Appendix — Southeastern Canteen Co. v. Commissioner

- In the Supreme Court of the United-States

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“ OCTOBER TERM, 1969. \

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SOUTHEASTERN CANTEEN CoO.,

~~. CANTEEN SERVICE CO. OF TOLEDO,

Petitioners, | * eet

v. 2 ae |

COMMISSIONER OF INTERNAL Wasa pes <7

Respondent. ie | ;

APPENDIX TO |

PETITION FOR A WRIT OF CERTIORARI inh |

To the United States Court of Appeals.

For the Sixth Circuit.

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JoHN J. Kewoarck: Esquire,

500 Libbey-Owens-Ford. Building,

_ 811 Madison Avenue,

Toledo, Ohio 43624,

~ Attorney for Petitioners. |

Of Counsel:

’ SHumaker, Loop & KEnprIcK,

500 Libbey-Owens-Ford Building,

811 Madison Avenue,

Toledo, Ohio 43624.

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THE GATES LEGAL PUBLISHING CO., CLEVELAND, OHIO—TEL. (216) 621-8647 &

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APPENDIX TO PETITION FoR WRIT OF CERTIORARI he .

+ Appendix A. Opinion of the Court of Appeals Lo. oa 7

Appendix B. Opinion of the Tax Court mee i . 2t

Appendix C.: Statute Involved ee eRe area 61 ;

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APPENDIX “A. ;

" OPINION OF THE UNITED STATES COURT OF APPEALS

FOR THE SIXTH CIRCUIT. = =

(Decided May .18, 1969.) pres :

Before: WEICK,, Chief Judge, (O’Suttivan and Z

PHILLIPS, Circuit Judges.

O'SuLLIVAn, Circuit Judge. Petitioners, Southeasterr

Canteen Co. and Canteen Service Co. of Toledo. petition

for our review of a decision of the Tax Court, entered

' September 19, 1967, upholding the Respondent-Commis-

sioner’s assessment of deficiencies in income tax in the

* amounts of $16,589.82 and $58,863.73, respectively. These

“deficiencies arose primarily from disallowance of parts of

deductions from income taken by taxpayer- corporations ~

for rent and commissions paid by them to ‘the then owner |

of the equipment used’ by, taxpayers, and from disallow- 0

ance of Southeastern Canteen\Co.’s claim of corporate

“exemption from surtax on the ast $25-000 of its earnings.

Reason for these rulings was provided by a —— that

the disallowed rent and commissions paid were not “ordi-

. “nary. and necessary expenses paid: oe incurred * * * in

carrying on” the taxpayers’ trade of ‘business, within the

meaning of the Internal : Revenue Code of 1954, 26 U.S.C.

§ 162(a). Disallowance of the ‘exemption from surtax of

the first-$25,000 of ssuthenaben Canteen Co. earnings, 26

U.S.C. § 11(d), was the product of the Tax Court’ s finding

that Southeastern Canteen Co. was formed by the owners

_of Canteen Service Co. with the principal purpose of secur- -

ing the surtax exemption of $25,000 of, jts earnings, con-

trary to Section 269 of the Internal Revenue —— of 1954,

26 U.S.C. § 269.

We agree with the Tax Court’ S sfliccrasion of the Com-

missioner’s disallowance of amounts: claimed as rent and

other business expenses. We reverse its holding which

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denied Southeastern, Canteen Co.’s use of the surtax ex-

The Tax Court decision, filed September 19, 1967, is

reported as Southeastern Canteen Co. and Canteen Service

Co. of Toledo v. Comm’r, 36 P-H Tax Ct. Mem. 973,

{ 67,183 (1967). The factual history is complicated. Bud- ©

dies Box Lunch, Inc. was formed as an Ohio corporation

on July 16, 1931. The outstanding capital stock was owned

fifty percent by Virgil A. Gladieux and fifty percent, by his

brother; Nelson Gladieux. In 1955, Virgil became sole

stockholder and in 1960 the corporate name was changed

to Gladieux Corporation (hereinafter.Gladco). Gladco

was principally engaged in the operation of cafeterias and

lunch counters and the dispensing of food in several manu-

facturing plants in Toledo, Ohio. It also sold candy, gum

and nuts both at its lunch counters and through vending

machines at locations in and near-Toledo.

~ Canteen Service Co. of Toledo was incorporated as an

“Ohio corporation on’ March 16; 1946, and was prineipally

engaged-in the operation of ven machines, in Lucas,

Fulton and Wood counties in Northwestern Ohio under a

, franchi$e granted by Au tic Canteen Company of

America. (hereinafter Aut®matic). Its sole shareholder _

was Ben T. Handwork. On May 10, 1946, Gladco entered

into an agreement with Canteen Service whereby Gladco

transferréd to Ganteen Service its vending machine busi-

ness in exchange for payment of location commissiqns on™

all gross salés of candy, gum and nuts sold through vend- -

ing machines previously operated by Gladco and at all

locations where Gladco then operated food dispensing

facilities. Gladco, pursuant to an option in the agreement,

purchased seventy-five percent of Canteen Service's stock

on or before October 31, 1946. Later, as a result of re-

demption of Handwork’s remaining twenty-five percent ©

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stock interest, Gladeo became the éole owner‘of Canteen

Service.

- “ Southeastern Canteen Co. was incor pétated as a

Michigan corporation on January 19, 1956. Its business

was the same as Canteen Servite’s—the sale of food and

‘ beverages through vending machihes under a franchise

granted by Automatié—but the territory of the business

was Lenawee and Monroe counties in southeastern Michi-

gan. Southeastern issued twenty shares of stock—fifteen

to Virgil Gladieux and five ‘to Ben Handwork. In 1959,

Southeastern redeemed Handwork's stock, with Gigdioux

thereby becoming sole stockholder.

Thus, by 1960 Canteen Sé¥vice Co., an Ohio corpora-

tion, was wholly owned by the Gladieux Corporation

(Gladco) and the corporate shares of Gladco and South-

eastern, the Michigan corporation, were wholly owned

by Virgil T. Gladieux. Virgil and his wife, Beatrice G.

Gladieux, were also the sole shareholders in twelve other

corporations engaged in the merchandising and vending

of food, beverages and gum in various areas of the United

States. On June 30, 1960, Virgil and his wife agreed to

transfer all fifteen corporations-to ABC Vending Cor-

poration, a large publicly owned Delaware corporation,

in exchange for 80,000 shares of its stock, an option to

purchase 5,000 additional shares, and an executive posi-

tion with ABC at an annual salary of $62,500.’ The fran-

chise agreements which Canteen Service and Southeast-

ern had with Automatic, however, gave Automatic a right

to withhold consent to a transfer of Canteen Service or

Southeastern.” Automatic exercised this right and refused

to permit the transfer of either company to ABC. Virgil

*. 1 ABC, este had 8,522 shareholders owning 1,228,328

shares of common stock included 48,960 treasury shares.

* Article V, Section 25 of Franchise Agreement.

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Gladieux’s arrangement to circumvent this refusal brought -

about most of the litigation before us.

Prevented from total performance of the June 30,

1960 agreement, Virgil, on January 26, 1961, by “Supple-

mental Agreement” transferred to ABC his other thirteen

corporations, including Gladco, in exchange for 68,500

shares of stock, the stock option, and the executive position

with ABC.’ There were also negotiated,‘as of January

31, 1961, agreements’ between Gladco (then owned by |

ABC) and Canteen Service (e6ntfolled by. Virgil Glad-

' jeux), and between Gladco and Southeastern (still con-

- trolled by Virgil). The terms of these latter agreemehts

were substantially as follows: Canteen Service and South-

eastern (petitioners) would. transfer to Gladco their

tangible physical assets at a price determined by their

~ net book value as of October 1, 1960. Gladco would then

lease back to petitioners all such asséts for a term of

twenty years, beginning October 1, 1960, and would

lease to petitioners “all additional equipment necessary

for the operation of the vending machine business.” Peti-

tioners would pay to Gladco for such leased assets a

“rental” equal to ten percent of their gross sales attribu-

table to the vending machine business during the term of

the lease, provided such “rental” did not create a deficit

in the net income of either petitioner. Petitioners would -

pay increased “fixed locatien commissions” to Gladco with

respect to all sales at vending machine locations derived

through Gladvo, Virgil or any affftiated corporations. In

‘consideration for the transfer of their physical assets,

Gladco paid“ to Canteen Service and Southeastern

. ® The six-month delay in negotiations was caused by the fact

that Automatic’s refusal to consent was submitted to arbitration,

and the arbitrator’s decision (in Automatic’s favor) was not ren-

- dered until December 27, 1960.

.

an

$184,659.85 and $5,109.43, respectively. All of this money

was usedsalong with $201,827.30 and $52,863.64, respec-

tively, out of their other funds, to purchase 11,500 shares

~ of ABC stock in the spring of 1961. By this purchase,

Virgil then held, directly or indirectly, the 80,000 shares

of stock he would have acquired had the original agree-

ment not been blocked by Automatic.

The Commissioner made the following deficiency as-

sessments: against Canteen Service Co. of Toledo and

Southeastern, together, $58,863.71_for the tax year end-

ing September 30, 1961;' agains{ Southeastern Canteen

Co. (the Michigan Corporhtion), $4,936.82, $5,458.89 and

$6,194.61 for the tax years ending October 3, 1959, Octo-

ber 1, 1960, and September 30, 1961, respectively.”

We consider then, 1) disallowance of rerital payments

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made by petitioners to Gladco, 2) disallowance of location ©

commissions paid by petitioners to Gladco, and 3) disal-

lowance of surtax exemption claimed by Southeastern.

1) Purported Rental Payments.

For their fiscal year ending September 30, 1961, peti-

tioners Canteen Service and Southeastern claimed deduc-,

tions of $121,172.15 and $12,211.30, respectively, for

amounts paid as rent to Gladco pursuant to the sale-lease-

back’ agreement of January 31, 1961. These deductions

were claim hs te Section 162(a)(3) of the Internal’

Revenue Code of 1954, 26 U.S.C. § 162(a) (3), which reads

in pertinent part as follows: |

‘ This amount represents the disallowance of a portion of the

rental and location commission deductions taken by Canteen

Service and Southeastern.

5 These were the consequence of disallowing Southeastern’s

surtax exemption for the mentioned years.

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“(a)’ 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—

a

* * * * *

(3) rentals or other payments required to be

made as.a condition to the continued use or posses-

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 ho equity.”

The — Commissioner, however, disallowed petitioners’

claimed’ deductions to the extent that they exceeded

$5392.79 and $1,906. 594, respectively. He based his de-

termination onthe conclusions that ‘the sale-leaseback

agreement was not negotiated at arm’s length between .

adverse parties and that the claimed rentals did not repre-

sent the fair rental value of the assets leased. The fact

that the parties designated, and one party became obli-

gated to pay to the other, a specified amount as rent does

not bind the government to treat that amount as rent.

Catherine G, Armston, 12 T.C. 539, 548 (1949), aff'd sub

- nom. W. H. Armston Co., Inc. v. Comm’r, 188 F(2)

531, 533 (5th Cir. 1951). Where there is an absence of

arm’s length dealing, the Commissioner may inquire into

what constitutes reasonable rental to determine whether

the amount paid exceeds what would have been paid had

the parties dealt at arm’s length. Roland P. Place, 17 T.C.

199, 203 (1951), affirmed, 199 F(2) 373 (6th Cir. 1952),

cert. denied, 344 U.S. 927 (1953). See also, J. J. Kirk,

Inc., 34 T.C. 130 (1960), affirmed 289 F(2) 935 (6th Cir.

1961).°

6 This power given the Commissioner is but a conden to

the broader proposition that the substance of a transaction rather

than the form is controlling. Gregory v. Helvering, 293 U.S.

465, 79 L.Ed. 596 (1935); Smith v. Comm’r, 370 — 178 (6th ,

Cir. 1966).

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The issue is whether fMe involved parties negotiated

‘the sale-leaseback agreement at arm’s length. This is an

issue of fact, and the Tax-Court’s findings can be reversed

only fund to be clearly erroneous. Comm’r v. Duber-

stein, 363 U.S. 278, 291 (1960). We consider that the

Court’s findings are not clearly erroneous, and agree with

the following from the Tax Court’s decision:

“The dominant motives of both Virgil and ABC

throughout the negotiations which culminated in the

sale-leaseback agreements are crystal clear. Virgil

sought to obtain ABC stock and an executive position

with the company and ABE sought to acquire Virgil’s

15 food service companies. In light of these facts,

we think it abundantly clear that the sale-leaseback

agreements were designed solely to fulfill the per-

sonal objectives of Virgil: There was no legitimate

business purpose for petitioners to undertake the

. sale and subsequent leaseback of their tangible assets

other than to satisfy Virgil’s purpose of shifting in-

come from petitioners to Gladco in order to induce

ABC to go through with the deal. Thus, this is not a

case where a corporation entered a sale-leaseback

arrangement in-order. to generate’needed cash for

business expansion. To the contrary, all the money

“ received by petitioners upon the sale of their tangible

assets, together with substantial additional amounts,

was used to purchase ABC stock, thus. serving no

meaningful business purpose to petitioners.

‘Petitioners’ position is further weakened by «the

fact that during the entire negotiation? leading up

to the execution of the sale-leaseback agreements, the

owner of both the lessor (Gladco) and the lessees

(petitioners) was the same person, Virgil Gladieux.

Petitioners’ attempt to transform such an identity

‘of interest into a relationship which petitioners

characterize aS adverse, transgresses reasonable im-

agination. All the more so since the facts show that

ey

AP er eM

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the sale-leaseback agreements were not intended to

be.ends in themselves but merely steps in an inte-

grated plan to secure to Virgil and ABC advantages

which could not benefit petitioners in any meaningful

way. From a review of all the facts bearing on this is-

sue®which have been set out at length in our findings,

we are convinced that the sale-leaséback agreements

in question were not the result of arm’s length negoti-

. ationsbetween adverse parties and, therefore, we must

determine whether the purported rentals were ‘in

excess of what the lessee[s] would have been required, :

to pay had * * * [they] dealt atvarm’ s length with a

stranger.’ Roland P. Place, supra.”

An important consideration is that Virgil Gladieux was, on

the one hand, sole stockholder of the petitioners and, on

the other, a stockholder and executive of ABC. It was not

essential to him that he profit in his capacity as owner of-

the petitioners, but only that he profit i in the snciuenaecmean

' transaction as a whole.

Petitioners do not squarely raise the contention. that,

ether or not the involved negotiations and dealings were

t arm’s length, the rental payments were reasonable. We |

are not compelled to reach this question but the following,

brought to our stteittion by the government’s brief, per-

_suades us that the Tax Court’s determination of deficiency

was not clearly erroneous:

“Taxpayers argue that the rentals paid were reason-

able in light of the fact that the lessor (Gladco) |

furnished them with additional equipment for their

use. However, even taking this fact into considera-

- tion, the record shows that the glaring disparity is

“—@

still present. For the period October 1, 1960, through

«, October 3, 1964, taxpayer, Sontheastern, _paid the

lessor (Gladco) total rentals of $62,487.98, receiving

on the other hand for the period October 1, 1960,

through December. 27, 1964; additional equipment .

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GOON , : wail ae CaaS tg ie

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costing Gladco $12, 097.91. For the same, periods Can-

teen Service paid Gladco total rentals of $432,835.18,

receiving from Gladco additional equipment costing

the latter $595,591. 12. .Thus, Southeastern paid

-Gladco $62,487.98 to lease equipment valued by the

parties at $17,207.34 ($5,109.43 sales price plus $12,-

3097.91) and Canteen Service’paid Gladco $432,835.18

to lease equipment valued by the parties at $780;250.-

97 ($184,659.85 sales price plus $595,591.12). ‘More-

over, an even greater disparity existed for the period

October 1, 1960, through December, 1962 with respect

to assets costing Gladco a total of $251,197.03 which

were rented to Canteen Service for $208, 17 S: 58 as g of -

September 29, 1962:”

¢ 2) Location Commissions.

te 1946, subsequent to Canteen Service's s incorpora-

tion, it entered into an agreemerit. with Gladco (then

named Buddies Lunch System, .Inc) whereby Gladco

~ transferred te Canteen Service its vending machine busi-

_ness in exchange for payment of location commissions on

sales: of candy, gunr and nuts sold through . vending

machines previously operated by Gladcd or at locations

where Gladco then operated food dispensing facilities. At

the time, Canteen Service was. whollgowned by Ben

Handwork, and Gladco by Virgil and Nelson Gladieux.

This 1946 agreement was continued and substantially

modified and extended by. the January 31, 1961 agreement

‘between Canteen Service (then ‘controlled by Virgil) and

_Gladco (then owned.by ABC). An agreement of the same _

_ date between Southeastern and Gladco established loca-

tion commissions payable from Southeastern to Gladco,

_ although there is no evidence of a = oo

_ between these parties.

In their fiscal year 1961, Canteen Bekris ail South-

eastern paid or accrued to :Gladco location secemw aia

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of $134,920.68 and $9,174.57, respectively. In their cor-

porate income tax returns for that year, they deducted

_ those amounts as “ordinafy*and necessary paid.

- or incurred * **,in carrying on any tradé¢:or business,”

under Section 162 (a) of the Internal Revenue _— of

1954, 26 U.S.C. $162(a).

Of these amounts, , the Cosnbiiesouee disallowed

$74,088.26 and $1,593.84, respectively. $69,429.16 of Can-.,

_teen Service’s disallowance was attributable to the entire

location commissions at two. large corporations, LOF Glass

(Libbey-Owens-Ford) and Toledo Scale.. The remaining *

~ amount disallowed to Canteen—$4,659.10—and the full

amount disallowed to Southeastern constituted excess

location commissions, computed under the higher, rates

_ determined in the Jan ary 31,1961 ,agreement but appli-

cable retroactively, beginning October 1, 1960, at a time

when the 1946 agreement was still in effect.

The. Commissioner found, and | the Tax Court affirmed,

that the disallowed portions of ma location commissions

were not “ordinary and necess&ury””. business expenses, nor

‘were they “appropriate and helpful’ to petitioners’ busi-

ness. See Comm’r v. Tellier, 383 U.S. 687, 689 (1966).

With regard to the location commissions at LOF Glass —

Toledo Scale, the Tax Court stated:

~ “TP )rior to the 1961 agreement, imposing in-

creased location commissions on petitioners retro-'

_ actively to October 1, 1960, Gladco had waived all ,

-commission payments due from Canteen Service on

_ the LOF Glass axid Toledo Scale business. The waivers _

as to those commission payments occurred at the time

Canteen Service began making location commission |

payments directly to the industrial clients, LOF Glass |

and Toledo Scale: Thus, for several years prior. to the \

1961 agreement, Canteen Service was not required °

to make any location commission payments to Gladco

11 .

id :

on its LOF Glass and Toledo Scale business. However,

in order for Virgil’s deal with ABC to be consum-

mated,’ it became nécessary to shift’ all income of

/petitioners to Gladco. To accomplish this objective

Canteen Service was ired to reinstitute location

commission payfients to Glédco on its LOF Glass and

Toledo Scale business, which was, of course, in addi-

~ tion to the amounts Canteen Servicewwvas required to

pay Gladco as purported rental payments. We can

find no reasonable explanation for reinstituting such

location commissions except as a further device’ to

accomplish the shifting of all petitioners’ income - to .

Gladco. The record specifically shows that at the time

Virgil was negotiating with representatives of ABC,

he felt ABC was intending‘to acquire, by the various

agreements, all the operating income of petitioners.

“Even “more objectionable . to” allowing Canteen

Service’s location commissicns in: question is the fact

that not only -prior to, but “for the year,in question,

Canteen Service paid location commissions directly to

LOF Glass and Toledo Scale for the right to operate

vending machines on the premises of those industrial

customers. In 1961, Canteen Servige paid to those.

customers the combined amount of /$12,401.70 in Jo-

, cation commissions. Iv spite of this, petitioners con-

tend that they are entitled to deduct the further

amount of $69,429.16 paid to = as location com-

missions for —: machine sales orf the premises

of the same /two customers. The record fails to re-

flect any business or economic need for Canteen Serv-" ‘=~

ice to eights location commission payments in ques- .

tion, and in/light of the fact that Canteen Service w2s

already making payments directly to LOF Glass and

Toledo Scale, we know of none. Lacking in any mean-

ingful business purpose we faikto see how the pay-

_ment of such obviously unnecessary amounts could

be ‘appropriate and helpful’ for ‘th development of °

Canteen Service’ 's business.”

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_ With regard to the additional, retroactive commissions, the

~ Court found that the Commissioner had —s only

that amount which, - @

“exceeded the commissions computed pursuant to the ©

rates in effect under the agreement between Canteen

Service knd Gladco, dated May. 10, 1946. Thus, for

the period October 1, 1960, through February 20,

1961, respondent disallowed only $4,659.10 out of

$25, 999. 22 claimed by Canteen Service and disallowed

- $1,593.84 out of $3,558.36 claimed by Southeastern.

Since respondent has allowed petitioners’ claimed lo-

cation commissions, although at the lower ‘rates in.

effect prior to the 1961 agreements, the only ques- ‘

_tion presented is whether ndent- correctly dis! |

._ allowed the retroactive increases required by the 1961

agreements. . ‘

“Petitioners contend that the location commissions

were made retroactive tp October 1, 1960, because that

was the date, originally contemplated by ABC and .

.Virgil in their agreement of June 30, 1960, when the

exchange of Virgil’s 15 companies wads to be made in °

return for ABC stock. This fact is apparently relied

upon by petitioners to justify making*the commission

payments retroactive to October 1, 1960. Even con- |

ceding that the October 1 date was set for that pur-

pose, which the record does not necessarily. support,

we think petitioners’ position is irrelevant with.regard.

. f? to the payment of location commissions aby Canteen

“Service and Southeastern inasmuch ‘as the limited

; questa for our determination is. whether the retro- -

payments: constituted ordinary and necessary

€ss expenses to petitioners. ‘Thus, while tite Oc- -

pr 1 date may have been required in order for Vir-

gil to consummate his deal with ABC, we find no valid

business reason in the record for petitioners to retro-

actively pay increased location commissions for more

than 4 months. The record is devoid of any méan-

ingful economic benefit flowing to petitioners for such

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payments, and consistent with our prior determina-

_ tion, sipra, we think the-retroactively increased pineal

imposed upon petitioners under.their 1961 agreements ;

with Gladco merely constituted a necessary concession ~

on Virgil’s part, in order“to consummate his personal

deal with ABC, irrespective of ‘whethet such a result

proved ‘appropriate and hejptul’ for the development

of petitioners’ business.”

The question of whether these claimed deductions

come within Section-162(a) is a factual. determination.

Comm’r v. Heininger, 320 U.S. 467, 475, 88. L.Ed. 171, 117,

(1943). It is thus reversible only if clearly erroneous.

Comm’r v. Duberstein, supra. We are of the opinion that

the Tax Court's findings dnd. conclusions in this regard are: >

not clearly erroneous. -

Petitioners’ principal,argument is that: the location

commissions were adopted by ‘the 1946 agreement ne-

-gotiated at arm’s length between Canteen Service and

‘Gladco which were, at that time, owned by separate, un-

. related parties. The 1946 agreement covered only comrhis-

« te

‘sions ongandy, gum and nuts. The 1961 agreements en- | :

compassed commissions on seven. additional items: coffee,

pastry, milk, ice cream, sandwiches, hot foods, and cig- -

arettes: The 1946 agreement was not merely “supple-

mented” by the 1961 agreement, as petitioners argue, but

was broadened and extended manyfold. It cannot be con-

sidered an erroneous. finding that the disallowed: loca-

tion commissions were derived from the 1961 agreements,

’ and failed to serve an exeludable business purpose. -

rk

3) Deniai of Surtax Exemption.

In 1956 Southeastern Canteen Co. was organized as a

Michigan corporation by Virgil Gladieux and Ben T. Hand-

work, who then were the owners of Canteen Service Co. of .

14

Toledo. Late? Virgil Gladieux became its sole shareholder.

Section 11 of the Internal Revenue Code of 1954, 26 U.S.C.

§ 11, imposes.a tax on the taxable income of corporations

consisting of a normal tax and a surtax. Under Section °

11(d), the surtax is not #¢mposed upon the first $25,000 of a

corporation’s taxable income. Both Canteen Service and

Southeastern had claimed his $25,000 surtax exemption:

each year. The Commissioner, however, determined that

Southeastern—which engaged in the same business’ as

Canteen but in two Southeastern Michigan counties while

Canteen operated in Northwest Ohio—was not entitled to

the surtax exemption for its fiscal years ending October 3,

1959, October 1, 1960, and September 30, 1961, on the.

authority of Section 269(a) of the Code, 26 U.S.C. —_

(a), which reads in pertinent part:

“In general—if— ‘)? 7 °

(1) any person or persons acquire, or acquired.

on or after October 8, 1940, directly or indirectly, con-

trol of a corporation,

* e 6 * *

and the principal purpose for which) gach acquisition

was made is evasion or avoidance of Federal income

tax by securing the benefit of a deduction, credit, or .

other allowance which such person or corporation

would not otherwise enjoy, then the Secretary or his

delegate may disallow such deduction, credit, or other

allowance. For purposes of paragraphs (1) and (2)

éontrol means the ownership of stock possessing at

least 50 ‘percent of the total combiried. voting power

of all classes of stock entitled to vote or at least 50

percent of the total value y shares of all classes of

stock of the corporation.”

Specifically, the Commissioner found that Virgil Gladieux

and Ben Handwork, sole stockholders in Canteen Service,

in 1956 formed or “acquired” Southeastern, of which they

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15.

becamé sole stockholders, for the principal purpose of ‘.

gaining a second $25,000 surtax exemption.

The Tax Court affirmed this determination, stating,

“Upon a consideration-of the entire record, we think the

facts require us to hold that Southeastern was incorporated

in 1956 for the principal purpose of avoiding Federal

income taxes * * *.” ee

The issue, then, is whether the “principal purpose” of

Southeastern’s’ acquisition was “avoidance of Federal in-

come tax.” “Principal purpose” ‘is further defined by

- Treasury Regulations, ‘Section 1:269-3(a), 26 C.F.R.

~ §1.269-3(a), as follows: ,

“If the purpose to evade or avoid Federal income tax

exceeds in importance any .other purpose, it is the

principal purpose. This does not mean that only those:

acquisitions fall within the provisions of Section 269

which would not have been made if the evasion or

‘avoidarice purpose was not present. The determina-

tion of the purpose for which‘an acquisition was made

requires a scrutiny of the entire circumstances in

which the transaction or course of conduct occurred,

in connection with the tax result claimed to arise

therefrom.” — F- :

This issue involves a factual determination which can be

reversed only if found to be clearly erroneous. Comm’r v.

Duberstein, 363 U.S. 278 (1960). The Commissione’s dis-

allowance of the surtax exemption is presumptively cor-

rect, and the burden of disproving such determination by a

preponderance ofthe evidence is on petitioners. 26 C.F.R.

§ 1.269-5; Welch v. Helvering, 290 U.S. 111, 115, 78 L.Ed.

212, 215 (1933) ; Helvering v. Taylor, 293 U.S. 507, 515, 79

L.Ed. 623, 629 (1935).

We believe, however, that petitioners met their bur-

den of proving by a preponderance of the evidence that the

N

16

__ principal pe Southeastern was’ not tax

avoidance. At trial before the Tax Court, the sgle witness

to testify on this issue was Virgil Gladieux, controlling

stockholder of both’Canteen Service and Southeastern at

the time in question. Gladieux testified that no considera-

tion to Federal income tax law was given at the time of

Southeastern’s incorporation,’ and that the reason for a

separate corporation was that “we needed itentity, local

identity, and we needed-a Michigan image.” Respondent

urges that neither this Court nor the Tax Court is bound’

to accept the testimony of Gladieux, ari interested party,

even though not contradicted, citing Quock Ting v. United

States, 140 U.S. 417 (1891). But this is not to say that

clear, convincing and uncontradicted testimony can be

ignored just because of the interest of the witness. The

correct rule is recited in Quock Ting:

“Undoubtedly, as a general rule, positive testimony as

to a particular fact, uncontradicted by any one, should

, control the decision of the court; but that rule admits

of many exceptions. There may be such an inherent’

improbability in the statements of a witness as to

induce the court or jury to disregard his evidence,

even in the absence of any direct conflicting testi-

mony.” 140 U.S. -at-42%.

Gladieux’s testimony went unchallenged by the govern-

ment. This Court has held that “where unimpeached,

competent, and relevant testimony on behalf of a taxpayer

is uncontradicted, it may not be arbitrarily discredited

and disregarded, and the Tax Court cannot reject or ignore

this evidence * * *.” Loesch & Green Const. .Co. v.

Comm’r, 211 F(2) 210, 212 (6th Cir. 1954). See also,

Tank v. Comm’r, 270 re) 477, 487 (6th Cir. 1959). The

7The attorney earave by Gladieux m incorporating

Southeastern, a Mr. Smith, was deceased at the time of hearing.

{

/

gx TF ee )

—— Treasury Regulations indicate that “a scrutiny of the entire -

" circumstances” surrounding the acquisition must be made.

26 C.F.R. § 1.269-3 (a). Obe¥ing such Regulations, we are — As | |

persuaded that a review of the “entire circumstances’ .

substantiates Gladieux’s testimony. Southeastern was § ‘ 4 }

given a separate “Michigan image” by Gladieux. Books

and records of Canteen Service and Southeastern were ©

‘ kept separate and distinct. There were separate ware-

houses and bank accounts in Michigan. None of Canteen’s

inventory was used in Southeastern’s operations. South-

eastern’s two resident managers were based in Adrian g

and Monroe, Michigan—the county seats of the two Michi- Bi

gan counties Southeastern serviced—rather than in ‘Toledo :

where Canteen’s headquarters was located. Virgil

Gladieux had established a tradition of incorporating a ~

__new company whenever he initiated a new, albeit related,

enterprise. In 1961 he controlled a total of fifteen corpo-

rations, all engaged in the food distribution business.

; For example, Ohio corporations, controlled by Gladieux,

operated in-plant feeding at corporations in Ohio whose i

vending machines were serviced by Canteen Service, but

in-plant feeding at the Revco Corporation plant in Deer- a

pea een field, Michigan—in the vending machine territory ‘of | -—

Southeastern—was performed by Buddies Lunch System, - :

a Gladieux-controlled Michigan corporation.

- The Tax Court sought to tarnish Gladieux’s “Michigan

image” argument’by noting that “the franchise agreenrent 7

_ under which Southeastern obtained virtually all its vend-

jc machines, specifically prohibited Southeastern from

using its name on the vending machines ina manner which ~~ ft

would give the appearance that Southeastern was the

/ owner of the machines.” (Emphasis: supplied.) The -

/ franchise agreement, however, permitted Southeastern tor

advertise on the machines that it was servicing them.

/

18 :

In this way, Scutheastern was able to effectively present a

“Michigan image” to the public.

A recent Court of Claims case parallels the instant

case in some respects. In Louisville Store of.- Liberty, Ky. i

Inc. v, United States, 179 Ct. Cl. 847; 376 F(2) 314 (1967),

a partnership consisting of five related partners owned.

thirteen clothing stores in nine Kentucky towns. In 1959,

, the partners incgrporated eleven of the stores in eleven

separate corporations. The Commissioner, relying on

Section 269, allowed but one surtax exemption to the

entire group df corporations. The Court of Claims, adopt-

ing the opinion of Court Commissioner Day, determined ;

that the purpose of incorporation of the companies was not

principally ‘to avoid tax within the meaning of Section 269,

and held that each company was entitled to the benefit

of the $25,000 surtax exemption. The Commissioner’s

opinion agreed with the United States Senate Finance —

Committee that, where corporations controlled by the same

persons engage in the same type business in different

geographic locations, there are legitimate business reasons —

for establishing Separate corporations. _ Ue ren a

-“Congress, in ‘considering the Revenue Act of 1964,

reviewed the application of the provisions of section

269, concluding that there were indeed legitimate

business reasons in the use of multiple corporations

where corporations owned or controlled by the same

interests, as here, conduct the same type of business

in different geographical locales, as here. The Senate —

Finance Committee made the following comment in

this connection:

¢.3 *¢ = 8

“ ‘While the House and your committee recognize the

advantages of use of multiple. corporations, it. is be-

lieved, as it has beér i in the*past, that, where cor-

-porations owned and controlled by the same interests

é

a

° -

19 ‘

engage in different businesses in the same area or

conduct the same type business in different geographi-”

cal locales, there are legitimate business reasons for ~~

use of separate corporations and, therefore, the sepa-

rate corporations should generally be. recognized as

separate taxpayers, retaining the benefit of use° of

multiple surtax exemptions. However, the House and

your committee do not intend to encourage the forma-

tion of these multiple corporations and therefore

propose to apply higher tax rates to corporations

which are members of an affiliated group of cogpo-

rations. Of course, nothing in this bil] is intended as

changing the application of sections 269, 1551, or 482

if the multiple corporation form’ of organization ‘is

adopted to avoid taxes:’ 7

” 1p MeN IN ae eae ATEN As &

“Sen, Rep. 830, 88th Cong. 2d Sess., pp. 149-150, Cum.

_ Bull. 1964-1 (Part 2) pp, 653-654. e

“The House Ways and Means Committee adopted

similar language in its report on the same subject.

See H.R. Rep. No. 749, 88th Cong. 1st Sess. Cum. Bull.

1964-1 (Part 2) p. 242.” 376 F(2) at 319.

Such, in substgftce, were the holdings in Bush Hog Mfg.

Co., 42. F.C. 713,.726-729 (1964), and V. H. Monette & Coy

45 'T.C. 15, 33-35 (1965), aff'd on other grounds, 374 F (2)

116 (4th Cir. 1967)... . _ 3 .

. We hold that, under the circumstances where th

controlling stockholder of both the. parent and ,acquired

corporation testified that the reason for creating a separate

corporation to engage in the same business in a different

geographic location was to present a local image and was

not tax avoidance, where the testimony. was uncon-

troverted and unimpeached, and where there was sub-

stantial evidence to corroborate his testimony regarding

a the presentation of the local image, it was improper for

the Commissioner to deny the acquired corporation its’

20

$25,000 surtax*exemption. To the extent that this holding

may be factually inconsistent with the Tax Court’s find- ©

ings of fact, we hold, obedient to Comm’r v. Duberstein,

~~ supra, that its findings are clearly erroneous. - | |

The judgment of the Tax Court sustained the Com-

missioner’s disallowance of rental and location commis-

sion payments is affirmed; the judgment of the Tax Court

sustaining the Commissioner’s disallowance of the surtax

exemption as to Southeastern Canteen Co. is reversed and

vacated. Each party shall pay its own costs. 3

‘ &

a

th SR ORR

21 . : i

APPENDIX B.

MEMORANDUM FINDINGS OF FACT AND OPINION OF *

ames UNITED STATES TAX.COURT.

_* (Filed September 19, 1967.) oe

Wrrnzy, J udge: Respondent determined deficiencies

in petitioners’ income tax for the years and in the amounts

as follows:

, Docket Taxable -_

Petitioner — No. year ended Deficiency

Southeastern Canteen ; Oct. 3, 1959. $ 4,936.32

Co. _ 4301-64, Oct. 1, 1960 " 5,458.89

Canteen Service Cb. ; Sept. 30, 1961 6,194.61.

of Toledo * 4302-64 .. Sept. 30, 1961 - 58,863.73

The cases have been consolidated and will be —_.

together. . Rae,

The issues for decision are:

(1) Whether the purported rentals paid or nouvined

in favor of the Gladieux Corporation by petitioners for

their fiscal year ended September 30, 1961, constitute

allowable deductions from their respective gross incomes

in that year, pursuant to section 162(a) (3) of the Internal

Revenue Code of 1954. ,

(2) Whether the location commissions paid or ac-,

crued in favor of the Gladieux Corporation by petitioners

for their fiscal year ended September 30, 1961, constitute.

allowable deductions from their respective gross incomes

in that year, pursuant to section 162(a) of the Code.

(3) Whether respondent properly disallowed South-

eastern Canteen Co. a statutory surtax exemption for its

fiscal years ended October 3, 1959, October 1, 1960, and

September 30, 196f, —— to section 269 or 1551 of.

the Code.

enue Code of 1954.

1 All ‘statutory nlite hereinafter are to the _— Rev- =

ee a la Sarat ae ence, ee Rae: eae,

AGREE E CLE TENE BATT ABR AIER, MEE ot MTS

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22 |

FINDINGS OF FACT.

Some of the facts have been stipulated and are found —

seurdinisly.

Petitioner Canteen Service Co. of Toledo (hereinafter

called Canteen Service) is, and ‘at at all times pertinent

hereto was, a corporation incorporated March 16, 1946,

under the laws of the State of Ohio with its principal

_ office in Toledo, Ohio. For the tax year ended September

30, 1961, Canteen Service filed its corporate income tax

return with the district director at Cleveland, Ohio, listing

its corporate address as 3156 Bellevue Road, Toledo 6,

Ohio. .

Petitioner Southeastern Canteen Co: (hereinafter

Southeastern) is, and at all times pertinent hereto was, a

corporation incorporated under the laws of the State of

Michigan on January: 19, 1956. Its: registered office was in

_ Detroit, Michigan, and its corporate officers were housed

in Toledo, Ohio. For the tax years ended October 3, 1959,

October 1, 1960, and September 30, 1961, Southeastern

filed its corporate income tax returns with the district.

director at Cleveland, Ohio, listing its corporate address

as 3156 Bellevue Road, Toledo 6, Ohio.

At the time Canteen Service was incorporated, its

entire capital common stock was issued to Ben T. Hand-

work (hereinafter Handwork) in exchange, among other

things, for the use by Canteen Service of a franchise

previously granted to Handwork by Automatic Canteen

Company of America (hereinafter sometimes Automatic)

for the sale of candy, gum, nuts, and related. items

through vending machine¥. In early 1953, Canteen Serv-

ice, with the oral permission of Automatic, began oper-

ating eight canteen locations at the Revco Manufaéturing

Co. in Deerfield, Lenawee County, Michigan. On May -15,

1956, Canteen Service filed a notice of withdrawal with.

. e rhhes

~ % oe ®

t ‘ ‘ * . .

a

°

3?

23

the Michigan Corporation~.and Securities -Commisssion

and, subsequent to that date, no longer conducted business ~

in Michigan.

During the tax year involving Canteen Service, 1961,

its books and records: were maintained under the accrual

system of accounting and the 13-period system of tabu

lating its income and expenses was employed, each such

period consisting of 4 weeks. Durifig that year, Canteen

Service sold food and beverages through vending ma-

chines in certain territories in western Ohio, such terri-

tories» being among those originally designated in a

franchise and distributor’s lease agreement entered into

between Automatic and Handwork on July 6, 1947, and

assigned to Canteen Service on that day by Handwork

with the éonsent of. Automatic: Under this franchise and

lease agreement, Canteen Service leased canteens” from

Automatic. in its fiscal year 1961, in numbers ' varying from .

1,627 to 1,676, and reported to Automatic gross sales from

those canteens of $1,318,9 Canteen Service reporte on

its tax return for fiscal-1961, gross sales of $1,651,490.29.*

Upon the incorporation of Southeastern in 1956, its

authorized capital stock consisted of 1, 000 common shares

of the par value of $50. Of that amount, Virgil Gladieux

(hereinafter sometimes referred to”as Virgil) and Hané-

work subscribed for 15 shares and 5 shares,-respectively.

On July 21, 1959, Southeastern redeemed the 5 shares’

owned by Handwork which redemption resulted in Virgil’s

becoming the owner of Southeastern’s entire outstanding.

common stock. «

XN

2 Under the franchise and lease agreement, a “Canteen” was

defined as a candy, gum, nut, or other vending machine, al-

* though that word will sometimes: be used hereinafter to desig-

nate more than one such machine at a given location.

3 The additional revenue reported on its tax return was at-

tributable to vending machines owned’ outright by Canteen

Service.

‘

my y

During the tax years involving Southeastern, its

books were maintained under the accrual system of ac-

counting and the 13-period system of tabulating its income

‘and expenses was employed, each such period consisting

of 4 weeks. During those years, Southeastern had the ex-

clusive rights to the sale of food and beverages through

, veriding machines in Lenawee and Monroe Counties in

southeastern Michigan, such counties being among those

originally designated in a franchise and distributor’s lease

agreement entered into between Automatic’ and Hand-

work on January 20, 1956, and ‘assigned to Southeastern

on that day by Handwork with the consent of Automatic.

Under this franchise and lease agreementt, Squtheastern

leased canteens from’ Automatic in its fiscal year 1961, in

‘numbers varying from 252 to 273, and reported to Auto-

matic gross sales from’ these canteens of $185,469.

Southeasfern’s franchise frop Automatic provided

not only for exclusive territory but also for the leasing

of ‘canteens from Automatic to Southeastern for rent. It

also provided: that Southeastern was to periodically de-

liver to Automatic a report of the canteen.sales, from which

such rentals were détermined. It provided further that

title to the rented canteens was to remain in Automatic,

that Southeastern was prohibited from attaching its name _

to the canteens except to show that it was‘servicing such

equipment, that the franchise could’ be canceled under

certain_circumstances, and that a sum of $50 would be

payable by Southeastern to Automatic, as liquidated

damages, for each canteen if either the franchise was

canceled or if there was any interference by Southeastern

with the continued ownership and-use of such canteen

locition by Automatic. The franchise further provided

that if Handwork disposed of, or attempted to dispoge' of

the franchise by sale, assignment, transfer, rent, or sub-

-*

6 area ge On ENE Bo

°

25 é

lease, without the prior consent of Automatic, the franchise .

agreement was to be null and void.

Southeastern commenced business on January 21,

1956, starting its route operations with vending machines,

inventory, and trucks. As of that date, Southeastern’s

capital was $1,000. On January 23, 1956, Southeastern’s

directors, at their first board meeting, adopted resolutions,

among other things, to purchase vending machines from

Automatic and to open an account at a bank in Mon-

roe, Michigan. Southeastern employed a resident of each

of those counties to supervise the company’s operations.

Thus, at its inceptién, Southeastern’s operations were con-*

ducted from the Michigan residences of those two em-

ployees. Later, Southeastern established warehouse and

refrigeration facilities in Monroe County, Michigan. Al-

‘though Southeastern acquired certain operating assets and

leased vending machines from Automatic, as provided in

its franchise agreement, Automatic had no stock interest

in Southeastern.

Prior to May 10, 1946, the Gladieux Corporation

(hereinafter Gladco)* was principally engaged in the

business of operating cafeterias and lunch counters, and

dispensing food in several manufacturing plants in the

city of Toledo and vicinity. It also sold candy, gum, and

nuts both over its counters and through vending machines

at such food locations, at gas stations, and other locations.

Gladco’s books and records were maintained on the ac-

crual system of accounting and on a calendar year basis.

* Gladieux Corporation’s predecessor business was incor- .

porated ‘in 1931 under the name of Buddies Box Lunch, Inc. It

was only after three corporate name changes that the name of

‘the business became Gladieux Corporation on November 2, 1960.

To avoid confusion, use of the name Gladco will be used to refer

Se ee ee

Gladieux Corporation.

EN! LD IRA, EN .

-

B -*

ger.

26

As of May 10, 1946, Gladco’s outstanding capital. stock

- was owned equally by Virgil Gladieux and his brother

Nelson. On May 25, 1955, Virgil became the sole stock-

holder of Gladco.

On May 10, 1946, an agreement was entered into be-

- tween Gladco and the Gladieux brothers, on the one hand,

and Canteen Service and Handwork, on the other. Pur-

suant to the agreement, Gladco transferred its vending

machine business in Lucas, Fulton, and Wood Counties,

Ohio, to Canteen Service. The agreement provided, in

part, that Canteen Service would pay Gladco a 12 per-

cent commission on all gross sales of candy, gum, and

nuts sold by CanteensService through vending @machines

at all locations within Lucas, Fulton, and Wood Counties,

Ohio, where Gladco “now or hereafter operate[{s] cafete-

_rias, lunch counters or. other food dispensing facilities.”

Pursuant to that provision and prior to 1958, Canteen

Service paid a 12 percent location commission to~Gladco

on sales:made by Canteen Service through vending ma-

chines located at the facilities of Libbey-Owens-Ford Glass

Company (hereinafter LOF Glass). The 1946 agreement

further provided that Canteen Service would assume

Gladco’s obligation to pay to the owners of the locations

where Gladco vending machines were operated, but where

no counter food was sold, an 8 percent commission on the —

gross sales of candy, gum, and nuts sold through vending

maching. It was provided, however, that Canteen Serv-

ice would not be required to pay Gladco any commis-

sion on sales made through vending machines at such

locations.”

_ 5 While Sougheastern never entered into any written agree-

ment respecting payment of location commissions to Gladco, it

followed the same pattern of paying such commissions on vending

business generated by Gladco’s in-plant feeding business as did

Canteen Service.

“6 27

Prior to 1958, Canteen Service had paid location com-

missions to Virgil on the LOF Glass business. In 1958,

LOF Glass negotiated for location commissions to be paid

directly to it by Canteen Service. Subsequently, Canteen

Service, as the result of a waiver by Virgil and the

Gladieux interests, neither paid nor accrued any further

location commissions to Virgil or Gladco 6m the LOF

Glass business until October 1, 1960 when such payments

_. Were again required pursuant to the sale-leaseback agree-

ment between Canteen Service and Gladco, dated January

1, 1961.

Beginning in .1953, Canteen Service paid ication

commissions to Toledo Scale. Although Canteen Service

did not pay Virgil or Gladco additional ‘location commis-

sions, as a result of -negotiations between Virgil and

Toledo Scale in 1955 or 1956, Toledo Scale thereafter re-

mitted to Gladco approximately 85 percent of the commis-

sions received by Toledo Scale from Canteen Service.

Canteen Service, however, never paid or accrued location

commissions directly to Gladco for vending machine sales

at Toledo Scale until October 1, 1960, pursuant to the

sale-leaseback «agreement between Canteen Service and

Gladco, dated January 31, 1961:

The transfer of Gladco’s vending operations to Can-

teen Service, pursuant to the agreement of May 10, 1946,

appealed strongly to Virgil for financial reasons since,

pursuant to Automatic’s franchise arrangement under

which Canteen Service was then operating, Canteen Serv-

ice could lease its vending. equipment from Automatic

whereas up to that time Gladcowas compelled to purchase

such equipment, thereby limiting its financial resources

for expansion. The agreement also appealed to Gladco

inasmuch as it provided an option’ pursuant to which

Gladco could purchase up to 75 percent of the stock in

|

)

, “

28

Canteen Service on or before October 31, 1946. In the’

event such option was exercised and in the further event

Handwork or Gladco later wished to sell their respective

stockholdings, they were required’ to offer them to tach

‘other under a reciprocal right of first refusal. Gladco later

exercised its right of purchase, and as a result of Canteen

Service’s subsequent redemption of Handwork’s 25 per-

cent stock interest in Canteen Service, Gladco became the

sole owner of Canteen Service.

After May 10; 1946, as vending machines were

adapted to handle food products other than candy, gum,

‘and nuts, such as milk, coffee, and ice cream, Virgil’ and :

Gladco exacted varying rates of location commissions

from Canteen Service depending upon the relative profit

margins of the foods béing vended as well as the amount

of location commissions Gladco was oh ie to pay to its

industrial clients. Thus in time there. arose an incon- ©

sistent pattern of location commissions payable to Gladco

by Canteen Service.

On or about December 4, 1953, Gladco began operat-

ing a restaurant and cafeteria at the plant and facilities of

Toledo Scdle Co. of Toledo, Ohio (hereinafter ‘Toledo

Scale), and continued such operations throughout Can-

teen Service’s taxable year in question. Also, about De-

cember 4, 1953, Canteen Service was permitted to install

canteens at nine different plant locations of Toledo Scale.

For a period occurring between 1953 and 1960, Gladco |

waived the location commissions payable to it by Canteen —

Service on the Toledo Scale business and did not again

require commission payments to be made to it on that

business until the sale-leaseback agreement entered -into

between it and Canteen Service on January 31, 1961,

which agreement increased such commission payments

retroactively to October 1, 1960. _~*

$2"

29 ,

GlJadco, during the years in question, operated various

food systems, such as in-plant employees feeding concerns,

cafeterias, snack bars, and dining rooms. During those

years and until February 2, 1961, of the outstanding capital

stock of Gladco, consisting of 500 no par common shares,

499 shares were owned by Virgil and the remaining share

by his wife. ;

On June 30, 1960, Virgil " his wife owned the

entire outstanding capital stock of 15 corporations en-

gaged in the merchandising and vending of food, bever-

ages, cigarettes, and gum. Included among those 15

corporations were Canteen Service, Southeastern, and

Gladco. | |

Immediately prior to June 30, 1960, ABC Vending

Corporation (whose name has since been changed to ABC

Consolidated Corporation and hereinafter will be re-

ferred to as ABC) was primarily engaged in the food itd

beverage merchandising and vending business with book

net worth in excess of $16 million and with annual sales

from\its vending business exceeding $60 million. At that

9 ABC was a publicly owned corporation with stock

listed on the New York Stock Exchange: In January of

1961, it had 8,522 shareholders who owned 1,228,328

shares of common stock. Additionally, it held 48, 960

shares of treasury stock.. Prior to February 2, 1961,

neither Virgil nor his wife owned any capital stock of

ABC.- \. Paes

On June 30, 1960, ABC and Virgil entered ito an

agreement whereby Virgil agreed, among other things, to

transfer to ABC all of the outstanding capital stock of the

15 corporations owned by him and his wife, in exchange

‘>. for 80,000 shares of the capital tommon stock of ABC. The

om provided that Virgil was to be retained by ABC -

‘in a “major managerial capacity’’ at an annual salary of

a

q

¢

30

$62,500 for 5 years, after which his salary would be

increased to $67,500. The agreement: further provided

at ABC would deliver to Virgil a stock option certificate

giving him the right to acquire 5,000 shares of ABC com-,

mon stock at a price equal to 85 percent of the market

“ value of the stock on the New York Stock Exchange on

the date of settlement of the foregoing: ‘agreement.

Automatic, relying on the provisions of the frarfchise

agreernent which it had entered into with Canteeh Serv-

ice on July 1, 1947, refused to consent to Virgil’s attempted

transfer to ABC of the outstanding capital stock of Can-

teen Service and Southeastern.’ Pursuant to a section of .

that. agreement which defined the procedure for handling

_ a digpute as to pefitioners’ right to transfer, Automatic’s

refusal to consent to the sale and transfer was submitted

to arbitration. On December 27, 1960, the arbitration tri-

bunal: decided that the withholdiny of such consent by

Automatic was not unreasonable, arbitrary, or capricious.

Subsequent ‘to the’ arbitration decision, Virgil and -

ABC executed a “Supplemental Agreement” on January

26, 1961, amending their agreement of June 30, 1960; by .

eliminating from the 1960 agreement the requirement that

Virgil transfer the outstanding stock of Canteen Service

and Southeastern to ABC. The amendatory agreement

also ‘reduced the number of ABC shares to be delivered to

- Virgil from 80,000 to 68,500. a

Also, on January 26, 1961, Virgil, ABC, Canteen

Service, Southeastern, and Gladco executed an agreement _

which provided that since Virgil, was no longer able to

transfer petitioners’ stock to ABC, Gladco and petitioners

6 The franchise agreement provided that petitioner could

not, without the consent of Automatic, sell, assign, or transfer

any interest in the agreement. It further provided that Auto- ~

matic would not “unreasonably, arbitrarily or capriciously” with-

hold its consent to such a sale, assignment, or. transfer.

23 oe #

would enter into an agreement which would” provide,

among other things, that: (1) petitioners would sell and

transfer to Gladco their designated tangible physical assets _

in the following amounts: $184,659.85 as. to Canteen

Service and $5,109.43 as to Southeastern;’ (2) Gladco

would lease back to petitioners all such assets for a term

df 20 years from October 1, 1960, with the further agree-

ment that.during that. term Gladco would provide and.

lease to petitioners “all additional equipment necessary

for the operation of the vending machine business” ‘con-

ducted by petitioners; * (3) petitioners would pay to Glad-

‘co for such leased assets a “rental” equal to 10 percent of -

the gross sales from the vending machine busfhess “on

and after October 1, 1960, and until the end of the term

of the said lease and any extended term thereof”;° (4)

such “rentals” were not to be such in amount as would

_ create a deficit in net income of either petitioner, net in-

come being ‘computed— ‘

7 The amount Gladco agreed to pay’ petitiofiers for their

tangible physical assets constituted their net book value, after

accrued depreciation as shown on petitioners’ books:as of October,

1, 1960. Included in such assets transferred were 299 vend-

ing machines owned by Canteen Service and 4 vending ma-

chines owned by Southeastern. Journal entries reflecting the

sale were posted on the books of Gladco and each petitioner on

February 18, 1961.

8 For the period October 1, 1960, through December 27, 1964,

Gladco purchased “additional equipment” for lease to petitioners

in the following amounts: As to Canteen Service, $595,591.12, and

as to Southeastern, $12,097.91, For the period October 1, 1960,

through December 1962, “additional equipment” in the amount

of $66,537.18 was purchased.for Canteen Service.

9 Por the period October 1, 1960, ough October 3, 1964,

petitioners made “rental” payments to Gladco in the following

amounts: Canteen Service, $432,835.18 and Southeastern,

$62,487.98. For the period October 1, 1960, through September

1962, Canteen Service made “rental” payments to Gladco totaling

$208, 176.58.

SELLE MIPIM ae IE RC NR aM CLO IgE Te

ae) ;

e Ft ir lorem IEP

32.

' before Federal income taxes and before any salaries

or expenses paid to or attributable to Virgil A.

Gladieux or any member of his family, * * *

(5) any income, loss, or expense of petitioners’ “derived

from or attributable to marketable securities or any — .

investment not germafie to the operation ofthe vending

machine business”: was to be excluded from the deter-" >

mination of such net income; (6) petitioners-were to pay

increased fixed location ‘commissions to Gladco as of

October 1, 1960, with respect to all sales at all vending _

locations derived through Virgil, Gladco, or any affiliated

corporations; and (7) Gladco could, at its option, extend

the lease provisions for four consecutive periods of 20

years each. An agreement, dated January 31, 1961, con-

taining the foregoing provisions, was executed by Gladco *

with each petitioner.” On February. 2, 1961, pursuant

to the terms of the “Supplemental Agreement” between

Virgil and ABC, ABC. delivered 68,500 shares of its capi-

tal common stock to Virgil and his wife in the respective

amounts of 54,200 and 14,300. ‘shares. On that same

day, Virgil and his wife transferred to ABC the outstand-

ing shares of stock in 13 corporations. wholly owned by

them, constituting all of the corporations referred to in:

the agreement dated June 30, 1960, with the exception of

Canteen Service and Southeastern.

10 During the aesiitaabens between ABC and Virgil in the

latter part of 1960 and early part of 1961, whicly culminated in

the January 1961 agreements, Virgil was-of the view that the

representatives of ABC contemplated that the sale-leaseback ar-

rangements ‘ provided for in those’ agreements would take most

of petitioners’ profits. As anticipated, the leaseback arrange-

ments absorbed all of the profits, with the exception of divi-

dends from petitioners’ ABC stock, of Canteen Service for its -

1961 through 1963 fiscal years, and Southeastern for its 1961

through 1964 fiscal years. .

33 |

The $184,659.85 received by Canteen Service under

the January 31, 1961, agreement, together with an addi-

tional $201,827.30 of its other funds, was used by Can-

teen Service to purchase shares of ABC stock in the .

spring of 1961. Similarly, the $5,109.43 received by South-

eastern under the January 31; 1961, agreement, together

with an additional $52,863.64 of its other funds, was used

by Southeastern to purchase ABC stock in the spring of

1961."! The total investment by petitioners of $444,460.22

-_in the spring of 1961, was used to: purchase 11,500 shares

of ABC stock.

During the negotiations between ABC: and Virgil

which were carried on both before and after the arbitration

’ decision, Canteen Service was the owner of an 814-acre :

parcel of vacant land, purchased by it in 1959, and located _

in Toledo, Ohio. Efforts were then being made by Canteen

Service to sell the property and on April 27, 1961, the

property was sold for $75,000 resulting in a net gain to

Canteen - Service, after expenses of sale, of $33,238.50.

This property was not included in the assets of Canteen

Service sold to Gladco under the agreement dated January

31, 1961, and Gladco at no time held title to this property.

For the fiscal ame g ended September 30, 1961, Canteen

Service paid or accrued on its books as a liability in favor

- of Gladco, as purported rentals under the January 31,

1961, agreement, the sum of $121,172.15, including an

amount of $28,897.95 with respect to the 8!4-acre parcel

11 Although the January 31, 1961, agreement between Gladco

and each petitioner provided that Gladco would deliver to each

petitioner its promissory note in the amount ‘of the respective

purchase price, the journal entries on the books of Canteen

Service and Southeastern, recording the sale of assets to Gladco,

recited that Gladco “gave a note to ABC Vending: Corporation

for * * * [stated dollar amount] and we received check from

ABC Vending’ Corporation.”

¢

J i i a

OSETIA:

°

ME SADE ID SELIG ETE MS EE AEM TET MELROSE NTR AEN TEENS a AL UR APL

. . |

34 | ms

sold by Canteen Service ‘o a 27, 1961.’° Canteen

Servict subsequently deducted the purported rentals |

__from its gross income for its fiscal year 1961: During the

calendar years 1960 and 1961, Gladco included as rental

‘income, in its. taxable income, the amount of $121,172.15

so paid to it or accrued as a liability in its favor by Canteen

Service. Respondent allowed Canteen Service a rental

deduction in the amount of $53,592.79 for the fiscal year

ended September 30, 1961. The amount so allowed consti-

tuted the. total depreciation, ona straight line method with

various lives, charged off and deducted as an expense by

Canteen Service for the. fiscal year ended October 1, 1960,

on the’ buildings, improvements, trucks, machinery, equip-

ment, furniture, fixtures, and vending machines trans-

ferred by Canteen Service to Gladco pursuant to'the agree- «__

ment of January 31, 1961, thus disallowing as a deduction

from the taxable income of Canteen Service = 579.36

of such rentals so paid or accrued.

During the fiscal year ended. September 30, 1961, ©

’ Southeastern paid, or accrued on its books as a liability in

~~ favor of Gladco, as purported rentals’ under the January

31, 1961, agreement, the-sum of $12, 211.30. Southeastern

subsequently deducted the puxported rentals from its gross

income for is fiscal year 1961. During the calendar years

1960 and 4961, Gladco included as rental income in its

taxable income the amount of such’rentals so paid to it

(o

or accrued as a liability in its favor by Southeastern during _

‘the fiscal year ended: September 30, 1961. Respondent

allowed Southeastern a ‘rental deduction in the amount of

- $1,906.59, for the fiscal year ended September 30, 1961.

, ge

12 During the negotiations between Virgil and representa-

tives of ABC leading to the agreements of January 1961, it was

agreed that the profit from the sale of this land ‘would be in-

cluded in ‘the operating income of’ Canteen Service for the pur-

pose of computing “rentals” under the contemplated contracts.

de

4

rs

35 |

The amount so allowed constituted the total depreciation,” .

on a straight line method with various lives, charged off

fd deducted as an expense by Southeastern“for the fiscal

year ended October 1, 1960, on ‘the trucks, furniture, ‘fix-

‘ tures, and vending machine§ assigned by Southeastern ‘to

Gladco pursuant to the agreement of January 31, 1961,

‘thus disallowing as-a deduction from the taxable income

of Southeastern. $10,304.71 of such rentals so paid or ~*

| ‘accrued. a by: ote ier . :

For the accounting periods ended' October 29, 1960,

November 26, 1960, December 24, 1960, January 22, 1961,

and February 20, 1961, location commissions payable by

Canteen Service to Gladco under their agreement “of ;

_ Janyary 31, 1961; were retroactively increased and ac-

’ crued, from and after October h 1960, by journal “entries

made to tlie books of Canteen Service ‘on March 18, 1961.

On April 15, 1961, Canteen Service paid these accruals to

- Gladco. - The foregoing Ipcation commissions, as well as

the location commissior$ paid or accruéd for the. account-

ing periods, of Canteen Service commencing. February 21,

1961,-and ended September 30, 1961; together with the

_ portions thereof which were allowed and disallowed by *

the Commissioner Were as follows:™

13In addition to locations commissions paid or accrued to.

-Gladco‘by Canteen Service for its fiscal year 1961, Ganteen Serv’ 3

ice also paid such commissions directly to LOF Glass in the -

amount of $8,656.76 and to Toledo Scale in the amount of ©

$3,744.94. ate

; - ae — . A pa Re He PLL TAS eA eye ROMP EE OE TS GD WE AL

RE) Sh A A Ae ON ee ORAL AREA TN TELE GLA LAO SEALER EI OMNI ig SPT

‘1961 ‘Ig Aaenuer jo yudWOOITe oY) 0} Jofid yOaye UT S2xV1 OY} 4BAO ‘OOPLIH *

_ + ° pUw aoqaseg UDs;UED UsEMjoq yUOUId.USY TgBT ‘TE AreNUEL ayy JO TT FMPIYPS UE THO} 39S Sayer oYy Fopun pond

“WO SE ‘SUOISSTUILIOD OY} JO SSOOX9 OY} JOM, ,SSOUTSNG 19yjO UV» uo Pamol[estp SuOPSs}WUI0D UONLIO] 9U =

: a a 2? “"te6r ‘tg Axenuee jo yooueGide ou jo suors}aoid

ey} 0} ~efqns you s1eMm YM SUOT}EDO, asOYy} [Te 0} oedser GM ‘TOGT'OE 494 pepue jeosy eu) Bur

“ANP BdIAIVG UId} Aq © pred suolssywU0g UO TBO] [[e PeNyWSUOCD ‘SS LPS'Sz$ JO JUMOUWIE By) HOH),

-onpop e& se saying WWOD SYg, 2OOpe[H PUe aIAsag UDd}URD UIEMjeq JUOWDAITE “T96T ‘TE AreNUEL

: yp 0} s02d OoYe Uy Sope1 AOPUN PoUTULID}IP G19M ,,S5OUISNG JMO [[V,, UO PIMO[[E SUPSS}UTUIOD OHV CLL |

OE PLIST e066, . s998ze . GOTHSET TOL

{S9ST9'T 80'66L'LS . <SPERO'E GO'THS'EI$ —«-SsauTSNQ

; “19470 lv

~ — oapepp 0} o21A29g woouED ‘.

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37

Lécation commissions sig the amount of $74,088.26

which were paid or accru y Canteen Service for the

fiscal year ended Septembet 30, 1961, and which were

disallowed by respondent as/a deduction from the gross

income of Canteen Service for Federal income tax pur-

poses for said fiscal year, were included in the taxable in-

_ come of the following corporations in the amounts and for

the taxable years as. follows:

Included by Gladco in its 1960 Federal

income tax return — $24,286.68

Included by Gladco in its 1961 Federal

income tax return 44,213.28

Included by Buddies of Lucas County,

Inc. (one of thie Gladco companies

acquired by ABC) in its 1961

Federal income tax return 5,588.30

. Total 74,088.26

For the accounting periods ended October 29, 1960,

November 26, 1960, December 24, 1960, January 22, 1961,

and #ebruary 20, 1961, location commissions payable by

Southeastern to Gladco under their agreement of January

31, 1961, were retroactively increased and accrued,: from

and after October 1, 1960, by journal entries made to the

' books of Southeastern on March 18, 1961. The foregoing

location commissions, as well as the location commissions

paid or accrued for the accounting periods of Southeastern

commencing February 21, 1961, and ended September 30,

1961, together with the portions thereof which were al-

lowed and disallowed by the Commissioner, are as follows:

PO OG “err

ag ret OF

’.°

2

‘OOpeTH pue UsayseoyNog u9EM}2q juaudaise ‘1961 ‘tg Arenuer oy) JO J] e[Npeyos

Aq poyst{qeyso oanjon.js 9781 Poseas9U! OY} JOPUN POUTULIA}IP 19M SUPISSTUIUIOD OPPO] BS9Y], ¢

“I96T ‘TE Arenuee jO JusUIVaIBe 8Yyy 0} JolId yao Ul Saze1 BY} 19A0

—foopeTH pue UsajseoyjNog useMj0q JUOWOEITe ‘TOGT “TE ArenueL ayy JO TT B[NPEeyS Ul YPAOJ Jos So}pe1 OY}

JapUN pazyndwios se ‘SUOTSSTUIUIOD BY} JO SSIOX9 BY} B1BM PIMOT[ESIP SUOISSTUILIOD UOT}BOOT OY], ¢

‘I96T ‘Ig Axenuer jo jueWaer3e ay} Jo suolstAosd ay} 0} yoafqns

- you azom yorum SubdTLooT asoyy [Te 0} Jadsar YIM “TO6I ‘OE FequIaj}deg pepe seat [eosy ay) Suranp

$8

urajseayNog Aq poniosoe JO pred SUOTSsTUIWIOD UOTVBDOT [TB PIyNISUOD Yor ‘TE'gPO'Z$ JO JUNOUTe au}

UOT|ONpap & SU PAMOT[E J9YIINJ JOUOTSSTUIWIOD OYJ, “COPE puke UID}JsSeay NOG UsEMjeq JUSWIOZITE “T9G6T

‘tg Arenueg ay) 0} 101id yaya UT Saye JOPUN POUTUIJa}9pP B19M P2IMOT[E SUOTSSTUIUIOD UOTBIO] IY], ;

peees'T$ sL0ss'L$ = elZ9T9's$ <l2@'s6s$ 168°Sz8$ 7£9'S66$ 1e9'ser'T$

POMOTTVSIG §PIMO[TY PIMOT[LSIGD PIMO[TY PIMOPVSIG PIMOTY —_— PEMOTTCSIG._—_ PEMOTIV

T96T “Of 4 0961 ‘bz 49quINI0q

. i

papua awot [wosty o} 1961 ‘Zz Asenuee 0961 ‘9Z 49qQuIZAON

1961 ‘Iz Aswnaqag 0961 ‘6z 2294920

TOL : : Spopiog Fupwumovy

Ope] 0} W1d}SeayINOg : ¥

&q V 10 preg SuOJssTUIMIO WOEIOT °

°

. .

for

fiscal

year ended September 30, 1961, and which were dis-

“<

tax purposes

which were paid or accrued by Southeastern for the

Location commissions in the amount of $1,593.84

allowed by respondent as a deduction from the gross in-

come of Southeastern for Federal income

39

said fiscal year, were included in the taxable income of

Gladco in its Federal income tax returns as follows:

For the year 1966 $995.63

) For the year 1961 * * §98.21

Total 1,593.84

OPINION. .

Issue 1. PurportEp RENTAL PayMENTs.

For the fiscal year ended September 30, 1961, Can-

teen Service and Southeastern claimed as a deduction for

purported rental payments, the respective amounts of

$121,172.15 and $12,211.30, constituting the amounts they

_ paid Gladco under certain sale-leaseback agreements dated

January 31, 1961. Respondent has determined that the

amounts so claimed are excessive to the extent that they

exceed. $53,592.79 as to Canteen Service and $1,906.59

as to Southeastern. Petitioners’ principal contention

appears to be that since the contracts imposing the ques-

tioned rentals were the result of arm’s length negotiation

between unrelated parties having adverse interests, the

claimed rental deductions are not subject to attack by

respondent as being unreasonable. Thus, it is argued that

under the relevant statutory provision, section 162(a) (3)

of the 1954 Code,” if the purported rentals were required

to be paid pursuant to an arm’s length agreement, the

# Sec. 162. Trape or Business EXPENSES.

(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—

. om - * -

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

condition to the continued use of possession, 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.

~ e,

40 hie

reasonableness of the reritals so paid cannot be judicially

assailed. In considering a similar contention in Roland P. @

Place, 17 T. C. 199, 203 (1951), affd. 199 F.2d 373 (C.A. 6,

1952), certiorari denied 334 U.S. 927 (1953), this Court

stated:

. The basic question is not whether these sums

claimed as a rental deduction were reasonable in ,

amount but rather whether they were in fact rent

instead of something else paid under the guise of rent.

The i inquiry is whether the petitioner was in fact and

at law “required” to pay these sums as rent. * * *

When there is a close relationship between lessor-and

lessee and in addition there is no arm’s length deal-

ing between them, an inquiry into what constitutes

reasonable rental is riecessary to determine whether

the sum paid is in excess of what the lessee would

have been required to pay had he dealt at arm’s length

with a stranger. * **™ .

Even though petitioners’ contention might be correct if the

purported rentals at issue were in fact arrived at as the

result of arm’s length negotiation between adverse parties,

it is incumbent upon this Court to determine, in the first

instance, whether such is in fact the case. In an attempt

to support their position, that the sale-leaseback agree-

ments were arrived at by arm’s length negotiation between

adverse parties, petitioners contend that thase agreements

arose out of negotiations between representatives of ABC,

who, on the one hand, were representing Gladco, and

Virgil, who, on the other hand, was representing peti-

tioners. According to this theory, since ABC was to ac-

‘quire Gladco from Virgil, ABC was interested in securing

the best possible rental agreement for Gladco, whereas

7

15 To the same effect, see J. J. Kirk, Inc., 34 T. C. 130 (1960),

affd. per curiam 289 F. 2d 935 (C. A. 6, 1961); Southern Ford

Tractor Corporation, 29 T. C. 833 (1958); and E-Z Sew Enter-

prises, Inc. v. United States, 260 F. Supp 100 (E. D. Mich. 1966).

41 ¥

Virgil, being the owner of Canteen Service and South-

eastern, was striving to—

1. maintain the close relationship which had

theretofore existed between Gladieux Corporation and

Petitioners, since Gladieux Corporation had generated

more than seventy-five per cent (75%) of the vending

_ business enjoyed by Petitioners,

» 2. assure the Petitioners against any operating

loss as the result of the rental arrangement, and

3. assure the Petitioners of the availability of

funds for expansion, for acquisitions of other vending

companies which he then had in mind and for the

eventual purchase by Gladieux Corporation of the ;

vending machines then being rented by the Peti-

- tioners from Automatic at no additional cost to

Petitioners. cs

While the foregoing objectives may have existed in

Virgil’s trmd_prior to the execution of the sale-leaseback

agreements, we are convinced, from a thorough considera- ~

tion of the entire record, that such objectives were sub-

servient to Virgil’s principak objective of consummating>

a business deal with ABC along the lines established by

their agreement of June 30,1960. . ae

Thus, the true motivating force for the sale-leasehack

agreements was a desire on the part of Virgil to fer

his interest in his food service companies in exchange for 4

an executive position with ABC at a starting salary of

$62,500, acquisition of 80,000 shares of ABC stock, and a

stock option for an additional 5,000 shares of ABC stock

at 85 pércent of market value. However, when Automatic,

who was petitioners’ franchisor as well as a competitor of

ABC, objected to the transfer of petitioners’ stock to. ABC,

and’ that objection was upheld by an arbitration award, it

-became-necessary for Virgil to devise an alternative plan

for accomplishing the same results without. transferring ©

2

inka than Vas I acer Avent Ae > My Aone

42

o . ®

petitioners’ stock to ABC. As shown by the record, Virgil «

and ABC agreed to a plan whereby Virgil would transfer

ownership\in 13 of his 15 companies to ABC, and funnel

the profits of the remaining 2 companies, Canteen Service

and Southeastern, into Gladco by way of the sale-leaseback

agreements. While that plan did not secure to ABC the

ownership of all 15 of Virgil’s food serfice companies as

ABC originally desired, the effect of the several agree-

ments between the parties accomplished much the same

thing inasmuch as ABC acquired stock gwnership in 13 of

the 15 companies and received, under the provisions of the

sale-leaseback agreements, virtually all the profits of &n-

teen Service and Southeastern: Virgil, on the other hand,

obtained his executive position with ABC, received 68,500

shares of ABC stock, and acquired the option to purchase ©

9,000 additional shares of ABC stock at 85 percent of

!

fr.

market value. Shortly after the foregoing results were

accomplished, Virgil caused petitioners to collectively

purchase 11,500 shares of ABC stock, thereby securing to

himself, directly and through his ownership of petitioners,

the 80,000 shares of ABC stock originally contemplated by

" the June 30, 1960, agreement between himself and ABC.

The dominant motives of both Virgil and ABC

throughout the negotiations which culminated in the sale-

leaseback agreements are crystal clear. Virgil sought to

obtain ABC stock and an executive position with the com-

pany and ABC sought to acquire Virgil’s 15 food service

companies. In light of’these facts, we think it abundantly

clear that the sale-leaseback agreements were designed

solely to fulfill the personal objectives of Virgil. There was

no legitimate business purpose for petitioners to under-

take the sale and subsequent leaseback of their tangible

assets other than to ‘satisfy Virgil’s purpose of shifting

income from petitioners to Gladco in order to induce ABC

°

43 |

to go through with the deal. Thus, this is not a case

where a corporation entéfed a sale-leaseback arrangement

in order to generate needed cash for business’ expansion.

To. the contrary, all the money received by petitioners

upon the sale. of their tangible assets, together with sub-

stantial additional amounts, was used to purchase ABC -

stock, thus serving no meaningful business purpose to

petitioners. — ;

Petitioners’ position is further weakened by the fact

that during the entire negotiations leading up to the execu-

tion of the sale-leaseback agreements, the owner of. both

the lessor (Gladco) and the lessees (petitioners) was the

same person, Virgil Gladieux. Petitioners’ attempt to

transform such an identity of interest into a relationship —

which petitioners characterize as adverse, transgresses

reasonable imagination. All .the, more so since the facts

show that the sale-leaseback agreements were not intended

to be ends in themselves but merely steps in an integrated

plan to secure to VirgH and ABC advantages which could.

not benefit petitioners in any meaningful way. From a

review of all the facts bearing on this issue, which have

been set out at length‘in’ our findings, we are convinced

-that the sale-leaseback agreements in question were, not

the result of arm’s length negotiation between adverse

parties and, therefore, we must determine whether the

purported rentals were “in excess of what the lessee [s]

would have’ been required to pay had * * * [they] dealt

_ at arm’s length with a stranger.” Roland P. Place, supra.

_ The terms of the sale-leaseback agreements provided

we

that-petitioners were to make purported rental payments

. to Gladco equal to 10 percent of petitioners’ gross sales on

and after October 1, 1960, derived trom their vending’

machine business. The agreements provided, however,

that if for any annual fiscal period any rent payable .to

4

ae é .

v7: eee

“644 ‘

Gladco would result in a deficit to petitioners’ net income,

then such rental would be “abated or refunded in such

amount as to eliminate such deficit.” The contract pro-

vided that net income, as used _to calculate the existence

* of a deficit, was to be determined—

before Federal income taxes and before any salaries

_ or expenses paid to-or attributable to Virgil A.

Gladieux or any member of his family, and excluding

from the determination of such net income any in-

come, loss or expense of * * * [petitioner] from or

@ittributable to marketable securities or any other

investment not germane to the operation of the

vending machine business of * * * [petitioner].

For the fiscal year ended September 30, 1961, 10 per-

cent of Canteen Service’s sales amounted. to $165,149.03

and 10 percent of Southeastern’s sales amounted to

$17,006.69. Inasmuch as the payment of such “rental”

would have resulted in a deficit to petitioners’ net operat-

ing income for that year, the rentals payable to Gladco

under the provisions of the January 31, 1961, ¢ontract

were reduced as to Canteen Service and Southeastern, to.

$121, 172.15 and $12,211.30, respectively. The foregoing

amounts were subsequently claimed by petitioners: as

rental deductions in their tax returns for their fiscal year

1961. | ;

As to the claimed deductions for the period com- Phos

mencing October 1, 1960, and ended January 31, 1961, we

failed to perceive how the amounts paid during that period

could satisfy the statutory requirements of section 162(a)

( 3). That provision specifically provides that to constitute

a deductible expense, the payment must be— se eckaa.

: " required * * * as a condition to the continued use

or possession * * * of property to which the taxpayer

has not taken or is not taking title or in which he has

no equity. [Emphasis supplied. |

45

The sale-leaseback agreements were not executed before

January 31, 1961. The language employed in those agree-’

ments in no way suggests that petitioners were attempting

to sell their tangible assets to Gladco as of October 1;

1960. To the contrary, the opening paragraph of the re-

spective agreements‘states that petitioner “hereby sells,

transfers and assigns to Gladieux Corporation,” thereby

evidencing an intent on petitioners’ part to make a present

sale of their assets on January 31, 1961. While it is true

that the agreements subsequently recite that Gladco “here-

by leases” to petitioners the aforementioned tangible as-

sets “for qa term*of twenty years from October 1, 1960,”

the retroactive aspect of this lease provision can in no way

convert ownership of petitioners’ assets to Gladco. It fol-

lows, that petitioners had not parted with title to their -

tangible assets, at least until the -execution of the sale-

leaseback agreements on.or after January 31, 1961. That

-being the case, the retroactive payments made by peti-

. tioners to Gladco for the 4-month period from October 1,

1960, to January 31, 1961, was for property which peti-

tioners owned. Such payments are therefore not deducti-

ble as rentals under the explicit language of section

162(a) (3) of the Code. -The fact that payments were

designated as “rentals” and Gladco may have had an en-

— forceable contract right against petitioners for the amounts

' so designated, in no way alters this result. As we stated

in Catherine G. Armston, 12 T.C. 539, 548. (1949), afid.

188 F.2d 531 (C.A. 5, 1951):

the mere designation of * * * amounts as rental -

does not legally characterize them as such: Nor does

the fact that as between the * * * [lessor and les-

sees], the parties to the agreement, the obligation to

pay may have been enforceable, render the payment”

deductible as rent or otherwise * * *

, area 46 ae

' Equally objectionable is Ciintoon Service’s inclusion

in its claimed rental deduction of the amount of $28, 897.95

which constitutes part of the profits realized by Canteen |

Service upon the sale of an 8%4-acre vacant lot on April

27, 1961. Although Canteen Service paid or accrued this

amount on its books as a liability in favor of Gladco, as -

/ Purported rental under’ the sale-leaseback agreement, »

_the facts. as well as the applicable Code provision fail to .

3° support petitioners’ treatment of this item as-a-“rental”

deduction. - The sale-leaseback agreement provided that —

the “rental” payment would be equal to 10 percent of

Canteen Service’s gross sales from its vending machine

business, with the further provision that the annual’ “‘ren-

tal” would not be permitted to cause a deficit in Canteen

; Service’s “net’income.” The agreement further provided.

that “net income,” as used ‘in the rental formula, would

‘| ae income “derived from-or attributable to market-

. able securities-or any other fnvestment not-germane to

the operation of the vending,machine business of Canteen |

_ [Service]. Since the foregoing contract, provisions were

‘in, effect at the time, the land in qyestion was sold, the

profits derived from its sale could not have been included °

in Canteen’ Senvice’s. net income'for purposes of calcu-

lating its “rental” liability to Gladco without violating

the express provisions of the sale-leasehack agreement.

The fact that the profits so derived were included in

- Canteen Servicé’s, net operating income-for purposes of

calculating the “rental” payment, lends additional support

to the fact thay the series: of transactions ‘entered into_

7 among petitioners, Gladco, ABC, and- Virgil’ in January -

». ¢ 1961 were intended to shift virtually all of pétitioners’

. income to Gladco rather than to serve: any legitimate busi-

ness purpose of. petitioners. However; an additional and

more serious obje@tion arises with regard to tpetitioners’

s

\e

47

treatment. of the real estate profits as Seheintid: Section

162 (a) (3) of the Code specifically excludes as rental

deductions, amounts paid for the use of. property where

- title remains in the taxpayer-lessee. Since we have pre-- igh

viously found that the land in question was never sold

--to Gladco by Canteen Service, and that.Gladco at. no time

held title to such property, any “rental”’ payments made

to Gladco by. Canteen Servic® with respe¢t to. profits

‘derived from the sale of that land could not satisfy the .

relevant -statutory provision. . Thus, as to the pur orted

‘rentals paid on the profits derived from the sale of Canteen

- Service’s vacant land, we hold that respondent's is-

allowance was proper. *

In determining the reasonableness of tise: remaining

amounts claimed petitioners as rental deductions for

, the fiscal year 06 on factor. which we deem significant

is the gross disparity-between the price Gladco paid peti- * »

tioners for their tangible assets and the purported rentals

petitibners were required to pay Gladco in fiscal 1961 in.

order to lease back those same assets. In 1961 Canteen

Service transferred its office, warehouse, trucks, cars,

furniture, fixtures, vending machines, and related hard-

were to Gladco for $184,659.85, and yet was required to -

pay a purported rental of $121,172.15 in order to lease -

back those samé-assets for 8 months. For the same year,

Southeastern similarly transferred its car, trucks, fur-

niture, fixtures, vending machines, and related hardware

to Gladco for $5,109.43, and .was required to pay a pur-

‘ported rental of $12, 211.30 in order to lease back those

same assets for 8 months. It is evident that the payments

made by petitioners in 1961.as “rentals” were patently ex-

ag and bore no reasonable relationship to an amount

d be required to be paid’as rentals for such

assets if Ck et petitioners had dealt with a lessor at arm ’s

%

Qerrcers:

length. Limericks, Inc.; 7 T.C. 1129 (1946), affd. 165 F.2d"

483 (C. A. 5, 1948). Petitioners contended, however,

that since the sale-leaseback agreements further requfted

Gladco to “provide and lease to * wd ns (petitioners) all

additional equipment reasonably necessary,” ‘the pur-

ported rentals were not’ unreasonable. Under the con-

tract provision relied upon, the determination of how

yungh, if any,.additional equipment “was reasonably neces-

sary” was apparently a judgment which Gladco alone

would make. ‘The record discloses that for the period

October 1, 1960, through October 3, 1964, Southeastern

paid Gladco total “rentals” of $62,487.98, receiving in

‘return, for the period October 1, 1960, through Decem-

‘ber 27, 1964, “additional equipment” costing Gladco

_ $12,097.91. .For the same pegiods, Canteen Service paid

Gladco total’ “rentals” of $432,835.18, receiving in return

“additional equipment” costing Gladco $595,591,12. Thus,

» Southeastern paid Gladco $62,487.98 to “lease” equipment

valued by the parties #t $5,109.43 ahd $12,097.91, for a

total amount of $17,207.34. Similarly Canteen Service

paid Gladco $432,835.18 to “lease” equipment valued by

the parties at $184,659.85 and $595,591.12, or a total of

$780,250.97. With regard to Canteen Service, an even

greater disparity occurred for the period October 1, 1960,

through approximately. December 1962. During that

period Gladco leased to Canteen Service former assets

valued at $184,659.85 plus additional assets costing Gladco

$66,537,18, or total assets of $251,197.03. As of Septem-

ber 29} , Canteen Service had paid Gladco $208,176.58

in rentals. -The unreasonableness of such rentals is strik-

ing. The amounts paid by. petitioners were almost suffi-

cient to purchase outright the assets “leased.” Consider-

ing the gross disparity existing between the value of the

properties rented to petitioners and “rentals” obtained by

“

49

-- Gladco under the sale-leaseback agreements, we must

/

reject petitioners’ contention that Gladco’s obligation to

, provide “all additional equipment reasonably necessary”

for petitioners’ vending machine operations justified their

otherwise excessive “rentals.” We have carefully- con-

sidered the many alternative contentions presented. by

_the parties respecting the rental issue and are satisfied

that they do not alter our conclusion that the purported

rentals paid by petitioners to Gladco for their fiscal year

ended September 30, 1961, were grossly excessive, did

-not represent the fair rental value of the assets leased,

and would not have been “required” tobe paid by peti-

' tioners had they negotiated at arm’s length with an adverse

_ party. Having so concluded, we must hold that the amount

respondent determined to be the maximum pétitioners

would, have been required to pay must stand, since it

has not been shown to be patently inadequate. Roland P.

Place; ‘supra, * &

,

‘

s «

‘Issuk 2>. LocaTIon Ciieaiabibiing:

During their fiscal year 1961, Canteen Service and

Southeastern paid or accrued tetal locatton commissions of

$163,468.56 and $11,221.38, respectively. Of those

amounts Canteen Service paid or. accrued to Gladco

$134,920.68 and Southeastern paid or accrued to Gladco ©

$9,174.57. Of the amounts pajd or accrued to Gladco by

petitioners, respondent disallowed $74,088.26 as to Can-

teen Service and $1,593.84 as to Southeastern.

The $74,088.26 disallowed Canteen Service consists

of two components, location commissions paid or accrued

to Gladco for sales at LOF Glass and Toledo Scale, and

location commissions paid ay accrued to Gladco for “all

other businéss.” The amount of the disallowances at-

tributable to the LOF Glass and Toledo Scale business was :

c

50

$69,429.16, which constituted the entire location commis-

sions claimed by Canteen Service as to those customers.

The remaining amount disallowed, $4,659.10, constituted

the excess in location commissions for Canteen Service’s

_ accounting periods beginning October 1, 1960, and end-

ing February 20, 1961, on all Canteen Service’s other busi-

ness as computed under the rates set forth in the January’_

31, 1961, agreement between Canteen Service and Gladco, -

over tke rates in effect under the May. 10, 1946, agree- -

ment."* The $1,593.84 owed Southeastérn constituted

the excess in location Commissions, for its entire 1961

fiscal year, as computed under the rates set forth in the

January 31, 1961, agreement between Southeastern and

. Gladco, over the rates in effect prior to that agreement.

Respondent has thus disallowed location commis-

sions which fall into two categories. The first category is

composed of the disallowance of all location commissions

paid or accrued to Gladco by Canteen Service for sales at

Toledo Scale and LOF Glass, for Canteen Service’s 1961

fiscal year. The second category covers a partial disallow-

ance of location commissions paid or accryed on Canteen

Service’s buSiness, other than LOF Glass and Toledo

Scale, and all of Southeastern’s business, for the period

October 1, 1960, through February 20, 1961.

The basic issue is whether that portion of the location

commissions paid or accrued by petitioners in their fiscal

year 1961, and ‘which hag been disallowed by respondent,

“constituted “ordinary and necessary expenses” to peti-

tioners under section 162(a) of the Code. - Petitioners con-

tend, and respondent appears to concede, that the statu-

1 Respondent allowed all location commissions claished on

this latter component, “all other business,” for the remainder of

Canteen Service’s fiscal year, February 21, 1961, _——e

tember 30, 1961.

k

51°

tory requirement of “ordinary and necessary” is satisfied

provided the claimed deduction is for an expense which

is merely “appropriate and helpful” to the development

of thétaxpayer’s business, citing the case of Commissioner

a. Tellier, 383 U. S. 687 (1966). In applying such a stand-

ard to the instant case, it has been necessary to consider a

multitude of facts, many of which have been contested

by the parties, in an attempt to reconstruct a meaningful

fact pattern. After careful consideration of all the relevant

facts bearing on this issue, as well as the numerous argu-

ments presented by both parties, we are of the view that —_

respondent’s disallowance of petitioners’ location com- |

missions must be sustained. 2

With respect to the disallowance of Canteen Service’s

commission payments to Gladco for sales at LOF Glass and ®

Toledo Scale, we are convinced’that’such payments satis-

fied no meaningful business purpose of Canteen Service,

but rather, constituted only a further effort on the part of

Virgil Gladieux to transfer virtually all petitioners’ income

to Gladco and thereby secure to himself an executive posi-

tion with ABC at a starting salary of $62,500, as well. as

to acquire 80,000 shares of ABC stock.

Petitioners contend that the location commissions:

paid to Gladco by Canteen Service for the year in question

arose out of a contractual gbligation between Canteen ~

Service and)Gladco which Was negotiated at arm’s length in]

in 1946, and was rewritten in 1961 in order to standardize

the raté structure on Canteen Service’s business, a change :

allegedly. made necessary by the increased number of

foods used in Canteen Service’s vending machines as well

as the different location commission rates prevailing in >

different geographical areas for the same foods.

We do not question that the 1946 agreement between

Canteen Service and Gladco was negotiated at arm’s length

52

between adverse parties. At that time Gladco was owned

equally by Virgil and his bréther Nelson, and Canteen

Service was owned by an unrelated party, Ben Haridwork.

The weakniess in petitioners’ contention, however, is that

all location commissions in question arose out of the 1961

agreement, not the agreement of 1946, and as we have al-

ready determined under issue 1, supra, the 1961 agreement

was entered into between corporations wholly owned by

Virgil and his wife; for the principal purpose of shifting in-

come from petitioners to Gladco and not for any meaning- .

ful business purpose as far as petitioners were concerned.

This conclusion is further supported by the fact that prior

to the 4961 agreement, imposing increased location com-

missions on petitioners retroactively to October 1, 1960,

Gladco had waived all commission payments due from

Canteen Service on the LOF Glass and Toledo Scale busi- |

ness. The waivers as to tho$e commission payments oc-

curred at the time Canteen Service began making location

commission payments directly to the it@lustrial clients,

LOF £zlass and Toledo Scale. Thus, for several years prior

to the 1961 agreement, Canteen Service was not required

to make any location commission payments to Gladco on

its LOF Glass and Toledo Scale business. However, in

order for Virgil’s deal with \ABC to be co ated, it

became necessary to shift all income of petitioners to

Gladco. To accomplish this objective Canteen Service was

required to reinstitute location commission payments. to

.. Gladeo on its LOF Glass and Toledo Scalé business, which

was, of course, in addition to the amounts Canteen Service

was required to pay Gladco as pyrported rental payments.

We can find no reasonable explanation for reinstituting

such location commissions except as a further device to

accomplish the shiftitg of all petitioners’ income to Gladco.:

The record specifically shows that at the time Virgil was

-

Ny

33

* negotiating with representatives of ABC, he felt ABC was:

intending to acquire, by the various agreements, all the

operating income of petitioners.

veh more objectionable to allowing Canteen Serv-

ice’s location commissions in question is the fact that not

only prior to, but for the year in question, Canteen Service

paid Jocation, commissions directly to°LOF $ and To-

ledo Scale for the right to operate vending machines on

the premises of those industrial customers. In 1961, Can-

teen Service paid to those customers the combined amount

of $12,401.70 in location commissions. In spite of this,

petitioners contend that they’ are entitled to deduct the

further amount of $69,429.16 paid to Gladco ‘as location

commissions for vending machine sales on the premises

of the same two customers. The record fails to reflect

any business or economic need for Canteen: Service to.

make the location commission payments in question, and

in light of the fact that Canteen Service was already

making payments directly to LOF Glass and Toledo Scale,

we know of @one. Lacking in any meaningful business

purpose we fail to see how the payment of such obviously

unnecessary amounts could be “appropriate and helpful”

for the development of Canteen Service’s business. Ac-

cordingly we hold that as to the location commissions paid

by Canteen Service to Gladco on the sales at LOF Glass

and Toledo Scale for the year in question, petitioners are

not entitled to a business expense deduction under sec-

tion 162(a).

There remains for our defermination the correctness

of respondent’s partial disallowance with respect to lo-

cation commissions made by Canteen Service to Gladco

on sales other than at LOF Glass and Toledo Scale, for.

the period October 1, 1960, through February 20, 1961

and with respect to location commissions made by S

-=

i

*

54

eastern to Gladco for the same period.” Respondent has

disallowed only so much of the foregoing location commis-

sions as’exceeded the commissions computed pursuant ©

to the rates in effect under the agreement between Can-'

- teen Service and Gladco, dated May 10, 1946. Thus

for the period October 1, 1960, through February 20, 1961,

respondent disallowed only $4,659.10 out of $25,999.22.

claimed by Canteen Service and disallowed $1,593.84 out

of $3,558.36 claimed by Southeastern. Since respondent

has allowed petitioners’ claimed location commissions, al- -

_ though at the lower rates in effect prior to the 1961 agree- .

ments, the only question presented is whether respondent -

correctly disallowed the retroactive increases required by

the 1961 agreements.

Petitioners contend that the ‘location commissions

were made retroactive to October 1, 1960, because that

was the date, originally contemplated by ABC and Virgil —

in their agreement of June 30, 1960, when the exchange ~

of Virgil’s 15 companies was to be made in return for ABC~

stock. This fact is apparently relied upon by petitioners

to justify making the commission paynfenfg retroactive to

October 1, 1960. Even conceding that the October 1 date

was set for that purpose, which thé record does not neces-

sarily support, we think petitioners’ position is irrelevant

with regard to the payment of location commissions by .

Canteen Service and Southeastern inasmuch as the litftited

question for our determination is whether the retroactive)

payments constituted ordinary -and necessary business

expenses to petitioners. Thus, while the October 1 date

17 Except for Canteen. Service’s commission seuusinite com-

puted upon sales to LOF Glass’ and Toledo. Scale, respondent

allowed all location commissions: claimed by petitioners ‘for the

period February 21, 1961, through September 30, ‘1961, at the

increased. rates contained in the 1961 agreements between peti-

tioners and Gladco.

a

ahs)

may have been required in order for Virgil to consum-

mate his‘deal with. ABC, we find no valid. business reason

in the record for petitioners to retroactively pay increased

location commissions for more than 4 months. The rec-

ord is devoid of any meaningful economic benefit flowing

to petitioners for such payments, and consistent with

our prior determination, supra, we think the retroactively

increased rates imposed upon petitioners under their

1961 agreements with Gladco merely constituted a’neces-

sary concession on Virgil’s part, in order to consummate °

his personal deal with ABC, irrespective of whether such

a result proved ‘ ‘appropriate and helpful” for/the develop-

ment of petitioners’ business. Accordin ly we sustain,

under section 162(a), respondent’s disallowance of that

portion of petitioners’ claimed location commissions com-

puted under the retroaetive provisions of their 1961 agree-

ments with Gladco. . Pee

| IssuE 3. SURTAX EXEMPTIONS.

Respondent has determined that Southeastern was

not entitled to a surtax exemption for its fiscal years ended

October'3, 1959, October 1, 1960, and September 30, 1961.

. In‘his deficiency notice, dated June 19, 1964, respondent,

assigned as his reason for such disallowance, the following:

In your income tax returns for the above taxable

_years, youClaimed a ‘surtax exemption. It’ is held

that pursuant to Section 1551 and/or Section 269 of

the Internal Revenue Code of 1954, no such surtax

exemption is allowable.

Section 1551 of the C } ides, in pertinent part,

A MULATED EARNINGS

If any corporation transfers, on or after J anuary 1, 1951, all

or Part of its property (ther than money) to another corpora-

£

€

SOATEST IONE RO TPE 8

56

that if a corporation transfers all or part of its property

(other ‘than money) to another corporation which was

either created for the purpose of acquiring such property

or was not'actively engaged in business at the time of -

such acquisition, and after such transfer the transferor

corporation ‘or its stockholders are in control of the trans-

feree corporation, then the transferee corporation shall not

be allowed the $25, 000 surtax. exemption unless it estab-

lishes by a clear preponderance of the evidence that the

securing of such exemption was not -a major purpose of

> the transfer. In order that Southeastern’s surtax exemp-

tion be ‘denied under section 1551; respondent recognizes

that there must have been a “‘transfer of property” from

another corporation to Southeastern at the time of its

incorporation. Respondent contends that consistent with

(Continued from preceding page)

tion which was created for the purpose of acquiring such prop-

erty or which was not actively engaged in business at the time

of such acquisition, and if after such trarisfer the transferor cor-

poration or its stockholders, or both, are 4x control of ance

transferee corporation during any part of the taxable year 0

such transferee corporation, then such transferee’ corporation

shall not for such taxable year (except as may be otherwise de-

’ termined under section 269 (b)) be allowed either the $25,000

exemption from surtax provided in section 11(c) or the

$100,000 accumulated earnings credit provided in paragraph (2)

or (3) of section 535 (c), unless such transféree’ corporation

shall establish by the clear preponderance of the evidence that.

the securing of such exemption or credit was not a major pur-

pose of such transfer. For purposes of this section, contgbl

means ‘the ownership of stock possessing at least 80 percent of

the total combined voting power of all classes of stock entitled

to vote or at least 80 percent of the total value of shares of all

classes of stock of the corporation. ‘In determining the ovnership

of stock forthe purpose of this section, the ownership of stock

shall be determined in accordance with the provisions of section

- §44, except that constructive ownership under section 544 (a)

@) shall be determined only with respect to the individual’s

ouse and minor children. The provisions of section 269 (b),

d the authority of the Secretary under such section, shall, to

the extent not inconsistent with the provisions of this section,

— scam * to this section.

}

em

*

57

the statutory requirement under section .1551, Cant an

Service transferred its eight “Canteen” locations al the

Revco Manufacturing Co., in Deerfield, Michigan to South:

eastern at a time when n Southeastern was not yet actively’

/:

engaged in business. . aye

While it is true that Southeastern, upon its incorpora-

* tion in 1956, began operating the eight ‘ ‘Canteens” for-

merly operated by Canteen Service, that fact does not’sat-

isfy the statutory transfer requirement. inasmuch as there

has been no showing that the “Canteens” transferred: to

Southeastern were in any way owned by Canteen Service:

To the contrary, Automatic owned the vending equipment

used at the Revco locations and, through its franchise,

sassy eae determined who would operate such “Can-

teens.” The record clearly reflects the fact that South-

eastern operated the “Canteens” at Revco under such a

franchise agreement with Automatic. In light of this fact

we do not think Canteen Service ever possesséd such; a

property right in the eight “Canteens” which could have — °

‘ been the subject of transfer to Southeastern. That being

‘the case, the transfer requirement of section 1551 has not

‘been met and Southéastern may not be denied its surtax

exemption under that statutory provision.

Respondent contends, however, that Southeastern’s

surtax exemption should also be denied under section 269

of the Code.’ The pertinent, provisions of that “section

= -

° Sec. 269. Acquisitions Mave To EvapE or Avo INCOME

Tax.

(a) In Genéral: 2s

(1) any person or persons acquire, or acquired on or

alten October 8, 1940, directly or indirectly, control of a cor-

poration, or

(2) any corporation acquires, or acquired on or after

October 8, 1940, directly or indirectly, property of another

« (Continued on following page)

a

‘

2

‘

Sea REET %

a aha ah

58

provide that where any paee. or | Persons acquire con- —

uld nai wilinbhie enjoy, the Secretary may disallow

ee ee

such ‘deduction or other allowance. Upon a cansideration

of the entire record, we think the facts require-us to hold

that Southeastern was incorporated in 1956 for the princi-

(Continued from. preceding page) \

corporation, hot controlled, directly, or indirectly, im- °

mediately before such acquisition, byYsuch acquiring cor-

‘poration or its stockholders, the basis of which property,

in the hands of the acquiring corporation, is determined by

reference to the basis in the hands of the transferor corpora-

° tion,

and the EE purpose fea which , uch acquisitign was eos

is evasion or avoidance of Feder: income tax by securing the:

benefit of a deduction, credit, or other: allowance which such

person or corporation would not otherwise enjoy, then, such de-

-duction, credit, or other allowance shall not be alldéwed. For

purposes of paragraphs (1) and (2), control means the owner- .

ship of’ stock possessing at least 50 percent ‘of the total com-

bined voting power of all classes of stock entitled to vote ores

least 50 percent of the total ye of all classes of stock

of the corporation.

(b) Power ‘of Secretary or His Delegate To. Allow Deduc-

tion, Etc., in Part—In any case to“which subsection (a) applies

the Secretary ar his delegate is authorized—

(1) to allow as a deduction, credit, or allowance any

part of any amount disallowed by such subsection, if he de-

termines that such ‘allowance will not result ini the evasion ‘

or avoidance of Federal i income tax@for which the acquisition

was ‘made; or

(2) to distribute, pe Dae or allocate gross income, .

and distribute, apportion, or allocate the deductions, credits,

_ or allowances th&benefit of which was sought to be secured,

». between or amor the corporations, or properties, or parts |

thereof, involved, and to allow such deductions, credits, or /

all8wances so distributed, apportioned, or allocated, ‘but to

give effect to such allowance only to such extent as he de-

termines will not result in the evasion or ayoidance of Fed-

- eral income tax for which the acquisition was made; or ’ ,,

(3) to exercise his powers“in part under paragraph

(1) and in part.under paragraph (2).

s

59

pal purpose of avoiding Federal income taxes, although -

in arriving at our. determination. we recognize that the —

' creation of Southeastern may also have served legitimate

business purposes, ° + AIS, :

In an attempt to convince us that tax avoidance’

- was not the principal purpose of incorporating South-

eastern, petitioners rely heavily on Virgil’s self-serving

testimony which ‘was to the effect that his company’ S pro-

* jected e expansion into.Michigan required the creation of a

“local identity” or “Michigan image.” We are asked’ to,

accord great weight to this conclusion because of the fact

that Virgil: ~has been experienced and successful in busi- -

ness.” ‘While the successful expansion of Virgil’s vending

at

business in Michigan may have necessitated the. use of: a .

“Michigan” ‘corporation, the record visi nét support such

a conclusion. a

* “In 1953 Canteén Service, an Ohio corporation, quali-

fied to do business in Michigan and received authorization,

from Automatic to. operate “Canteens” at Revco’s plant in

Deerfield, Michigan. Canteen Service continued to oper- -

ate those. “Canteens” until Southeastern began its Michi-

gan operations in 1956. Virgil’s testimony, as well as

petitioners’ briefs, goes to sin length to show that after

Southeast@érn began its operations it established head-

quarters in Michigan, hired two men residing in Michigan ™

to supervise its operations, opened bank accounts in

’ Michigan, and established warehouse and refrigeration

facilities in Michigan. While we: do not*question ‘these

facts, the weakness in petitioners’ position is that there is

no reason shown, and i we know of none, which would have

forbidden Canteen - Service from adopting the same

Michigan contacts. Of additional significance is the fact

_ that although Virgil’s testimony stressed the importance

of a Michigan image, the franchise agreement under which

Southeastern obtained virtually all its vending machines,

af

O

60

specifically prohibited Southeastern from using its name

on the vending machines in a manner which would give

the appearance that Southeastern was the owner of the

. Thus, at the time of Southeastern’s incorpora-

“tion, both Canteen Service and Southeastern were owned

by the same individuals (Virgil and Handwork) in the

same percentages.(75 and 25, respectively); Southeastern

took over virtually the same Michigan business that Can-

teen Service gave up; both businesses were based upon a

© franchise with Automatic which provided the necessary

“Canteens” for an agreed rental; -both corporations were

on the 13-period system of tabulating income and ex-

penses, using the same fiscal year; and both corporations

used the samé street address, in Toledo, Ohio, to designate

their corporate address on their Federal income; tax re-

turns. It is in no way apparent from the record why Can-

“teen Service could not have cortinued to operate and

‘

expand the Michigan business. / Virgil’s conélugory state-

ment regarding the need for/a Michigan finds no

support in the record, ConSidering his experi-

-ence and success, as vouched for by petiti and re- _

vealed by the number and extent of his service

corporations, we think .it a fair assumption that he, was

well aware of"the Federal income tax advantages to be

by the addition of yet another corporation.to his

y &xtensive operations. Considering the totality of -~

bearing upon this issue, we are satisfied that petition-

ers have failed to show that the acquisition of an addi-

surtax exemption was not the ‘ ‘principal purpose”

of ineorporating Southeastern in 1956. Accordingly we

must sustain respondent's disallowance 6f Southeastern’s -

surtax exemption for the years at issue, pursuant to-sec-

tion 269 of the Code\

peas sia Care

.

*.

61

| APPENDIX C.

STATUTE INVOLVED.

§ 162(a) of the Internal Revenue Code of 1954 states

in pertinent parts: —...°

“Sec. 162(a) In General—There shall be allowed

as a deduction all the ordinary and necessary ex-

penses paid or incurred luring the taxable year in

carrying on any trade or, business, including * * *.

(3) rentals or other payments required to be

made as a condition to thecontinued use or posses-

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. * * *”

~

?

roe em O —*?

OS A ey ome ae ~~

4

we? Ve

° ’

) Faces