Petition — Sun Oil Co. v. Commissioner

FILED

MAR 1? 1978

In THE MICHAEL RODAK, JR., CLERK

| *~ Supreme Court, U. a.

'

'

Supreme Court of the United States

October Term, 1977

No77- 13803 |

Sun Om Company, Transferee,

Sunray DX On Company and

Subsidiaries, Transferor,

Petitioner,

v.

CoMMISSIONER OF INTERNAL REVENUE,

Respondent.

PETITION FOR A Writ OF CERTIORARI TO THE

Unrrep States Court or APPEALS FOR THE

Turp Circuit

Burorp P. Berry

Emizy A. ParKER

2300 Republic National

Bank Bldg.

Dallas, Texas 75201

J. Daviy ANDERS

P. O. Box 2880

Southland Center

Dallas, Texas 75221

Counsel for the Petitioner

INDEX

ee 1

ES Se a PERE RED 2

QUESTIONS PRESENTED ..................... 2

STATUTE INVOLVED ..................000000- 2

3

5

9

TABLE OF AUTHORITIES

CASES:

American Realty Trust v. United States,

Ge ee Be GN GS BPD occ cccccccccccccce:

Commissioner v. Duberstein, 363 U.S. 278 (1960) ....

Cubic Corporation v. United States,

ee ee Ge GI BUTE io ve sccnccc sccccceses 6

Frank Lyon Company v. United States,

536 F.2d 746 (8th Cir. 1976), cert. granted,

45 U.S.L.W. 3570 (February 22, 1977) ........... 5-8

STATUTES, RULES AND REGULATIONS:

Internal Revenue Code § 162(a)(3) ................

Federal Rules Civ. Proc., Rule 52(a) .............. 7

a1

In Tue

Supreme Court of the United States

October Term, 1977

No. 77-

Sun Om Company, Transferee,

Sunray DX Om Company and

Subsidiaries, Transferor,

Petitioner,

v.

CoMMISSIONER OF INTERNAL REVENUE,

Respondent.

PETITION FoR A Writ oF CERTIORARI TO THE

Unitep States Court or APPEAIS FOR THE

Turep Circuit

Petitioner, Sun Oil Company, respectfully prays that a

writ of certiorari issue to review’ the judgment and opinion

of the United States Court of Appeals for the Third

Circuit entered on September 7, 1977 reversing a judgment

of the United States Tax Court.

OPINIONS BELOW

The opinion of the United States Court of Appeals for

the Third Circuit is reported at 562 F.2d 258, as amended

on November 29, 1977, and is set forth as Appendix B,

infra pp. 10a-33a as further amended on January 26, 1978.

The memorandum opinion of the United States Tax Court,

unofficially reported at 35 T.C.M. 173, CCH Dee. 33,664

and 1976 P.H. T.C. Memo 176,040, is set forth as Appendix

A, infra pp. la-9a.

2

JURISDICTION

The judgment of the Court of Appeals for the Third

Circuit was entered on September 7, 1977. (Appendix C,

infra p. 34a). A timely petition for rehearing was denied

on Qetober 19, 1977, and this petition for certiorari was

filed within 150 days of that date, which 150 day period

includes a 60 day extension to and including March 18,

1978 granted on December 16, 1977. The jurisdiction of

the Court is invoked under 28 U.S.C. § 1254(1).

QUESTIONS PRESENTED

1. Whether Sunray DX Oil Company (“Sunray”) was

entitled to deduct for Federal income tax purposes rental

payments made to the General Electric Pension Trust

(the “Trust”) under certain leases entered into between

the Trust, as lessor, and Sunray, as lessee, as part of a

sale and leaseback transaction.

2. Whether the United States Court of Appeals for the

Third Circuit erred in disregarding the Tax Court’s finding

and judgment that Sunray did not retain, or intend to

retain, any equity in the leased properties and was entitled

to rental deductions, and in concluding, based solely on a

de novo review of the record, that the sale and leaseback

transactions were financing arrangements.

STATUTE INVOLVED

Section 162(a)(3) of the Internal Revenue Code

provides :

(a) IN GENERAL. — There shall be allowed as a

deduction all the ordinary and necessary expenses paid

or incurred during the taxable year in carrying on any

trade or business, including —

(3) rentals or other payments required to be

made as a condition to the continued use or posses-

3

sion, for purposes of the trade or business, of

property to which the taxpayer has not taken or is

not taking title or in which he has no equity.

STATEMENT

This case arises out of certain sale and leaseback

transactions of unimproved service station sites entered

into between Sunray and the Trust. A brief summary of

the transactions and the sale and lease terms is set forth

under section I of the opinion of the United States Court

of Appeals for the Third Circuit (App. pp. 12a-16a), ref-

erence to which is hereby made.

The Tax Court after reviewing the stipulated facts and

documents, testimony of the parties, and testimony of

expert witnesses, determined that under section 162(a) (3)

Sunray was factually and legally entitled to deduct in full

rental payments made pursuant to the leases. This con-

clusion was based primarily on the Tax Court’s factual

determination that Sunray did not retain or intend to

retuin an equity interest in the leased properties.

Sunray held certain options under the leases to reacquire

the leased properties, which options were exercisable at

specified intervals following the primary term of the lease.

The respondent in the Tax Court maintained that the

option price, as established by the formula “fair appraised

value of the leased premises to lessor”, was equal to the

present value of future rentals. The Tax Court recognized

that if the option price were equal to the present value

of futwry rentals, Sunray could preclude the Trust from

enjoyiag any appreciation in the value of the property

subsequent to the purchase from Sunray. After considering

conflicting testimony and evidence concerning the proper

interpretation of the option price formula, however, the

Tax Court determined that the formula, based upon an

4

appraisal of the property, would secure to the Trust the

benefit of such appreciation. The Tax Court then concluded

that Sunray did not retain an equity interest in the leased

properties under the provisions of the lease governing

the option. (App. p. 8a).

The leases also provided that, under certain circum-

stances, Sunray could make “rejectable offers” to purchase

the leased properties from the trust for a specified price,

and if rejected the lease would terminate. With respect

to these rejectable offer provisions, the Tax Court stated:

“Respondent contends that in providing for such

offers, the leases preserved for Sunray an equity in-

terest in the leased properties by providing Sunray

with the means of reacquiring the properties for less

than their appraised value.

“In passing upon respondent’s contention we must

consider the purpose of the parties to the leases in

including the offers to repurchase among their provi-

sions. Karl R. Martin, 44 T.C. 431 (1965), affd. on this

issue 379 F.2d 282 (6th Cir. 1967). The purpose of the

parties to the leases in providing for the offers to re-

purchase was not to provide Sunray with the means to

reacquire the leased properties. This is evidenced by

the fact that the Trust was under no obligation to

accept such offers as might be made. The sole purpose

of the provision in question was to insure Sunray of

a way to cancel the lease of any property which might

have proven uneconomical to operate as a service sta-

tion site. That the offers to purchase were provided for

in the leases does not, therefore, substantiate respond-

ent’s contention that Sunray retained an equity interest

in the lease properties.” (App. pp. 8a-%a).

Despite these clear findings, which petitioner submits

are factual underpinnings to the ultimate question to be

decided, the court below reversed the decision of the Tax

Court. The court of appeals initially concluded that the

question before it was a question of law and fully review-

5

able by the court. Accordingly, the court of appeals con-

ducted a full review of the record and reached its own

conclusions concerning facts which were contested at trial.

Specifically, the court of appeals rejected the Tax Court’s

determination of how the option price was to be deter-

mined, concluding that application of the formula was a

question of law even though the lease agreement was am-

biguous, documentary evidence concerning the negotiations

of the parties was confused and conflicting testimony con-

cerning the application of the formula was introduced at

the trial. The court below then proceeded to interpret the

formula price in a manner not only inconsistent with the

interpretation made by the Tax Court, but also in a man-

ner inconsistent with the interpretation of the formula

made by the respondent’s expert witness at trial.

The court of appeals also rejected the Tax Court’s find-

ing that the rejectable offer provisions did not cause

Sunray to retain an equity interest in the properties. The

Tax Court specifically found that the Trust was under no

obligation or compulsion to accept Sunray’s rejectable

offers. And yet, the court of appeals recited a litany of

reasons why the Trust would be compelled by practical

considerations to accept all rejectable offers. This approach

demonstrates the manner in which the court of appeals

extended its review of the Tax Court decision to purely

factual determinations and conclusions.

REASONS FOR GRANTING THE WRIT

CERTIORARI SHOULD BE GRANTED IN

THIS CASE FOR THE SAME REASONS

THAT PROMPTED THIS COURT TO GRANT

CERTIORARI IN NO. 76-624, FRANK LYON

COMPANY V. UNITED STATES, ARGUED

NOV. 2, 1977.

This Court heard argument on November 2, 1977 con-

cerning tax aspects of a similar sale and leaseback transac-

1Frank Lyon Company v. United States, 536 F.2d 746 (8th Cir.

1976), cert. granted. (

6

tion in the case of Frank Lyon Company v. United States,

Docket No. 76-624, on certiorari from the United States

Court of Appeals for the Eighth Circuit. Although the

Lyon case deals with depreciation, a crucial issue in that

case, as in this case, is the extent to which characterization

for Federal tax purposes of a sale and leaseback transac-

tion should be treated as a question of fact and subjected

to the “clearly erroneous” standard of appellate review

under Fed. R. Civ. P. 52(a). This petition should be held

pending resolution of this question in Lyon and then

evaluated.

1. FOR THE SAME REASONS PRESENTED

BY THE PETITIONER IN THE LYON PETI-

TION FOR WRIT OF CERTIORARI, THE DECI-

SION BELOW CONFLICTS WITH DECISIONS

OF OTHER COURTS OF APPEALS.

The arrangement in this case was a realistic one, made

by unrelated parties on an arm’s length basis, and entered

into for a variety of business reasons. Nonetheless, the

court of appeals rejected the arrangement on a retrospec-

tive determination that Sunray retained the bundle of

risks and responsibilities of an owner of real estate as

opposed to that of a lessee. The decision of the court of

appeals is in conflict with the decision of the Court of

Appeals for the Fourth Circuit in American Realty Trust

v. United States, 498 F.2d 1194 (1974), where, on a set of

facts involving a sale and leaseback, the court treated the

characterization of the sale and lease as essentially ques-

tions of fact rather than questions of law. In that case the

Fourth Circuit emphasized that the jury’s finding (that

the transaction in issue was a bona fide sale and lease-

back and not a financing arrangement) was binding unless

shown to be clearly erroneous. Additionally, the decision

of the court of appeals is in conflict with the decision by

the Ninth Circuit in Cubic Corporation v. United States,

7

541 F.2d 829 (9th Cir. 1976) where the court likewise

upheld a sale-leaseback saying: “That the intent of the

parties was to provide a legal means by which the counties

[lessees] could eventually acquire title does not change

a clear lease-option agreement into a contract of a con-

ditional sale.” (Emphasis in original.) In the particular

situation being considered, the fact, as the Tax Court

correctly determined, that the rejectable offer provisions

provided Sunray with a means to cancel the lease, and

not a means to reacquire the leased properties, does not

change a lease-option agreement into a retention of owner-

ship transaction.

2. FOR THE SAME REASON PRESENTED BY

THE PETITIONER IN THE LYON PETITION

FOR WRIT OF CERTIORARI, THE DECISION

BELOW CONFLICTS WITH A PRIOR DECISION

OF THIS COURT. |

The decision below, in its treatment of the findings made

by the Tax Court, as trier of the facts, is contrary to this

Court’s decision in Commissioner v. Duberstein, 363 US.

278 (1960).

In this case the Tax Court, after a full review of the

facts, determined the transactions were valid sales and

leases. It specifically determined that Sunray did not re-

tain an equity interest in the properties; that Sunray was

not in a position to take advantage of appreciation in the

fair market value of the property after it had been con-

veyed to the Trust. These basic findings were rejected by

the court of appeals. Such matters were in dispute, and

are not properiy characterized as legal conclusions, as so

characterized by the Third Circuit. Accordingly, the action

by the court of appeals is directly in conflict with Rule

52(a) of the Rules of Civil Procedure which provides that:

Findings of fact shall not be set aside unless clearly

erroneous, and due regard shall be given the oppor-

tunity of the trial court to judge the credibility of the

witnesses.

The court of appeals below relied specifically upon the

Eighth Cireuit’s decision in the Lyon case in support of

its position that the case was not subject to the clearly

erroneous rule. The approach by the Eighth Circuit in

Lyon and the court of appeals in this case with respect to

the appellate scope of review in a sale-leaseback transac-

tion was basically identical, each court performing an

emasculation of the clearly erroneous rule.

3. THIS COURT’S FINAL DISPOSITION OF

THE LYON CASE MAY DETERMINE THE NEED

FOR CERTIORARI IN THE INSTANT CASE.

If this Court should reverse the Lyon decision from the

Eighth Circuit, a grant and remand of this case to the

Third Cireuit for proceedings consistent with this Court’s

opinion in Lyon might then be appropriate. A further

reason for granting the writ of certiorari would then exist

because the decision below would conflict with this Court’s

decision in Lyon. Moreover, in the event the Lyon case

does not fully resolve the proper standard of federal ap-

pellate review, this case presents an excellent alternative

vehicle for clarification of that important federal question.

ee eg

9

CONCLUSION

This petition for a writ of certiorari should be held until

the decision in Lyon is finalized, at which tine it should

be determined if certiorari is to be granted and if this case

should be heard by this Court or remanded to the United

States Court of Appeals for the Third Circuit.

Respectfully submitted,

Burorp P. Berry

Exity A. Parker

2300 Republic National

Bank Bldg.

Dallas, Texas 75201

J. Davip ANDERS

P. O. Box 2880

Southland Center

Dallas, Texas 75221

Counsel for the Petitioner

Date: March 16, 1978

APPENDIX

la

APPENDIX A

United States Cax Court

T. C. Memo. 1976-40

Sun Ou. Company, Transferee,

Sunray DX Or Company

and Subsidiaries, Transferor,

Petitioner,

v.

CoMMISSIONER OF INTERNAL REVENUE,

Respondent.

Docket No. 877-73.

Filed February 17, 1976.

Burorp P. Berry and Tom G. Parrott,

MicHace. J. Henry, for the respondent.

for the petitioner.

MEMORANDUM FINDINGS OF FACT AND OPINION

FAY, Judge: Respondent determined the following defi-

ciencies in the Federal income tax of Sunray DX Oil Com-

pany and its subsidiaries, and notified petitioner that it was

liable for the deficiencies as transferee of the assets of the

said corporations:

TYE Deficiency

December 31, 1965 $ 14,055

December 31, 1966 47,806

December 31, 1967 95,733

October 25, 1968 217,343

We are to decide if amounts paid by Sunray DX Oil Com-

pany to the General Electric Pension Trust during the

years in issue were rentals deductible under section 162(a),

Internal Revenue Code of 1954.!

1Unless otherwise indicated, all statutory references are to the

Internal Revenue Code of 1954, as amended.

2a

FINDINGS OF FACT

Incorporated in these findings are the stipulations of

facts and appended exhibits.

Petitioner, Sun Oil Company, is a corporation organized

and existing under the laws of the Commonwealth of Penn-

sylvania wherein was located petitioner’s principal place

of business when the petition herein was filed.

Petitioner acknowledges that it is the transferee of the

assets of Sunray DX Oil Company (Sunray) and its sub-

sidiaries within the meaning of section 6901(a)(1)(A) (i)?

During the years in issue, Sunray was an integrated oil

company, engaged in the acquisition, exploration, develop-

ment and operation of oil and gas properties and the pro-

duction, refining, transporting and marketing of petroleum

and petroleum products. Together with its subsidiaries

Sunray filed consolidated corporation income tax returns

with the District Director of Internal Revenue, Oklahoma

City, Oklahoma, for 1965 and 1966 and with the Internal

Revenue Service Center, Austin, Texas, for 1967 and the

taxable year ended October 25, 1968.

The General Electric Pension Trust (Trust) is a fidu-

ciary trust to which the General Electric Company and its

2SEC. 6901. TRANSFERRED ASSETS.

(a) Method of Collection—The amounts of the following

liabilities shall, except as hereinafter in this section provided, be

assessed, paid, and collected in the same manner and subject to

the same provisions and limitations as in the case of the taxes

with respect to which the liabilities were incurred:

(1) Income, Estate, and Gift Taxes.—

(A) Transferees.—The liability, at law or in equity, of

a transferee of property—

(i) of a taxpayer in the case of a tax imposed by sub-

title A (relating to income taxes),

in respect of the tax imposed by subtitle A * * °

3a

affiliates contribute funds pursuant to plans of deferred

compensation which qualify the Trust for exemption from

Federal income taxation under sections 401 and 501.

On or about October 13, 1964, Sunray and the Trust exe-

cuted a document hereafter referred to as the first letter

agreement. Under its terms Sunray was to convey to the

Trust, in fee simple absolute, the land underlying approxi-

mately 120 marketing facility properties, mostly unim-

proved, located in Sunray’s 17-state marketing area. In

consideration of the conveyance of these properties, the

Trust agreed to pay Sunray an amount equal to the cost

incurred by Sunray in acquiring them, although in no

event was the aggregate consideration paid for the prop-

erties to exceed $6 million. Sunray agreed to sell the

properties at cost because, with one exception, they had

been purchased at different times within the preceding

year and a half; and it was therefore felt that their cost to

Sunray approximated their fair market value.

Sunray’s purpose in effecting these transactions was to

improve its liquidity posture.

The first letter agreement provided that the Trust would

lease the several properties purchased by it to Sunray for

a primary term of 25 years with options to renew for up

to 65 years. The rentals were fixed so that over the primary

term the price paid for the properties by the Trust would

be fully recovered and a return of 45g percent per annum

realized. If Sunray were to exercise all the options to re-

new, the Trust would realize a return of approximately 54%

percent per annum on its investment “ver the term of the

lease as extended.

Three leases were executed pursuant to the first letter

agreement: one on May 3, 1965, one on May 13, 1965, and

one on November 23, 1965. The format of these leases

4a

which covered 81, 7 and 44 marketing facility properties,

respectively, was similar in its essentials to that of a large

number of leases which Sunray had entered into with re-

spect to marketing facility properties sold to numerous

investors other than the Trust. ;

Each lease afforded Sunray an option to purchase any

of the leased properties on specified dates, provided Sunray

had discontinued or would discontinue the then business

use of the property to be purchased. In each instance the

price to be paid for the property was to equal its “fair

appraised value * * * to Lessor.” The appraisal of the

property was to be conducted by three appraisers: one

chosen by the lessor, one chosen by the lessee, and one

chosen by the other two appraisers. The decision of any two

appraisers was to be conclusive.

Sunray required that it be able to terminate its obliga-

tions to lease any property that might prove uneconomical

to operate as a service station. Each lease was therefore

made to provide:

During the Primary Term of this Lease, Lessee may,

if Lessee intends to discontinue or has discontinued the

use of the Leased Premises for its then business use,

make a rejectable offer to purchase the Leased Prem-

ises as of any Basic Rent payment date occurring in

the Primary Term at a price in cash equal to the sum

of the present values * * * of all quarterly Basic Rent

payments to become due on and after the proposed

purchase date * * *°

plus an amount sufficient to insure the Trust of a return of

5 percent per annum over the term of the investment.

3Under the leases executed pursuant to the first letter agreement,

the present value of a rent payment was to be determined by

ag = from the date on which it was payable to the date

on which present value was to be determined, on the basis

of an annual interest rate of 45% percent.

EY <a

5a

Each lease further provided that if on any one of sev-

eral specified dates

* * * Lessee, in the scle exercise of its business judg-

ment, determines that the continued leasing of the

Leased Premises has become unprofitable or unreason-

able or unnecessary in the conduct of its business use,

Lessee may make a rejectable offer to purchase * * *.

Offers to purchase made pursuant to this clause were to be

identical to those offers that might have been made by

Sunray had it discontinued the then business use of the

property.

The Trust was given 30 days in which to consider any

rejectable offer that might be made and was nowise obli-

gated to accept such an offer. In the event such an offer

were rejected, however, Sunray would be released from

its obligation to lease the property which it had offered

to purchase.

Each lease further provided :

In lieu of making any rejectable offer to purchase the

Leased Premises permitted * * * under this Lease,

Lessee shall have the right to substitute for the Leased

Premises other property (to consist of land only) hav-

ing a then value at least equal to the rejectable offer to

purchase consideration which otherwise would have

been applicable. * * *¢

To enhance its liquidity further, Sunray entered into a

second letter agreement with the Trust on or about April

24, 1967. Under the terms of the agreement the Trust com-

mitted itself to purchase approximately 200 marketing

facility properties in Sunray’s marketing area.

‘The right of substitution was initially included in the leases, but

on a 9, 1972, the leases were amended to effect a rescis-

sion phen of substitution. As of that time the right had not

been by the lessee.

6a

As in the case of the first letter agreement, the purchase

price was fixed at the cost to Sunray of the properties to

be conveyed to the Trust. In this instance, however, the

limit on the aggregate purchase price was set at $11 million.

Closings were scheduled for June 1967 and January 1968.

Sunray agreed to lease the properties sold on terms

similar to those contained in the leases executed pursuant

to the first letter agreement. However, an annual return

of 53% percent was to be provided for over the primary

term and 614 percent over the extended term; and if a

rejectable offer to repurchase were to be made during the

primary term, the price to be offered would be sufficient

to insure the Trust of a 534 percent return over the term

of the investment.

Leases covering 129 and 84 marketing facility proper-

ties were executed pursuant to the second letter agreement

on June 19, 1967, and February 28, 1968, respectively.®

As of July 15, 1974, over 130 rejectable offers were

made to purchase properties which it was decided would

not be used for business purposes. Each of these offers

was accepted by the Trust.

Statutory notice of the deficiencies at issue herein was

mailed on November 9, 1972.

OPINION

Petitioner maintains that the periodic payments which

Sunray made pursuant to its agreements with the Trust

constituted consideration for the use for business pur-

5Under the leases executed pursuant to the second letter agree-

ment, the present value of a rent payment was to be determined

by oe it from the date on which it was payable to the

date on which the present value was to be determined, on the

basis of an annual interest rate of 5% percent.

6See footnote 4 above.

7a

poses, of the marketing facility properties which Sunray

had conveyed to the Trust; and that the payments were

therefore deductible under section 162(a)(3).”

Respondent maintains that the transactions in issue

were financing devices or, in the alternative, installment

sales of the marketing facility properties back to Sunray.

If this were the case, Sunray would have retained an

equity interest in the leased properties, disqualifying the

periodic payments made pursuant to the leases from be-

ing deductible under section 162(a) (3).

Respondent’s position assumes that if Sunray had

ceased to use any leased property as a marketing facility,

it would have been able to regain unencumbered title to

the property by, in effect, restoring to the Trust the cost

the Trust incurred in acquiring the property, plus a reason-

able return in the nature of interest. Sunray would have

thus been able to take advantage of appreciation in the fair

market value of any leased property subsequent to its

having been conveyed to the Trust. Were this the case,

Sunray would have retained an equity interest in the

property. Union Bank v. United States, 285 F.2d 126, 128

(Ct. Cl. 1961). See also Clay B. Brown, 37 T.C. 461, 484-488

(1961), affd. 325 F.2d 313 (9th Cir. 1963), affd. 380 U.S.

563 (1965).

The marketing facility properties were conveyed for a

price intended by Sunray, which dealt with the Trust at

arm’s length, to approximate their fair market value at

the time of the conveyances.

7SEC. 162. TRADE OR BUSINESS EXPENSES.

(a) In General.—There shall be allowed as a deduction * * °

(3) rentals or other pa ts required to be made as a

condition to the continued use or possession,

the trade or business, of property * ° ° in

payer] has no equity.

f. of

which the tax-

8a

Each lease afforded Sunray options to reacquire any of

the leased properties on several specified dates for a price

equal to the “fair appraised value of the Leased Premises

to Lessor.” Respondent maintains that the price established

by this formula would be the appraised value of the

property as encumbered by the Sunray leases — an amount

equated by respondent with the present value of future

rentals. Thus understood, the provision establishing the

option price would preclude the Trust from enjoying

appreciation in the value of the property subsequent to

the conveyance by Sunray. In our opinion, however, the

formula, based as it is upon an appraisal of the property,

would secure to the Trust the benefit of such appreciation.

Respondent’s contention that Sunray retained an equity

interest in the leased properties is not substantiated by the

provisions of the lease governing the option.

The leases further provided that if Sunray discontinued

the use of any of the leased properties for its then busi-

ness use or intended to do so, it might offer to purchase

such property for a price sufficient to restore to the Trust

its original investment, plus a return in the nature of

interest. Similar offers to repurchase were also authorized

if, on certain specified dates, Sunray determined that con-

tinued leasing of the property had become unprofitable,

unreasonable or unnecessary in the conduct of its business.

Respondent contends that in providing for such offers,

the leases preserved for Sunray an equity interest in the

leased properties by providing Sunray with the means of

reacquiring the properties for less than their fair ap-

praised value.

In passing upon respondent’s contention we must con-

sider the purpose of the parties to the leases in including

the offers to repurchase among their provisions. Karl R.

Martin, 44 T.C. 731 (1965), affd. on this issue 379 F.2d

9a

282 (6th Cir. 1967). The purpose of the parties to the

leases in providing for the offers to repurchase was not

to provide Sunray with the means to reacquire the leased

properties. This is evidenced by the fact that the Trust

was under no obligation to accept such offers as might

be made. The sole purpose of the provision in question

was to insure Sunray of a way to cancel the lease of any

property which might have proven uneconomical to operate

as a service station site. That the offers to purchase were

provided for in the leases does not, therefore, substantiate

respondent’s contention that Sunray retained an equity

interest in the leased properties.

We therefore hold that under section 162(a)(3) Sunray

was entitled to deduct in full rental payments made pur-

suant to the leases under consideration.

To reflect concessions on other issues,

Decision will be entered

under Rule 155.

10a

APPENDIX B

United States Court of Appeals

For THe Turrp Circuit

No. 76-2388

Sun Om Company, Transferee,

Sunray DX Or Company

and Subsidiaries, Transferor,

Appellee,

v.

CoMMBSSIONER OF INTERNAL REVENUE,

Appellant.

AppeaL F'rom THE DEcISION OF THE UNITED STATES

Tax Court

Argued May 5, 1977

Before Serrz, Chief Judge, and Rosenn, Circuit Judge, and

Lorp, Chief Judge*

Myron C. Baum,

Acting Assistant Attorney General

GrtBert E. ANDREWS

Gary R. ALLEN

Joun A. Dupeck, JR.

Attorneys, Tax Division

Department of Justice

Washington, D.C. 20530

Attorneys for Appellant

Burorp P. Berry, Esquire

J. Davin Anvers, Esquire

Emity A. Parker, ATTORNEY

2300 Republic National Bank Building

Dallas, Texas 75201

Attorneys for Appellee

i —~ S. Lord, III, Chief Judge of the Eastern District of

ennsylvania, sitting by designation.

lla

OPINION OF THE COURT

(Filed September 7, 1977)

Rosenn, Circuit Judge

In the quest to obtain capital, to generate business

liquidity, or to minimize taxes, private enterprise often

resorts to the sale of property and a simultaneous lease-

back to the seller. A recurring question in transactions of

this sort is whether after the transfer of title to the prop-

erty some or all of the critical incidents of ownership still

remain with the grantor despite his newly designated status

as lessee.

This case concerns conveyances of 320 parcels of unim-

proved service station sites at cost by Sunray DX Oil Com-

pany (“Sunray”) to a tax-exempt trust and simultaneous

leasebacks to the grantor. The sole question is whether the

transaction was a mere financing arrangement between the

parties or an authentic sale. The Commissioner disallowed

Sunray’s deduction of its rental payments on the ground

that the transaction did not constitute a true sale and that

the rental payments were not a bona fide business expense

deductible under section 162(a)(3) of the Internal Revenue

Code of 1954 (“the Code”).! In a proceeding for redetermi-

nation of the deficiency brought by Sun Oil Co., Sunray’s

successor in interest, the United States Tax Court held that

1Section 162(a)(3) of the Internal Revenue Code of 1954 provides

in part that,

(a) In general._there shall be allowed as a deduction all the

ordinary and necessary expenses paid or incurred during the

taxable year in carrying on any trade or business, including—

. .. (3) rentals or other payments required to be made as a

condition to the continued use or possession, for purposes of

the trade or business, of p to which the taxpayer has

not taken or is not taking title or in which he has no equity.

12a

the rental payments were deductible. The Commissioner

appealed and we reverse.

I.

During the taxable years in issue (1965-1968), Sunray,

together with its subsidiaries and predecessors, was an

integrated oil company engaged in all phases of the petro-

leum business including marketing of petroleum and petro-

leum products. It was merged on October 25, 1968, into

Sun Oil Company, a New Jersey corporation which was

subsequently restructured as the Sun Oil Company, the

appellee taxpayer herein. During the 1950’s and early

1960’s Sunray was actively involved in acquiring service

station sites primarily in seventeen central states along

interstate highways and in certain urban areas. For a vari-

ety of business reasons, Sunray concluded that the most

preferable means of obtaining working capital would be to

convey its service station sites and then simultaneously

lease them back rather than to mortgage the properties and

incur a debt obligation on its books. After deciding to pur-

sue this course of action, Sunray ascertained that General

Electric Pension Trust (the “Trust”) was interested in

taking title to the properties, advancing funds to Sunray

equal to the cost of the properties, and then entering into

lease agreements with Sunray on a long term basis together

with options to purchase.?

2The General Electric Pension Trust is a fiduciary trust to which

the General Electric Company and its affiliates contribute funds

pursuant to plans of def. compensation which meet the re-

enema seine See ae Se Se ee Srey ee Sees

or exemption from federal income taxes. The Trust had assets of

approximately two and one-half billion dollars at the time of the

tax court hearing in this case. No relationship whatsoever existed

between Sunray and the Trust prior to the sale and leaseback

transaction now under consideration.

A

13a

After extensive negotiations concerning terms and con-

ditions of the proposed sale and leasebacks, Sunray and

the Trust entered into their first letter agreement, dated

October 13, 1964, under the terms of which Sunray agreed

to convey by general warranty deed and the Trust agreed

to purchase approximately 120 service station sites. The

agreed purchase price for the parcels of land, mostly unim-

proved, was equal to Sunray’s cost® of acquisition and in

the aggregate was not to exceed six million dollars. Simul-

taneous with purchase, Sunray agreed to lease the proper-

ties from the Trust for a primary term of 25 years with

quarterly rentals sufficient to enable the Trust to amortize

its investment in full over such initial term at an interest

return of 454 percent on its investment. The lease con-

tained options exercisable by Sunray to renew the lease for

two five-year terms at annual rentals equivalent to 214 per-

cent of the purchase price of the land and for an additional

eleven five-year terms at annual rentals equivalent to 1%4

percent of the purchase price.

On April 24, 1967, Sunray entered into a second letter

agreement with the Trust under the terms of which the

Trust agreed to purchase and Sunray agreed to sell ap-

proximately 200 additional service station sites at a price

equal to Sunray’s acquisition costs but not to exceed an

aggregate price of eleven million dollars. Sunray again

agreed to leasebacx the properties for a primary term of

25 years with quarterly rentals sufficient to amortize the

Trust’s investment in full over such initial term at an in-

terest return of 53g percent with similar renewal options

3Sunray agreed to convey the properties at cost because it believed

there would be no substantial difference between the appraised

value and Sunray’s actual cost of acquisition, most acquisitions

having been made during the preceding 18 months. This also

relieved Sunray of the necessity for expensive and time consuming

appraisals.

l4a

to Sunray as in the first letter; the annual rentals for the

first two five-year terms were equivalent to 3 percent of the

purchase price, for five additional five-year terms were

equivalent to 214 percent of the purchase price, and for

six final five-year terms equaled 2 percent of the purchase

price.

Sunray consummated the second letter agreement by

conveying 213 separate parcels of land each by separate

warranty deed. At or about the same time, Sunray leased

the properties for rentals under the terms set out in the

letter agreement. Sunray and the Trust executed master

leases at each of the closings, the terms of such leases being

essentially the same except for the effective dates, proper-

ties described, and the quarter-annual payments. The leases

require that the basic rent be payable absolutely net to the

Trust throughout the term without deduction or setoff and

that Sunray, as lessee, pay all taxes, assessments, or sim-

ilar charges assessed against the premises.

The major provisions of the leases were capsulized by

the Tax Court as follows:

Each lease afforded Sunray an option to purchase

any of the leased properties on specified dates, pro-

vided Sunray had discontinued or would discontinue

the then business use of the property to be purchased.

In each instance the price to be paid for the property

was to equal its “fair appraised value * * * to Lessor.”

The appraisal of the property was to be conducted by

three appraisers: one chosen by the lessor, one chosen

by the lessee, and one chosen by the other two ap-

praisers. The decision of any two appraisers was to

be conclusive.

Sunray required that it be able to terminate its

obligations to lease any property that might prove un-

economical to operate as a service station. Each lease

was therefore made to provide:

During the Primary Term of this Lease, Lessee

may, if Lessee intends to discontinue or has dis-

15a

continued the use of the Leased Premises for its

then business use, make a rejectable offer to pur-

chase the Leased Premises as of any Basic Rent

payment date occurring in the Primary Term at a

price in cash equal to the sum of the present values

* * * of all quarterly Basic Rent payments to be-

come due on and after the proposed purchase

date * * *

plus an amount sufficient to insure the Trust of a re-

turn of 5 percent per annum over the term of the

investment.

Each lease further provided that if on any one of

several specified dates

* * * Lessee, in the sole exercise of its business

judgment, determines that the continued leasing

of the Leased Premises has become unprofitable

or unreasonable or unnecessary in the conduct of

its business use, Lessee may make a rejectable

offer to purchase * * *.

Offers to purchase made pursuant to this clause were

to be identical to those offers that might have been

made by Sunray had it discontinued the then business

use of the property.

The Trust was given 30 days in which to consider

any rejectable offer that might be made and was nowise

obligated to accept such an offer. In the event such an

offer were rejected, however, Sunray would be re-

leased from its obligation to lease the property which

it had offered to purchase.

Each lease further provided:

In lieu of making any rejectable offer to pur-

chase the Leased Premises permitted * * * under

this Lease, Lessee shall have the right to substi-

tute for the Leased Premises other property (to

consist of !and only) having a then value at lease

equal to the rejectable offer to purchase consid-

eration which otherwise would have been appli-

cable. * * *

l6a

(Footnotes deleted.)

As of July 15, 1974, Sunray made over 130 rejectable

offers to repurchase properties which it had decided would

not be used for business purposes. The Trust accepted each

of the offers, reconveyed the properties, and released Sun-

ray from all obligations under the lease.

Il.

Relying heavily on Helvering v. Lazarus ¢ Co., 308

U.S. 252 (1939), the Commissioner contends that Sunray

retained all of the benefits and burdens of ownership to

the 320 service station sites it conveyed to the Trust. He

maintains that the purported transfer of title and lease-

back agreements were, in substance, nothing more than an

elaborate financing device in which the Trust stood essen-

tially in the position of a secured lender. The leaseback

agreements, the Commissioner asserts, enabled Sunray to

reflect the transactions as a footnote on its balance sheets

rather than a liability, minimizing any impact on its credit

rating, and, at the same time, enabled Sunray to claim a

100 percent “rental” deduction for its full cost of acquir-

ing non-depreciable land; and that Sunray in fact retained

an equity interest in the properties disqualifying the pe-

riodic payments under the leases from being deductible

under section 162(a) of the Code. The Commissioner as-

serts that his position is supported by: (1) the “net” lease

arrangement, (2) the condemnation and casualty loss pro-

visions of the lease, (3) Sunray’s absolute options to re-

purchase under the terms of the leases; (4) Sunray’s

unique right to substitute properties in the event its offers

were rejected, and (5) “rental” provisions which served

simply to return to the Trust the principal sum advanced

with fixed interest. Sunray, however, argues that the pe-

riodic quarterly payments made pursuant to its agreements

nore Oo tee weet

eee Boe

17a

with the Trust constituted consideration for the use for

business purposes of the service station sites, that the

properties were sold for a iair sales price in an arm’s

length transaction, and that the payments were, therefore,

deductible as rentals under section 162(a) (3).

The Tax Court concluded that the terms of the leases

did not support the Commissioner’s contention that Sunray

retained an equity interest in the leased properties after

the conveyances. The court believed that the purpose of

the provisions for repurchase of the leases was not “to

provide Sunray with the means to reacquire the leased

properties,” the Trust being under no obligation to accept

any offers which might be made, but to insure Sunray’s

ability to cancel the leases of any property which might

prove uneconomical to operate as a service station site.

We disagree.

Ti.

A threshold problem confronting us is the standard of

review. Sunray asserts that the Tax Court based its deci-

sion on findings of fact, which included a finding as to the

parties’ intent, and that these findings are binding upon us

unless clearly erroneous. The record in the instant case,

however, rests substantially on an indisputed record, con-

sisting principally of stipulations of the underlying facts

and appended exhibits, including the leases at issue. The

basic rights, duties, and economic interests of the parties

are essentially not in dispute. The dispute centers around

the characterization for income tax purposes of the letter

and lease agreements. The oral testimony offered by each

of the parties was either expert testimony interpreting the

documents or background testimony of some of the prin-

cipals pertaining to the negotiations and their views of the

transaction. In ABKCO Industries, Inc. v. Commissioner,

482 F.2d 150, 155 (3d Cir. 1973), we held the “interpreta-

18a

tion and construction of a contract is a question of law and

that the interpretation by the Tax Court is reviewable by

this court.” Of course, the subjective intent of the parties

may be a consideration in interpreting an agreement where

the documents are ambiguous or incomplete and, in such

circumstances, the court’s determination of the unex-

plained subjective intent is a finding of fact. When, how-

ever, the documents embodying the transaction are clear

and complete, “the court is called upon to interpret the

documents, and from their substance, to characterize the

transaction for tax purposes as a matter of law.” Frank

Lyon Co. v. United States, 536 F.2d 746, 751 (8th Cir.),

cert. filed, November 3, 1976, 45 U.S.L.W. 3347. Regard-

less of whether the parties honestly believe the transaction

to be a lease, where the documents they have executed fully

embody the elements of their bargain it is the documents

themselves, not the parties’ conceptions of them, which

must govern the legal characterization of the transaction.

See Oesterreich v. Commissioner, 226 F.2d 798, 801-02 (9th

Cir. 1955). We view the question here as essentially legal,

not factual, and fully reviewable by this court. Helvering

v. Lazarus & Co., supra; American Realty Trust v. United

States, 408 F.2d 1194, 1198 3d Cir. 1974).

IV.

In the usual mortgage transaction between a debtor

and creditor, the funds advanced to the debtor are secured

by a lien on his property. The debtor agrees to repay the

funds over a fixed term together with specified interest for

their use; generally, the ownership of property does not

change hands. The usual business bargain between a com-

mercial lessor and lessee is far more complex. Real estate

interests between a lessor and lessee normally are divided

into a number of parts, each of which represents an owner-

ship interest in property. In order to sort out these inter-

19a

ests, the following pragmatic approach has recently been

suggested :

If the characterization for federal income tax law pur-

poses of the interests of a lessor and a lessee is to be

determined in a marner consistent with business reali-

ties, the inquiry must change from “Who is the owner

of the property for tax purposes?” to “Are the owner-

ship interests of lessor and lessee as characterized by

the parties consistent with traditional substantive busi-

ness bargains between lessors and lessees?”

Rosenberg & Weinstein, Sale-Leasebacks: An Analysis of

These Transactions After The Lyon Decision, 45 J. of Tax,

146, 148 (1976).

In the instant case, the actual conveyance to the Trust

of title to the properties and the fair market value of the

prices assigned to them does not appear to be an issue.

Although Sunray argues that the presence of fair market

value as a consideration for the transfer distinguishes the

instant case from Helvering v. Lazarus ¢ Co., supra; and

Leeds & Lippincott Co. v. United States, 276 F.2d 997 (3d

Cir. 1960), we doubt that this is a controlling consideration.

We deem much more significant the relationships of the

parties after the transfer of the properties as a result of

the burdens, benefits, and risks imposed on each of them by

the terms and conditions of their lease agreements. In de-

termining whether the sale-leaseback transactions in the

instant case created the traditionally bargained for busi-

ness relationships between owner and lessee or whether

Sunray in fact retained an equity in the real estate despite

the conveyances, we look to the economic realities of the

leases and not to the labels applied by the parties.

In Lazarus, supra, the taxpayer claimed depreciation

on three buildings in which it operated a department store,

the legal title to two of which and the assignment of a 99

20a

year lease to the third it had transferred to a bank as trus-

tee for certain land trust-certificate holders. The trustee

had at the same time leased all three back to the taxpayer

for 99 years with options to renew and purchase. The tax-

payer claimed depreciation as a deduction because it bore

the capital loss from wear, tear, and exhaustion of the

buildings. The Commissioner disallowed the deduction on

the ground that the statutory right to depreciation follows

legal title. The Court of Tax Appeals, however, allowed

the deduction, concluding that the transaction between the

taxpayer and the trustee bank was in reality a mortgage

loan; that the conveyance of title to the bank was actually

given merely as security for a loan and that the “rent”

stipulated in the leaseback was intended as a promise to

pay an agreed 5 percent interest on the loan. The circuit

and Supreme Courts affirmed, the Supreme Court noting

that in the field of taxation the courts are “concerned with

substance and realities, and formal written documents are

not rigidly binding.”

A. Tue Risks anp RESPONSIBILITIES

As in Lazarus, the lease arrangements between the

parties in the case sub judice provide that the lessee, Sun-

ray, pay all taxes and assume the full burden and cost of

keeping the premises in good condition. The Trust is re-

lieved of the responsibility to repair, rebuild, or renew any

buildings, structures, or improvements “or to make any

expenditures whatsoever in connection with this lease . . .”

Moreover, Sunray has agreed to indemnify the Trust and

hold it harmless from any and all liabilities arising from

the use and occupancy of the premises, including liability

for any causes of action, judgments or violations of laws

or regulations affecting the premises. Sunray has also ob-

ligated itself to pay rent absolutely net throughout the

term without deduction or setoff under any circumstances.

21a

Diminution of rental even because of casualty or condem-

nation is not permitted. Thus, it is apparent that the

leases impose essentially all burdens, risks, and responsi-

bilities for the properties upon the lessee. Thrusting all

of such burdens and risks on the lessee under every condi-

tion and circumstance and none on the lessor is hardly

consistent with customary substantive bargains in the

market place between lessors and lessees.

B. Tue Benertts oF THE TRANSACTION

1. Rejectable offers upon condemnation or seizure

by eminent domain.

In addition to assuming the risks and burdens incident

to the ownership of property, Sunray also controls certain

important benefits which traditionally are reserved to the

owner in the event leased premises are condemned or seized

by eminent domain. During the primary term, if all or any

part of the leased premises becomes “in the sole and ab-

solute judgment of lessee” undesirable for the lessee’s

business or for any use then existing, because of a taking

by condemnation or eminent domain, the lessee has the

right to make a “rejectable offer” to purchase the prop-

erty. The Trust has thirty days after receipt of the writ-

ten offer to accept or reject it and failure to act within the

prescribed period constitutes an acceptance. Significantly,

the lessee not only has the unilateral right to determine

whether the taking is sufficient to make the premises “un-

desirable” for its further use, but the repurchase price

fixed for the offer is equal to the sum of all present values*

“Under the leases executed pursuant to the firm letter agreement,

the present value of a rent payment is to be determined by dis-

counting it on the basis of an annual interest rate of 456 percent

from the date on which it is payable to the date on which the

p resent value is to be determined.

22a

of the quarterly payments to become due after the proposed

date of repurchase, plus a pre-determine? premium.® If

Sunray’s offer to repurchase during the primary term is

rejected by the Trust, then the condemnation award is pay-

able both to Sunray and the Trust as “their interests may

appear” at the time of the taking. During the extended

term of the leases, Sunray also has the absolute right to

share in any condemnation award as “their interest may

appear.” Significantly, if a portion of the premises is

taken by condemnation or eminent domain but the lessee

elects to occupy the balance, there is no abatement of rent

and the entire award for the taking belongs to the lessee.

The lessee is also irrevocably empowered to negotiate the

terms and price for any taking and to sell and convey the

properties without the prior approval or joinder of the

Trust. We view the retention of such broad powers by the

lessee in the event of condemnation or government seizure

of the land, especially the power to negotiate the price for

the land, and the absence of rent abatement in the event of

a partial taking and continued occupancy of the balance as

inconsistent with the traditional role of a lessee.

2. Rejectable offers upon discontinuance of use.

Sunray also enjoys the unique right when, “in the sole

exercise of its business judgment,” it decides that the use

of a parcel of land is no longer profitable or necessary in

conducting its business to make a rejectable offer to pur-

23a

chase it. Again, the price is not dependent upon the fair

market value of the land at the time but is fixed in an

amount equal to the sum of the present values of all quar-

terly basic rent payments to become due in the future

plus the applicable prepayment premium shown in Sched-

ule “C” attached to the leases.

3. Lessee’s rights of substitution.

Sunray also had the extraordinary and absolute right,

in lieu of making any rejectable offer or upon rejection of

such an offer, to substitute other land having at least equal

value for the leased premises. The value of the land to be

substituted “[was to] be determined by the lessee’s book

value therefor.” This unilateral right of substitution thus

enable Sunray to reacquire legal title to any parcel of land

whenever it made a rejectable offer.’

4. Analysis of rejectable offer provisions.

We believe that the substance and reality of the “re-

jectable offer” provisions, particularly the rights of sub-

stitution, enabled Sunray during’ the taxable years in issue

to retain ultimate control over the leased properties subject

to repayment with interest of the advances made by the

Trust. We cannot accept the Tax Court’s conclusion that

6R. Paul Henry, former senior vice-president for Finance and

Planning for Sunray, testified that “we put [this provision] in

there in the event tax law changed and the tax ~~

of this deal changed for either party, it permitted the to be

unwound. But, I know we had some discussion of possible

changes in tax law and it was decided it would not be wise to

identify that as an occasion for rejectable offer and I think this

language [in the leases] was adopted to substitute for that.”

7Sunray’s right to substitute other parcels in the event the Trust

rejected a rejectable offer was rescinded by the parties 8 years

later, after the commencement of an audit by the Commissioner.

24a

the rejectable offer provisions do not vest any equity inter-

est in the lessee because “the trust was under no obligation

to accept such offers as might be made.” The Tax Court,

failed to analyze the lessee’s rights of substitution, dis-

missing them with the observation that they were never ex-

ercised and were ultimately rescinded on August 9, 1972;

we believe these rights of substitution rendered illusory

the lessor’s rights to reject an offer.

The limitations of time, distance, and subject matter

also erode whatever substance may have existed in the

lessor’s rights to reject an offer. The Trust had only thirty

days after the receipt of rejectionable offers to reject them

and the failure to act was deemed to be an acceptance. The

offers left the Trust with virtually an impossible task of

securing independent appraisals on comparative low unit

value properties, securing competent advice, and reaching

an intelligent, considered decision within a short time on

multiple pieces of diverse properties geographically dis-

persed over many states. In fact, the Trust initially ob-

jected to the thirty-day limitation but ultimately accepted

it and agreed to waive an appraisal requirement. Reject-

ing the offer would have required the Trust, having no

employees with background or experience in real estate

management, to undertake the heavy burden of managing

small real estate parcels and properties scattered over 17

states. The acceptance of such a burden was viewed by

trust officials as being inconsistent with the investment

goals of this 214 billion dollar trust. Furthermore, since

Sunray had to certify that the property would no longer be

used for its then existing business purposes, the only time

the parcels would be repurchased as a practical matter

would be for resale. The extreme impracticality of rejecting

a rejectable offer is evidenced by the Trust’s acceptance

of all 136 of Sunray’s “rejectable” offers made during

25a

the first few years of the leases. The Trust never took

possession of any property described in a rejectable offer.

Thus, Sunray, even though it was the titular lessee of

the properties, had the exclusive means of realizing the

benefits in appreciation in the market value of the proper-

ties by making a rejectable offer which had little like! iood

of being rejected; if perchance it were rejected, Sunray

had the absolute right to substitute other parcels of prop-

erty. In addition, as we later discuss, Sunray had also the

absolute option to repurchase the properties during the ex-

tended terms of the leases for an option price equal to the

fair appraised value of the leased premises to the lessor.

In our view, the powers vested in the lessee in the

event of condemnation or seizure of property pursuant to

the power of eminent domain, including the right to nego-

tiate the sale or settlement price, the right to make rejecta-

ble offers, and the extraordinary rights of substitution are

significant benefits characteristic of the ownership of prop-

erty rather than that of a leasehold.

C. Tue Rentaqs

Rentals in these transactions were apparently geared

to return the Trust’s advances plus interest. To achieve

such a result, the rentals for the primary term were set at

a predetermined figure. According to R. Paul Henry, who

negotiated these transactions for Sunray, the rental value

was fixed by formula based on a twenty-five year period to

enable the Trust to recover the amount of money advanced

for the properties plus “a reasonable agreed amount for

what would be comparable to interest. And then, should

the leases be terminated prior to the end of the twenty-five

year primary term, an added amount would be paid to G.E.

26a

[the Trust] because this was a rather awkward type trans-

action.’””®

Additional evidence in the record indicates that the

rentals do not reflect the market value of the properties.

We think it significant that the Trust determined the fair

rental value for the properties by merely treating the

transaction as an “investment alternative,” rather than

applying the capitalization of earnings methed as an ac-

cepted appraisal methed. Dr. Pope, the Commissioner’s

expert, prepared a valuation report for the properties

which is in the record. It reveals that the rentals fixed for

the primary term are quite high.® A fair rental value for

a non-wasting asset such as unimproved land to a lessee

with Sunray’s high credit standing would be the cost of

money times the investment. Dr. Pope’s valuation report

reveals that in October 1964, Government bonds were

yielding 4.15 percent, triple A utility bonds were paying

434 percent, and top grade corporate bonds were paying

4.52 percent. Effective mortgage rates ranged from 5.5

percent to 6.1 percent, depending upon the lending institu-

tion. Although the annual rate of return due under the

transactions with the Trust was 6.79 percent, Dr. Pope re-

vealed that a reasonable rate of return would have been

454 percent, the interest rate specified in the lease agree-

8Mr. Henry acknowledged that in this instance the premium was

“the factor applied to bring the effective rate up to either 5

percent or 5% percent in the event of premature termination of

the leases,” and that prepayment penalties arise in mortgage

transactions, debenture financing, or private placement loans.

The Tax Court in the instant case did not make any findings of

fact or conclusions of law regarding the reasonableness of the

rent payable by Sunray during either the primary or extended

terms of | the lease. Cumpare Leslie Co. v. CIR. 539 F.2d 943 (3rd

Cir. 1976), in which we relied on the Tax Court's findings as to

the fair rental value of the leasehold.

27a

ment, without the amortization of the cost of the land. The

amortization of unimproved land as part of the rental,

represented by the difference of 2.144 percent, is not a com-

mon practice in the marketplace. In short, the rentals were

mathematically geared to amortize the moneys advanced

by the Trust at the agreed annual rate of 454 percent over

the primary 25 year term of the lease or through the exer-

cise of Sunray’s repurchase rights; they bear little resem-

blance to the true economic value of the properties.

Also supporting the Commissioner’s contention that

the rentals do not reflect market value but were merely

based on a formula which included the current interest rate

plus an amortization factor is the underlying “Schedule of

Direct Reduction Loan” attached to the leases which sets

forth in typical loan arrangement form the interest rate,

the amount of the principal loan, the term of years, the pay-

ment number and the apportionment of the quarterly pay-

ments between principal and interest. This schedule of

payments is identical to the procedures utilized in conven-

tional direct reduction mortgage loans which became popu-

lar in this country during the “Great Depression” of the

1930’s. Likewise, in their negotiations, the patries fre-

quently referred to the payment of interest and principal,

to “standby fees” and loan “commitment fees,” terms

common in mortgage financing and not in the traditional

relationships between lessor and lessee.!®

In the letter dated September 21, 1974, to Eastman

Dillon, Sunray’s counsel also points out that in the

10[n his lengthy letter dated September 21, 1964, to Eastman Dillon,

chief oommael for Sunray understood the essence of the transaction

as a loan. He wrote: “A money lender who is being offered at

least a return of the principal together with 5 percent interest

thereon should have no reason to insist on an appraisal.” Another

aragraph of the same letter refers to the unacceptability of the

rust’s proposal because of its adverse effects on “the economics

of the financing.” (Emphasis supplied. )

28a

twenty-sixth year of the proposed lease, “the unencum-

bered appraised value would probably exceed the original

investment if present inflationary trends continue.” Not-

withstanding his conception of the increased value in the

land and his prophetic view of inflationary trends, the

rentals payable in the twenty-sixth year and thereafter

during the next sixty-four years of the thirteen extended

terms do not increase but are sharply reduced. The quar-

ter annual rents drop from $1015.38 to $375.00 for the first

two extended terms and then drop again to $225.00 for the

next eleven extended terms. Thus, Sunray having paid for

the properties in full during the primary term, was entitled

to remain in possession for the next sixty-five years at

nominal rents. If it exercised all of its options for each

of the extended terms, the additional cost therefor, as the

Tax Court recognized,’ was merely to increase the Trust’s

return from 45g percent per annum to 51% percent. It is

hardly conceivable that an owner of real estate — especially

a large sophisticated trust — concerned with a fair rental

on its land rather than a return of its loan and interest,

would enter into a lease with sharply declining rentals for

sixty-five years following the conclusion of the primary

term on December 31, 1989. The extended term features

of the lease further indicate to us that the Trust, as a

lender, was only looking to a return at a fixed rate on its

advances, and not to a reasonable return on the fair market

value of property which it held as owner.

D. Txe Options to REPURCHASE

The repurchase provisions of a sale and leaseback

agreement serve the same function as a mortgage loan

when the repurchase price is geared to the unamortized

11The Tax Court stated that “[i]f Sunray were to exercise all the

options to renew, the Trust would realize a return of approxi-

mately 5% percent bat annum on its investment over the terms

of the lease as exten

29a

principal advanced by the purchaser-lessor. See Frank

Lyon Co., supra, 536 F.2d at 752-54. In the instant case, in

addition to Sunray’s right to make rejectable offers to re-

purchase the parcels in certain situations by, in effect, pay-

ing off the unpaid principal balance of the Trust’s advance

plus the applicable schedule “C” premium payment, Sun-

ray has the absolute right to purchase leased parcels under

section 9 of the leases during the first year of each of the

thirteen extended terms. This right is subject to the same

conditions stipulated in connection with the rejectable

offers (1) that Sunray must discontinue the use of the

premises “fcr its then business use” and (2) that the re-

purchase price be equal to the “fair appraised value of the

leased premises to Lessor” as fixed by three appraisers.

These provisions give Sunray considerable flexibility de-

spite the requirement that it must discontinue “its then

business use” of the property. Since most of the sites were

unimproved non-income properties at the time of the lease

arrangements, Sunray could improve the properties and

resell them to investors whenever it deemed conditions ap-

propriate in the future, as it previously had done on other

occasions with similar properties, and such a sale would

work a change in the “then business use.” Furthermore,

nothing prevented Sunray from diversifying its operations

and using the land for other income producing purposes.

The Commissioner contends that the appraisal pro-

cedure prescribed for these non-rejectable options gives

Sunray another avenue by which to enjoy appreciation and

the “equity” built up through its “rental” payments. The

contract provides that upon exercise of the option, the

lessor and lessee will each appoint an appraiser and the

two appraisers thus chosen will select a third. The ap-

praisers are required by majority decision to fix “the fair

appraisal value of the leased premises to the Lessor”

and the appraisal fees and expenses are to be paid solely

30a

by the lessee. The Tax Court disagreed with the Commis-

sioner’s analysis of this provision, reasoning:

Respondent [Commissioner] maintains that the price

established by this formula would be the appraised

value of the property as encumbered by the Sunray

leases — an amount equated by respondent with the

present value of future rentals. Thus understood, the

provision establishing the option price would preclude

the Trust from enjoying appreciation in the value of

the property subsequent to the conveyance by Sunray.

In our opinion, however, the formula, based as it is

upon an appraisal of the property, would secure to the

Trust the benefit of such appreciation.

We believe the Tax Court misconstrued the provisions

when it read them as requiring the lessee to pay the fair

market value for the property upon the exercise of the

options. In the absence of a provision to the contrary, the

appraisers had to consider all legal obligations encumber-

ing the property in appraising its value and had to recog-

nize the present value of any reversion in the land at the

termination of the encumbrance. Plaza Hotel Assn. v.

Wellington Assn., 55 N.Y. Mise. 2d 483, 285 N.Y.S.2d 941

(Sup. Ct. 1967), aff’d 28 App. Div. 2d 1209, 285 N.Y.S.2d

267 (1967), aff'd 22 N.Y.2d 846, 239 N.E.2d 736 (1968).

Counsel for Sunray recognized that the leases encumbered

the properties and adversely affected their appraisal after

the primary term.” Thus, in assessing the “fair appraised

value . . . to Lessor,” the appraisers would have to consider

the encumbrances of the properties with leases of very low

rentals, thereby seriously reducing the present value of

future rentals.

12This view is reflected in his letter of September 21, 1964, to East-

man Dillon wherein he writes: “Since, as of the time of the

i with the Lease,

Ht

ih

oF

i

fel

3la

The Commisioner also contends that since the option

price was equal to the present value of future rents pay-

able under the lease the appraisers must recognize that the

reversionary value of the property in the year 2055 is de

minimis because of the high discount factor applicable to

a sum due sixty-five years in the future. If the fair market

value had doubled or quadrupled, Sunray would be able to

acquire the property for a fraction of its original cost.

Sunray argues, on the other hand, that the lease agree-

ments are not totally clear, and that the Commissioner’s

interpretation conflicts with the language of the lease, with

the interpretation of his own expert, and with that of the

trustees of the Trust. Sunray asserts that the Tax Court

appropriately found that the option price was not merely

equivalent to the present value of future rents but that it

would secure to the Trust, upon appraisal, the benefit of

any appreciation in value of the properties.

Our review of this holding by the Tax Court is not

limited to the clearly erroneous rule, as Sunray argues,

since the interpretation of the option provisions is a ques-

tion of law. We disagree with the Tax Court’s view of

these provisions of the leases for the reasons previously

expressed and hold that the “then appraised value” to the

lessor is essentially equivalent to the present value of the

future rents under the lease. Thus, the options to repur-

chase provide Sunray with a built in latch-string by which

it could spring legal title to the properties whenever it

served its convenience without obligating Sunray to pay

the fair market value. Sunray could thereby acquire the

benefits of appreciation in the property by merely paying

the present value of future rents payable under the lease.

13Dr. Pope illustrated this point with the following example. Assum-

ing a property cost $60,000 at the outset of the sale in 11965 and it

has a market value of $100,000 in 1990. any SOY 7 eae

1,000

Sunray could repurchase the property for about

32a

Finally, Sunray contends that the Trust may, without

notice to or consent of Sunray, assign or transfer to any

party, for any purpose, at any time its rights under the

lease, even for purposes of refinancing. It argues that the

Trust’s ability to refinance its investment is a significant

attribute of real estate ownership. This may be true as a

general principle. In the instant case, however, the right

to assign or refinance may be hollow since it is subject to

the extraordinary low rentals during the lengthy extended

terms of the leases. Furthermore, any significance attached

to the right to refinance is eroded in the instant case by

other significant attributes of ownership retained by the

Jessee.

V.

In conclusion, we recognize that sale-leaseback arrange-

ments play a useful and accepted role in our economy. We

also note that some of the provisions of the leases in the

instant case when viewed independently do not brand the

transaction as a financing arrangement. A number of other

important features, however, “have been employed in the

same transaction with the cumulative effect of depriving

[the lessor] of any significant ownership interest.” Frank

Lyon Company v. United States, supra, 536 F.2d at 754.

As the lessee, Sunray bore the burdens, risks, and re-

sponsibilities for the properties, including the obligation to

provide the Trust with a fixed guaranteed return under all

circumstances and conditions. The lessee also controlled

important benefits traditionally reserved to the owner of

property: the lessee had the right to negotiate the settle-

ment or accept the condemnation award and receive the

payment; in the event of total or partial condemnation the

lessee retained the right to terminate the lease whenever

in its sole judgment a parcel of land was no longer profit-

33a

able or necessary in its business and to make a “rejectable

offer” which for all practical purposes was unrejectable;

the lessee, in any event, enjoyed the right to substitute

other land if perchance an offer was rejected or in sub-

stitution of a rejectable offer. These risks, burdens, and

benefits are strong attributes of ownership, not of a lease-

hold interest.

The leases also bear marked similarities to debt financ-

ing, particularly to direct reductions loans, including the

structural and guaranteed interest rate, consistent with the

going market interest rate for quality firms of Sunray’s

credit standing, the prepayment penalties, the schedule of

payments, and the rejectable offer procedures. The rents

have no visible connection with the economic value of the

property but are evidently related to a fixed interest return

on the advances. Finally, the options to acquire the prop-

erty at the end of the primary term at the value to the

lessor is a form of “equity” because the value to lessor is

really the present value of future payments for sixty-five

years at a specified rate.

We therefore conclude that the sale-leaseback transac-

tions were a financing arrangement. Sunray’s claim under

section 162(a)(3) for rental payments made pursuant to

the leases will accordingly be disallowed.

The decision of the Tax Court will be reversed and the

case remanded for the entry of an appropriate decision not

inconsistent with this opinion.

A True Copy:

Teste:

Clerk of the United States Court of Appeals

for the Third Circuit. 4

(A.0.-U.S. Courts, International Printing Co., Phila., Pa.)

34a

APPENDIX C

United States Comt of Appeals

For THe Txrrp Crrcuir

No. 76-2388

Sun On Company, Transferee, Sunray DX On Company &

Sussipiazies, Transferor, J. R. Layton, Vice-PREsSIDENT),

240 Randor-Chester Road, St. Davids, Penn. 19087

v.

CoMMISSIONER OF INTERNAL REVENUE,

Appellant

(T.C. No. 877-73)

On AppEat From a Decision OF THE Untrep States

Tax Court

Present: Serrz, Chief Judge and Rosenn, Circuit Judge and

Lorp, Chief Judge*

JUDGMENT

This cause came on to be heard on the record from the

United States Tax Court, and was argued by counsel.

On consideration whereof, it is now here ordered, ad-

judged and decreed by this Court that the decision of the

said Tax Court in this cause be, and the same is hereby

reversed and the cause is remanded for the entry of an ap-

propriate decision in accordance with the opinion of this

Court. Costs taxed against appellee.

ATTEST:

Clerk

September 7, 1977

*Joseph S. Lord, III, Chief Judge of the Eastern District of

ennsylvania, sitting by designation.