UNITED STATES TAX COURT

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T.C. Memo. 2006-153

UNITED STATES TAX COURT

FEDERAL HOME LOAN MORTGAGE CORPORATION, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 3941-99, 15626-99.

Filed July 25, 2006.

At the close of business on Dec. 31, 1984, P had

30 debt instruments outstanding on which it paid

effective contract interest rates that were below

current interest rates that P would have incurred had

it issued comparable debt instruments. P’s right to

use the proceeds of these financing arrangements with

below-market interest rates constitutes an economic

benefit generally referred to as “favorable financing”.

In a prior Opinion, we held that special legislative

provisions entitled P to use the fair market values of

its intangible assets on Jan. 1, 1985, as its bases for

purposes of amortization. Fed. Home Loan Mortgage

Corp. v. Commissioner, 121 T.C. 125 (2003). In another

prior Opinion, we held that the benefit of below-market

financing can, as a matter of law, constitute an

intangible asset which P may amortize if it establishes

a fair market value and a limited useful life. Fed.

Home Loan Mortgage Corp. v. Commissioner, 121 T.C. 254

(2003).

- 2 P calculated the fair market value of its

favorable financing intangible assets to be

$428,391,551 using the market approach; the market

approach compared the adjusted issue prices of P’s debt

instruments to their market prices on Jan. 1, 1985. P

calculated the limited useful lives of its 30 debt

instruments to be their average weighted lives. R

argues that P’s favorable financing had no value and

was not an asset. R also argues that P did not

properly adjust for the volatility of the market in

determining the useful lives.

Held: P may amortize its favorable financing

intangible assets because it reasonably estimated the

fair market value of its favorable financing to be

$428,391,551 and reasonably estimated the remaining

limited useful lives.

Robert A. Rudnick, B. John Williams, Jr., James F. Warren,

Alan J.J. Swirski, and Richard J. Gagnon, Jr., for petitioner.

Gary D. Kallevang, John A. Guarnieri, Ruth M. Spadaro, and

Charles E. Buxbaum, for respondent.

CONTENTS

MEMORANDUM FINDINGS OF FACT AND OPINION . . . . . . . . . . . . 3

FINDINGS OF FACT

. . . . . . . . . . . . . . . . . . . . . . . 5

Favorable Financing Intangible Assets . . . . . . . . . . 6

Ginnie Mae Bonds . . . . . . . . . . . . . . . . . . 7

Notes Issued to Federal Home Loan Banks . . . . . . . 7

Debenture . . . . . . . . . . . . . . . . . . . . . . 7

Note Payable to North Dakota Bank . . . . . . . . . . 8

Capital Debentures . . . . . . . . . . . . . . . . . 8

Zero Coupon Bonds . . . . . . . . . . . . . . . . . . 8

Collateralized Mortgage Obligations (CMOs) . . . . . 8

Guaranteed Mortgage Certificates (GMCs) . . . . . . 10

II.

Average Weighted Lives of the Debt Instruments . . . . .

III. Tax Returns

. . . . . . . . . . . . . . . . . . . . . .

- 3 OPINION . . . . . . . . . . . . . . . . . . . . . . . . . . .

The Values of Petitioner’s Favorable Financing

Intangible Assets . . . . . . . . . . . . . . . . . . . 21

Petitioner’s Valuation of Its Favorable Financing

Intangible Assets as of January 1, 1985 . . . . . . 21

Respondent’s Position That Favorable Financing Has No

Value . . . . . . . . . . . . . . . . . . . . . . . 27

1. Expectation of Income . . . . . . . . . . . . . 28

2. Realization of Value . . . . . . . . . . . . . 30

3. Contra-Liability Theory . . . . . . . . . . . . 31

a. Favorable Financing Is an Asset . . . . . 32

b. Favorable Financing Can Be Assigned a

Separate Value . . . . . . . . . . . . . 33

c. Double Counting the Value . . . . . . . . 35

4. Petitioner’s Purchase of Its Debt Obligations

Would Result in Discharge of Indebtedness

Income . . . . . . . . . . . . . . . . . . . . 37

Respondent’s Argument That the Value of Petitioner’s

Favorable Financing Is Limited to the Value of

Petitioner’s Income Spread . . . . . . . . . . . . 38

Respondent’s Argument That Taxes Reduce the Value of

Favorable Financing . . . . . . . . . . . . . . . . 43

II.

Favorable Financing Intangible Assets Have a Reasonably

Estimable Useful Life As of January 1, 1985 . . . . . .

III. Conclusion . . . . . . . . . . . . . . . . . . . . . . .

APPENDIX:

Investment Bank Bid Prices . . . . . . . . . . . .

MEMORANDUM FINDINGS OF FACT AND OPINION

RUWE, Judge:

In docket No. 3941-99, respondent determined

deficiencies in petitioner’s Federal income tax of $36,623,695

for 1985 and $40,111,127 for 1986.

Petitioner claims

overpayments of $9,604,085 for 1985 and $12,418,469 for 1986.

In docket No. 15626-99, respondent determined deficiencies

in petitioner’s Federal income tax of $26,200,358 for 1987,

$13,827,654 for 1988, $6,225,404 for 1989, and $23,466,338 for

- 4 1990.

Petitioner claims overpayments of $57,775,538 for 1987,

$28,434,990 for 1988, $32,577,346 for 1989, and $19,504,333 for

1990.

When petitioner was chartered, it was exempt from Federal,

State, and local taxation, except for real estate tax imposed by

any State or local taxing authority.

Pursuant to the Deficit

Reduction Act of 1984 (DEFRA), Pub. L. 98-369, sec. 177, 98 Stat.

709, petitioner became subject to Federal income tax effective

January 1, 1985.

In a prior opinion, Fed. Home Loan Mortgage

Corp. v. Commissioner, 121 T.C. 129, 147 (2003), we held “that

petitioner’s adjusted basis for purposes of amortizing intangible

assets under section 167(g)[1] is the higher of regular adjusted

cost basis or fair market value as of January 1, 1985.”

ref. omitted.)

(Fn.

In another prior opinion, Fed. Home Loan Mortgage

Corp. v. Commissioner, 121 T.C. 254, 272 (2003), we held that

“The benefit of petitioner’s below-market financing can, as a

matter of law, constitute an intangible asset which could be

amortized if petitioner establishes a fair market value and a

limited useful life as of January 1, 1985.”

The benefit of

below-market financing is generally referred to as “favorable

financing”.

In this opinion, we decide whether petitioner has

Unless otherwise indicated, all section references are to

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

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

Procedure.

- 5 established that its favorable financing intangible assets have

fair market values that may be reasonably estimated and have

ascertainable limited useful lives as of January 1, 1985.2

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulations of facts and the attached exhibits are

incorporated herein by this reference.

At the time the petitions

were filed, petitioner’s principal office was in McLean,

Virginia.

Congress created petitioner in 1970 to promote access to

mortgage credit throughout the United States by increasing the

liquidity of mortgage investments and improving the distribution

of investment capital for mortgage financing.

Since its

incorporation, petitioner has facilitated investment by the

capital markets in single-family and multifamily residential

mortgages in two ways.

First, petitioner has acquired mortgages

from originators and resold them in securitization transactions,

principally by pooling the mortgages and issuing participation

certificates (PCs).

Second, petitioner bought mortgages from

originators and held them until maturity in its retained mortgage

portfolio, generally financing this activity by issuing various

This issue is one of several involved in these cases. See

Fed. Home Loan Mortgage Corp. v. Commissioner, 125 T.C. 248

(2005); 121 T.C. 129 (2003); 121 T.C. 254 (2003); 121 T.C. 279

(2003); T.C. Memo. 2003-298.

- 6 debt instruments.

Petitioner financed approximately 10 percent

of its mortgage purchases through the issuance of long-term

debt.3

Favorable Financing Intangible Assets

At the close of business on December 31, 1984, petitioner

had outstanding long-term indebtedness on a number of debt

instruments.

The effective contract interest rates4 on some of

these outstanding long-term debt obligations were below the

interest rates that petitioner would have incurred on January 1,

1985, had it issued comparable debt instruments in the market for

the remaining term of the particular debt instrument.

Petitioner’s favorable financing intangible assets consisted of

the benefits it derived from financing arrangements that required

it to pay interest at rates below those prevailing in the

financial markets as of January 1, 1985.

As of January 1, 1985, petitioner had the following 30

outstanding long-term debt instruments, which had below-market

interest rates and market prices that were lower than the

adjusted issue prices.

In this context, debt includes collateralized mortgage

obligations (CMOs) and guaranteed mortgage certificates (GMCs).

The effective contract interest rate is the adjusted

coupon interest rate (or for zero-coupon bonds, the adjusted

effective interest rate). The adjusted coupon interest rate

equals the sum of the coupon rate of interest, the hedging gain

or loss percentage, and any discount from the face value when the

debt obligation was issued.

- 7 A.

Ginnie Mae Bonds

Ginnie Mae Bonds G-15, G-16, and G-17 were mortgage-backed

bonds, which consisted of promissory notes secured by mortgage

loans owned by petitioner.

The underlying mortgages were held in

trust by petitioner as trustee as security for payment of the

bonds.

These mortgage-backed bonds were guaranteed as to

principal and interest by the Government National Mortgage

Association, a wholly owned corporation within the Department of

Housing and Urban Development.

Notes Issued to Federal Home Loan Banks

Notes F-8, F-12, F-15, F-18, F-11, and F-13 were promissory

notes payable to Federal Home Loan Banks (FHLB).

These notes

were passthroughs of the FHLBs’ own obligations.

Under the

Federal Home Loan Mortgage Corporation Act, Pub. L. 91-351, sec.

303(a), 84 Stat. 452 (1970), petitioner was deemed to be a member

of each FHLB and was entitled to borrow from those institutions

subject to certain security requirements.

Debenture

Debenture D-2 was issued under section 306(a) of the Federal

Home Loan Mortgage Corporation Act.

This debenture was an

unsecured general obligation of petitioner.

- 8 D.

Note Payable to North Dakota Bank

The note bearing code ND was a fixed-rate loan that

petitioner issued in a private transaction to the Bank of North

Dakota.

Capital Debentures

CD-1, CD-2, and CD-3 were capital debentures.

These capital

debentures were subordinated and junior in right of payment to

all obligations and liabilities of petitioner.

Zero Coupon Bonds

Petitioner issued zero coupon bonds Z-2 and Z-3, which were

subordinated capital debentures junior in right of payment to all

senior obligations of petitioner.

Zero coupon bonds have no

stated interest rate but are issued at a substantial discount to

face value.

At maturity, the holder is entitled to receive the

face of amount of the bond.

Collateralized Mortgage Obligations (CMOs)

CMO A-2, CMO A-3, and CMO C-4 were debt instruments secured

by mortgages which were outstanding on December 31, 1984.

These

CMOs were subject to put and call options; the call dates, put

dates, and final maturity dates were as follows:

- 9 Debt

Instrument

Call

Date1

Put

Date2

Final

Maturity Date

CMO A-2

CMO A-3

CMO C-4

N/A

6/15/03

1/31/04

N/A

6/15/08

1/31/04

12/15/95

6/15/13

1/31/09

The call date is the earliest date on which petitioner, if

it so chose, could repay the debt in full.

The put date is the earliest date on which the holder had

the right to require petitioner to pay any remaining unpaid

principal balance plus accrued interest.

Each series of CMOs was collateralized by pools of mortgages

owned by petitioner and held by it as trustee.5

Petitioner made

principal payments to holders in the greater amount of (1) the

minimum scheduled payments, or (2) monthly and other payments of

principal petitioner received on the mortgages serving as

collateral.

Petitioner structured the CMOs to permit holders of

certain classes to receive payment in full before other classes.

The terms of each CMO required petitioner to apply all

payments of principal and interest on the subject mortgages into

a sinking fund for the benefit of the holders.

Petitioner was

required to make payments to the sinking fund semiannually.

The

balance of the sinking fund was then used to make semiannual

principal payments on the senior class of bonds until they were

fully retired.

Thereafter, additional amounts of principal were

paid semiannually to the holders of the class of bonds next in

The mortgages used as collateral for the outstanding CMOs

as of Jan. 1, 1985, were entirely first lien, conventional

residential mortgages having fixed rates of interest.

- 10 seniority until those bonds were fully paid, and then on the same

basis to holders of the most junior classes.

The holders

received semiannual interest payments at the stated rate.6

The

holders of CMOs received payments of principal at a rate at least

corresponding to the schedule of minimum payments set forth in

the offering circular or prospectus.

The holders received

payments at a faster rate if the principal amount of the

mortgages that served as collateral paid down faster than implied

by the schedule of minimum payments.

Petitioner never had to

satisfy any minimum sinking fund obligation (i.e., cover a

deficit between funds received from mortgages and minimum

payments of principal to CMO holders).

Guaranteed Mortgage Certificates (GMCs)

GMC A 1975, GMC B 1975, GMC A 1976, GMC B 1976, GMC A 1977,

GMC B 1977, GMC C 1977, GMC A 1978, GMC B 1978, GMC C 1978, GMC A

1979, GMC B 1979, and GMC C 1979 were certificates guaranteed by

petitioner and denominated as representing an interest in a pool

of single-family mortgages held by petitioner as trustee.7

In some cases, interest on the most junior class of bonds

was not paid currently but accrued until the senior classes had

been paid in full.

Respondent issued to petitioner Priv. Ltr. Rul.

7607233060D (July 23, 1976), which states, in pertinent part:

Although the issuance of [Guaranteed Mortgage]

Certificates takes the form of a transfer to the

Certificate holders by * * * [petitioner] of undivided

(continued...)

- 11 The terms of each GMC series obligated petitioner to pay

interest at a rate stated on the face of its prospectus and to

repay the face amount of the certificate to the holder.

Principal payments were made annually.

GMC holders received

principal repayments in amounts equal to the greater of (1)

minimum scheduled payments, or (2) monthly and other payments of

principal petitioner received on the mortgages serving as

collateral.

Petitioner was unconditionally required to make

annual principal payments to the GMC holders in an amount at

least equal to the minimum levels specified, regardless of the

amounts of principal received from the underlying mortgages.

mortgages that served as collateral paid down the principal

amount faster than implied by the schedules of minimum payments,

GMC holders received payments of principal at a faster rate than

required by the schedule of minimum payments.

GMCs holders had

the option to require petitioner to purchase their certificates

(...continued)

interests in the Mortgages, the terms of the

Certificates are such that for Federal income tax

purposes * * * [petitioner] will not be selling

undivided interests in the Mortgages but will be

issuing debt obligations for which the Mortgages held

by the Trustee are security. * * *

On May 13, 1983, respondent revoked this private letter ruling

and related rulings. See Priv. Ltr. Rul. 8337016 (May 23, 1983).

Respondent does not presently regard GMCs as debt for tax

purposes; however, under the provisions of sec. 7805(b),

respondent has permitted petitioner to treat its GMCs issued

before May 23, 1983, including all of the GMCs at issue in this

case, as debt for tax purposes.

- 12 at the then-unpaid principal balance plus accrued interest at a

future date specified by the prospectus.

With respect to the 13 GMCs in issue, the put dates and the

final maturity dates were as follows:

Debt

Instrument

Put

Date

Final

Maturity Date

GMC A 1975

3/15/90

3/15/05

GMC B 1975

9/15/90

9/15/05

GMC A 1976

3/15/91

3/15/06

GMC B 1976

3/15/96

9/15/06

GMC A 1977

3/15/97

3/15/07

GMC B 1977

3/15/02

3/15/07

GMC C 1977

9/15/02

9/15/07

GMC A 1978

3/15/03

3/15/08

GMC B 1978

9/15/03

9/15/08

GMC C 1978

9/15/03

9/15/08

GMC A 1979

3/15/04

3/15/09

GMC B 1979

3/15/04

3/15/09

GMC C 1979

9/15/04

3/15/09

With the possible exception of GMC B 1975, petitioner made

minimum payments pursuant to the schedule for all GMCs on all

payment dates after March 1980 through September 1993.8

For GMC

Petitioner made minimum payments pursuant to the

respective schedule on GMC A 1978, GMC B 1978, GMC C 1978, GMC A

1979, GMC B 1979, and GMC C 1979 on all payment dates from the

inception of the GMC through March 1980.

- 13 B 1975, petitioner made minimum payments on all payment dates

after December 31, 1984.

Petitioner initially funded the acquisition of the mortgages

held as collateral for each of the CMOs and GMCs at issue by

means other than the issuance of those particular CMOs and GMCs.

When issuing its GMCs, petitioner disclosed that the proceeds

would provide funds for petitioner to engage in additional

activities consistent with its statutory purposes, including the

purchase of additional mortgages and interests in mortgages and

that some portion of the proceeds could be used to repay part of

petitioner’s borrowings.

When issuing its CMOs, petitioner

disclosed that the proceeds would be used to provide funds for

the corporation to finance its purchase of the mortgages securing

the CMOs.

With respect to the CMOs and GMCs, petitioner received

monthly payments of interest and principal on the mortgages that

served as collateral.

Petitioner made semiannual or annual

payments of principal and interest to the CMO and GMC holders.

Petitioner paid interest through the date of payment to the

holders on the outstanding principal balance of the CMOs or GMCs,

notwithstanding any receipt of principal amounts on the mortgages

serving as collateral since the previous date of payment.

Petitioner received spread and float income with respect to

the CMOs and GMCs.

Spread income is the amount by which the

- 14 effective interest income rate on the mortgages serving as

collateral exceeds the interest payments to the holders of the

CMOs and GMCs.

The float income is the interest on the monthly

principal and interest payments that could be earned between

receipt of the payments by petitioner and remittance to the CMO

and GMC holders.

The debt instruments in issue had issue dates, maturity

dates, outstanding principal on December 31, 1984, effective

contract rates, and market prices per $100 on January 1, 1985, as

follows:

Issue Date

Maturity

Date

Principal

Outstanding

On 12/31/1984

Effective

Contract

Interest

Rate1

Market Price Per

$100 on

1/1/19852

G-15

11/19/1970

11/27/1995

$70,000,000

8.681

87.335069

G-16

8/2/1971

8/26/1996

82,500,000

7.813

81.835069

G-17

5/25/1972

5/26/1997

150,000,000

7.250

70.381944

F-12

2/25/1977

2/25/1985

200,000,000

7.407

99.906250

F-15

2/27/1978

5/28/1985

200,000,000

8.158

99.890625

F-8

ll/25/1976

11/25/1985

40,000,000

8.442

99.187500

F-18

5/25/1979

2/25/1986

200,000,000

9.581

99.937500

F-11

10/25/1973

11/26/1993

400,000,000

7.412

77.000000

F-13

2/25/1977

2/25/1997

300,000,000

7.910

75.687500

D-2

3/30/1983

3/30/1990

300,000,000

10.937

98.062500

7/1/1975

11/1/1986

11,363,000

7.750

95.968750

CMO-A2

6/15/1983

12/15/1995

350,000,000

11.162

97.664063

CMO-A3

6/15/1983

6/15/2013

435,000,000

11.803

96.390625

CMO-C4

1/31/1984

1/31/2009

85,052,100

12.403

94.890625

Z-2

11/29/1984

11/29/2019

212,584,000

10.252

2.703125

Z-3

11/30/1984

11/30/1994

11.820

31.458333

Debt

Instrument

79,678,000

- 15 CD-1

12/26/1978

12/27/1988

150,000,000

9.412

94.671875

GMC A-75

2/25/1975

3/15/2005

98,100,000

8.200

92.437500

GMC B-75

2/25/1975

9/15/2005

63,400,000

8.750

93.125000

GMC A-76

2/25/1976

3/15/2006

70,600,000

8.550

92.593750

GMC B-76

8/25/1976

9/15/2006

75,600,000

8.375

88.000000

GMC A-77

1/25/1977

3/15/2007

77,600,000

8.050

88.937500

GMC B-77

5/25/1977

3/15/2007

94,000,000

8.125

85.875000

GMC C-77

11/25/1977

9/15/2007

108,200,000

8.200

83.468750

GMC A-78

6/1/1978

3/15/2008

186,000,000

8.850

86.250000

GMC B-78

9/1/1978

9/15/2008

98,800,000

9.000

87.218000

GMC C-78

12/4/1978

9/15/2008

98,800,000

9.400

89.656250

GMC A-79

2/1/1979

3/15/2009

114,000,000

9.875

92.125000

GMC B-79

6/4/1979

3/15/2009

114,000,000

10.250

93.875000

GMC C-79

8/2/1979

9/15/2009

114,000,000

10.000

91.937500

See supra note 4.

The market prices per $100 on Jan. 1, 1985, are based upon petitioner’s

calculations. Respondent’s calculations of the market price per $100 on Jan. 1,

1985, are slightly different. Respondent agrees that this difference is not

significant.

This figure represents the outstanding principal on Dec. 31, 1984. Because

Z-2 did not pay interest periodically, the principal amount at maturity will equal

$7 billion.

This figure represents the outstanding principal on Dec. 31, 1984. Because

Z-3 did not pay interest periodically, the principal amount at maturity will equal

$250 million.

II.

Average Weighted Lives of the Debt Instruments

The average weighted life represents the time it takes for

the average dollar of principal borrowed to be repaid to the

lender.

When principal repayment can vary, or when there is a

chance an option will be exercised to retire the security early,

the average weighted life is calculated using certain assumptions

regarding principal payment rate and exercise timing.

The

expected remaining average weighted life of each debt instrument

- 16 as of January 1, 1985, depends on:

(1) The remaining term to

maturity; (2) whether the debt was subject to any call or put

options; and (3) whether any principal repayments would be made

pursuant to either a mandatory schedule or terms that provided

for repayment of principal on the debt based on the rate of

principal repayments received on the mortgages serving as

collateral.

On January 1, 1985, the average weighted lives of

petitioner’s 30 debt instruments in issue were as follows:

Debt

G-15

G-16

G-17

F-8

F-11

F-12

F-13

F-15

F-18

D-2

Z-2

Z-3

CD-1

GMC A 1975

GMC B 1975

GMC A 1976

GMC B 1976

GMC A 1977

GMC B 1977

GMC C 1977

GMC A 1978

GMC B 1978

GMC C 1978

GMC A 1979

GMC B 1979

GMC C 1979

CMO A-2

CMO A-3

CMO C-4

Average weighted life

5 years,

6 years,

12 years,

5 months

8 months

5 months

11 months

8 years, 11 months

2 months

12 years, 2 months

5 months

1 year, 2 months

5 years, 3 months

34 years, 11 months

9 years, 11 months

1 year, 8 months

4 years, 0 months

3 years, 4 months

3 years, 9 months

3 years, 10 months

5 years, 6 months

4 years, 9 months

6 years, 3 months

8 years, 2 months

8 years, 5 months

7 years, 4 months

6 years, 10 months

7 years, 4 months

5 years, 11 months

17 years, 7 months

14 years, 6 months

- 17 III. Tax Returns

Petitioner claimed a tax basis for its favorable financing

equal to its claimed fair market value at close of business on

December 31, 1984.

On its 1985 Federal income tax return,

petitioner claimed that as of December 31, 1984, its favorable

financing intangible assets had an aggregate amortizable value of

$456,021,853.9

Petitioner now claims that its favorable

financing intangible assets had an aggregate amortizable value of

$428,391,551 on January 1, 1985.10

OPINION

As part of the legislation that subjected petitioner to

Federal income taxation, Congress enacted a dual-basis rule for

On its original Federal income tax returns for the years

at issue, petitioner reported the aggregate adjusted bases of its

favorable financing intangible assets as follows:

Year

Aggregate adjusted

basis of favorable

financing intangible assets

1985

1986

1987

1988

1989

1990

$456,021,853

391,552,352

337,931,651

283,234,501

237,398,945

196,718,525

Petitioner adjusted the bases of the favorable financing

intangible assets for tax benefits received and the lost bases on

retirements.

Petitioner reduced the value of its favorable financing

intangible assets using the valuation performed by Dr. Stephen M.

Schaefer.

- 18 petitioner.

DEFRA sec. 177(d)(2), 98 Stat. 711.

Specifically,

DEFRA section 177(d)(2)(A) provides:

(2) Adjusted basis of assets. -(A) In general.--Except as otherwise provided in

subparagraph (B), the adjusted basis of any asset of

the Federal Home Loan Mortgage Corporation held on

January 1, 1985, shall-(i) for purposes of determining any loss, be equal

to the lesser of the adjusted basis of such asset or

the fair market value of such asset as of such date,

and

(ii) for purposes of determining any gain, be

equal to the higher of the adjusted basis of such asset

or the fair market value of such asset as of such date.

The “special basis rules [were] designed to ensure that, to the

extent possible, pre-1985 appreciation or decline in the value of

* * * [petitioner’s] assets will not be taken into account for

tax purposes.”

H. Conf. Rept. 98-861, at 1038 (1984), 1984-3

C.B. (Vol. 2) 1, 292.

Section 167(a) allows taxpayers to depreciate property used

in a trade or business, or held for the production of income, for

exhaustion, wear and tear, and obsolescence.

Section 167(g)

provides that “The basis on which exhaustion, wear and tear, and

obsolescence are to be allowed in respect to any property shall

be the adjusted basis provided in section 1011 for the purpose of

determining the gain on the sale or other disposition of such

property.”

The depreciation of intangible assets is specifically

- 19 addressed in section 1.167(a)-3, Income Tax Regs., which

provides:

If an intangible asset is known from experience or

other factors to be of use in the business or in the

production of income for only a limited period, the

length of which can be estimated with reasonable

accuracy, such an intangible asset may be the subject

of a depreciation allowance. * * * An intangible

asset, the useful life of which is not limited, is not

subject to the allowance for depreciation. No

allowance will be permitted merely because, in the

unsupported opinion of the taxpayer, the intangible

asset has a limited useful life. No deduction for

depreciation is allowable with respect to good will.

* * *

Petitioner’s favorable financing intangible assets arise

from debt obligations in existence on January 1, 1985, that

required petitioner to pay interest to the holders at rates

below-market rates on that date.

In Fed. Home Loan Mortgage

Corp. v. Commissioner, 121 T.C. at 147, we held that

“petitioner’s adjusted basis for purposes of amortizing

intangible assets under section 167(g) is the higher of regular

adjusted cost basis or fair market value as of January 1, 1985.”

In Fed. Home Loan Mortgage Corp. v. Commissioner, 121 T.C. at

272, we held that “The right to use the proceeds of financing

arrangements with below-market interest rates constitutes an

economic benefit” and that “The benefit of petitioner’s belowmarket financing can, as a matter of law, constitute an

intangible asset which can be amortized if petitioner establishes

a fair market value and a limited useful life as of January 1,

- 20 1985.”

In this opinion, we decide the fair market values and

useful lives of petitioner’s favorable financing assets.

Both parties rely heavily on expert opinions and testimony

to support their respective positions concerning the values and

useful lives of the favorable financing intangible assets.

“[W]e

* * * consider expert opinion testimony to the extent that it

assists us in resolving the issues presented”.

IT&S of Iowa,

Inc. v. Commissioner, 97 T.C. 496, 508 (1991).

We may exercise

our broad discretion to accept or reject an expert’s opinion in

its entirety.

Neonatology Associates, P.A. v. Commissioner, 115

T.C. 43, 86 (2000), affd. 299 F.3d 221 (3d Cir. 2002).

Alternatively, we may selectively rely on those portions of an

expert’s opinion that we find most helpful to our decision.

IT&S

of Iowa, Inc. v. Commissioner, supra at 508; Parker v.

Commissioner, 86 T.C. 547, 561 (1986).

“[A]n objective reason

for * * * [rejecting an expert’s testimony] is that another

expert’s opinion is more persuasive.”

supra at 562.

Parker v. Commissioner,

“We are not bound * * * by the opinion of any

expert witness where such opinion is contrary to our judgment.”

IT&S of Iowa, Inc. v. Commissioner, supra at 508.

- 21 I.

The Values of Petitioner’s Favorable Financing

Intangible Assets

Petitioner’s Valuation of Its Favorable Financing

Intangible Assets as of January 1, 1985

The fair market value of property is a question of fact.

Bank One Corp. v. Commissioner, 120 T.C. 174, 306 (2003); Estate

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

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

Fair market

value is defined as “‘the price at which the property would

change hands between a willing buyer and willing seller, neither

being under any compulsion to buy or sell and both having

reasonable knowledge of the relevant facts.’”

United States v.

Cartwright, 411 U.S. 546, 551 (1973) (quoting section 20.20311(b), Estate Tax Regs.); Bank One Corp. v. Commissioner, supra at

209; Estate of Newhouse v. Commissioner, supra at 217; see also

sec. 20.2031-1(b), Estate Tax Regs.; sec. 25.2512-1, Gift Tax

Regs.

This is an objective standard that uses a hypothetical

willing buyer and seller.

T.C. 227, 231 (2005).

Estate of Kahn v. Commissioner, 125

This Court considers all relevant evidence

in the record when deciding the value of property.

Bank One

Corp. v. Commissioner, supra at 306; Estate of Jung v.

Commissioner, supra at 431-432.

As valuation is not an exact

science, the taxpayer is not required to establish the precise

value of the asset.

See Estate of Jung v. Commissioner, supra at

423-424; Snyder v. Commissioner, 93 T.C. 529, 545 (1989).

- 22 Furthermore, “A taxpayer is not required to use the most

theoretically correct method * * * to establish the amount of

depreciation to which he is entitled; rather, his method must be

reasonable.”

IT&S of Iowa, Inc. v. Commissioner, supra at 522

(citing Citizens & S. Corp. & Subs. v. Commissioner, 91 T.C. 463,

514 (1988), affd. without published opinion 900 F.2d 266 (11th

Cir. 1990)).

Petitioner argues that the benefit of below-market interest

should be measured by the present values of the difference

between the contract interest rates on its debt instruments and

market interest rates over the terms of the loans.

Petitioner

calculated that the January 1, 1985, fair market value of each

favorable financing intangible asset was as follows:

Debt

Fair Market Value

G-15

G-16

G-17

F-8

F-11

F-12

F-13

F-15

F-18

D-2

Z-2

Z-3

CD-1

GMC A 1975

GMC B 1975

GMC A 1976

GMC B 1976

GMC A 1977

GMC B 1977

$8,865,451

14,986,068

44,427,083

325,000

92,000,000

187,500

72,937,500

218,750

125,000

5,812,500

24,389,887

1,448,674

458,071

7,992,188

7,418,813

4,358,750

5,228,813

8,342,336

8,146,021

12,825,330

- 23 GMC C 1977

GMC A 1978

GMC B 1978

GMC C 1978

GMC A 1979

GMC B 1979

GMC C 1979

CMO A-2

CMO A-3

CMO C-4

Total

17,407,946

24,814,023

12,413,781

9,776,662

8,521,734

6,626,888

8,946,893

6,254,753

12,511,453

623,683

428,391,551

Petitioner relies on the expert opinion and testimony of Dr.

Stephen M. Schaefer to determine the value of its favorable

financing.

Professor Schaefer received his doctor of philosophy

at the University of London, Faculty of Economics.

He currently

serves as a professor of finance at London Business School and

has been a visiting professor at seven universities around the

world.

Professor Schaefer has also served on the editorial

boards of numerous publications, published two books, and

published over 30 articles and notes relating to finance and

economics.

Professor Schaefer explained that the benefit of favorable

financing is based on the difference between the interest

payments on an existing debt obligation and the interest payments

made at the prevailing market rate.

The value of the favorable

financing benefit equals the present value of this difference.

When debt obligations are exchanged in a free market, the price

paid for the debt instruments equals the fair market value of the

future cashflows.

The market price reflects uncertainties; for

- 24 example, when a bond is prepayable, the market price incorporates

the likelihood that the bond will be prepaid.

A comparison of

the adjusted issue prices of petitioner’s debt instruments and

the market prices indicates that petitioner’s instruments were

traded at a discount as of January 1, 1985.

The difference

between the adjusted issue price and the market price is the

market discount.

The discount reflects the present value

difference between petitioner’s contractual interest rate for

each debt instrument and the market rate for comparable debt on

January 1, 1985.

From petitioner’s perspective, the amount of

the discount is the present value of the additional interest cost

that the debtor would have to incur to borrow the amount of the

existing debt at market rates.

Professor Schaefer calculated the fair market value of the

favorable financing inherent in each of the 30 debt instruments

as of January 1, 1985, as the difference between the adjusted

issue price per $100 of principal and the January 1, 1985, market

price per $100 of principal, multiplied by the unpaid principal

balance divided by $100.11

Professor Schaefer’s report provided

the January 1, 1985, market price, adjusted issue price, and

unpaid principal balance for the 30 debt instruments as follows:

FMV = (adjusted issue price per $100 - market price per

$100) x (unpaid principal balance / $100).

- 25 Adjusted

issue price1

Jan. 1, 1985

market price2

Unpaid

principal balance

G-15

100.0000

87.335069

70,000,000

G-16

100.0000

81.835069

82,500,000

G-17

100.0000

70.381944

150,000,000

F-8

100.0000

99.187500

40,000,000

F-11

100.0000

77.000000

400,000,000

F-12

100.0000

99.906250

200,000,000

F-13

100.0000

75.687500

300,000,000

F-15

100.0000

99.890625

200,000,000

F-18

100.0000

99.937500

200,000,000

D-2

100.0000

98.062500

300,000,000

Z-2

3.0516

2.703125

7,000,000,000

Z-3

32.0378

31.458333

250,000,000

100.0000

95.968750

11,363,000

CD-1

100.0000

94.671875

150,000,000

GMC A 1975

100.0000

92.437500

98,100,000

GMC B 1975

100.0000

93.125000

63,400,000

GMC A 1976

100.0000

92.593750

70,600,000

GMC B 1976

99.0348

88.000000

75,600,000

GMC A 1977

99.4349

88.937500

77,600,000

GMC B 1977

99.5190

85.875000

94,000,000

GMC C 1977

99.5574

83.468750

108,200,000

GMC A 1978

99.5909

86.250000

186,000,000

GMC B 1978

99.7826

87.218000

98,800,000

GMC C 1978

99.5517

89.656250

98,800,000

GMC A 1979

99.6002

92.125000

114,000,000

GMC B 1979

99.6881

93.875000

114,000,000

GMC C 1979

99.7857

91.937500

114,000,000

Debt

instrument

- 26 CMO A-2

99.4511

97.664063

350,000,000

CMO A-3

99.2668

96.390625

435,000,000

CMO C-4

95.6239

94.890625

85,052,100

The adjusted issue price is the unpaid principal balance

minus the fraction of any unamortized original issue discount

remaining as of the valuation date. For a debt instrument issued

at a price that equaled its face value and for which there had

been no redemption before Dec. 31, 1984, the adjusted issue price

equals the initial face amount. The adjusted issue price listed

above is the adjusted issue price per $100 of unpaid principal

balance.

The Jan. 1, 1985, market price equals the middle price-this is the average of the bid and asked prices. With the

exception of G-15 and G-16, Professor Schaefer used the average

of the bid prices obtained by Arthur Andersen and petitioner from

the Salomon Brothers, First Boston, Merrill Lynch, and Shearson

Lehman investment banks as the bid price. See appendix. The bid

prices for G-15 and G-16 equaled the average of the available

prices.

We find that petitioner’s method of valuing its favorable

financing intangible assets provides a reasonable estimate of

fair market value.

The Supreme Court in Dickman v. Commissioner,

465 U.S. 330, 337-338 (1984), indicated that the value of the

right to use borrowed money is readily measurable by reference to

current interest rates.

See also Rev. Proc. 85-46, sec. 3.01,

1985-2 C.B. 507 (stating that the value of a gift below-market

loan is “the difference between the rate at which the money is

loaned and the prevailing market rate.”).

Similarly, we believe

that the favorable financing aspect of petitioner’s debt

instruments may be valued by comparing petitioner’s effective

contract interest rates to the prevailing market rates for those

- 27 instruments as of January 1, 1985.

The market price of each of

petitioner’s existing debt instruments provides an accurate

indication of the price at which investors would exchange the

debt instruments.

That price reflects the relationship between

the contract rate of interest on the debt and the market rate of

interest as of January 1, 1985.

The market approach used by

petitioner captures the values of the debt instruments using the

prices at which willing buyers and sellers actually exchanged

these instruments as of the valuation date.

We find that the sum

of the market discounts for petitioner’s debt instruments

provides a reasonable estimate of the present value of the

interest costs petitioner saved by paying below-market interest

rates on its outstanding debt instruments on January 1, 1985.

Respondent’s Position That Favorable Financing Has No

Value

Respondent primarily argues that petitioner failed to show

that the favorable financing intangibles had any value because:

(1) Petitioner did not show it expected to receive a stream of

income from the favorable financing intangible assets; (2)

petitioner did not prove that it could realize the value of the

favorable financing; (3) the favorable financing is a contraliability, not an asset; and (4) petitioner could realize the

value of favorable financing only by buying back its debt

instruments in the market, which would be impractical because it

would have to pay tax on the discharge of indebtedness.

- 28 The main thrust of respondent’s arguments is that

petitioner’s favorable financing is not an asset.

We addressed

this contention in Fed. Home Loan Mortgage Corp. v. Commissioner,

121 T.C. 254 (2003).

In that Opinion, we concluded:

(1) That

the right to use money at below-market rates is a valuable

economic benefit in terms of the cost savings that can be

achieved in income-producing activities; (2) that favorable

financing is a benefit for which a third party would pay a

premium if the favorable financing were included as part of a

purchase transaction; (3) that petitioner’s favorable financing

arrangements on January 1, 1985, represented something of value;

and (4) that the differential between the market rate of interest

and petitioner’s contract rate of interest serves as a measure of

the economic value of that right on January 1, 1985.

261.

Id. at 260-

Nevertheless, we will briefly discuss respondent’s

arguments that petitioner’s favorable financing had no value.

Expectation of Income

Respondent argues that the favorable financing intangible

assets do not have any value because petitioner did not receive

any additional income or earnings from these assets.

Respondent

relies on the expert opinion and testimony of Dr. Scott D.

Hakala.12

Dr. Hakala explained that “Intangible assets are

Dr. Scott D. Hakala received his doctor of philosophy,

economics at the University of Minnesota. Dr. Hakala is

(continued...)

- 29 defined as all elements of a business enterprise that exist in

addition to monetary and tangible assets.

Their existence is

dependent on the presence, or expectation of earnings.” (Fn. ref.

omitted.)

First, it seems clear that petitioner’s favorable financing

had a positive effect on its net income.

To the extent that

petitioner’s financing costs were lower than they would have been

had petitioner financed its operations with the market rates

prevailing on January 1, 1985, its net income was enhanced.

Second, respondent does not support with legal authority his

contention that the value of the favorable financing intangible

must be based on income.

Indeed, courts have determined the

value of similar intangible assets using cost savings methods.

IT&S of Iowa, Inc. v. Commissioner, 97 T.C. at 514-515; Citizens

& S. Corp. & Subs. v. Commissioner, 91 T.C. at 498.

We have already held that petitioner’s favorable financing

constituted an economic benefit that can be an amortizable

intangible asset if petitioner establishes a fair market value

and limited useful life as of January 1, 1985.

Fed. Home Loan

(...continued)

currently a director and principal in CBIZ Valuation Group, LLC.

His expertise includes: Corporate finance, restructuring and

cost of capital; valuation of securities and business interests;

valuation of intangible assets; analysis of publicly traded

securities; economic loss analyses; wage and compensation

determination; transfer pricing; and derivative securities. He

has testified as an expert in over 60 cases in U.S. District

Courts, this Court, and various State courts.

- 30 Mortgage Corp. v. Commissioner, 121 T.C. at 272.

We also

concluded that the core deposit cases, which use cost savings to

measure value, “support petitioner’s position that favorable

financing is an intangible asset subject to amortization.”

at 264.

Id.

Rather than addressing the valuation issue presently

before the Court, respondent’s argument seems to challenge our

prior holdings.

Realization of Value

Respondent argues that the favorable financing intangible

assets do not have a fair market value and that any value is

hypothetical because petitioner could not transfer favorable

financing to a willing buyer.

We might agree that petitioner’s

favorable financing could not be transferred by itself.

However,

we have previously rejected respondent’s argument that favorable

financing could not be valued because it could not be transferred

except as part of a larger acquisition.

Obviously, intangibles

such as core deposits or deposit base13 might have economic

The term “deposit base” represents the present value of

the future stream of income to be derived from employing the core

deposits of a bank. See Fed. Home Loan Mortgage Corp. v.

Commissioner, 121 T.C. at 262. “Core deposits are a relatively

low-cost source of funds, reasonably stable over time, and

relatively insensitive to interest rate changes.” Citizens & S.

Corp. & Subs. v. Commissioner, 91 T.C. 463, 465 (1988). In First

Chi. Corp. v. Commissioner, T.C. Memo. 1994-300, we defined core

deposits as follows:

Core deposits can be an essential part of a

commercial bank when they represent a low cost and

(continued...)

- 31 significance only in a larger context, but that does not prevent

giving them a separate value.

See Fed. Home Loan Mortgage Corp.

v. Commissioner, 121 T.C. at 266-267, where we stated:

We also cannot distinguish the cases involving

deposit base for the reason that those cases involved

an acquisition of deposit base in conjunction with a

larger acquisition of assets of a company. We might

agree that, as a practical matter, a debtor’s position

with respect to its favorable financing would not be

transferred, except as a part of a larger acquisition

of a company or property. However, this is not, in our

view, determinative of the question of whether there

exists an amortizable asset of value. * * *

Contra-Liability Theory

Respondent argues that petitioner’s favorable financing is a

contra-liability, not an asset.

Respondent’s expert Dr. Hakala

explained that a contra-liability is a liability on the balance

sheet that is misstated in some economic sense because the

liability is worth less than face value and the liability has

been marked to market.

Dr. Hakala further explained that

transferring the liability to the asset side of the balance sheet

(...continued)

stable source of funds. Banks typically invest the

funds in loans or other income-producing assets, and

receive fees for services rendered to the depositors.

The excess of the income generated from the core

deposits over the associated expenses contributes to

the profitability of the bank. Core deposits are a

separate and distinct intangible asset with an inherent

value because they provide an inexpensive means to

generate income. Therefore, when one bank considers

acquiring another bank, core deposits can represent an

attractive intangible asset and a reason for acquiring

a bank. [Fn. ref. omitted.]

- 32 creates an unrealizable asset.

As a result, respondent argues

that the favorable financing intangible assets cannot be valued

separately, without looking at the value of the underlying

mortgages.

According to respondent, petitioner’s valuation

method results in overvaluation, double counting of assets, and

accounting irregularities because petitioner marks its

liabilities to market without making the corresponding downward

adjustment to its assets.

Favorable Financing Is an Asset

Respondent’s contra-liability argument revisits the question

of whether favorable financing can be an amortizable asset.

have already rejected respondent’s argument that favorable

financing is a liability.

See Fed. Home Loan Mortgage Corp. v.

Commissioner, 121 T.C. at 269, where we stated:

Respondent argues that petitioner’s favorable

financing represents a “liability”, not an “asset”.

Respondent claims that petitioner is “attempting to

adjust, for tax purposes, the asset side of its balance

sheet to account for an overstatement in fair market

value terms of its liabilities.” We cannot agree with

respondent’s proposed characterization of petitioner’s

favorable financing as a liability. Indeed, as

petitioner points out, there is a valuable economic

benefit associated with the below-market interest rates

on its financing arrangements as of January 1, 1985.

It is this economic benefit which petitioner claims as

an intangible asset and upon which it bases its claimed

amortization deductions.

- 33 b.

Favorable Financing Can Be Assigned a

Separate Value

As previously indicated, the fact that favorable financing

could not be transferred apart from a transfer of other assets

and liabilities does not prevent assigning it a separate value.

At trial, petitioner’s counsel developed the following

hypothetical situation while examining respondent’s expert, Dr.

Herbert Kaufman:14

* * * The houses are both worth $300,000.

They are identical. They are next door to each other.

They both have a “for sale” sign in front of them. The

first house just says, “For sale, House, No Assumable

Debt.” The second house has “House for Sale Plus 1

Percent Mortgage Assumable as Part of the Purchase.”

Do you believe the second seller is going to

receive more money at closing than the first seller?

Assuming that market interest rates are--

They’re five.

Sure.

money.

So the second seller would receive more

Right?

I would think so.

Dr. Herbert M. Kaufman received his Ph.D. in economics

from the Pennsylvania State University. He is a professor of

finance at Arizona State University, W.P. Carey School of

Business. Dr. Kaufman’s fields of specialization are:

Investments; financial markets and institutions; monetary

economics; and applied econometrics. He provided a valuation

analysis of petitioner’s asserted favorable financing intangible

assets.

- 34 Q:

Why is that?

Because the assumable mortgage is in place.

Does it have value?

The assumable mortgage?

Yes.

Yeah. The value of the assumable mortgage

with regard to the house, which is the asset,-*

--has value.

Further, Dr. Kaufman was asked and answered as follows:

* * * Back to my other hypothetical about

the two homes next door to each other, let’s assume you

can’t decide which house to buy, the $300,000 one with

no assumable mortgage or the $300,000 house with the 1

percent mortgage. Market rates are five.

Do you think it’s possible to calculate how

much more you would pay for that house with the

assumable 1 percent mortgage? Is that possible to do?

I think it’s probably possible.

But a buyer certainly would have the tools to

determine how much more to pay for the below-market

financing. Is that right?

Not for the below-market financing; for the

house with the below-market.

Again, you keep wanting to separate. I can’t

separate that because you’re not going to buy a

liability.

Let’s say the buyer hired an appraisal

company and had in the buyer’s hand an appraisal saying

- 35 the house is worth $300,000. Right? How would the

buyer decide how much more to pay for the house with

the 1 percent mortgage? It would determine the value

of the below-market mortgage and add that to the price.

Isn’t that fair?

That’s true, yeah.

Like the purchaser and seller of the houses in the

hypothetical situation, we think that petitioner can ascertain

the value of the favorable financing.

As we have mentioned,

financial markets determined the current price of petitioner’s

debt obligations on the valuation date; a comparison of the

contract price and the prevailing market price provides a

reasonable measure of the value of the favorable financing

associated with the debt instrument.

Therefore, we disagree with

respondent that a separate value cannot be assigned to

petitioner’s favorable financing.

Double Counting the Value

Respondent also argues that petitioner’s method of valuing

its favorable financing overvalues and double counts petitioner’s

assets because petitioner’s “real assets”--the mortgages--have

lost value when compared to prevailing market rates.

We think that respondent’s concerns of double counting are

misguided.

When petitioner was chartered, it was exempt from

Federal, State, and local taxation, except for real estate tax

imposed by any State or local taxing authority.

Congress enacted

special legislation that subjected petitioner to Federal income

- 36 taxation.

In that special legislation, Congress created a dual-

basis rule for petitioner’s assets “to ensure that, to the extent

possible, pre-1985 appreciation or decline in value of * * *

[petitioner’s] assets will not be taken into account for tax

purposes.”

H. Conf. Rept. 98-861, supra at 1038, 1984-3 C.B.

(Vol. 2) at 292.

Just as this legislation applies to

petitioner’s favorable financing intangible assets, DEFRA section

177(d)(2) governs the adjusted bases of petitioner’s so-called

real assets.

For the purposes of determining a loss, DEFRA

section 177(d)(2)(A) provides that “the adjusted basis of any

asset of * * * [petitioner] held on January 1, 1985, * * * be

equal to the lesser of the adjusted basis of such asset or the

fair market value of such asset” as of January 1, 1985.

Congress

created the special dual-basis rule specifically for petitioner

when it became a taxable entity to ensure that pre-1985

appreciation or decline in value would not be taken into account

for tax purposes.

H. Conf. Rept. 98-861, supra at 1038, 1984-3

C.B. (Vol. 2) at 292.

The adjusted basis rules of DEFRA section

177(d)(2)(A), which requires petitioner to calculate a loss using

an adjusted basis equal to the lesser of fair market value or

adjusted basis, address the kind of double counting that appears

to concern respondent.

- 37 4.

Petitioner’s Purchase of Its Debt Obligations

Would Result in Discharge of Indebtedness Income

Respondent appears to argue that the only way petitioner

could realize the value of favorable financing would be to buy

back its debt instruments at their discounted market prices.

Respondent claims that this is impractical because petitioner

would incur tax on the resulting discharge of indebtedness

income.

When a taxpayer repays a debt at a discount, the taxpayer

normally realizes income from the discharge of indebtedness.

See

sec. 61(a)(12); United States v. Kirby Lumber Co., 284 U.S. 1, 3

(1931).

Section 1.61-12(a), Income Tax Regs., provides that “The

discharge of indebtedness, in whole or in part, may result in the

realization of income.

* * *

A taxpayer may realize income by

the payment or purchase of his obligations at less than their

face value.”

When a taxpayer receives borrowed funds, those

funds are excluded from income because the taxpayer has an

obligation to repay the funds.

United States v. Centennial Sav.

Bank FSB, 499 U.S. 573, 582 (1991).

The rationale for including

discharge of indebtedness in a taxpayer’s income is that the

taxpayer “realizes an accession to income due to the freeing of

assets previously offset by the liability.”

Jelle v.

Commissioner, 116 T.C. 63, 67 (2001) (citing United States v.

Kirby Lumber Co., supra at 3).

- 38 If petitioner entered the market and purchased its debt

obligations for less than the amount that it had borrowed,

petitioner would normally realize income equal to the difference

between the amount it borrowed and the amount it paid to purchase

its debt instruments.

We think that respondent’s argument that

petitioner could have received discharge of indebtedness income

by repurchasing its debt at a discount supports our conclusion

that petitioner’s favorable financing had value.

Respondent’s Argument That the Value of Petitioner’s

Favorable Financing Is Limited to the Value of

Petitioner’s Income Spread

Assuming, without conceding, that favorable financing is a

valuable asset, respondent argues that the price an acquirer

would pay to purchase petitioner’s rights and obligations with

respect to its CMOs or GMCs would not exceed the present value of

petitioner’s spread income associated with those instruments.

of January 1, 1985, respondent asserts that the present value of

the spread related to petitioner’s GMCs and CMOs equaled

approximately $11.4 million and $7.2 million, respectively.

Dr. Hakala concluded that favorable financing is not an

intangible asset; however, Dr. Hakala found that petitioner’s

income spread has value because its assets and liabilities are

closely matched.15

According to Dr. Hakala, when previously

Dr. Hakala indicates that the CMOs and GMCs are exactly

matched.

- 39 issued debt is matched to income-earning assets, the issued debt

does not have any intangible value by itself.

In his report, Dr.

Hakala explained that “what is of value to a potential buyer is

the potential income stream between mortgages and obligations to

holders of the securities.”

To determine the value of the income spread from the GMCs,

Dr. Hakala used the net management and guarantee income16

petitioner reported for the 6 months that ended June 30, 1985,

and compared that to the average principal balance outstanding

over that same 6-month period.

He concluded that the management

and guarantee income totaled $3.5 million.

Dr. Hakala assumed

general and administrative costs of 9 basis points annually and

reduced the total value to incorporate the effect of taxes; these

adjustments reduced the net management and guarantee income to

$1.6 million.

“Taking into account the actual runoff of each GMC

and discounting to present value the future net spread income at

the weighted average cost of capital results in a value of

approximately $11.4 million for the spread associated with all of

the GMCs.”

Dr. Hakala used the same analysis to find that the

present value of the CMOs’ future net spread income at the

weighted average cost of capital equaled $7.2 million.

Management and guarantee income is the excess

income/expense during a month from each GMC trust, including the

excess of the effective interest income on mortgages backing the

GMCs over the amount payable to GMC investors and short-term

investments.

- 40 We disagree with respondent that the value of petitioner’s

favorable financing intangible assets is limited to the value of

the income spread.

Dr. Hakala’s income spread analysis is

premised on his conclusion that favorable financing cannot be an

intangible asset.

However, in Fed. Home Loan Mortgage Corp. v.

Commissioner, 121 T.C. at 272, we held that favorable financing

was an economic benefit and that “the benefit of * * * belowmarket financing can, as a matter of law, constitute an

intangible asset”.

Professor Schaefer explained that the income spread is a

measure of petitioner’s equity value, and that equity is

different from the value of petitioner’s assets, including the

favorable financing intangible assets.

Equity is generally

described as the excess of the value of assets (tangible and

intangible) over liabilities.

The value of petitioner’s

favorable financing assets is the present value of the cost

savings between the effective contract interest rate on

petitioner’s debt obligations and the prevailing market interest

rates on equivalent debt obligations at the valuation date.

illustrate the differences between the value of an intangible

asset and equity value, Professor Schaefer gave the following

examples:

To illustrate this further, suppose a company has a

long lease on office space at $5 per square foot when

the market price for similar space is, say, $70. It is

clear that this lease is valuable to the company; if it

- 41 did not own the lease at $5 per square foot it would

have to rent more expensive space and, as a result,

both the earnings and the value of the company would be

lower. Of course the price an acquirer would pay is

the value of the earnings stream from the whole

company, i.e., its revenues less its total costs,

including the costs of space. However, it is clear

that paying $5 rather than $70 per square foot for

space increases the earnings of the company and

therefore has value to an acquirer.

Similarly, suppose two companies, A and B, have

identical assets and identical amounts of debt but pay

different rates of interest on their debt. Company A’s

liabilities pay the Prevailing Market Interest Rate

while company B’s liabilities pay a below-market

interest rate. In this case, company B’s earnings will

be higher than company A’s and an acquirer would

clearly pay more for company B than for company A. The

difference in the earnings of the two companies is the

difference between interest payments at the Prevailing

Market Interest Rate (the rate on company A’s

liabilities) and the lower rate on company B’s

liabilities. Thus, the difference between the earnings

of the two companies is equal to company B’s Favourable

Financing benefits and the higher amount that an

acquirer would pay for company B over company A is the

value of company B’s Favourable Financing Assets.

To further rebut respondent’s claim that favorable financing

cannot exceed the value of equity, Professor Schaefer explained:

This claim is clearly flawed since all that is required

for the value of the Favourable Financing Assets to

exceed the value of equity is for the present value of

the Asset Spread to Market[17] to be negative. * * *

Professor Schaefer describes Asset Spread to Market as

follows:

the difference between the rate the firm actually earns

on its assets and the rate it would earn if it had to

invest in the market (at the Prevailing Market Interest

Rate), measures the benefit to the firm of the specific

assets it holds. I refer to this rate as the Asset

Spread to Market. If positive, this difference

(continued...)

- 42 the value of Freddie Mac’s equity is always equal to

the present value of its Asset Spread to Market plus

the value of its Favourable Financing Assets. Thus, if

the present value of the Asset Spread to Market is

negative, the value of the Favourable Financing Assets

will exceed the value of equity. * * *

In order to illustrate this point, Professor Schaefer used the

following example:

A more concrete example is provided by the S&L crisis,

which featured negative Asset Spreads to Market, and

therefore Favourable Financing Assets with a higher

value than equity. In the early 1980s, when interest

rates rose sharply, the condition of many S&Ls

deteriorated as the value of their fixed-rate mortgage

assets fell. Suppose that, in September 1981 when

mortgage rates were above 15%, an S&L held fixed-rate

mortgages paying a rate of 6% and therefore selling at

around 40% of their face amount. Suppose further that

this S&L was fortunate in the sense that it was

entirely financed with core deposits * * * that paid 2%

and therefore, despite earning 6% on its assets when

market rates were 15%, it nonetheless earned a positive

spread of 4% (equal to the rate on its assets of 6%

less 2% paid on its liabilities).

To the extent that the core deposits remain in place,

this S&L is solvent. However, its positive net worth

does not come from its assets--these have fallen in

value by 60%--but from its liabilities. The total

spread of 4% is made up of a substantial and negative

Asset Spread to Market of--9% (a 6% asset return less a

15% market rate) and a large and positive Favourable

Financing benefit of 13% (the 15% market rate less the

2% paid on deposits). The value of the Favourable

Financing Assets for this S&L (the present value of the

13% spread) would clearly exceed the value of its

equity (the present value of the 4% spread).

(...continued)

represents the “favourableness” of the firm’s assets,

just as the difference between the market and actual

financing rates represents the “favourableness” of the

firm’s liabilities. * * *

- 43 We must decide the value of petitioner’s favorable financing

intangible assets.

Because income spread measures equity and not

the value of individual assets, we find that the value of

petitioner’s favorable financing intangible assets is not limited

to the income spread.

Respondent’s Argument That Taxes Reduce the Value of

Favorable Financing

Assuming that petitioner’s favorable financing intangible

assets do have value, respondent argues that petitioner’s

calculations over-valued these assets because its method failed

to incorporate the effect of taxes.

In his rebuttal report, Dr.

Hakala explained that “the reduction in the value of the

liability would be partially offset by a deferred tax liability.”

Dr. Hakala calculated value by reducing the value of the

intangible assets for income taxes and increasing the value by

the tax shield.18

After incorporating the tax effect, Dr. Hakala

prepared a summary analysis of the favorable financing intangible

assets using Professor Schaefer’s market prices as follows:

Debt

Corrected Value

G-15

G-16

G-17

F-8

F-11

$6,977,205

11,448,352

30,735,708

296,491

67,179,640

The reduction of value for income taxes reflects the

present value of cashflows on an after-tax basis. The tax shield

is the amortized tax benefit associated with creating an

intangible asset.

- 44 F-12

F-13

F-15

F-18

D-2

Z-2

Z-3

CD-1

GMC A 1975

GMC B 1975

GMC A 1976

GMC B 1976

GMC A 1977

GMC B 1977

GMC C 1977

GMC A 1978

GMC B 1978

GMC C 1978

GMC A 1979

GMC B 1979

GMC C 1979

CMO A-2

CMO A-3

CMO C-4

Total

176,830

50,628,337

203,957

112,856

4,594,048

14,598,063

1,039,813

405,439

6,538,498

6,194,495

3,592,694

4,299,020

6,551,705

6,524,267

9,891,261

12,890,475

18,287,188

9,347,594

7,361,840

6,486,039

5,043,839

6,737,022

4,862,086

8,187,424

420,731

311,612,917

Petitioner argues that its market-based valuation approach

integrates the effect of taxes into the value of an asset.

other words, petitioner argues that the market prices of its debt

instruments already reflect the tax considerations of buyers and

sellers.

In his rebuttal report, Dr. Hakala quoted the following

excerpt from “Assets Acquired in a Business Combination to be

Used in Research and Development Activities:

A Focus on

Software, Electronic Devices, and Pharmaceutical Industries”

(2001) by the AICPA’s IPR&D Task Force:

“The task force believes

that the valuation of an intangible asset would include (a) the

- 45 expected tax payments resulting from the cashflows attributable

to the intangible asset and (b) the tax benefits resulting from

the amortization of that intangible asset for income tax

purposes.”

At trial, Dr. Hakala was asked to read the two

sentences that immediately followed the sentence he quoted in his

rebuttal report:

“‘Including the tax affects [sic] in the

valuation is common in the income and cost approaches.

It is not

typical in the market approach because any tax benefits would

already be factored into the quoted market price through the

negotiation of market participants during the bid and ask

process.’”

Petitioner’s expert, Mr. Howard A. Scribner,19 testified

that taxes can affect the value of intangible assets but that the

market approach incorporates taxes into the valuation.

Specifically, Mr. Scribner was asked and answered as follows:

Are taxes relevant or irrelevant in a marketbased valuation of an intangible asset?

A market-based intangible asset reflects the

interactions of buyers and sellers. All factors,

including taxes, are reflected in those prices.

We agree with petitioner that the market approach of valuing

an asset incorporates the effect of taxes.

Respondent’s expert

relied on a source that states that the effect of taxes typically

is not included in the market approach because the quoted market

See infra pp. 48-49.

- 46 price already reflects taxes.

Mr. Scribner confirmed that the

market price incorporates the effect of taxes.

We find that

petitioner properly valued its favorable financing intangible

assets using the market-based method and that no further

adjustment is necessary to account for the tax effect.

We agree that petitioner has proven that its favorable

financing intangible assets have values that were reasonably

estimated.

We hold that the values of petitioner’s favorable

financing intangible assets are as follows:

Debt

G-15

G-16

G-17

F-8

F-11

F-12

F-13

F-15

F-18

D-2

Z-2

Z-3

CD-1

GMC A 1975

GMC B 1975

GMC A 1976

GMC B 1976

GMC A 1977

GMC B 1977

GMC C 1977

GMC A 1978

GMC B 1978

GMC C 1978

GMC A 1979

GMC B 1979

GMC C 1979

CMO A-2

Fair market value

$8,865,451

14,986,068

44,427,083

325,000

92,000,000

187,500

72,937,500

218,750

125,000

5,812,500

24,389,887

1,448,674

458,071

7,992,188

7,418,813

4,358,750

5,228,813

8,342,336

8,146,021

12,825,330

17,407,946

24,814,023

12,413,781

9,776,662

8,521,734

6,626,888

8,946,893

6,254,753

- 47 CMO A-3

CMO C-4

Total

II.

12,511,453

623,683

428,391,551

Favorable Financing Intangible Assets Have a Reasonably

Estimable Useful Life As of January 1, 1985

To amortize favorable financing, a taxpayer must show that

the intangible assets have limited useful lives, the duration of

which may be ascertained with reasonable accuracy.

Section

1.167(a)-3, Income Tax Regs., provides:

§ 1.167(a)-3.

Intangibles.

If an intangible asset is known from experience or

other factors to be of use in the business or in the

production of income for only a limited period, the

length of which can be estimated with reasonable

accuracy, such an intangible asset may be the subject

of depreciation allowance. Examples are patents and

copyrights. An intangible asset, the useful life of

which is not limited is not subject to the allowance

for depreciation. * * *

“A taxpayer may establish the useful life of an asset for

depreciation based upon his own experience with similar property,

or, if his own experience is inadequate, based upon the general

experience in the industry.”

Citizens & S. Corp. & Subs. v.

Commissioner, 91 T.C. at 500 (citing section 1.167(a)-1(b),

Income Tax Regs.); Banc One Corp. v. Commissioner, 84 T.C. 476,

499 (1985) (citing section 1.167(a)-1(b), Income Tax Regs.),

affd. without published opinion 815 F.2d 75 (6th Cir. 1987).

The

taxpayer is not required to prove the precise useful life for

purposes of depreciation--a “‘reasonable approximation’” of the

useful life is sufficient.

Citizens & S. Corp. & Subs. v.

- 48 Commissioner, supra at 500; Banc One Corp. v. Commissioner, supra

at 499 (citing Burnet v. Niagara Falls Brewing Co., 282 U.S. 648,

655 (1931), Super Food Servs., Inc. v. United States, 416 F.2d

1236 (7th Cir. 1969), and Spartanburg Terminal Co. v.

Commissioner, 66 T.C. 916 (1976)).

The taxpayer must base the

useful life estimation upon facts that existed at the valuation

date.

Citizens & S. Corp. & Subs. v. Commissioner, supra at 500;

Banc One Corp. v. Commissioner, supra at 499.

Taxpayers may use

evidence of their subsequent experiences to corroborate their

projections.

Citizens & S. Corp. & Subs. v. Commissioner, supra

at 500.

Petitioner argues that on January 1, 1985, the reasonably

estimated remaining useful lives of the 30 favorable financing

intangible assets equaled the average weighted lives.

Petitioner

relies on the expert opinion and testimony of Mr. Howard A.

Scribner.

Mr. Scribner received a B.S.C. in accounting from

Rider University and an M.B.A. in finance from Rutgers Graduate

School of Management.

He is also a licensed certified public

accountant (C.P.A.) and an accredited business valuation

specialist in the American Society of C.P.A.s.

He is a partner

in the Economic and Valuation Services practice of KPMG LLP.

Mr.

Scribner has more than 20 years of valuation experience involving

intangible assets, debt, common and preferred stock, partnership

- 49 interests, and stock options of privately and publicly held

companies.

Mr. Scribner determined that the estimated useful lives of

the favorable financing intangible assets equal the average

weighted lives of the debt obligations that give rise to them.

According to Mr. Scribner, the estimated useful lives of the

favorable financing intangible assets did not change on account

of subsequent unforeseen events because

the interactions of market participants force the

incorporation of all known and expected information

available at that date into the existing prevailing

market interest rate. Therefore, the market consensus

establishes the current market interest rate to be the

best estimate of the prevailing interest rate over the

life of the investment.

Mr. Scribner states that the average weighted life

represents the time it takes for the average dollar of principal

borrowed to be repaid to the lender.

is calculated by:

The average weighted life

(1) Multiplying the principal payment by the

number of years or pro rata portion of a year that the principal

amount has been outstanding, (2) adding the results for all

payment periods, and (3) dividing that sum by the total principal

paid.20

For debt obligations that do not repay any principal

The average weighted life formula is as follows:

E PMT x n

PMT is the principal payment, n is the number of years that the

principal amount has been outstanding, and P is the total

(continued...)

AWL =

- 50 until maturity, the average weighted life is the time remaining

to maturity.

The following example illustrates how Mr. Scribner’s

calculated the average weighted life for ND:

Date

Years

Outstanding (A)

1/1/1985

-11/1/1985

0.8333

11/1/1986

1.8333

Total average weighted life

Principal

Payment (B)

-$1,407,703

9,954,795

(A*B)/11,363,0001

-0.10

1.61

1.71

This figure is the total principal outstanding on ND as of

Dec. 31, 1984.

Mr. Scribner estimated that ND had an average weighted life of

1.71 years, or 1 year, 9 months.

When an issuer holds an option to repay debt, Mr. Scribner’s

report explains that the option may affect the average weighted

life because the issuer may elect to redeem the instrument before

maturity.

Petitioner would elect to exercise an option to repay

debt before maturity if it would save interest expense.

For

example, petitioner would exercise the option to redeem the

instrument before maturity when the interest rate of the

instrument exceeded the market rate.

Similarly, if the holder of a debt has a put option, the

holder will exercise the option when the debt obligation pays

interest at a rate below the market rate of interest because the

(...continued)

principal paid.

- 51 holder could reinvest at a higher rate.

Favorable put options

would shorten the estimated remaining useful life of favorable

financing intangible assets.

Respondent argues that petitioner has not established a

limited useful life for the favorable financing intangible assets

because petitioner’s calculations failed to consider the

volatility of the markets, which may eliminate the benefit of

these assets before the useful lives asserted by petitioner

expire.

Respondent’s theory would seem to produce shorter useful

lives for the favorable financing intangible assets, which would

accelerate petitioner’s depreciation allowance.21

Instead,

petitioner used a more conservative estimate of the useful life

measured by the averaged weighted life.

We disagree with respondent that petitioner failed to take

market volatility into account when determining the useful lives

of its assets.

Mr. Scribner explained that the market

incorporates all known information and expected information into

establishing the prevailing market rates.

Mr. Scribner concluded

that “the market consensus establishes the current market

interest rate to be the best estimate of the prevailing interest

rate over the life of the investment.”

Respondent did not offer alternative useful life

calculations for petitioner’s favorable financing intangible

assets.

- 52 Because respondent contends that there is no fair market

value to support the existence of the favorable financing

intangibles, respondent offered no view as to their useful lives.

Although Dr. Hakala disagrees that the average weighted lives

equal the remaining useful lives of the assets, Dr. Hakala

substantially agreed with the average weighted life calculations

performed by petitioner’s experts.

We find that petitioner has

proven that its favorable financing intangible assets have

reasonably estimable useful lives equal to the average weighted

lives of the debt obligations from which these assets arose.

hold that petitioner’s favorable financing intangible assets had

useful lives as follows:

Debt

G-15

G-16

G-17

F-8

F-11

F-12

F-13

F-15

F-18

D-2

Z-2

Z-3

CD-1

GMC A 1975

GMC B 1975

GMC A 1976

GMC B 1976

GMC A 1977

GMC B 1977

GMC C 1977

GMC A 1978

Average Weighted Life

5 years,

6 years,

12 years,

5 months

8 months

5 months

11 months

8 years, 11 months

2 months

12 years, 2 months

5 months

1 year, 2 months

5 years, 3 months

34 years, 11 months

9 years, 11 months

1 year, 8 months

4 years, 0 months

3 years, 4 months

3 years, 9 months

3 years, 10 months

5 years, 6 months

4 years, 9 months

6 years, 3 months

8 years, 2 months

8 years, 5 months

- 53 GMC B 1978

GMC C 1978

GMC A 1979

GMC B 1979

GMC C 1979

CMO A-2

CMO A-3

CMO C-4

7 years, 4 months

6 years, 10 months

7 years, 4 months

5 years, 11 months

17 years, 7 months

14 years, 6 months

III. Conclusion

Petitioner has proven that the favorable financing

intangible assets have reasonably estimable values and

ascertainable remaining useful lives in accordance with our

findings.

Since other issues in these cases remain unresolved,

our conclusions, as stated herein, will be incorporated in a Rule

155 computation upon resolution of the remaining issues.

- 54 APPENDIX:

Investment Bank Bid Prices

The following table lists the investment bank bid prices

obtained by petitioner and Arthur Andersen, which were used to

value petitioner’s favorable financing.

Bid Price

Debt

Instrument

First Boston

Salomon

Brothers

Merrill

Lynch

Shearson

Lehman

G-15

87.250000

G-16

81.750000

G-17

70.343750

70.250000

F-12

99.875000

99.812500

F-15

99.875000

99.812500

F-8

99.187500

99.093750

F-18

99.906250

99.812500

F-11

77.125000

76.625000

F-13

75.375000

75.750000

D-2

97.750000

98.125000

CMO A-2

97.468750

96.875000

96.625000

97.687500

CMO A-3

96.406250

95.687500

96.250000

95.218750

CMO C-4

95.906250

93.343750

95.375000

92.937500

95.562500

95.625000

CD-1

94.718750

94.500000

Z-2

2.500000

2.656250

Z-3

31.625000

31.000000

31.375000

GMC A 1975

92.062500

GMC B 1975

92.750000

GMC A 1976

92.218750

GMC B 1976

87.625000

GMC A 1977

88.562500

- 55 GMC B 1977

85.500000

GMC C 1977

83.093750

GMC A 1978

85.875000

GMC B 1978

86.843000

GMC C 1978

89.281250

GMC A 1979

91.750000

GMC B 1979

93.500000

GMC C 1979

91.562500

Mean of dealer bid prices obtained from First Boston and Salomon Bros.

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.