# Appendix — Southeastern Canteen Co. v. Commissioner > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385604_0697%3A2 ## Record - **Collection:** Supreme Court brief - **Document type:** Appendix - **Published:** January 1, 1969 - **Citation:** 396 U.S. 833 ## Text - In the Supreme Court of the United-States =. re , SOUTHEASTERN CANTEEN CoO., ~~. CANTEEN SERVICE CO. OF TOLEDO, Petitioners, | * eet v. 2 ae | COMMISSIONER OF INTERNAL Wasa pes 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 o e 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 PTET II ONES IG EL LOE TOIT EY ? = OL ESPORTS UAE MY MRT DoE LET aT? ET LE LOE hy OA LEE EG - 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 — . 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GOTHSET TOL {S9ST9'T 80'66L'LS . .- (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 --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385604_0697%3A2. Public record. Not legal advice.