was used in the deficiency notice adjustments. The notices of deficiency contained the same cost plus 15 percent markup method for the transfer fee adjustment as they did for the imbalance fee adjustment. Respondent’s trial expert on the transfer and imbalance fees advocated a 4-percent cost plus markup. In determining the imbalance and transfer fee adjustments, Huff applied the 1987 adjustment amount, $2,019,600, to the years 1975 through 1986 and a prorated amount for 1974, even though the shipment volumes were much higher in 1987. Huff did not subtract the trademark royalties, imbalance fees, and transfer fee - 71 allocations from the network fee allocation, causing some duplicate income allocation. In proposing the network fee adjustment, Huff based his conclusion on available information, and he did not think it necessary to analyze DHL’s profitability on international outbound and domestic shipments. OPINION I. Background The nucleus about which the controverted issues revolve is a transaction among the shareholders of petitioners and related foreign DHL corporations and foreign investors. Those investors collectively became the majority shareholders in the related foreign DHL entities. That transaction involved the sale of more than 50 percent of the portion of the DHL network outside the United States. Respondent determined that section 482 should be employed to allocate income among petitioners and the related foreign corporations. Those allocations involve the sale and use of trademark and the exchange and performance of services with the potential for arm’s-length pricing issues. In particular, respondent determined that, between controlled entities, the DHL trademark was sold for less than its fair market value, that DHL, as owner of the trademark, failed to charge royalties for DHLI’s use of same, that the controlled corporations did not charge or charged less than an arm’s-length amount for services between them, and that part of DHLI’s income was allocable to DHL. - 72 Under section 482, the Commissioner has broad authority to allocate income among commonly controlled corporations to prevent the artificial shifting of net incomes of controlled taxpayers and to place them on a parity with uncontrolled, unrelated taxpayers. 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. The Commissioner’s section 482 determination must be sustained absent a showing that he has abused his discretion. Paccar, Inc. v. Commissioner, 85 T.C. 754, 787 (1985), affd. 849 F.2d 393 (9th Cir. 1988). Consequently, the taxpayer bears the heavier than normal burden of proving that the Commissioner’s section 482 allocations are arbitrary, capricious, or unreasonable. 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. American Terrazzo Strip Co., Inc. 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 - 73 employed. Bausch & Lomb, Inc. v. Commissioner, supra at 582; see also Eli Lilly & Co. v. United States, 178 Ct. Cl. 666, 372 F.2d 990, 997 (1967). II. Were Respondent’s Determinations in the Notices of Deficiency Arbitrary, Capricious, or Unreasonable? As explained above, taxpayers generally bear a heavier than normal burden of proving that the Commissioner’s section 482 allocations are arbitrary, capricious, or unreasonable. Petitioners argue that their burden should be lessened once they can show that the notices of deficiency are arbitrary, capricious, or unreasonable. Petitioners contend that the determinations in the notices are significantly different from the determinations advanced by respondent’s experts at trial. Because of that and a procedural question, petitioners assert that their burden in these cases should be to show, by only a preponderance of the evidence, that the prices with any commonly controlled entities were consistent with an arm’s-length price, citing Seagate Tech., Inc. & Consol. Subs. v. Commissioner, supra at 164. Respondent contends that the actions taken and determinations made were reasonable under the circumstances. Initially, petitioners point out that respondent did not issue or provide petitioners with any notice or report of the proposed adjustments before issuance of the notices of deficiency. Petitioners then outline four instances where they contend that respondent’s notice determinations were either - 74 abandoned and/or ignored, and differing amounts and/or theories were advanced by respondent through expert witnesses. Respondent does not deny that petitioners were not provided reports before the issuance of the notices of deficiency. Respondent generally explains that pre-notice reports were not compiled and/or provided because petitioners postponed meetings, delayed production, were uncooperative, and attempted to “mislead” respondent with respect to the relationship between DHL and DHLI. In that regard, the Court has observed that, throughout the pretrial and trial portions of these cases, the parties were contentious and intractable. During the pretrial and trial portions of these cases, respondent’s third-party summonses seeking information about petitioners remained in litigation in other courts. In the proceedings before this Court, the parties’ representatives gave no ground on any point, causing, in some instances, the unnecessary protraction of the trial and parts of the pretrial portion of these cases. Petitioners did not agree to extend the period for assessment, triggering issuance of the notices of deficiency prior to respondent’s receipt of complete information. The production of documents and responses to interrogatories by petitioners lingered beyond the commencement of the trial and necessitated certain procedural adjustments to accommodate generally dilatory compliance by petitioners and the untimely receipt of information by respondent. This pattern of - 75 activity likely permeated the administrative portion of these cases, as respondent contends. As a result, respondent’s determinations were based on the information that had been made available. The issues in these cases are, in substantial part, factual and concern the value or price of an asset or service. A vastly disproportionate amount of the transcript and record consists of a “battle of experts”. After the notice of deficiency was sent, respondent received substantial amounts of information that had not been available to respondent prior to the issuance of the deficiency notices. Respondent’s experts used that information to reach their conclusions. The adjustments in respondent’s notices exceeded the amounts respondent’s experts opined for purposes of trial. The examples cited by petitioners in support of their position include the trademark determination. During the administrative portion of this controversy, respondent’s economist, Baran, estimated that the worldwide value of the DHL trademark was $516.5 million on the first of two valuation dates, and $601.4 million on the second. Respondent’s experts, using differing assumptions and factual information, reached substantially reduced amounts. Baran also developed a trademark royalty based on a 3-percent rate relying on certain comparables. He concluded that for the 1974 through 1992 period the arm’slength royalty should have been $232,109,000, whereas respondent’s trial experts, again using differing assumptions, - 76 concluded that arm’s-length royalties should be $83,129,000 for 1982 through 1992 or $57,095,000 for 1984 through 1992, respectively. With respect to imbalance and transfer fees, duplications were contained in the notices of deficiency. The imbalance adjustments included the cost of deliveries that had already been reported on petitioners’ returns. The determination, in addition to the cost amounts, added a 15-percent markup instead of the 2percent markup reported. Respondent’s trial expert, however, recommended a 4-percent markup, and respondent, for purposes of trial, conceded that the determination was overstated to the extent of the cost duplication portion of the above-described adjustment. Finally, with respect to the network fee, the adjustment contained some duplication. Respondent’s trial expert on this subject used a differing terminology to describe his proposed adjustment, and petitioners argue that either respondent has therefore abandoned the network fee adjustment set forth in the notices of deficiency or the network fee determination must be regarded as arbitrary, capricious, and unreasonable. Respondent counters that the network fee adjustment has not been abandoned and the approach taken in the notices and by the respondent’s trial expert are reasonable.3 3 Due to our holding on the network fee issue, it is unnecessary to decide the parties’ contentions. - 77 Petitioners seek to lessen their burden with respect to each and every section 482 adjustment in controversy. Petitioners’ burden is to show that each section 482 adjustment is arbitrary, capricious, and unreasonable. To do that, taxpayers normally show that the questioned transactions were conducted under an arm’s-length standard. For purposes of seeking a lesser burden, petitioners do not address the ultimate question of what the proper arm’s-length standard is. Instead, they argue that respondent’s notices of deficiency are generally arbitrary because of failure to provide advance notification of the proposed determinations and because each of the section 482 determinations differs from the amounts, positions, and evidence offered by respondent at trial. In Perkin-Elmer Corp. v. Commissioner, T.C. Memo. 1993-414, the Commissioner based the notice of deficiency section 482 determination on a particular theory and then abandoned that theory before trial. It was held that those circumstances were sufficient for the taxpayer to meet “its burden of showing respondent’s allocations to be arbitrary, capricious, or unreasonable.” Therefore the taxpayer in that case needed only to show that the questioned transactions were arm’s length. In National Semiconductor Corp. & Consol. Subs. v. Commissioner, T.C. Memo. 1994-195, the determinations in the notice of deficiency were based on a different methodology than the Commissioner’s expert relied on at trial. In addition to the - 78 differing methodology, the Commissioner’s proposed reallocations, for purposes of trial, were substantially lower than the notice determination amounts. Finally, at the trial in that case, the Commissioner did not support the notice determination and, instead, relied on the trial expert’s analysis of the case. In these cases, respondent’s failure to prepare or provide pre-notice reports is not a violation of petitioners’ rights. See Luhring v. Glotzbach, 304 F.2d 560 (4th Cir. 1962); Vallone v. Commissioner, 88 T.C. 794, 806-807 (1987); Estate of Barrett v. Commissioner, T.C. Memo. 1994-535, affd. 87 F.3d 1318 (9th Cir. 1996). Nor is respondent’s failure to provide pre-notice reports a procedural flaw that, per se, renders respondent’s notice determinations arbitrary, capricious, or unreasonable. That is especially true here where petitioners’ resistance and dilatory approach was, to some extent, the cause of respondent’s agents’ inability to provide pre-notice reports to petitioners. For the most part, petitioners complain of the excessive nature of respondent’s notice determinations or that respondent’s trial experts’ reports and testimony would support substantially smaller income tax deficiencies. That, in itself, does not make respondent’s determinations arbitrary. essence of the controversy here. Those matters are the Respondent’s trial and briefing positions do not result in an increased adjustment from those in the notices of deficiency. Nor has respondent advanced a new legal theory or issue for which respondent would bear the burden - 79 of proof. Unlike the circumstances in Perkin-Elmer Corp. v. Commissioner, supra, respondent has not abandoned the notice positions and advanced new ones.4 Petitioners have not shown that any of respondent’s section 482 determinations are arbitrary, capricious, or unreasonable on the basis of the information available to respondent at the time of the issuance of the notices of deficiency.5 We hold that respondent’s failure to provide pre-notice reports, either alone or in conjunction with the larger amounts determined in the notices as opposed to the trial position amounts, does not provide a predicate for the remedial action sought by petitioners. In this setting, respondent’s notice determinations were not shown to be arbitrary, capricious, or unreasonable. Although respondent’s trial position amounts are considerably less than the amounts determined in the notices, with the exception of the network fee adjustment, respondent’s notice positions were not abandoned or ignored. To some extent, the reduced adjustments 4 Our reference to “positions” here does not include the “network fee adjustment”. 5 Petitioners ask us to judge respondent’s actions in the notices of deficiency. Obviously, we cannot judge whether respondent’s determinations were arbitrary, capricious, or unreasonable on the basis of the information available to respondent after the trial record has been made, unless that information was available to respondent when the determination was made. In the context of petitioners’ preemptive approach, we consider respondent’s actions on the basis of the knowledge that was made available by petitioners. To do otherwise would encourage taxpayers to keep from the Commissioner the information they possess and then criticize the Commissioner’s lack of information to the taxpayers’ advantage. - 80 proposed by respondent at trial are attributable to information acquired by respondent after issuance of the notices of deficiency. Ultimately, the factual information exchanged by the parties and then offered into evidence forms the basis for our opinion. The amounts decided are considerably less than the amounts determined in the notices. The decided amounts, however, fall somewhere in between the extreme trial positions of the parties. The large difference between the amounts contained in respondent’s notices and those proposed at trial and the differences between the parties’ trial positions are largely attributable to the assumptions adopted by the parties’ experts. For example, respondent’s in-house expert used a 15-percent markup on the imbalance costs, whereas respondent’s trial expert used a 4-percent markup. Ironically, because petitioners’ expert advocated a full cost approach to the imbalance adjustment, he was able to appear magnanimous by using the same 15-percent markup that had been used by respondent’s in-house expert in the notice. This serves to illustrate that differences in assumptions made large differences in the determinations and the parties’ positions. The assumptions relied on by respondent were not arbitrary, capricious, or unreasonable considering the circumstances here. Accordingly, respondent’s notice determinations, although resulting in determinations at the outside margins, represent a - 81 reasonable protective approach based on the information that was made available and the conditions extant at the time of the determination. Therefore, petitioners have not shown that they should be relieved from showing an abuse of discretion by respondent.6 III. The Question of Control Respondent’s authority to allocate income is predicated on the entities’ being commonly controlled. For purposes of section 482, “control” is broadly defined to include “any kind of control, direct or indirect, whether legally enforceable, and however exercisable or exercised.” Tax Regs. Sec. 1.482-1A(a)(3), Income In determining whether entities are commonly controlled, the courts look to “reality of control” rather than just to actual stock ownership. Grenada Indus., Inc. v. Commissioner, 17 T.C. 231 (1951), affd. 202 F.2d 873 (5th Cir. 1953). Further, when the interests controlling one entity and those controlling another have a common interest in shifting income from the former to the latter, entities may be considered commonly controlled. This is especially true where one entity deals with another on other than an arm’s-length basis. Sec. 1.482-1A(a)(3), Income Tax Regs. 6 Ultimately, our ruling on this aspect has no effect on the outcome of the issues. In one instance, petitioners showed an abuse of discretion; in all others the outcome was based on a preponderance of the evidence to decide fair market value or arm’s-length prices. The ultimate findings or holding generally fell somewhere in between the parties’ trial positions. - 82 Because petitioners argue that DHL and DHLI were operated in a separate manner, and because of the two-step progression of the transaction with the foreign investors, the question of control must be addressed at three different points. First, there is the period prior to 1990 when there was some common stock ownership between DHL and DHLI. Then we must consider the interim period 1990 to 1992 when the foreign investors collectively had less than a majority of the stock holdings and had a majority of the DHLI board seats. And finally, there is the period after the foreign investors exercised their “option” collectively to acquire a shareholding majority. Until the time of trial, petitioners denied the existence of any common control within the meaning of section 4 [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3Ab96f54577e66543e. Public record. Not legal advice.