Petition for Writ of Certiorari — B. Forman Co. v. Commissioner

Supreme Court brief1972

Ask Donna

What actually matters in this document.

Text

ates : ews

- @ pyar a 4

vO ca |

mee 12800 STi

arr 6 1972

IN THE *

Supreme Court of the UnitedSrates:. :2.ccenn

October Term, 1971

B. FORMAN COMPANY, INC.,

Petitioner,

VS.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

Docket No.:

McCURDY & COMPANY, INC.,

Petitioner,

. vs.

COMMISSIONER OF INTERNAL REVENUE,

' Respondent.

Docket No.: .............

‘PETITION FOR WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR

| THE SECOND CIRCUIT

ELLSWORTH A. VANGRAAFEILAND,

PETER L. FABER,

Attorneys for Petitioners,

700 Midtown Tower,

Rochester, New York 14604.

Wiser, SuHaw; FREEMAN,

VanGRAAFEILAND, Harter & Secrest,

Ricuarp B. Secrest,

WituuM M. Corsy, of Counsel.

—===<=—[@ma[{7x=K[TqZ=m—aER[E=zEC*_~_OOSl™)"=™])])=]"]]]™™™E=S=

BATAVIA TIMES, LAW PRINTERS, :

Pe BATAVIA, N. Y. =

TABLE OF CONTENTS.

RE IPS tree gt to cs eae Lice

WE Cibo access neue cceseus SiN eS pen 9

Questions Presented .................. aera A ee 2

- Statute and Regulations Involved .................. 2

Statement of the Case ..................... RENE! oI

Reasons for Granting the Writ ...... SPereere ee rpg AVE

i. Both Questions Involve Issues of General Im-

portance in T'ax Administration and in Defining the

Limits of Federal Administrative Discretion. The

Volume of Litigation About these Issues is Increas-

ing Rapidly and Will Continue to Increase Until

They are Authoritatively Settled ...............

II. The Decision of the Court of Appeals on the

Creation of Income Question Contradicts all Indi-

cations of the Intent of Congress as Well as stab-

lished Precedent, both in Principle and in Result.

The Decision Conflicts With a Sixth Cireuit De-

Sia aaa a Be A ey Rg eat Mane NS

III. The Decision of the Court of Appeals on

the Control Issue Conflicts with the Intent of Con-

gress and with Long Established Precedent and, by

Approving the Commissioner’s Virtual Elimination

of any Meaningful Control Requirement from § 482,

Sanctions an Abuse of Accepted Standards of Ad-

ministrative Discretion ....................0s00-

cae |

10°

Fey Ce ey

Conclusion ......... ers cveass Nr Gh Fain aw ca ale a es * 23

Appendix (Separately Bound)

Relevant Treasury Regulations ............. Al

Opinion of the Tax Court ..................02 AIF

Opinion of the Court of Appeals ...............A40

Judgment of the Court of ‘Appeals Rien ae ue ae A73

Spain dD eh MAG ca eae IE Maso

STARS Fe AGILE SASSY PO SB el AI on IZ $ 7

il.

TABLE OF CITATIONS.

PAGE

CasEs: | :

Campbell County State Bank, Incorporated of Her-'

reid, South Dakota v. Commissioner, O11 F. 2d 374

(Sth Cir. NEE Gee caig ak a rn recog win ace ema ee 13

First Security Bank of Utah v. Commissioner, 436 F.

i. SE Re Re Ge, SPE 6 co a es os eae oes we oes 9

. Huber Homes, Inc., 55 T. C. 928 (1971) ... 2.2.22... 15,16

Lake Erie and Pittsburg Railway Company, 5 T. C.

558 (1945) Non-Aeq. 1965-1 Cum. Bull. 5; Aeq. 1945

Cum. Bull. 5 (withdrawn) .................. 18, 19, 22

Laster, EF. C.,43 B. T. A. 159 (1940) Aeq. 1941-1 Cum.

Bull. 7, modified on other grounds, 128 F. 2d 4 (5th

Cir: 1942) leas Rite eee ea ua ee ane ea A inte 16

PPG Industries, Inc., 55 T. C. 928 (1970) ......... 14, 16

Smith-Bridgman & Company, 16 T. C. 287 (1951) ;

Acq. 1951-1 Cum. Bull.3 ................ 13, 14, 15, 16

Tennessee-Arkansas Gravel Company v. Commis-

- stoner of. Internal Revenue, 112 F. 2d 508 (6th Cir.

PT ps becca ance ee tia 4 tee 12, 13, 14, 15, 16

Texsun Supply Corporation, 17 T. C. 483 (1951) Acq.

ne PETE eT Eee ee re eee 16

United States v. Correll, 389 U.S. 299 (1967) ...... 20

STATUTES:

Revenue At of 1021, $200 .. ........0cssesceces 20.

Revenue Act of 1921, § 240(d) ............... 11, 20, 21

ee eS ee er eer er 21

Revenue Act of 1928, § 45 .................22005- 11

Revenue Act of 1934, $45 ....................0.. 12

Revenue Act of 1948, §128(b) ...... PTET ELE ENTE 13

Internal Revenue Code of 1939; § 45 ............0.... 13

Internal Revenue Code of 1954, § 482 ....2, 3,5, 6, 7, 8,9, -

10, 11, 12, 13, 14, 16, 17, 18, 20, 21, 23

Income Tax-Recu LATIONS:

Section 1.482-1°.........: LEE eee RON eae 3

Ee re rere 14

Section 1.482-2(a) .............. eee e cece ete eeeee. 3

iil.

PAGE

MISCELLANEOUS:

Aland, “Section 482: 1971 Weicndion 49 TAXES 815 .

(December, cece EPPS CONE oir ane 7.9,.10

CCH Federal Tax Articles 1954-1967 .........0..... 9

CCH Federal Tax Articles ....................... Q

Cohen, How the IRS intends to administer the new

Regulations under Section 482, 28 JOURNAL OF

TAXATION 73 (February, 1968) ............... 7

Cohen, Section 482: Treasury’s Effort to Teach an

Old Dog Some New Tricks, 48 TAXES 835, (De-

a WE Soro See ic eee tea tie as ce eatin a aes S

Crawford, Are the courts expanding the scope of Code

Section 482?, 36 JOURNAL OF TAXATION 15

I Sth he ee 10, 11, 12

i rE NS os oak ow wk 16.

RR, I a oe nk ea ceensanweewmesnceuc 18, 19

eee I ee euakaweusawwas 013

ee I I es kee pe udesdvwske. ~ 49

ee es Peo oe 14

Hamlin, Correct Allocations Under Section 48? ar

Still Difficult Despite New Regs, 33 JOURNAL OF

TAXATION 358 (December, 1970) ............. 10

- Hewitt, Section 482—Reallocation of Income and De-

ductions Between Related Persons—Up to Date, —

NEW YORK UNIVERSITY TWEEN TY SE COND

_ ANNUAL INSTITUTE ON FEDERAL TAXA-

ee PN ht tires ee pannabens waa ccs 17

H. R. Rep. No. 350 67th Cong., Ist Sess. 14 ........ 20

H.R. tg No. 1337, 88rd Cong., 2d Sess. A165 (1954) 19

Internal Revenue Service, Reports and Information

Retrieval Activity (November, 1971) ............ 8

Jenks, The “Creation of Income”, Doctrine: A Com-

ment on the Proposed Section 482 Regulations, 43

TAXES 486 (August, 1965) .................... 10

P-H U.S. Taxation of International Operations .... 8

Rev. Rul. 65-142, 1965-1 Cum. Bull. 223 ........2... 19)

Rev. Rul. 67-79, 1967-1 Cum. Bull. 117... 2.2.0.2... 14

Rogovin, Unilateral Treatment of Multilateral Prob-

lems, 19 Bulletin of the Section of Taxation of the

American Bar Association, No. 3, April, 1966 p. 65

Seieroe and Gerber, Section 482—Still Growing ai the

Age of 50, 46 TAXES 893 (December, 1968) .... 7)

‘&

SE Ae aie Ree a ae ee ee

Fe ay

iv.

PAGE

Spaeth, Section 482—Past and Future, 47 TAXES 45

UNE © oo vos vcs pV Oxo aa Och ne pee aes 8, 10

S. Rep. No. 275, 67th Cong. 1st Sess. 20 .../........ 20

S. Rep. No. 1622, 83rd Cong. 2d Sess. 310 (1954) .... 19

Surrey, Treasure y’s need to curb tax av oidance in

foreign business through use of 482, 28 JOURNAL

OF TAXATION 75 (February, 1968) . Paige eae e 8

Wall Street Journal 1/26/72, p.1.¢.5.............. 10

Ways and Means Committee Report on Internal Rev-

enue Bill of 1921 (H. R. Rep. No. 350, 67th Con-

gress, lst Session 14) 1939-1 4 Bull. (Part 2)-

fede gee an Ie ieee AB AANS ee, ce tar Men gre DT Bete 11, 20

IN THE

Supreme Court of the United States

October Term, 1971

B. FORMAN COMPANY, INC.,

Petitioner,

Vs.

COMMISSIONER OF INTERNAL REVENUE,

: Respondent.

Docket OE es

McCURDY & COMPANY, as

_ Petitioner,

; _ Vs.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

Docket No.: |...

PETITION FOR WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR

. THE SECOND CIRCUIT

Petitioners ask that a writ of certiorari issue to review

the judgment ‘of the United States Court of Appeals for

the Second Circuit.

Opinions Below

' The opinion of the Court of Appeals (Appendix, pp.

A40ff.) is not yet officially reported but is unofficially

reported at 29 AFTR2d { 72-348 and 72-1 USTC { 9182.

The opinion of the Tax Court (Appendix, pp. A17fl.;

R. *25a-48a) is reported officially at 54 T, C. 913 (1970).

Jurisdiction

The deci§ion of the Court of Appeals was rendered on

January 10, 1972, and the judgment was entered on the

same day (Appendix, pp. A73ff.) The jurisdiction of this

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

Questions Presented for Review

i) Whether the authority of the Commissioner of In-

ternal Revenue under § 482 of the Internal Revenue

Code to “distribute, apportion or allocate” items of

income among related taxpayers permits him to in-

crease the taxable income of the maker of an interest-

free loan by a hypothetical arms-length interest charge

without showing that the proceeds of the loan gener-

ated net income for the borrower.

2) Whether a corporation and one of its shareholders

are “owned or controlled directly or indirectly by the

same interests” for purposes of applying § 482 of the

Internal Revénue Code to a single transaction in which

all shareholders of the corporation acted in concert,

even though the shareholder, acting alone, could not

control the corporation.

Statute and Regulations Involved —

The statute involved is {482 of the Internal Revenue

Code of 1954, 26 U.S. C. § 482, which provides:

*<R” refers to the portion of the printed record in the Court of

Appeals entitled “APPENDIX”. “Ex.” refers to the Exhibit Volume

from the APPENDIX. For the conyenience of the Court, we trav

had one copy of cach of these volumes certifie! by the. Clerk of th

Court of Appeals, and we are forwarding these copies willl this petition.

3 .

§ 482. Allocations of income and deductions among tax-

* _‘-payers

In any case of two or more organizations, trades, or

businesses (whether or not ineérporated, whether or

not organized in the United States, and whether or not

afliliated) owned or controlled directly or indirectly by

the same interests, the Secretary or his delégate may

distribute, apportion, or allocate gross income, dedue-

tions, credits, or allowances between or among

organizations, trades, or businesses, if he determines

that such distribution, apportionment, or allocation is

necessary in order to prevent evasion of taxés or clear-

ly to reflect the income of any of such organizations,

trasles, or businesses.

The regulations involved are §§ 1.482-1 and 1.482-2(a) of

the Income Tax Regulations [26 C.F. R. §§ 1.482-1 and

1.482-2(a)], pertinent portions of which are reprinted in

fhe Appendix, pp. AL-A4ff.

Statement of the Case

The material facts in this ease have been stipulated or

found as follows:

Petitioners, both New York corporations, had operated

competing retail department stores on adjacent sides of the

same block in Rochester, New York, for periods in excess

of fifty years prior to the taxable years in question. All

of the stock of petitioner MeCurdy & Company, Inc. (Me-

Curdy’s) was owned by or on behalf of members of the Me-

Curdy family. All of the stock of petitioner 1. Forman

Company, Int. (Forman’s) was owned by or on behalf of

members of the Forman family. MeCurdy’s and Forman’s

had no common shareholders, directors, or office (R. pp: 57a,

58a). In an effort to stem declining incomes, MeCurdy’s and

Forman’s caused Midtown Holdings Corp. (Midtown) to be

formed in 1958, for the purpose of building and operating a

: as

shopping plaza and office building complex adjoining their

- Stores (R. pp.-58a, 93a-97a). MeCurdy’s and Forman’s

each received fifty percent of the issued and outstanding

shares of Midtown when Midtown was incorporated.

On March 23, 1959, the two shareholders entered into an

agreement governing their relationship and their obliga-

tions to finance Midtown during the construction of the

plaza. The agreement provided that, in exchange for the

transfer of various real estate interests and additional

eapital contributions, additional shares of Midtown were to

be transferred to MeCurdy’s and Forman’s in equal

amounts. The parties also agreed to lend equal amounts to

Midtown from time to time (Ex. 7-G).

The agreement required each party to designate three of

the six Directors of Midtown. In the event of a deadloek

on the Board, provision was made for the designation of a

Justice of the Appeilate Division of the Supreme Court of

the State of New York, Fourth Judicial Department, to

resolve the impasse (Ex. 7-G).

Although the agreement provided for the designation of

three Midtown directors hy each of the parties, there were

only four directors acting during the periods in question.

At all times, the Board of Directors was comprised of two

persons representing MeCurdy’s interests and two persons

representing Forman’s interests (R. p. 59a).

On September 9, 1960, each petitioner made a loain to

Midtown of $1,000,000, represented by three-year notes and

bearing interest at the rate of three and one-half percent per

year. These notes were cancelled in April, 1961, without

payment of any principal or interest. At that time they

were replaced by notes of $1,000,000 to each petitioner, pre-

dated to September 9, 1960, and hearing no interest. On

5 .

their due date of September 9, 1963, they were replaced by

three-year notes in the same principal amounts, bearing no

interest, and without any payment of interest or principal

having been made on the original notes. These notes were

replaced on September 9, 1966 by other three-year notes in

the same amounts, bearing no interest, and. again, without

any payment of interest or principal having been made on

the original notes. No payments of principal or interest

have ever been made on the notes dated September 9, 1960,

September 9, 1963, or September 9, 1966 (R. p. 66a). The

proceeds of these loans were used by Midtown in the con-

struction of the Midtown Plaza complex. Midtown received

the bulk of its income from rentals during this period, and

it had net operating losses in two of the three relevant

years (Ex. 35-AT, 36-AJ, 37-AK). The Commissioner

introduced no evidence that the loan proceeds generated

any income or deductions for Midtown during the vears in

question.

On audit of the tax returns for each petitioner's fiscal

years ending in 1965, 1966 and 1967, the Commissioner of

Internal Revenue added $50,000 to the taxable income of

each taxpayer which represented hypothetical ‘imputed

“interest” at the rate of five per cent per year on the

$1,000,000 interest-free loans made by each of the petition-

ers to Midtown. The Commissioner based his addition of

$50,000 to each of the petitioner's taxable incomes for the.

‘Years in question on §482 of the Internal Revenue

Code (supra) which provides, in’ substance, that the

Secretary of the Treasury may distribute, apportion, or

allocate items of gross income, deductions, credits. or allow-

ances hetween commonly controlled business entities, if he

determines that such action is necessary in order to prevent

the evasion of taxes or clearly to reflect their income (R.

RINT’ oF

ers ae oe Pe eee eee

, . 6 °

pp. 39a-40a). The Commissioner did not specifically indi-

cate which items of gross income, if any, he was attempting

to “distribute, allocate or apportion,” nor did he contend

that the loans generated any income at all for Midtown.

No allocation was made of any deductions resulting from

the building constructed, in part, with the proceeds of the

loans (R. pp. 25a-48a).

Follow ing receipt of the notices of deficieney, each tax-

payer filed a petition with the Tax Court-for a review of the

Commissioner’s determination. The cases were consoli-

dated for trial and have remained consolidated on appeal.

The Tax Court, in an opinion written by Judge Theodore

Tannenwald, Jr. and reviewed by the Court without dissent,

reversed the Commissioner’s determination, holding. that

Midtown was not “controlied directly or indirectly” by

either MeCurdy’s or Forman’s and that MeCurdy’s and

Forman’s could not be regarded as a “joint venture” in

control of Midtown. The Tax Court disposed of the ease

on this issue and was ‘therefore not compelled to address

itself to the question of whether § 482 authorizes the alloca-

_tion of income where no income is realized (R. p. 43a,

Appendix pp. A17ff). The United States Court of Appeals

for the Second Cireuit, in an opinion of District t Judge

Zavatt, reversed the holding of the Tax Court. Tt held that

the fact that the taxpayers together controlled the corpora-

tion satisfied the control requirement of § 482, even though

neither taxpayer and the corporation were commonly con-

trolled. The court additionally held that the Commissioner

of Internal Revenue could allocate hypothetical loan inter-

est from a corporation to another commonly controlled

business entity without showing that any item of the gross

income of the corporation was attributable to the proceeds

of the loan (Appendix pp. A47ff.).

The proceedings in the Tax Court and the Court of

Appeals also involved the disallowance of a claimed busi-

ness expense deduction. That issue is not relevant to this

petition.

REASONS FOR GRANTING THE WRIT

I. Both Questions Involve Issues of General Import-

ance in Tax Administration and in Defining the Limits of

Federal Administrative Discretion. The Volume of Litiga-

tion Involving these Issues is Increasing Rapidly and Will |

Continue to Increase Until They are Authoritatively

The far-reaching importance of § 482 of the Internal

Revenue Code of 1954 can searcely be overstated. - Since its

beginnings in 1921, the present § 482 has evolved from a

simple provision for the consolidation of returns to a decep-

tively simple ooking authorization to override customary

accounting practices in order “to prevent evasion of taxes

or clearly to reflect” the respective incomes of related

organizations.’

Xs a result of this evelution, Section 482 has attained

the clear potential to become a “revenue code in itself”

which would affect most large business enterprises and

many small ones.2 Furthermore, it has been thought by

some commentators that the section is being perverted from

' See Seieroe and Gerber, Section 482—NStill Growing at th» Age of

0, 46 TAXES 893, (December, 1968) ; see also, Aland. S clion 482:

1971 Version, 49 TAN ES 815, (December, 1971).

* Rogovin, Unilateral Treatment of Multilateral Problems, 19 Bulle-

tin of the Section of ‘Taxation of the American Bar Association, No. 3,

April, 1966, p- 65; Cohen, Mow the IRS intends to administer the new

Regulations under Section 482. 23 JOURNAL OF TAXATION 73,

74. (February, 1968).

its original purpose as a shield against tax avoidance to be

used as a sword for revenue production.*

~The litigation under § 482 is increasing exponentially.

Between 1928 and 1951, 43 cases were tried under predeces-

sor statutes. Between 1960, and, 1964, 40 cases were

brought.* In 1966, 230 groups of cases were pending under

§ 482, and, as of November, 1971, 511 groups representing

1,298 cases awaited disposition.®

The persistence of the Commissioner in seeking to expand

his authority under §¢ 482 is strong evidence of its increased

importance. Notwithstanding consistent set-backs, he has

continued to press for the most expansive interpretation of

the statutory provisions.* The comparatively exhaustive

regulations proposed in 1965, and made final in 1968, have

evoked considerable commentary both because of their

scope and because of the announcements which accompanied: .

them and which indicated: that their application in the field

would he more assiduous."

_ The commentary on (482 has increased markedly in

recent years and has indicated forcefully that the issues

have graduated from relatively prosaic factual questions

of accounting to vital problems of administrative dis-

3 Spaeth. Section 482—Past and Future, 4% TAXES 45, 50, (Janu-

ary, 196%); Cohen, Section 482: Treasury's Effort to Teach an Old

Dog Some New Tricks, 43 TAXES 835, 836: (December, 1965) P-TT

U.S. Taxation of International Operations ©5001.2,

* Rogovin, supra note 2, p. 66.

5 Id. p. 66: Internal Revenue Service, Reports and Information

Retrieval Activity, (November, 1971).

® See Sections IT and III of this petition, infra.

* See articles by Rogovin and Cohen, supra note 2: see wlso, Sur-

rey, T'reasury’s need to curb tax avoidance in forvign business th rough

use of 482, 28 JOURNAL OF TAXATION %5, (February, 1968) ;

Rev. Rul. 65-142, 1965-1 Cum. Bull. 223.

cretion and tax administration. Of 151 articles pub-

lished since 1954 dealing with § 482, 117 have appeared

since 1965. -Many of these articles have addressed them-

selves to the questions of administrative discretion raised

hy the expansive Treasury interpretation of the statute,

and almost: all of them have noted the trend toward in-

creasing deployment of the section as a major weapon in

the Commissioner's arsenal.®

The Commissioner has been criticized by a number of

commentators for his recent attempts to employ § 482 as

a “substitute for well-defined Code sections and well-estab-

lished judicial principles.’” Recently this Court held, in

First Security Bank of Utah v. Commissioner, No. 70-305

(March 21, 1972), that the Commissioner lacked authority

under § 482 to allocate fo an organization income that it

could not legally have received. The question now remains

whether the Commissioner can “allocate” income which has

not in fact heen shown to exist.

The case at bar, involving as it does issues of control

and creation of income, presents two of the most im-

portant issues concerning the Commissioner’s discretion

under § 482. Since 1954, at least 34 major articles have

addressed the question of the creation of income and at

least 18 have considered the problem of control. The

ease at bar has generated a great deal of interest in the

profession. Three major articles have dealt with it in

some detail, and it has heen the subject of wide interest in

8 CCH, Federal Tax Articles 1954-1967, pp. 693-705 ; CCTI, Federal

Tax Articles pp. 160-162, © 8119, 8320, 8: HOG, 87 an, R901, FORK,

9493, 9626,

.* Aland, supra note 1, p. 84.

1 This data is obtained by a review of the articles cited in CCH

Federal Tax Articles, supra note 8.

the financial and .tax communities. At every stage,

the issues presented in this petition have involved only

questions of law, and all relevant facts have been stipu-

lated or introduced without opposition.

The issue of creation of income is the. most far-reaching —

issue in the administration of § 482, and has heen thought

by at least one commentator to involve a constitutional

question."* The decision of the Court of Appeals in this

case will affect large numbers of taxpayers and promises

to force reorganization of the very modes by which business

is conducted at great expense and wae a corresponding

increase in profit.”

The issue of control and its ramifications is at the basis

of a § 482 application and is, of course, the sine qua non

for the Commissioner’ s authority. :

II. The Decision of the Court of Appeals on the Crea-

tion of Income Question Contradicts all Indications of the

Intent of Congress as Well as Established Precedent, both

in Principle and in Result. The Decision Conflicts With

a Sixth Circuit Decision.

It is clear from the legislative history of § 482 that the

statute was not intended as an omnibus provision for the

collection of revenue or the enforcement of tax laws. The

1 Hamlin, Correct Allocations Under Section 482 are Still Dif-

ficult Despite New Regs, 33 JOURN: AL OF TAXATION 358, (De-

cember, 1970); Aland, swpra note 1: Crawford, Are the courts ex-

panding the scope of Code Section 482 2? 36 JOURNAL OF TANA-

TION 150, (March, 1972) : See also Wall Street Journal, 1/26/72,

p. Le. 5.

12 Jenks, The “Creation of Income” Doctrine A Comment on the

Proposed®Nection 482 Regulations, 43 TAXES 486, 491, (August,

1965).

13 Spaeth, supra note 3, p. 53.

11.

_ Ways ‘and Means Committee Report on § 240(d) of the

Revenue Act of 1921, the earliest predecessor to § 482, in-

dicated that the provision was intended to give the Com-

missioner the authority to “consolidate the accounts” of

related trades or businesses “for the purpose only of mak-

ing an accurate distribution or apportionment -of gains,

profits, income, deductions, or capital between or among

such related trades or businesses.”'* - The Committee

thought this was necessary “to prevent the arbitrary

shifting of profits among.related businesses, particularly

in the case of subsidiary corporations organized as foreign

corporations.” |

These Congressional sentiments expressed an intention

that § 482 he applied only in those cases where the arbi-

_trary shifting of diserete items of income distorted the

taxable incomes of related parties and that, in view of the

drastic nature of the power to override customary account-

. ing practices, the statute should be strictly construed.?®

Congress did not indicate a desire to reconstruct transac-

tions hetween related parties as an end in itself but, rather,

as a means to ensure that income actually earned was

taxed to the real earner and not diverted to a related

taxpaver. |

The statement in the Report of the House Ways and

Means Committee concerning §45 of the Revenue Act of

1928 that the powers of the Commissioner were “broadened

considerably” by the 1928 changes in the statute reflects

only the elimination of the previous Revenue Act provision

Ways and Means Committee Report on Internal Revenue Bill

of 192] (TT. R. Rep. No. 350. 67th Congress. Ist Session 14). 1939-1

Cum. Bull. (Part 2) 195.

Td.

® Crawford. supra note 11. p. 153.

12°

requiring the Commissioner to force consolidated returns

and was not a new license for the large-scale readjustment

of transactions among related parties.!7 .

In keeping with Congressional intent, the Court of Ap-

peals for the Sixth Circuit has held that the Commissioner

cannot create income under § 482 and is limited to allocat-

ing income that already exists. In Tennessee-Arkansas

Gravel Company v. Commissioner of Internal Revenue. °

112 F. 24.508 (6th Cir. 1940), the taxpayer had, during the

taxable year in question, allowed its subsidiary to use

rent-free certain equipment for which the subsidiary had

previously paid. $1,000 -per month. The Commissioner

sought to allocate rental income of $1,000 per month to

the petitioner under § 45 of the Revenue Act of 1934, a |

substantially identical predecessor section to ¢ 482, with-

out making any attempt to show that the equipment pro-

. duced gross income for the subsidiary.

In rejecting the attempted creation of income by the

Commissioner, the Court of Appeals for the Sixth Cireuit

held: nl

Section 45, supra, did not authorize the Commis-

sioner to set up income where none existed. The

principal purpose of the section was to clearly reflect

income that did exist.

It is suggested that the law will imply that the

Commissioner apportioned the $12,000 to petitioner

from the gross income of Mississippi, but the law per-

mits no inferences contrary to fact.’ (Jd. p. 510)

In this way, the principle was reaffirmed that § 482, ap-

pearing as it does in the accounting section of the tax law,

countenances only the reallocation, not the creation of

income.

7 Td. p. 153.

‘Three years after Tennessee-Arkansas_ was decided,

*§ 45 was amended by § 128(b) of the Revenue Act of ‘1943,

which changed the words “gross income or deductions” to

read “gross income, deductions, credits or allowances.”

If Congress had been dissatisfied with Tennessee-Arkansas

it surely would have amended § 45 to reverse the -result

reached by the Sixth Circuit at the same time as it changed

the very provisions dealing with the scope of the Commis-

sioner’s discretion. 2

Kleven years after Tennessee-A rkansas, in Smith-Bridg-

man € Company, 16 T. C. 287 (1951) Acq. 1965-1 Cum.

Bull. 3, the Tax Court reaffirmed the interpretation of

§ 482 made in Tennessee-Arkansas and held that the Com-

missioner improperly increased the taxpayer’s income by

an amount deemed to represent-an arms-length interest

charge where the taxpayer had made interest-free loans to

‘a related corporation. The Court noted that the applica-

tion of § 45 of the 1939 Code was predicated on the exist-

ence of income that could be allocated and said, at page 293:

_ We think this record clearly establishes that the

respondent has not distributed, apportioned, or al-

located gross income, but has created or attribute:

income where none in fact existed. .

In Campbell County State Bank, Jacornevaiid of IlTer-

reid, South Dakota v. Commissioner, 311 F. 2d 374 (8th

‘Cir. 1963), the Commissioner’s allocation of expenses

among two controlled corporations in proportion to their

gross incomes was held to be improper because he failed

to show that there was any relationship between the ex-

i penses and the gross income realized.

The Commissioner acquiesced in Smith-Bridgman in

1951-1 Cum. Bull. 3, and this ‘aequiescence remained with-

out qualification for fourteen years. It was generally

assumed during this period of time that the issue had been

resolved. Then, in 1965, the Treasury proposed new regu-

lations substantially similar to those now in effect. The

regulations flew in the face of the principles laid down in

Tennessee-Arkansas and Smith-Bridgman. As finally

adopted, they purported to give the Commissioner the

power to reconstruct transactions between related taxpay-

ers so as to put them in the same position as they would

have heen in had they met the Commissioner's notion of

“arms-length” standards. The concept of “distributing,

apportioning, and allocating” income that had in fact been

earned by someone was completely ignored. In fact, the |

regulations, in § 1.482-1(d)(5), went so far as to claim that

the Commissioner could “allocate” income from a taxpayer

even if that taxpayer never realized any income at all.

When the inconsistency hetween the proposals and the

acquiescence in Smith-Bridqgman was called to his atten-

tion. the Commissioner attempted to explain it by indicat -

ing that the Smith-Bridgman holding was haged on his

failure to make a correlative adjustmenteto the income of

the taxpayer from whom the income was shifted. Rev.

Rul. 67-79, 1967-1 Cum. Bull, 117.

The Commissioner's attempted expansion of his author-

ity received its first judicial test ‘in 1970, and was soundly

rebuffed by the Tax Court.

In PPG Industries, Inc., KT. C. 928 (1970), the Court

once again held that § 482 does not authorize the Commis-

sioner to impute interest by reason of interest-free loans

where there is no showing that the loans ereated in-

come in the vear of the imputation. The court rejected

the Commissioner's argument that the N% interest rate

which he sought to apply was merely used as a formula for

allocating to the taxpayer that part of the earnings of -

the subsidiary “attributable” to the loans. It held that the

Commissioner must show what, in fact, is being allocated

and cannot shift dollar amounts from.one taxpayer to

another pursuant to a mathematical formula bearing no

relationship to the facts of the case. The court dismissed

out of hand the Service's attempt to limit Smith-Bridgman

to situations in Which no correlative adjustment was made

to the tax liability of the other party, indicating that this

failure was a minor evidentiary factor without controlling

significance. :

In Huber Homes, Inc., 55°T. C. 598 (1971), the Tax

Court rejected an attempt by the Commissioner to shift

income to the taxpayer from its wholly owned subsidiary

corporation where the Commissioner failed to show that

houses transferred at cost from the taxpayer to the sub-

sidiary earned income for the subsidiary that could be

“allocated” to the taxpayer. The houses were rented by

the subsidiary to tenants and the subsidiary in fact sus-

tained a loss from the rental operation. Under the cir-

cumstances, the Court properly reasoned that noe income

was realized by the group of controlled corporations from

dealings with third parties and that, therefore, there was

no income to he allocated from‘one member of the group to

another. The arms-length standard relied on by the Com.

missioner was said to be appropriate where used as a

method for reallocating income derived from dealings with

third parties among members of the group, but the Court

refused to stretch the statute so far as to authorize its

use to create income within the group where none actually

existed. The Court said:

The present case closely parallels Tennessee-Ar-

kansas in that the Commissioner here, as there. did not

allocate to the taxpayer any of the gross income of

the related party to which there was a transfer at less

than arms-length. Instead, here, as there, the Com-

missioner created income out of a transaction which,

in the Commissioner’s opinion, only would hare pro-

duced income had the petitioner dealt with the con-

trolled parties at arms-length. Thus, it is apparent

that the Commissioner here did not “distribute, ap-

portion, or allocate gross income” within the mean-

ing of section 482. .

The Court expressly reaffirmed its earlier holding in

_Smith-Bridgman and rejected the Commissioner's attempt

to explain that ease and Tennessee-Arkansas in terms of

his failure to make a correlative adjustment to the liability

of the other taxpayer. Other cases cited were E. C. Laster,

43 B. T. A. 159 (1940) Acq. 1941-1 Cum. Bull. 7, modified

om other grounds, 128 F. 2d 4 {5th Cir. 1942); Tersun-

Supply Corporation, 17 T. C. 433 (1951) Acq. 1952-1 Cum.

Bull. 4.

The basic facts in Tennessee-Arkansas, PPG Industries

and Huber Homes are indistinguishable in any. material

respect from those of the instant ease. In the ease at har.

as in the cases cited, the Commissioner has attempted to

charge a taxpayer with income hy reason of a transfer of

property to a related corporation without showing that

the property produced any income for the related corpora-

tion that-could be allocated back to the taxpayer. PPG

Industries involved interest-free loans as does the case

before this Court. In Huber Homes, the taxpayer trans-

ferred rental property to the related corporation; in ‘the

case at har, money advanced was use] to construct rental

property.

Notwithstanding Tennessce-Arkansas, Smith-Bridgman,

PPG Industries and Huber Homes, the Court of Appeals

for the Second Circuit in the present case has brushed aside

the expectations of the last 32 years by begging the ques-

tion, thus: |

To the extent that the above cases cited by taxpayers

may he read as holding that no interest can be allocated

under § 482 under the facts of this case, they are not

in accord with either economic reality, or with the de-

clared purpose of section 482. They seriously impair

the usefulness of § 482. Those cases may be correct

from a pure accounting standpoint. Nevertheless,

interest income may be added to taxpayers’ incomes,

as long as a correlative adjustment is made to Mid-

town, for then the true taxable income of all involved

will he properly_refle¢ted (Appendix p. A59).

The fundamental question posed is whether § 482 au-

thorizes the Commissioner to reconstruct transactions be-

tween related taxpayers in accordance with an arms-length |

standard as an end in itself without showing that the re-

construction results in shifting income actually earned

from one party to another. The Second Cirenit has held

that the Commissioner has this power; the Sixth Circuit

and the Tax Court have disagreed. The issue affects great

numbers of taxpayers throughout the country, and will be

present whenever related businesses deal with one another.

The disregard of well-established and unbroken prece-

dent by the Second Cirenit in the name of “economic re-

ality” with virtually no legal analysis and absolutely no

economic analysis", the ensuing confusion that will be

caused by the sweeping imprimatur given to the attempts

™* Economic reality certainly cannot be a proper subject for judicial

notice in this case. Compare Spaeth, supra p. 47 and P-1E U.S.

Taxation of International Operations supra © 5001.2 p. 5015, with

Hewitt, Sretion 482—Reallocation of Income and Deductions Be-

tween Related Persons—Up to Date, NEW YORK UNIVERSITY

TWENTY-SECOND ANNUAL INSTITUTE ON FEDERAL

TAXATION, pp. 398-399, (1964).

a vane espa I A

et eae ey Ss Ce re ee es

ee eee. . ee eee ee ae

of the Commissioner to make allocations under § 482

wherever “useful,” and the different treatment of taxpayers

in different parts of the country resulting from the con-

flict between the courts of appeals will result in continu-

ous and costly litigation until the issue is resolved by this

Court..

-JII. The Decision of the Court of Appeals on the Con-

trol Issue Conflicts with the Intent of Congress and with

Long Established Precedent and, by Approving the Com-

missioner’s Virtual Elimination of any Meaningful Control

Requirement from § 482, Sanctions an Abuse of Accepted

Standards of Administrative Discretion.

Section 482 does not give the Commissioner the authority

to allocate income.and deductions whenever he feels it is

appropriate. The section becomes operative only where

the necessary common control exists. The decision of the

Court of Appeals in this case repudiates a judicial con-

struction-of this common control requirement that has gone

unquestioned by the courts and Congress for twenty-five

years.

In Lake Erie and Pittsburg Railivay Company, ' =. <

558 (1945), Non-Aeq. 1965-1 Cum. Bull. 5; Aeq. 1945 Cum.

Bull. 5 (withdrawn), a corporation was organized hy two

independent railroad companies for the purpose of aequir-

ing, building, maintaining, leasing and operating a railroad.

Fach company owned 50% of the stock of the subsidiary,

the taxpayer in question. The Tax Court held that the

Commissioner could not allocate income from the. parent

corporations to the taxpayer on the ground that neither

shareholder and the taxpayer were controlled by the same _

interests. It noted that the shareholder corporations were,

in turn, owned by different shareholders and did not con-

stitute the same interests and said, at pages 564-565:

- ; The stockholders of the New York Central are

not the “same interests” as the stockholders of Penn-

sylvania. And neither the New York Central nor the

Pennsylvania has control of the petitioner. Together

they do have. But that amounts to saying nothing

more than that the stockholders of a corporation con-

trol it. We do not think that it ean be said that where

~. two or more corporations owned by different sets of

stockholders control another corporation such other

corporation is controlled by the same interests. . _ .

The Commissioner acquiesced in the Tax Court’s hold-

ing. 1945 Cum. Bull. 5. This acquiescence remained in

effect for twenty years, being withdrawn during the second

of the taxable years in issue in these eases. 1965-1 Cum.

Bull. 5, explained in Rev. Rul. 65-142, 1965-1 Cum. Bull. 223.

The certainty and predictability created by this long stand-

ing administrative interpretation of the statute, continuing

as it did into the period during which the advances in ques-

tion were made, have now heen removed by the Court of

Appeals.

During the time that the Lake Erie ease represented the

. only judicial authority on this question (the Commissioner

made no attempt to distinguish it from the ease before this

Court) and the Commissioner’s aequiescence was in effect.

Congress had numerous opportunities to change the law.

Several major revenue laws were enacted during that time

and the entire Internal Revenue Code was overhauled in

1954, vet no changes were made to $45. See H. R. Rep.

No. 1337, 83rd Cong., 2d Sess. A165 (1954): S. Rep. No.

1622, 83rd Cong., 2d Sess. 310 (1954). The reenactment of

the statute in 1954, almost ten vears after the Tax Court’s

holding in Lake Erie and the Commissioner's acquiescence,

tris

Ne an

gave this interpretation the force of law. United States v..

Correll, 389 U.S. 299, 305-306 (1967).

An examination of the legislative history of § 482 and its

predecessors shows that the common control language was

intended by Congress to have a limiting effect on the Com-

missioner.

The first predecessor of § 482 was § 240(d) of the Rev-

enue Act of 1921 which, in the case of “two or more related

trades or businesses . . .owned or controlled directly or

indirectly by the same interests”, authorized the Commis-

sioner to “consolidate the accounts . . . for the purpose of

making an accurate distribution or apportionment of gains,

profiits, income, deductions, or capital between or among

such related trades or businesses.” Section 240 of the 1921

Act dealt generally with related corporations and § 240(a)

provided for the filing of consolidated returns by “af-

filated” corporations. The purpose of the provisions was

to prevent parent corporations from manipulating sub-

sidiaries so as to avoid taxes.. H. R. Rep. No. 350, 67th

Cong., Ist Sess. 14: S. Rep. No. 275, 67th Cong., Ist Sess.

20. |

Tn the Revenue -Act of 1924, § 240(d) was amended to

permit the taxpaver to invoke that provision as well as

the Commissioner. The language relating to control that

- had been used in the 1921 Act when only the Commissioner

could use the provision was retained. At the same time,

the provisions of § 240(a) of the Act allowing taxpayers to

file consolidated returns were made more restrictive. In

view of Congress’ continuing concern at the time with the

problem of manipulation, it is obvious that it must have

felt that’the words “owned or controlled directly or indi-

rectly hy the same interests” were words of limitation, Un-

der the circumstances, it is inconceivable that Congress

would have granted taxpayers the privilege of shifting in-

come, deductions and similar items around whenever some

semblance of a relationship existed. It is clear that Con-

gress intended to confer the new benefits of § 240(d) only

where there was effective working control. The taxpayer's -

right to use § 240(d) was taken away in the Revenue Act

of 1928 but the control language remained the same and

has not changed to this day.

Tt is evident that it was -and has heen the intention of

Congress that the application of ¢ 482 and its predecessors

should he confined to situations in which the same interests

exercise effective control over two or more businesses. The

common control language eannot be expanded indefinitely

for the effect would he to give § 482 almost unlimited ap-

plicahility to corporate dealings with shareholders and to

allow the Commissioner to second-guess legitimate busi-

ness judgement in all such cases. Until the decision of the

Court of Appeals in this case, the courts had properly re-

jected any attémpts by the Commissioner to expand the

language.

The reasoning of the Commissioner if followed to its

logical conclusion, would read the phrase “owned or eon-

trolled directly or indirectly hy the same interests" out of

the statute entirely,

Whenever a corporation acts. it may be assumed that

there is a mnity of interest among the corporation and at

least 517 of its shareholders. However, unity of interest

is not the test under the statute. The test is unity of eon-

trol. Petitioners submit that if the Commissioner ean find

unity of control between a corporation and a 50% share-

holder, he ean find the same unity even with reeard to 4

10% shareholder, so long as that shareholder votes with .

the majority.

The Tax Court in Lake Erie and in the case at bar recog-

nized that it would be a distortion of the statutory lan-

guage to find that the mere existence of a common objective

in a single transaction was sufficient to combine two in-

dependent competitors into a “business” for purposes of

§ 482. The Court of Appeals for the Second Cirenit has

ignored precedent as well as the intent of Congress in

holding to the contrary.

Section 482 is a powerful weapon which both Congress

and the courts have carefully sought to cireumscribe. The

erosion of the jurisdictional control requirement by the

Court of Appeals for the Second Circuit in this case repre-

sents an unwarranted judicial approval of the Commission-

er’s increasing utilization of 4482 in unintended and in-

appropriate circumstances and opens up a Pandora’s hox

of questions as to the scope of the statute. Further con-

fusion about the limits of § 482 and considerable litigation

are hound to result unless those limits are clarified by this

Court. |

’ Conclusion

For the foregoing Teasons, the petition for a. writ of

certiorari should be granted.

Respectfully submitted,

ELLSWORTH A. VAN GRAAFETLAND,

PETER L. FABER, |

Attorneys for Petitioners,

700 Midtown Tower,

Rochester, New York 14604.

Wiser, Suaw, Freeman,

VanGraarerLanp, Harter & Secresr,

Ricuarp B. SECREST,

Wru1am M. Cosy, of Counsel.

March 27, 1972.

i ine el, Ania

‘ ° ° OA RR 2 tes hf DREN Het neh ates Catt Sun. al

it i ao .

SME Count, U,

<1-1280

; IN THE ;

Supreme Court of the Unitert States. us.

' se & te

October Term, 1971 | apR 6 1912.

~ B. FORMAN COMPANY, INC.,

Bist nai eR. LEE

Vs.

COMMISSIONER OF INTERN, AL REVENUE,

Respondent.

Docket No.:

McCURDY & COMPANY, INC.,

Petitioner,

vs.

COMMISSIONER OF INTERNAL REVENUE,

Respondent. .

Docket No.:

APPENDIX TO PETITION FOR WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

ELLSWORTH A. VAN GRAAFEILAND,

PETER L. FABER,

Attorneys for Petitioners,

700 Midtown Tower,

Rochester, New York 14604.

Wiser, Suaw, Freeman,

VAN GRA AFEILAND, H ARTER & Secrest,

Ricuarp B. Secrest,

WitiiaM M. Corsy, of Counsel.

BATAVIA TIMES, LAW PRINTERS, whe

BATAVIA, N.Y.

INDEX TO APPENDIX.

PAGE.

Relevant Treasury Regulations ................ Al

Opinion of the Tax Court ................-.-+-4 Aly

Opinion of the Court of Appeals ..............4 A40

Judgment of the Court of Appeals ............/ ATS

IN THE

Supreme Court of the Uaised States

October Term, 1971

B. FORMAN COMPANY, INC.,

Petitioner,

vs. .

COMMISSIONER OF INTERNAL REVENUF,

Respondent.

Docket No.:

McCURDY & COMPANY, INC.,

° Petitioner.

Vs.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

Docket No.:

APPENDIX TO PETITION FOR WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

I. Relevant Treasury Regulations

§ 1.482-1. Allocation of income and deductions among

taxpayers.—(a) Definitions. When used in this section

and in § 1.482-2— !

(1) The term “organization” includes any organization

of any kind, whether it be a sole proprietorship, a partner-

a ad

os — hi

ship, a trust, an estate, an association, or a corporation (as

each is defined or understood in the Internal Revenue Code

or the regulations thereunder), irrespective of the place

_ where organized, where operated, or where its trade or

business is conducted, and regardless of whether domestic

or foreign, whether exempt, whether affiliated, or whether a

party to a consolidated return.

(2) The term “trade” or “business” includes any trade

or business activity of any kind, regardless of whether or

where organized, whether owned individually or otherwise,

and regardless of the place where carried on.

(3) The term “controlled” includes any kind of control,

direct or indirect, whether legally enforceable, and however

exercisable or exercised..It is the reality of the control

which is decisive, not its form or the mode of its exercise.

A presumption of control arises if income or deductions

have been arbitrarily shifted.

(4) The term “controlled taxpayer” means any one of

two or more organizations, trades, or businesses owned or

controlled directly or indirectly by the same interests.

(5) The terms “group” and “group of controlled tax-

payers” mean the organizations, trades. or businesses

- owned or controlled by the same interests.

(6) The term “true taxable income” means, in the case

of a controlled taxpayer, the taxable income (or, as the

case may be, any item or element affecting taxable income)

which would have resulted to the controlled taxpayer, had

it in the conduct of its affairs (or, as the case may he, in

- the particular contract, transaction, arrangement, or other

act) dealt with the other member or members of the group

at arm’s length. It does not mean the income, the dedue-

tions, the credits, the allowances, or the item or element of

income, deductions, credits, or allowances, resulting to the

controlled taxpayer by reason of the particular contract,

transaction, or arrangement, the controlled taxpayer, or

the interests controlling it, chose to make (even though

such contract, transaction, or arrangement be legally bind-

ing upon the parties thereto).

(b) Scope and purpose. (1) The purpose of section

482°is to place a controlled taxpayer on a tax parity with an

uncontrolled taxpayer, by determining, according to the

standard of an uncontrolled taxpayer, the true taxable

income from the property and business of a controlled tax-

payer. The interests controlling a group of controlled

taxpayers are assumed to have complete power to cause

each controlled taxpayer so to conduct its affairs that its

transactions and accounting records truly reflect the tax-.

able income from the property and business of each of the

controlled taxpayers. If, however, tliis has not been done.

an] the taxable incomes are thereby understated, the

district director shall intervene, and, by making such dis-

tributions, apportionments, or allocations as he may deem

necessary of gross income, deductions, credits, or allow-

ances, or of any item or element affecting taxable ineome,

hetween or among the controlled taxpayers constituting

the group, shall determine the true taxable income of each

controlled taxpayer. The standard to be applied in every

ease is that of an uncontrolled taxpaver dealing at arm’s

' length with another uncontrolled taxpayer.

(2) Section 482 and this section apply to the ease of

any controlled taxpayer, whether such taxpayer makes a

separate or a consolidated return. Tf a controlled taxpayer

makes a separate return, the determination is of its true

separate taxable income. Tf a controlled taxpayer is a

party to a consolidated return, the true consolidated tax-

able income of the affiliated group and the true separate

taxable income of the controlled taxpayer are determined

consistently with the principles of a consolidated return.

(3) Section 482 grants no right to a controlled taxpayer —

to apply its provisions at will, nor does it grant any right to

compel the district director to apply such provisions. It is

not intended (except in the case of the computation of

consolidated taxable income under a consolidated return)

to effect in any case such a distribution, apportionment, or

allocation of gross income, deductions, credits, or allow-

_ ances, or any item of gross income, deductions, credits, or

allowances, as would produce a result equivalent to a com-

putation of consolidated taxable income under subchapter

A, chapter 6 of the Code.

(ec) Application. Transactions between one controlled

taxpayer and another will be subjected to special scrutiny

to ascertain whether the common control is being used to

reduce, avoid, or escape taxes. In determining the true

taxable income of a controlled taxpayer, the district director

is not restricted to the case of improper accounting, to

the ease of a fraudulent, colorable, or sham transaction, or

to the case of a device designed to reduce or avoid tax by

shifting or distorting income, deductions, credits, or allow-

ances. The authority to determine true taxable income

extends to any case in which either by inadvertence or

design the taxable income, in whole or in part, of a con-

trolled taxpayer, is other than it would have heen had the

taxpayer in the conduct of his affairs heen an uncontrolled

taxpayer dealing at arm’s length with another uncontrolled

taxpayer. -

(d) Method of allocation. (1) The method of allo-

eating. apportioning, or distributing income, dedhiictions,

- ADS:

credits, and allowances to be used by the district director in

any case, including the form of the adjustments and the

character and source of amounts allocated, shall be deter-

mined. with reference to the substance of the particular

transactions or arrangements which result in the avoidance

of taxes or the failure to clearly reflect income. The appro-

priate adjustments may take the form of an increase or

decrease in gross income, increase or decrease in deductions

(including depreciation), increase or decrease in basis of

assets (including inventory), or any other adjustment

which may he appropriate under the circumstances. See

§ 1.482-2 for specific rules relating to methods of allocation

in the case of several types of business transactions.

(2) Whenever the district director makes adjustments

to the income of one member of a group of controlled tax-

payers (such adjustments being referred to in this para-

graph as “primary” adjustments) he shall also make appro-

priate correlative adjustments to the income of any other

member of the group involved in the allocation. The corre-

lative adjustments shall actually be made if the U. S

income tax liability of the other member would be affected

for any pending taxable vear. Thus, if the district dirertor

makes an allocation of income, he shall not only increase

the income of one member of the group, but shall decrease.

the income of the other member if such adjustment would

have an effect on the U.S. income tax liability of the other

member for any pending taxable vear. For the purposes of

this sub-paragraph. a “pending taxable vear” is anv tax-

able vear with respect to which the U. S. income tox return

of the other member has heen filed by the time the alloea-

tion is made, and with respect to which a credit or refund is

not harred by the operation of any law or rule of law. Tf a

correlative adjustment is not actually made heeause it

would have no effect on the U. S. income tax liability of the

other member involved in the allocation for any pending

taxable year, such adjustment shall nevertheless be deemed

to have been made for the purpose of determining the U. S.

income tax liability of such member fora later taxable

year, or for the purposes of determining the U. S. income

tax liability of any person for any taxable year. The dis-

trict director shall furnish to the taxpayer with respect to

which the primary adjustment is made a written statement

of the amount and nature of the correlative adjustment

which is deemed to have been made. For purposes of this

- subparagraph, a primary adjustment shall not he con-

sidered to have been made (and therefore a correlative

adjustment is not required to he made) until the first oceur-

ring of the following events with respect to the primary

adjustment : | |

(i) The date of assessment of the tax following exeen-

tion by the taxpayer of a Form 870 (Waiver of Restrie-

tions on Assessment and Collection of Deficiency in Tax

and Acceptance of Overassessment) with respect to such

adjustment,

(ii) Acceptance of a Form 870-AD {Offer of Waiver of

Restriction on Assessment and Collection of Deficieney in

Tax and Acceptance of Overassessment),

(iii) Payment of the deficiency,

(iv) Stipulation in the Tax Court of the United States,

(v) Final determination of tax liability by offer-in-

compromise, closing agreement, or court action.

The principles of this subparagraph may be illustrated by

the following examples in each of which it is assumed that

een, AT

X and Y are members of the same group of controlled

entities and that they regularly compute their incomes on

the basis of a calendar year:

Example (1). Assume that in 1968 the district director

proposes to adjust X’s income for 1966 to reflect an arm’s

length rental charge for Y’s use of X’s tangible property

in 1966; that X consents to an assessment reflecting such

adjustment by executing a Waiver, Form 870; and that an

assessment of the tax with respect to such adjustment is

made in 1968. The primary adjustment is therefore con-

sidered to have been made in 1968. Assume further that

hoth X and Y are United States corporations and that Y

had net operating losses in 1963, 1964, 1965, 1966, and 1967.

Although a correlative adjustment would not have an

effect on Y’s U. S. income tax liability for any pending

taxable year, an adjustment increasing Y’s net operating

loss'for 1966 shall he deemed to have heen made for the

purposes of determining Y’s U. S. income tax liability for

1968 or a later taxable vear to which the inereased operat-

.~ ing loss may be carried. The district director shall notify

X in writing of the amount and nature of the adjustment

which is deemed to have heen made to Y.

Example (2). Assume that X and Y are United States

corporations; that X is in the business of rendering

engineering services: that in 1968 the district director pro-

poses to adjust X’s income for 1966 to reflect an arm’s

length fee for the rendition of engineering services by X in

1966 relating to the construction of Y’s factory: that X °

eonsents to an assessment reflecting such adjustment by

executing a Waiver, Form 870: and that an assessment of

the tax with respect to such adjustment is made in 1968.

Assume further that fees for-such services would properly

constitute a capital expenditure hy Y. and that Y does not

place the factory in service until 1969. Although a corre-

lative adjustment (increase in basis) would not have an

effect on Y’s U.S. income tax liability for a pending taxable

year, an adjustment increasing the basis of Y's assets for |

1966 shall be deemed to have been made in 1968 for the

purpose of computing allowable depreciation or gain or

loss on disposition for 1969 and any future taxable vear.

The district director shall notify X in writing of the amount

and-nature of the adjustment which is deemed to have

heen made to Y.

FEvample (3). Assume that X is a U.S. taxpayer and Y

is a foreign taxpayer not engaged in a trade or business in

the United States; that in 1968 the distriet director pro-

poses to adjust X’s income for 1966°to reflect an arm’s

length interest charge on a loan made to Y: that X eon-

sents to an assessment reflecting such allocation by execut-

ing a Waiver, Form S70: and that an assessment of the

tax with respect to such adjustment is made in’ 1968.

Although a correlative adjustment would not have an

effect on Y's U.S. income tax liability. an adjustment in Y's

income for 1966 shall be deemed to have been made in

1968 for the purposes of determining the amount of Y's

earnings and profits for 1966 and subsequent vears. and of

any other effect it may have on any person's U.S. ineome

tax liability for any taxable vear. The district director

shall notify X in writing of the amount and nature of the

allocation which is deemed to have heen made to Y.

(3) In making distributions, apportionments, or alloca-

tions hetween two members of a group of controlled entities

with respect to particular transactions, the distriet director

shall consider the effect upon such members of an arrange-

ment hetween them for reimbursement within a reasonable

peried before or after the taxable vear if the taxpayer ean

establish that such an arrangement in fact existed during

the taxalile year under consideration. The district director

shall also consider the effect of any other nonarm’s length

transaction hetween them in the taxable year which, if’

taken into account, would result in a setoff against any allo-

cation which would otherwise he made, provided the tax-

payer is able ta establish with reasonable specificity that

the transaction was not at arm’s length and the amount of

the appropriate arm's length charge. For purposes of the

preceding sentence, the term arm’s length refers to the

amount which was charged or would have been charged in

independent transactions with unrelated parties under the

same or similar cireumstanees considering all the relevant

facts and without regard to the rules found in ¢ 1.482-2 by

which certain charges are deemed to be equal to arm’s

length. For example, assume that one member of a group

performs services which benefit a second member, which

would in itself require an allocation to reflect an arm’s

length charge for the performance of such services. Assume

further that the first member can establish that during the

same taxable year the second member engages in other non-

arm’s length transactions which benefit the first member.

such as by selling products to the first member at a dis-

count, or purchasing products from the first member at a

premium, or paying rovalties to the first member in an

excessive amount. In such case, the value of the benefits

received by the first member as a result of the other activi-

ties will he set off against the allocation which would other-

wise he made.. Tf the effect of the set-off is to change the

‘characterization or source of the income or deductions. or

otherwise distort taxable income, in such a manner as to

affect the United States tax liability of anv member, allo-

cations will he made to reflect the correct amount of each

Al0

category of income or deductions. In order to establish

that a set-off to the adjustments proposed by the district

director is appropriate, the taxpayer must sotify the dis

trict director of the hosix of any claimed set-off at om

time before the expiration of the period ending 30 days

after the date of a letter bw which the district director

transmits an examination report notifving the taxpayer of

proposed adjustments or before July 16, 1968, whichever is

later. The principlercof this <niparacranh may be ins

trated by the following examples, in each of whieh it ix

assumed that P and S are calendar yen corporations nm!

are beth members of the same group of controlled entites:

Example (1). VP performs services in 1966 for the bene-

fit of S in connection with S's manufacture and sole of a

product. S does not pay P for such services in 1968, bat in

consideration for such services, agrees in L906 to pay Po

, Percentage of the amount of soles of the product in 1908

through 1970. In 1966 it appeared this agreement wouk!

provide adequate consideration for the serviers. -No alleen

tion will he made with respect to the servicers performe!

by P.

Example (2). VP renders services to S in connection

with the construction of S's factory. An arm's leneth

charge for such services, determined umler paragraph (h)

of § 1,482.2, would be $100,000. During the came taxable

year P makes available to S & machine to he need in each

construction. P bills S $125,000 for the services, but doex

not bill for the use of the machine. No allocation will he

made with respect to the excessive charge for services or

the undercharge for the machine if P can estallich that

the excessive charge for services was equal to an erm’.

lentth charge for the nee of the machine. and if the taxable

All

income and income tax liabilities of P and S ars not

«distorted.

Example (3). Assume the ume facts as in exampic (2),

exeept that, if P had reported $25,000 as rental income and

$25,000 less service income, it would have been subject to

the tax on personal holding companies. Allocations will be

made to reflect the correct amounts of rental income and

(4) If the members of a group of controlled taxpayers

engage in transactions with one another, the district

director may distribute, apportion, or allocate income,

tleductions, credits, or allowances to reflect the true taxable

income of the individual members under the standaris set

forth in this section and in § 1482-2 notwithstanding the

fact that the ultimate income anticipated from a series of

income during such year. The provisions of this amb.

paracraph apply even if the gross income contemplated

a a es

AlZ

from a series of transactions ix never, in fact, realized by

the other members.

(5) Section 482 may, when necessary to prevent the

avoidance of taxes or to clearly reflect income, be applied! in

circumstances deserile<| in sections of the Code (such as

section 351) providing for nonrecocnition of gain or los.

See, for example, Netional Securities ¢ ‘or poration ©. Com-

mixsiower of Internal Receuwe, UT F. 31 Goo (And Cir.

IMS), cert. denied 720 U.S. 74 (PEt).

(6) If payment or reimbursement for the «ale.

exchange, or use of property, the rendition of services. or

the alvanee of other consileration amonz members of a

croup of controlled! entities was prevented, or would have

heen prevented, at the time of the transaction lecan< of

currency or other restrietians impose! under the kiws of

any foreign country. any «istrilution<, gPpertionment«. or

allorations whieh may be mode under section 482 with

fespeet to such transaction< may be treated! ax deferrable

income or sleiuetions, providing the taxpayer hes. for the

year to which the slistrilutions, appertionment< or sleer

tiens relate, elected to use a meth! of accountine in whieh

the reporting of deferrable income ix deferred until the

income erases to he deferrable income. Uneler uch metherl

of accounting. referred to in thix section ax the deferred

income methexd! of accounting. any pavment« or reimburse

ments which were prevented or woukl have heen prevented,

aml any deluctions attributable directly or indirectly te

such payments or reimbursements, shall he deferred until

they cease to he deferrable under each methel! of account.

ing. Tf such methed of accounting hex nat heen cleete!

with respect to the taxable vear to which the allocations

section 482 relate. the taxpaver may elect euch

umler

’ methed with respect te such allerations (hat net with

Al3

respect to other deferrable income) at any time before the

first occurring of the following events with respect to the

allocations:

{i) Execution by the taxpayer of Form 870 (Waiver of

Restrictions on Assessment and Collection of Deficiency in

Tax and Acceptance of Overassessment) :

(ii) Expiration of the period ending 30 days after the

date of a letter by which the district director transmits an

examination report notifying the taxpayer of the

adjustments reflecting such allocations or before July 16,

1968, whichever is later: or

services for the benefit of Y in 1965. The direct and in-

‘lirect costs allocable to such services are $60,000, and an

arm’s length charge for such services is $100,000. Assume

that the district director proposes to increase X’s income

by $100,000, but that the country in which Y is located

would have blocked payment in 1965 for such services, If.

prior to the first occurring of the events described in sub.

divisions (i), (ii), or (iii) of this subparagraph, X elects to

use the deferred income method of accounting with respect.

to such allocation. the $100,000 allocation and the $60,000 of

costs are deferrable until such amounts cease to be defer.

rable under X"s method of accounting. | Reg. ¢ 1.482.-1.]

5 1.482-2. Determination of taxable income in specific

situations.—(a) Loans or advances—(1) In general. Where

‘

PER ee ag mee

eh a i ee ed

9 ee ep

ee ee oe |

Al4

one member of a group of controlled entities makes a loan

or advance directly or indirectly to, or otherwise becomes a

creditor of, another member of such group, and charges no

interest, or charges interest at a rate which is not equal to

an arm's length rate as defined in subparagraph (2) of this

paragraph, the district director may make appropriate allo-

cations to reflect an arm's length interest rate for the use

of such loan or advance.

(2) Arm's length interest rate. For the purposes of

this paragraph, the arm's length interest rate shall be the

rate of interest which was charged, or would have been

charged at the time the indebtedness arose, in independent -

transactions with or between unrelated parties under simi-

lar circumstances. All relevant factors wi'l lc considered.

including the amount and duration of the loan, the security

involved, the credit standing of the borrower, and the inter-

est rate prevailing at the situs of the lender or ereditor for

comparable loans. If the creditor was not regularly

engaged in the business of making loans or advances of the

same general type as the loan or advance in question to

unrelated parties, the arm's length rate for purposes of this

paragraph shall be—

(i) The rate of interest actually charged if at least 4 lnuat

not in excess of 6 percent per annum simple interest,

(ii) 5 pereent per annum simple interest if no interest

was charged or if the rate of interest charged was less than

4, or in. excess of 6 percent per annum simple jnterest,

unless the taxpayer establishes a more appropriate rate

under the stamlards set forth in the first sentence of this

subparagraph. For purposes of the preceding sentence if

the rate actually charged is greater than 6 percent per

antium simple interest and less than the rate determined

Al5

under the standards set forth in the first sentence of this

subparagraph, or if the rate actually charged is less than

4 percent per annum simple interest and greater than the

rate determined under the standards set forth in the first

sentence of this subparagraph,* then the rate actually

charged shall be deemed to be a more appropriate rate

under the standards set forth in the first sentence of this

subparagraph. Notwithstanding the other provisions of

this subparagraph if the loan or advance represents the

proceeds of a loan obtained by the lender at the situs of the

borrower the arm's length rate shall be equal to the rate

actually paid by the lender increased by an amount which

reflects the costs’ or deductions ineurred by the lender in

borrowing such amounts and making such loans, unless the

taxpayer establishes 2 more appropriate rate under the

standards set forth in the first sentence-of this subpara-

graph.

(3) Loans or advances to which subparagraph (1)

applies. Subparagraph (1) of this paragraph applies to

all forms of bona fide indebtedness and includes :

(i) Loans or advances of money or other consideration

(whether or not evidenced by a written instrument), and

(ii) Indebtedness arising in the ordinary course of busi-

ness out of sales, leases, or the rendition of services by or

between members of the sxroup, or any other similar exten-

sion of credit.

Subparagraph (1) of this paragraph does not apply to

alleged indebtedness which was in fact a contribution of

capital or a distribution by a corporation with respect to its

shares. The interest period shall commence at the date the

indebtedness arises, except that with respeet to indebted-

ness described in subdivision (ii) of this subparagraph that

, : —_ : - ee

Al6

is not evidenced by a written instrument requiring pay-

ment of interest, the interest period shall not commence

until a date 6 months after the date the indebtedness arises,

or until a later date if the taxpayer is able to demonstrate

that either it or others in its industry, as a regular trade

practice, permit comparable balances in the case of similar

transactions with unrelated parties to remain outstanding

for a longer period without charging interest. For the

purpose of determining the period of time for which a

balance is outstanding, payments or credits shall be applied

against the earliest balance outstanding, unless the tax-

payer applies such payments or credits in some other order

on its beoks in accordance with an agreement or under-

standing of the parties if the taxpayer can demonstrate

that either it or others in its industry, as a regular trade

* practice, enter into such agreements or understandings.

Al7

II. Opinion of the Tax Court

54 T. C. No. 88

UNITED STATES TAX COURT

B. FORMAN COMPANY, INC.,

Petitioner,

COMMISSIONER OF INTERNAL REVENUE, :

Respondent.

McCURDY & COMPANY, INC.,

‘Petitioner,

, v.

COMMISSIONER OF INTERNAL REVENUE, |

Respondent.

Docket Nos. 468-69, 469-69.

(Filed May 4, 1970.)

In 1958, petitioners organized Midtown Holding Corp.

. for the purpose of constructing and operating an enclosed ~

mall shopping center adjacent to their department stores.

They had equal ownership and control of Midtown. The

shopping center opened for business in 1962. During the

years in issue, Midtown paid no interest on certain loans

made to it by petitioners. - In addition, petitioners made

certain equal payments to Midtown ostensibly to prevent

the erection of kiosks in the part of the mall adjacent to

Als

their stores. Held, that respondent may_not utilize sec.

482, I. R. C. 1954, to impute interest income to petitioners

on said loans, since Midtown and petitioners were not con-

trolled, directly or indirectly, by the same interests. J/eld,

further, that, at least by 1962, Midtown had decided in its

own interest not to erect kiosks, with the result that pur-

ported kiosk prevention payments constituted disguised

capital contributions to Midtown, and not ordinary and

necessary business expenses within the meaning of see.

162, I. R. C. 1954.

Ellsworth A. Van Graafeiland, Peter L. Faber, and

William M. Colby, for the petitioners. .

Marvin FE. Hagen and Stephen M. Miller, for the re-

spondent.

TANNENWALD, Judge: Respondent has determined

deficiencies in petitioners’ Federal income taxes as follows:

Petitioner Taxable Year ending Deficiency

B. Forman Company, Ine. January 30,1965 $66,025.55

January 29,1966 58,775.14

January 28,1967 59,692.00

MeCurdy & Company, Ine. January 30,1964 59,181.90

January 29,1966 61,323.29

January 28,1967 62,343.56

Only two issues were raised in the petitions:

(1) Whether respondent properly imputed to petitioners

interest income on certain loans made by pettioners to a_

corporation, pursuant to section 482"; and »

(2) Whether certain payments petitioners made to a

corporation in which they wére sole and equal shareholders

~ PAN references, unless otherwise noted, are to the Inttrnal Revenue

Code of 1954.

Al9

are ordinary and necessary business expenses, deductible

under section 162. :

io Findings of Fact

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

Both petitioners are corporations organized under the

Jaws of New York. Each had its principal place of business

at Rochester, New York, at the time of filing its pétition

herein. Eaclt petitioner filed its corporate income tax

returns for the taxable years herein in issue with the

district director of internal revenue, Buffalo, New York.

McCurdy & Company, Ine. (hereinafter MeCurdy’s)

operates a general department store located on Main Street

East in Rochester. “B. Forman Company, Ine. (hereinafter

Forman’s) operates a department store specializing in

men’s and women’s apparel located on Clinton Avenug

South in Rochester. The two stores are located on adja:

cent sides of the same block and are competitors.

During all times herein relevant, the stock of MeCurdy’s

was owned primarily by or for members of the McCurdy

family. The stock of Forman’s was owned by Maurice R.

Forman and by Fred S. Forman or his estate. MeCurdy’s

and Forman’s had no shareholders, directors, or officers in

common.

During the 1950's, the gross sales of Forman’s declined

rapidly. MeCurdy’s experience at its downtown store? was

similar. These difliculties reflected a general decline in the

downtown area of Rochester. Sinee both petitioners owned

the land upon which their stores stood, this decline con-

cerned them not only in connection with the prosperity of

* McCurdy’s appears to have had suburban branch store, not ma-

terial herein.

a. oe eee ae

+2 bbb

rca a 2

A20

- 4

their businesses, but also in connection with the value of

their real estate investment.

In 1958, petitioners organized Midtown Holdings —

(hereinafter Midtown) for the purpose of constructing and

operating an enclosed mall shopping center adjoining the

two stores. This project was intended to revitalize peti-

bemeapied business and protect and enhance their real estate

investment. "

On March 23, 1959, petitioners entered into an agreement

| pertaining to their investment in Midtown. The agreement

provided that MeCurdy’s and Forman’s should each have

equal representation on the Board of Directors of Midtown.

Provision was made for the designation of an additional

odd-numbered director, if either party so requested. Such

additional director was to be selected by mutual consent or,

if such consent was not forthcoming, by an independent

third party.

In accordance with the agreement and at the times rele-

vant herein, Midtown had four directors: Gilbert J. C.

McCurdy, Gordon W. McCurdy, Maurice R. Forman, and

Fred Forman until his death in 1963, when he was replaced

by Robert Aex. During the same period, the officers of

Mid-town were : 2 Fi

President Gilbert J. C. MeCurdy

Vice President Maurice R. Forman

Secretary Gordon W. McCurdy

Treasurer Fred Forman (until his

death in September 1963).

Robert Aex (replaced

Fred Forman in November

1963).

Vice President Lynn re (to April 1,

and General 1963). Angelo Chiarella

Manager . _ (from May 27, 1963).

A21

The 1959 agreement also provided that stock purchases

from Midtown should be made equally by each petitioner

and, in accordance with this provision, each petitioner in

due course acquired for value an equal number of shares of

common stock of Midtown. The agreement further pro-

_ vided, in part, that:

VII. The parties hereto agree to loan to Midtown

additional amounts so that their aggregate loans to

Midtown shall be One Million Dollars ($1,000,000)

each, at any time and from time to time, if, prior to

January 1, 1965, the Board of Directors of Midtown,

by resolution, shall determine that such additional

funds in the form of borrowing are necessary or ad-

visable. Loans shall be made equally by the parties.

Such loans shall be represented by notes, or other

evidence of indebtedness, of Midtown, the essential

features of which shall be as follows: >

(A) The notes shall pay interest at the rate of

five (5) percent per annum payable semi-annually on

the first days of January and July in each year.

(B) The notes shall be due and payable thirty (30) -

years after issuance. ‘

notes in whole or in part on any interest paying date

prior to maturity upon the payment’of the principai

amount thereof and accrued interest.

(D) The notes may be-unsecured but shall not be

subordinated _to the claims of any other unsecured

creditor of Midtown. .

(2) The notes shall be part of a series, and there

shall be no preference between the parties hereto, as

payment of the notes of a series.

Midtown began construction of the shopping center in

1959. The costs of construction had initially been esti-

mated at $8,000,000; they turned out to be far higher,

eventualy amounting to about $18,000,000.

A22

During 1958 and the first four months of 1959, each peti-

tioner made a number of loans to Midtown. On May 1,

1959, these loans were consolidated into single obligations

totalling $662,500 to each petitioner in the form of 30-year

notes bearing interest at 5 percent. In July 1959, Midtown

satisfied these notes, without payment of interest, from

the proceeds of a $2,700,000 line of credit established by

Midtown with the Lincoln Rochester Trust Company.

On September 9, 1960, each petitioner loaned to Midtown

$1,000,000, receiving in return a three-year note bearing

interest at 3% percent. In April 1961, these notes were

eancelled without payment of principal or interest and re-

placed by three-year notes in the same principal amount,

bearing no interest and dated back to September 9, 1960.

When the notes fell due, on September 9, 1963, they were

replaced by new three-year notes. These notes were in turn

replaced by new three-year notes on September 9, 1966.

None of these notes bore interest and no payments have

ever heen made on any of them. The loans evidenced by

these 1963 and 1966 notes are. the subject matter of the

interest issue involved in this case.

During 1961 through 1963, Forman’s loaned an additional

$1,445,000 to Midtown, which was fully repaid in December

1964 from the proceeds of loans which Midtown secured

from the Lincoln Rochester Trust Company. Also during

1961 through 1963, Gilbert J. C. MeCurdy, Virginia G.

McCurdy, and Maurice Forman made various loans total-

ling $1,895,000 to Midtown. These loans also were paid off

in December 1964 with the proceeds of a Lincoln Rochester

Trust Company loan.

The enclosed mal! shopping center was named Midtown

Plaza Shepping Center and is hereinafter referred to as

Midtown Plaza. Midtown Plaza is constructed around a

A23

mall which measures 300 feet north and south and is here-

inafter referred to as the Mall. Over most of its length,

the Mall is 110 feet wide, but in the northernmost 90 feet or

so there is an aleove opening out to the east which «nakes °

the Mall close to 200 feet wide. The entire northern border »

of the Mall is taken up by MeCurdy’s, except for an arcade

going through to Euclid Street. Forman’s borders the

Mall on the west, taking’ up approximately the northern

half of the western border. _The remaining borders of the

Mall are oceupied by a miscellany of different stores.

The Mall is entirely roofed over; the decorated ceiling is

45 feet above the main level. There is a terrace level of

stores which front on a broad baleony 16 feet above the

main level. .

Forman’s has 145 feet of frontage, three entrances, and

seven display windows on the main level. On the terrace

level, Forman’s has 145 feet. of frontage, two entrances

(one blocked off), and eight display windows. MeCurdy’s

has 214 feet of frontage (including frontage on the corridor

leading off to the northeastern arcade), two entrances,-and

six display windows on the main level and 76 feet of front-

age and two display windows on the terrace level. Pillars

approximately 18 inches square support the baleony’s inside

edge. yas ’

One means of access to the terrace level is a pair of

escalators athwart the open part of the Mall; at this point

the Mall is bridged over by a causeway connecting the

haleonies on either side of the Mall. The escalators de-

bouch onto this causeway. The escalators and causeway

effectively divide the Mall into two unequal parts. The

southern part is approximately 90. feet by 110 feet and is

referred to as the “South Mall”; the northern part is ap-

proximately 180 feet by 110 feet (not including the alcove

ele NS ss aR enlist es eed Saggy Rae Ge WiBac ale

A24

at the northeast corner) and is referred to as the “North

Mall.” The North Mall thus has roughly twice the area of -

the South Mall. “e

In addition ‘to the Mall itself, Midtown constructed and

owns an 18-story building abutting the southern end of the

Mall; one of the floors opens out onto the main level of the

Mall. Midtown also constructed and owns a four-story

building which abuts onto the alcove at the northeast corner

of the Mall. An arcade goes through this building to Euclid

Street, thus providing access to Midtown Plaza from the

northeast. Below the southern end of Midtown Plaza is a

three-level underground parking garage with a capacity of

1,700 automobiles. An escalator from the garage opens

directly onto the South Mall. A bus terminal is located

outside the southeastern corner of Midtown Plaza and there

are pedestrian passageways leading directly into the South

Mall. Buses using the terminal run frequently throughout ©

the day and service many suburban areas near Rochester.

Midtown has constructed and rented four different kiosks

in the South Mall; at any one time, however, there have

been no more than three kiosks there. American Airlines

rented a kiosk of 125 square feet at a rental of $26.10 per

square foot during each of the years herein in issue. John

- T. Nothnagle, Inc., a real estaté concern, rented a 60-foot

kiosk at $40.35 per square foot during 1964 through 1966.

The National Key Company rented a kiosk of 64 square feet

during 1964-1967. The base rental in each year was $23.48

per square foot. The total’rental in each year was $67.16

per square foot in 1964, $58.13 in 1965, $69.37 in 1966, and

$72.27 in 1967. In 1967, the Allstate Insurance Company

' rented 100 square feet of floor space at $54 per square foot.

The North Mall contains a pool with a fountain, a large

pit filled with earth and planted with indoor plants, and

A25

a permanent exhibit known as the Clock of Nations. This

clock is 25 feet high. Around its base are 4 series of

cylinders containing animated dolls; these dolls are dressed

in costumes characteristié of various foreign countries. At

appropriate times, each cylinder is lit up, the dolls within

move, and ‘music ‘characteristic of the particular country

is played automatically. The Clock of Nations is con-

sidered a focus of interest at Midtown Plaza and a signi-

ficant attraction to tourists and shoppers. To be fully

effectiv e, it was necessary that the clock be visible from as.

large a part of the North Mall as possible. The North,

Mall also contains a small structure which acts as a bulletin®

board for advertisements and announcements of community

events.

The architect who designed Midtown Plaza initially econ-

templated that both parts of the Mall would have kiosks.

At a late stage in the construction, it was decided to save

money by cutting out unnecessary costs. The possibility

of making no provision at all for kiosks was explored.

But construction was so far advanced that very little, if

any, money would have heen saved by eliminating the utility

pits for the kiosks. Ilowever, certain planned plumbing

and lighting facilities for kiosks were omitted. The in-

stallation and placement of utility pits did not commit

Midtown to any particular number or placement of kiosks:

. several kiosks could be serviced from one utility pit.

The design of a kiosk varies w sdely with the type of

tenant for which it is intended, so widely that there is no

point in building the kiosk until the nature of the tenant

is known. " .

Midtown Plaza opened for business on April 10, 1962.

At that time, there were no kiosks in the North Mall and

none were contemplated. Midtown had decided to keep the

Sov bey ala

A26

North Mall available for non-commercial events and ex-

hibits—civic, cultural, educational, social, ete. The presence

of kiosks would have made the North Mall physically less

useful for such activities, some of which would require

a large open space. In addition, the presence of kiosks

with mercantile tenants would have given the North Mall

an excessively commercial aura, incompatible with many

non-commercial activities.

The North Mall has in fact been extensively used for

‘non-commercial activities, including a National Aeronautics

and Space Administration exhibit, a high school dance, and

a non-denominational Easter sunrise religious service.

These events and exhibits have attracted considerable

pedestrian traffic to Midtown Plaza. Even more import-

antly, they have occasioned considerable publicity, which

in turn, has made Midtown Plaza better known, kept Mid-

town Plaza in the minds of the residents of the Rochester

area, and generated good will. In effect, making the North

Mall available for non-commercial purposes has served

as a very effective. form of institutional advertising for

Midtown Plaza as a whole. Space on the North Mall is

normally made available for use free of charge, but Mid-

town has occasionally charged and received a fee for. its

use.

The advertising, with the generalized good will it built

up, made Midtown Plaza a more attractive business. loca-

“ _ tion for merchants; the advertising thus had long-run hene-

fits to Midtown, since it placed Midtown in a better posi-

tion to charge higher rents in later years. Petitioners’

‘businesses also benefited from this advertising, since their

stores were identified with Midtown Plaza in the public

mind. The businesses of the other mercantile tenants

of Midtown Plaza benefited from this advertising. Since

CAE RRA

A27

most such tenants were on percentage leases, Midtown.

would in all probability immediately share in these benefits

through increased rental receipts.

From the point of view of Midtown’s independent

economic interest, the use of the North Mall as it was in

fact used, for non-commercial activities, was preferable to

using it for commercial kiosks, even without payments by

petitioners in lieu of kiosk rentals. The immediate and

long-term benefits to Midtown from the advertising effect

outweighed the loss of potential kiosk rental payments.

From the point of view of the owner of an enclosed mall

shopping center, kiosks are desirable, other things being

equal, since they generally increase the total rental to be

expected from the entire project. But from the point of

view of a store tenant, they are undesirable in that they

obstruct the free flow of pedestrian traffie and, under some

circumstances, may block the vision of potential customers.

Insofar as petitioners were concerned, the presence of _

kiosks would not have materially interfered with the

vision of potential customers.

In May 1968, Angelo Chiarella (hereinafter Chiarella),

who had worked for the architect who designed Midtown

Plaza, became vice president and general manager of Mid-

town under an oral agreement as to his duties and com-

pensation. A written employment contract was executed

in August 1964 and was subsequently modified in 1966.

Chiarella was entitled, in addition to a base salary, to

honuses based on Midtown's “operating income.” In gen-

eral, Midtown’s then current income had to increase sub-

stantially before Chiarella would get any bonus at all. Such

an increase in Midtown’s operating income would increase

Chiarella’s bonus. Chiarella has, in fact, received bonuses

under this formula (as modified in 1966).

ave Ver Te

{RRR

RN ATE REY

LPL TILE AEE LO ETO

A28

Since the completion of construction, Midtown’s income

has come largely from rental of space in Midtown Plaza.

The owners of all stores adjoining the Mall, including |

petitioners, made payments during the years in question

-to Midtown to cover the cost of operating and maintaining

the common mall area upon which their stores fronted.

Midtown’s profit and loss statements are prepared on the

basis of a fiscal year ending July 31. The profit and

loss statement for each of the years herein relevant shows

a net loss, except for the year ending July 31, 1967, as

to which the statement shows a small profit. At least dur-

ing 1964 and 1965, Midtown was in need of working capital.

Midtown had no taxable income subject to Federal tax

during the years herein in issue. |

During the years in issue, MeCurdy’s reported. gross

sales and taxable income as follows:

Year ending ~ Gross sales Taxable income

Jan. 30, -1965 $22,536,052.21 $ 780,137.30 |

Jan. 29, 1966 24,116,410.91 © = 1,155,580.84

Jan. 28, 1967 = -.25,184,893.61 1,216,421.17

During the years in issue, Forman’s reported gross sales

and taxable income as follows:

Jan. 30, 1965 $10,077,631.00 $286,420.00

Jan. 29, 1966 10,807,663.00 420,264.00 .

Jan. 28, 1967 11,041,748.00 425,144.00

On May 7, 1964; Chiarella wrote a letter to each peti-

tioner, proposing that each petitioner pay Midtown $75,000 |

per year not to rent out kiosks on the North Mall. The

letter pointed out that petitioners benefited from. the non-

commercial events held in the North Mall. To justify the

amount requested, the letter argued that ten kiosks could

A929

be put into the North Mall and that $150,000 per year

could be obtained in rentals from ten kiosks in that loca-

tion.. On November 6, 1964, petitioners and Midtown

executed a written contract embodying this proposal. Under

the contract, Midtown was to “retain complete control, di-

’ rection and management” of the North Mall. Each peti-

tioner agreed to pay Midtown $75,000 per year, starting

with the year beginning February 1, 1964. Each petitioner

‘paid Midtown $75,000 during each of the taxable years in-

- volved herein. The sums were included in Midtown’s “oper-

ating income” for the purpose of computing Chiarella’s

bonus. None of Midtown’s tenants has ever been approach-

ed by Midtown to make payments for the purpose of pre-

venting the establishment of kiosks in the shopping mali,

and no such. payments have ever been made. None of the

leases prohibits the erection of kiosks and only oné lease re-

stricts the placement of kiosks.

Advertising expenses are ‘usually about 5 percent of

the gross sales of department: stores. During the years

in issue, McCurdy’s advertising and publicity expenditures,

counting the $75,000 payments to Midtown as advertising, .

ranged from 3.7 percent to 4.1 percent of gross salés. Dur-

ing the years in issue, Forman’s advertising and publicity

expenditures, counting the $75,000 payments to Midtown

as advertising, ranged from 3.7 percent to 3.9 percent of

gross sales.

ULTIMATE FINDINGS OF FACT

1. Neither petitioner was directly or indirectly ¢on-

trolled by the same interests, nor was Midtown and either

of the petitioners so owned or controlled. :

9, Had Midtown decided to construct and rent kiosks ~

on the North Mall, it could have realized at least $150,000

ES LD eR ET IO ey

a er Ee Bree Oe eet

pay ad Cate

A30

annually during the periods relevant herein in rents from

..such kiosks.

3. At least by April 10, 1962, when Midtown Plaza

opened for business, Midtown had made a firm decision

not to construct and rent kiosks on the North Mall and

such decision continued in full force and effect during all

-periods relevant herein.

4. The $75,000 paid to Midtown by each petitioner in

each of the taxable years herein in issue did not constitute

an ordinary and necessary business expense.

‘OPINION

' Tmputation.of Interest Income

under Section 482

Each petitioner owns and operates a department store

in downtown Rochester, New York. In 1958, petitioners

organized Midtown Holdings Corporation as a vehicle for

constructing and operating an enclosed mall shopping

center abutting upon their department stores. It was

hoped that the shopping center would not only revitalize

their business, but also enhance the value of their real

. estate investment.

The project (know as Midtown Plaza) turned out to be

far more expensive than expected. In consequence, peti-

tioners from time to time made various loans to Midtown.

As our findings of fact show, no interest was paid on these

loans. With respect to $1,000,000 of such loans, originally

made in equal amounts in September 1960 and renewed in

‘September 1963 and again’in September 1966, respondent

has imputed interest income at 5 percent per annum to

each petitioner. In so doing, respondent has relied on

A31

- @&

section 482% and the regulations issued thereunder. See

section 1.482-2(a), Income Tax Regs.

At all relevant times Forman’s and McCurdy’s were the

sole shareholders of Midtown, each owning 50 percent ‘of

its issued and outstanding stock. Members of the Forman

family controlled Forman’s and members of the McCurdy

family controlled McCurdy’s. There is not the slightest

suggestion in the record that any members of the McCurdy

family and the Forman family were in any way related

and respondent has made no contention in this respect. —

Section 482 grants respondent authority to allocate

income, deductions, credits, and allowances among two or

more “organizations, trades or businesses * * * owned or

controlled directly or indirectly by the same interests.”

This means actual, practical control rather than any par-

ticular percentage of stock ownership. South Texas Rice

Warehouse Co. v. Commissioner, 366 F. 2d 890, 894-896

(C. A. 5, 1966), affirming 43 T. C. 540, 561-562 (1965) ;

Jesse E. Hall, Sr., 32 T. C. 390,°409-410 (1959), affd. 294

F. 2d 82 (C. A. 5, 1961); section 1.482-1(a) (3), Income Tax

Regs. Respondent contends, and petitioners deny, that the

requisite control existed. We agree with petitioners.

Each petitioner had only a 50-percent interest in Mid-

town, but this, standing alone, would not enable it to

Sec. 482. ALLocaTion or INcoME AND Depvuctions AMONG

- TAXPAYERS. é;

In any case of two or more organizations, adie or businesses

(whether or not incorporated, whether or not organized in the Umted

States, and whether or not affiliated) owned or controlled directly or

indirectly by. the same interests, the Secretary or his delegate may

distribute, apportion, or allocate gross income, deductions, credits, or

allowanres between or among such organizations, trades. or businesses.

if he determines that such distribution, apportionment, or allocation

is necessary in order to prevent evasion of taxes or clearly to reflect

the income of any of such organizations, trades, or businesses.

~ A32

dominate or manipulate Midtown. With the possible ex-

ception of forcing a dissolution (see N. Y. Bus. Corp. Law,

see. 1104 (6 McKinney)), the best that either petitioner

. acting alone could achieve was a deadlock. There was no

relationship between the shareholders of petitioners which

could form the basis for finding that any group of share-

holdefs could be said to have control of hoth Forman’s and

McCurdy’s and thus, control of Midtown as well. It was just

such a relationship which supported a finding of control in

Advance Machinery Exch. v. Commissioner, 196 F. 2d 1006

(C. A. 2, 1952), affirming a Memorandum Opinion of this

Court, Grenada Industries, Inc., 17 T. C. 83 (1951), affd.

202 F. 2d 873 (C. A. 5, 1953), and Jesse FE. Hall, Sr., supra,

heavily relied upon by respondent. In Advance Machinery

and J/all, the necessary relationship rested on family

solidarity, and in Grenada Industries, it stemmed from a

-. proportional common ownership of the entities involved.

These cases are consequently clearly distinguishable. In

short, there was no ownership or control (in the usual

sense of those terms) of “tio or more organizations, trades

or businesses,” (Emphasis added.)

Respondent does not seriously contest this conclusion.

Rather, he argues that the requirements of section 482 are

met because Forman’s and MeCurdy’s had a common inter-

est as far as their department store businesses were con-

cerned which dictated that they act in concert with respect

to Midtown. In urging this expansive interpretation of

section 482, respondent recognizes that our holding in Lake

Erie & Pittsburgh Railroad Co., 5 T. C. 558 (1945), is di-

rectly contrary to his position. ie urges us to overrule our

prior decision and articulates on brief the analysis set

forth in Rev. Rul. 65-142, 1965-1 C B. 223. .In essence, this

analysis is premised on the assertion that, in organizing

A33

and operating Midtown, Forman’s and McCurdy’s should

be considered as acting as a partnership and that there is,

therefore, ‘the requisite control of two entities, namely, the

partnership and Midtown.

* We have carefully reexamined our decision in Lake Erie

& Pittsburg Railway Co., supra, and have concluded that

it should be reaffirmed. The clear language of section 482

requires that there be two business entities with respect

to which direct or indirect control by the same interests

ean be found. If we look at Midtown and Forman’s or

Midtown and MeCurdy’s, no such control- existed. To im-

port a common objective test into section 482, and thereby

create a theoretical partnership between Forman’s and

MeCurdy’s, would require an unwarranted elasticized read-

ing of the statutory language. Perhaps the absence of an

obligation to pay interest on the loans produced a dis-

tortion of income as between Midtown and petitioners, but

we find nothing in the legislative history which would

justify the interpretation of the phrase “same interests”

urged by respondent. Congress clearly had in mind a

finding of ownership or control of two or more businesses

by the same interests. See HI. Rept. No. 2, 70th Cong., Ist

Sess., pp. 16-17 (1927). See also Fred J. Sperapani, 42

T. C. 308, 336, n..6.

The hard fact is that Congress did not design section

482 to cover every potential distortion of income and dedue-

tion. To refer to MeCurdy’s shareholders and Forman’s

shareholders as “the same interests” would be a distortion,

not of income, but of words. We are reinforced in our

* In enacting the 1954 Code, Congress explicitly stated it was making

no substantive changes in section 482. See H. Rept. No. 13%? 23d

Cong., 2d Sess., p. A165 (1954); S. Rept. No. 1622, 8%d Cong. 24

Sess., p. 310 (1954).

A34

conclusion by the fact that respondent acquiesced in our

decision in Lake Erie & Pitisburgh Railway Co., supra, for

twenty vears. See 1945 C. B. 5; acquiescence withdrawn

1965-1 C. B. 5; Rev. Rul. 65-142, supra. Such long-stand-

ing administrative interpretation of statutory language

may properly be taken into account. See Ianover Bank v.

Commissioner, 369 U. S. 672, 686 (1962).

In view of our conclusion that the requisite control under

section 482 did not exist, we do not decide whether this

ease would fall within the ambit of those decisions dealing

with the question of the extent to which that section au-

thorizes the allocation of income where no income is

realized. See, ¢.g., Smith-Bridgman & Co., 16 T. C. 287,

293 (1951). Nor need we consider the impact on section

482 of the specifie provisions of section 483 dealing with

imputed interest in certain situations. Compare also

"J. Simpson Dean, 35 T. C. 1083, 1087-1090 (1961).

Deductibility of Kiosk

Prevention Payments

During each of the years in question, each petitioner

paid Midtown $75,000 to keep kiosks off the North Mall and

deducted the payments as ordinary and necessary business

_ expenses. Respondent has disallowed the deductions.

Whether or not a payment constitutes an ordinary and

necessary business expense constitutes primarily a ques-

tion of fact. Commissioner r. Heininger, 320 U. S. 467,

475 (1943). See Welch r. IHelrering, 200 U. S. 111, 115

(1933). Clearly, there is no automatic barrier to resolv-

ing that question in favor of a taxpayer even though the |

payor and payee are in a corporation-shareholders rela-

tionship. Compare Pay's Clothes, Inc., 22 T. C. 1332

A385

(1954). But where such a relationship exists, the payment

should be subjected to close scrutiny to ensure that it is

indeed what it purports to be. EF. g., Darco Realty Cor-

poration v. Commissioner, 301 F. 2d 190 (C. A. 2, 1962). .

A pair of escalators and a causeway divided the shop-

ping mall of Midtown Plaza into two.unequal parts. The

South Mall, the smaller of the two, had kiosks in it,

tenanted by various commercial enterprises. The North

Mall, which ‘had petitioners’ department stores along two

of its sides, was kept clear of kiosks so that it could be used

for non-commercial events. In eect, the North Mall fune-

tioned as a sort of community center, The various events .

held there drew people to Midtown Plaza who would not

otherwise come. This extra traffic was of value to Mid-

town, to petitioners’ department stores, and to all the

commercial tenants of Midtown Plaza. Even more im-

portant is the quite considerable publicity. generated by

these events; this publicity served as a very effective form

of institutional advertising.

Petitioners posit their assertion of deductibility on the

ground that the payments served an advertising function,

since they made possible the use of the North Mall for

promotional events from which they directly benefited.

They further seek to support their claim by arguing that

they, in effect, rented the North Mall from Midtown and

that. since $150,000 constituted a reasonable rental, com-

mensurate with what 4n independent lessee would pay, it

follows that that amount was paid exclusively for the use

of the Mall and is therefore deductible. Compare Polak’s

Frutal Works, Inc. v. United States, 176 F. Supp. 521 (S.

D. N. Y. 1959), affd. 281 F. 24 261 (C. A. 2, 1960). We have

no quarrel with petitioners’ arguments as far as they go.

ete ear hes

vs ss 45Joes

, * A386

‘The difficulty is that they are not determinative of the

question before us.

Use of the North Mall as a sort of community center

doubtless benefited the petitioners, but equally beyond doubt

is the benefit to Midtown Plaza as a whole. Midtown stood

to benefit immediately to the extent that it would share in

the increased business through percentage leases. And

beyond this immediate benefit, the attractiveness of Mid-

town Plaza to business tenants ‘was increased, thereby

enhancing the ability of. Midtown to obtain higher rentals

in‘the future. These faetors made it in the interest of

Midtown to keep the North Mall free of kiosks. Coneeded-

ly, landlords of shopping centers may normally want to rent

out kiosks in order to obtain additional rentals. But

Midtown was not faced with a simple choice between

kiosks and no kiosks; it had to choose between kiosks and

an extremely effective form of institutional advertising.

In short, Midtown was faced with a choice as to what was

in its own: hest independent interests. In our opinion, as

our findings of fact show, it made that chaice no later than

April 10, 1962, the date on which Midtown Plaza. opened

and*long before the contractual obligation to pay the

$150,000 was undertaken by petitioners.

As we see it, the test is whether the arrangements calling

for the payment of the $150,000 were in fact what they

purported to be, namely, an annual expenditure for a eur-

rent benefit to petitioners which Midtown had to be indueed

to eonfer. Clearly, the mere fact that petitioners were

legally hound to make the payment is not determinative.

See, e.g., Atlantic Monthly Co., 5 T. C. 1025, 1032 (1945).

The question is: should petitioners he allowed a deduction

as an ordinary and necessary business expense for reenr-

A37

ring payments for a promise by the payee not to undertake

an activity which it had already decided not to undertake

in its own independent interests? While we have found

no decision which furnishes us with direct guidance, we

conclude that the question should be answered in the nega-

tive. Cf. Swed Distributing Company v. Commissioner,

323 F. 2d 480 (C. A. 5, 1963), affirming a Memorandum

Opinion of this Court on remand from 272 F. 2d 330 (C.

A. 5, 1959), which, in turn, had reversed 31 T. C. 84 (1958) ;

Ingle Coal Corporation v. Commissioner, 174 F. 2d 569 (C.

A. 7, 1949), affirming 10 T. C. 1199 (1948); Ray's Clothes,

Inc., supra; Granberg Equipment, Inc., 11 T. C. 704 (1948).5

Our conclusion that the afs#iagements were not what they

purport to be is furthey reinforced by several additional

elements present herein:

(1) The fact that petitioners’ payments to Midtown

were equal is highly suggestive. Petitioners’ sales volumes

and income «differed markedly. The effect upon the revenue

of their-department stores of the North Mall activities

would almost certainly be different. If the decision to

.. keep kiosks off the North Mall had been made in connec-

tion with the department store businesses of petitioners, it

would seem that the petitioner who could expect to reap a

lesser benefit from the advertising would have demanded

that payment be proportional to its expected benefit.

Moreover, we note that none of Midtown’s tenants were

asked to make such payments, although they henefited

from the promotional events. Finally, the original agree-

ment between petitioners required that their investment be

equal. Thus, the equality of payments suggests that they

were intended as eapital contributions.

* (Compare also Mar J. Epstein, T. C. Memo. 1964-192.

A38

(2) There were good reasons for artificially inflating

. Midtown’s income at the expense of the department store

businesses. Midtown needed cash; petitioners therefore

had to make capital contributions or loans to Midtown.

Petitioners had substantial taxable income against which

deductions could be used, Midtown had substantial tax

losses to soak up increases in income, and Chiarella’s bonus

would be increased by increased rental income. To the

extent that a capital contribution could be disguised as

income to Midtown and business expense to the petitioners,

everybody benefited-and no one was hurt significantly.

While tax avoidance may be a permissible objective where

the substance and form of the transaction coincide, the

presence of -a pattern of tax benefits certainly constitutes

a yellow caution signal on our road to decision. Cf. George

L. Schultz, 50 T. C. 688, 694 (1968), affirmed per curiam

420 F. 2d 490 (C. A. 3, 1970).

We again emphasize that we are not dealing with a situa-

tion where the payment in question is for a benefit con-

ferred which the payor was concerned it might lose

through bona fide action action by the payee. Under such

circumstances, the measurement of the value of the pay-

ments against the benefit conferred in order to support the

‘ contention of a quasi rental,® or the justification of the pay-

ments as an advertising expenditure, or the possibility of

interference by the kiosks with the visibility of petitioners’

store windows, or whether the petitioners were under obli-

gation to Chiarella to maximize the income of Midtown in

order to enhance his bonus would have been highly relevant.

* In this connection, we note that. under the agreement of November

6, 1964, Midtown was to “retain complete control, direction and

management” of the North Mall. And when charges were made for

the use of North Mall space. Midtown, not petitioners. received the

money.

A39

But in the posture of ‘this particular case, those considera-

tions are totally beside the point. |

We conclude that the payments of $75,000 by each of

‘the petitioners to Midtown were disguised capital con-

tributions and therefore not deductible expenses.

In order to reflect certain adjustments made in the

notices of deficiency and not contested in the . petitions,

as well as our resolution of the first issue, Decisions will.be

entered under Rule 50.

Reviewed by the Court.

A40

III. Opinion of the Court of Appeals for the

Second Circuit

UNITED STATES COURT OF APPEALS

For tHE Seconp Circuit ae «

- Nos. 768, 769, 770, 771—September Term, 1970.

(Argued June 1, 1971 Decided January 10, 1972.)

Docket Nos. 35434, 35839, 71-1026, 71-1027

B. FORMAN COMPANY, INC., .

Petitioner- Appellee,

against

COMMISSIONER OF INTERNAL REVENUE,

; Hespondent- Appellant. ~*

MeCURDY & COMPANY, INC.,

Petitioner-A ppelle e,

against

COMMISSION ER OF INTERNAL REVEN UE,

Respondent-A ppellant.

B. FORMAN COMPANY, INC.,

Petitioner-A ppellant,

against

COMMISSIONER OF INTERNAL REVENUE,

Respondent-A ppellee.

McCURDY & COMPANY, INC.,

Petitioner-A ppellant,

against

COMMISSIONER OF INTERNAL REVENUE,

Respondent-A ppellee.

Before: Clark, Associate Justice,"

Smith, Circuit Judge,

Zavatt, District Judge.**

* Retired Associate Justice of the Supreme Court, sitting by desig-

ation.

** Senior District Judge for the Eastern District of New York,

sitting by designation.

A41

’

Cross- —w froma aadiiieis of the Tax Court, Tannen-

wald, Judge, 54 T. C. 913 (1970), holding that (1) § 482°

of the. Internal Revenue Code of 1954 did not authorize

the Commissioner to allocate to taxpayers interest income

attributable to interest free loans made by taxpayers to

‘Midtown and (2) that annual payments made by taxpayers

to Midtown were not ordinary and necessary business ex-

penses deductible under ¢162 of the natornes Revenue

Code of 1954. ;

Reversed as to the first holding, affirmed as to the second

holding. ;

' Ellsworth A. VanGraafeiland and Peter L. Faber

(Wiser, Shaw, Freeman, VanGraafeiland, Harter & Se-

- crest, Rochester, New York, Richard B. Secrest and William

M. Colby, of counsel), for Taxpayers.

‘Stephen Schwarz, Attorney, Tax Division (Johnnie M.

Walters, Assistant Attorney General, Meyer Rothwacks

and Harry Baum, Attorneys, Tax Division, Department

of Justice, Washington, D. C., of counsel), for the Com-

missioner. . .

ZAVATT, D.d.:

These are cross-appeals from a decision of the Tax Court.

54 T. C. 913 (1970), holding (1) that 26 U.S. CG. 4 482 (the

Internal Revenue Code of 1954, hereinafter the “Code’’)

did not authorize the Commissioner to allocate to B. For-

man Co., Ine. (Forman) and McCurdy & Co., Ine. (Me-

Curdy) (both referred to herein as taxpayers) interest

income attributable to interest free loans made by the

taxpayers to Midtown Holdings Corp. (Midtown), because

of the absence of the requisite § 482 control of Midtown by

the taxpayers ; and (2) that annual payments of $75,000.00

each made by the taxpayers to Midtown were ‘not ordinary

and necessary business expenses deductible under 26 U.

A42

S. C. $162. The Commissioner appeals from the first of

these holdings; the ‘taxpayers appeal -from the second. We

reverse the decision of the Tax Court as to the first and

affirm as to the second of these holdings.

These consolidated cases involve the corporate income.

tax liability of Forman and of MeCurdy for the fiscal

years 1965, 1966 and 1967. Having disallowed the annual

payments of $75,000.00 each year by the taxpayers to Mid-

town and having allocated. as income to each taxpayer in-

terest at the rate of 5% per annum on a $1,000,000.00 loan

made by each taxpayer to Midtown prior to the fiscal

years in question, the Commissioner assessed tax deficien-

cies against each taxpayer (now in dispute) as follows:

1965 $ 62,425.55 $ 59,181.99

1966 58,775.14 59,643.92

1967 59,692.00 — 62,343.56

Totals $180,892.69 $181,169.47

Following receipt of the Commissioner’s notices of these

deficiencies and on January 31, 1969, each taxpayer filed

a petition with the Tax Court for a review of the respective

tax deficiency determinations of the Commissioner, hoth of

which petitions were consolidated. |

For several years prior to and as of the date of the in-

corporation of Midtown, McCurdy (a New York corpora-.

tion since 1901) operated a retail general department store

at 285 Main Street East, Rochester, New York and For-

man: (a New York corporation since 1912) operated a re-

-tail department store, specializing in men’s and women’s

apparel, at 46 Clinton Avenue South, Rochester, New York.

All of the stock of McCurdy was owned by or in behalf: of

‘members of the McCurdy family. All of the stock of For-

A43

man was owned by or in behalf of members of the- Forman

family. McCurdy and Forman had no common share-

holders, directors or officers. Both corporations were

competitors. |

In an effort to stem declining incomes, McCurdy and

Forman caused Midtown to be formed in 1958. On March

23, 1959 they entered into an agreement with reference to

their participation in the building and development of a

the rear entrances to their respective stores. -By that

time the Board of Directors and ‘officers of Midtown con-

_ sisted of the following:

Relationship to McCurdy

and Forman

Gilbert J. C. MeCurdy

(President and Chairman

of Board of. Directors

of Midtown)

Gordon W. McCurdy

(Secretary and a

Director of Midtown)

—Chairman of the Board of

‘Directors and President of

McCurdy

—Vice-Chairman of the

Board of Directors and

Senior Vice-President

of McCurdy

Maurice R. Forman

(Vice-President and

a Director of Midtown)

" Fred Forman

(Treasurer and a

Director of Midtown)

Lynn Johnston

‘(Vice-President and

General Manager of

Midtown)

—Chairman of the Board of

Directors and President

of Forman

—Member of the Board of

Directors and Senior

Vice-President of Forman .

At#4

It would appear from that agreement that when, in 1958,

McCurdy and Fornian decided to form Midtown and erect

a shopping center in downtown Rochester, they each

entered into lease agreements (with options to purchase)

with the owners of the property on which they contem-

plated the construction of the shopping center. These

properties are described in the appendices to the agree-

ment of March 23,°1959. In and by that agreement Me-

Curdy and Forman agreed to assign and transfer to Mid-

town their respective interests in these leases and options

and to convey title to any such property already vested.

McCurdy: and Forman had already acquired 50% each

of the issued and outstanding shares of Midtown. In ex-

change for the real estate interests they were to assign

and convey to Midtown, each of them was to receive an

additional 810 common, no par value shares of Midtown,

thus continuing their equal stock ownership in Midtown.

If, prior to January 1, 1965, the Board of Directors of

Midtown should determine, by resolution, that additional

funds were netessary or advisable, McCurdy and Forman

agreed to purchase additional shares of Midtown “so that

their aggregate holding shall be One Million Dollars

($1,000,000) each, at any time, and from time to time . . .”

In addition, each party to this agreement agreed to loan

to Midtown additional amounts :

“so that their aggregate loans to Midtown shall be One

Million Dollars ($1,000,000) each, at any time and from

time to time, if, prior to January 1, 1965, the Board

of Directors of Midtown, by resolution, shall deter-

— that such additional funds in the form of bor-

are necessary or advisable. Loans shall he

male equally by the parties.

Such loans shall be represented by notes, or other

evidence of indebtedness, of Midtown, the essential

features of which shall be as follows :

A45

(A) The notes shall pay interest at the rate of five

(5) | yw per annum, payable semi-annually on

the first day of January and July in each year.

(B) The notes shall be due and payable thirty (30)

years after issuance. .

notes in whole or in part on any interest paying

date prior to maturity upon the payment of the

principal amount thereof and acarund interest.

(D) The notes may be unsecured but shall not be

subordinated to the claims of any other unsecured

creditor of Midtown.

(E) The notes shall be part of a series, and there

shall be no preference between the parties hereto as

to payment of the notes of a series.

This agreement also provided for the control of Mid-

town by McCurdy and Forman by requiring each party

thereto to vote its respective Midtown stock so as to pro-

vide for a Board of Directors consisting of three Directors

designated hy the Board of Directors of MeCurdy and

three Directors designated by the Board of Directors of

Forman. At the request of either MeCurdy or Forman,

each party to the agreement undertook to vote its Midtown

stock for a seventh Director. In,the-event they were un-

able to agree upon the seventh Director, MeCurdy and

Forman were to designate their respective representatives

who would designate the seventh Director to be elected “by

the parties hereto . . .” In the event that these representa-

tives were unable to agree upon a seventh Director, a

Justice of the Appellate Division of the Supreme Court,

Fourth Judicial Department, was to act with the two rep-

resentatives and the seventh Director of Midtown was then

to be designated by majority vote of the Justice and the

two representatives of the parties.

A466

The agreement also limited the right of the parties to

dispose of their Midtown stock to detailed conditions set

forth therein.

Although the agreement provided for the designation of

three Midtown Directors each by the parties, there were

- ‘only four. During all of the relevant times the officers and

directors of Midtown were :

Vice President and Director Gilbert J.C. MeCurdy

Secretary and Director Maurice R. Forman

Treasurer and Director Gordon W. McCurdy

President and Director Fred Forman (until hix

death)

Robert Aex (after Fred

Forman’sgleath )

Aex represented Forman’s .

interests

Vice President and Lynn Johnston (to April 1.

General Manager 1963)

Angelo Chiarella (from Mav

27, 1963 on)

The shopping center, completed and opened for business

in 1962, consisted of-an eighteen story building, a four story

building (adjoining the Mall), and a three level under-

ground parking garage. Each taxpayer initially invested a

total of $1,000,000.00 in return for Midtown stock. ‘The orig-

inal estimated cost of the shopping center was $8,000,000,00,

The actual cost exceeded $18,000,000.00.

Construction commenced in 1959. The record does not

reveal all of the financing for this project. It does show

that Midtown entered into a building loan agreement with.

A47

Lincoln Rochester Trust Company (Lincoln), dated April

18, 1961, providing for advances not to exceed $11,000,000.00

to be evidenced by notes bearing interest at the rate of

six percent per year, secured by the “personal guarantees

of certain officers of the Company and others” and “a con-

ditional assignment of rents of the premises.” During 1958

and 1959,-MeCurdy and Forman made several loans to

Midtown, the amounts of which are not revealed by the

record or stated in the stipulation of facts in the proceed-

ing before the Tax Court. It was so stipulated, however,

that, on May .1, 1959, the several loans were consolidated

into single obligations of Midtown of $662,500.00 each to

McCurdy and Fermin, represented by thirty-year notes

of Midtown, each bearing interest at the rate of five per-

cent per annum. (These notes were satisfied in July of

1959, without interest, from the proceeds of a $2,700,000.00

line of credit established by Midtown with Lincoln. The

fact that MeCurdy and Forman each waived interest on

these notes is not involved in the instant case.)

Allocation of Interest Income

under 26 U.S.C. 482

’

The issue as to allocation of income to McCurdy and

Forman for the fiscal years 1965, 1966 and 1967 stems from

loans of $1,000,000.00 each by the taxpayers to Midtown on

September 9, 1960, each represented by a three-year note

of Midtown to each taxpayer, bearing interest at the rate

of three and one-half percent per annum. These notes were

cancelled in April 1961, without payment of any principal

or interest. In lieu thereof, they were replaced by notes of

$1,000,000.00 each, predated September 9, 1960 and bearing

no interest. On their due date, September 9, 1963, they

were replaced by three-year notes in the same principal

amounts, bearing no interest—without any payment of

A48

principal or interest having been made thereon. These

notes, dated September 9, 1963, were replaced on Septem-_

ber 9, 1966 by three-year notes in the same amounts, bear-

ing no interest, without any payment of principal or inter-

est having been paid thereon. No payments of principal

or interest have ever been made on the notes dated, respec-

tively, September 9, 1960, September 9, 1963 and September

9, 1966. The issue as to the Commissioner's allocation of

income to MeCurdy and Forman relates to the notes dated

September 9, 1963 and September 9, 1966.

The Commissioner imputed interest income at the rate

of five percent per annum on those $1,000,000.00 loans by

McCurdy and Forman to Midtown ($50,000.00 of income

to each taxpayer during their fiscal years 1965, 1206 and

1967), pursuant to 26 U.S. CL § 482, which provides: |

“489 Alloeation of income and deductions

among taxpayers

In any case of two or more organizations, trades,

or businesses (whether or not incorporated, whether or

not organized in the United States, and whether or not

affiliated) owned or controlled direetly or indirectly by

the same interests, the Secretary or his delegate may

distribute, apportion, or-allocate gross income, deduc-

tions, credits, or allowances between or among such

organizations, trades, or businesses, if he determines

that such distribution, apportionment, or allocation is -

necessary in order to prevent evasion of taxes or

clearly to reflect the income of any of such organiza-

tions, trades, or businesses.”

The Tax Court reversed the Commissioner's determination,

holding in effect that Midtown was not ‘controlled directly

or indirectly” by either MeCurdy or by Forman and thet

McCurdy and Forman may not be regarded as a single

entity controlling Midtown.

. “The clear language of section 482 requires that there

be two business entities with respect to which direct or

~ _ se

A49

indirect control by the same interests can be found.

‘If we look at Midtown and Forman’s or Midtown and

MeCurdy’s, no such control existed. To import a com-

mon objective test into section 482, and thereby create

a theoretical partnership between Forman’s and Me-

Curdy’s, would require- an- unwarranted elasticized

reading of the statutory language.”

54 T. C. at 923.

Legislative History

26.U. 8. C. § 482 derives from section 45 of the Internal

Revenue Code of 1928. The House report with reference to

section 45 of the 1928 Code explained that its purpose was

to allow the Commissioner to

‘distribute the income or deductions between or among

[commonly controlled taxpayers] . . ., as may be nee-

essary in order to prevent evasion (by the shifting of

profits, the making of fictitious sales, and other meth-

ods frequently adopted for the purpose of ‘milking’),

and in order clearly to reflect their trne tax liability.”

H. Rep. No. 2, 70th Cong., Ist Sess., pp.

16-17 (1939-1 Cum. Bull. Part 2 384, 395).

Provisions somewhat similar to those in section 45 were

contained in prior Revenue Acts. Section 240 (d) of the

Revenue Act of 1924, 43 Stat. 288, Internal Revenue Acts of

1924 to Date, 26 U. S. C. A. p. 45, authorized the Commis-

sioner to consolidate the accounts of two or more related

trades or businesses owned or controlled by the same inter-

ests. It did not authorize him to distribute, apportion. or

allocate, as in section 482. Section 240(f) of the Revenne

Act of 1926, 44 Stat. 46, Internal Revenue Acts of 1924 to

Date, 26 U.S. C. A. p. 191 contained the very same language

as in section 240(d) of the Revenue Act of 1924. Section 45

of.the Revenue Act of 1928, 45 Stat. 806. Internal Revenue

Acts of 1924 to Date, 26 U.S. C. A. p. 364, effeeted a change.

A50

The sections of the prior acts were under the caption

_ “Consolidated Returns of Corporations.” The caption of

section 45 of the Revenue Act of 1928 was “Allocation of

Income and Deductions.”’ Its language is substantially iden-

tical to that in present section 482. The same is truc of

section 45 of the Revenue Act of 1932, 47 Stat. 186, Internal

Revenue Acts 1924 to Date, 26 U.S. C. A. p. 498; seetion 45

of the Revenue Act of 1934, 48 Stat. 695, Internal Revenue’

Acts of 1924 to Date, 26 U.S. C. A. p. 680; section 45 of the

Revenue Act of 1936, 49 Stat. 1667, Internal Revenue Acts

of 1924 to Date, 26 U.S. C. A. p. 840; section 45 of the Rev-

enue Act of 1938, 52 Stat. 474, Internal Revenue Acts of

1924 to Date, 26 U. S. C. A. p. 1028 and section 45 of the

Internal Revenue Code of 1939, 26 U.S. C. A. § 45; the Inter-

nal Revenue Code of 1954, section 482. The Revenue Act

of 1928 eliminated the right of affiliated corporations to file

consolidated returns and the right of the Commissioner

to consolidate the accounts of two or more related trades

or businesses controlled by the same interests. In lieu

thereof section 45 was inserted which “broadened consider:

ably”: former section 240(f) of the 1926 Act “in order to

afford adequate protection to the Government made neces-

sary by the elimination of the consolidated return provi-

sions of the 1926 Act.” National Securities Corp. v. Com-

missioner, 137 F. 2d 600, 662 (3d Cir.), cert. denied, 320

' U.S. 794, 64 S. Ct. 262, 88 L. Ed. 479 (1943): H. R. 2, 70th

Cong., 1st Sess.

Lake Eric

The decision of the Tax Court in Lake Erie & Pittsburg

Railway Co. v. Commissioner, 5 T. C. 558 (1945), is the only

_ judicial determination based on facts substantially similar

A51

to those in the instant case. The Tax Court reaffirmed that

decision in the instant case. In Lake Erie, the New York

Central Railroad and the Pennsylvania Railroad (two inde-

pendent competing corporations, having no common stock-

holders, officers or directors), formed a third corporation,

the Lake Erie & Pittsburg Railway Co. (Lake Erie), for

the purpose of acquiring, building, maintaining, leasing and

operating a railroad between Lorain and Youngstown, Ohio.

New York Central and Pennsylvania railroads were the

sole, equal stockholders of Lake Erie. .They used the facili-

ties of Lake Erie for which use they originally paid rent

pursuant to a 1908 agreement and Lake Erie paid dividends

to these two stockhekters. This agreement was modified in

1939 so as to release the two railroads from their obliga-

tion to pay rent to Lake Erie and release Lake Erie of its .

oblization to pay them (as stockholders) dividends. The .-

Commissioner allocated to Lake Erie as income to it, dur-

ing 1937, 1938, 1939 and 1940, from the gross income of

the railroads an amount equal to the rent which the rail-

roads were originally obligated. to pay to Lake Erie. Lake

Erie had reported.no taxable net income for each of these

years. The Tax Court reversed the determination ofthe’

Commissioner on the ground that he was without authority

to make the questioned allocation pursuant to section 45 of

the Internal Reverine Code of 1939: ‘

“The stockholders of the New York Central are not the

‘same interests’ as the stockholders of Pennsylvania

and neither the New York Central nor the Pennsy]l-

have. But that amounts to saying nothing more than

that the stockholders of a corporation control it. We

do not think that it can be said where two or more

corporations owned by different sets of stockholders

control another corporation such. other corporation is

controlled by the same interests.”

: 5 T. C. at 564-565.

A52

The Commissioner acquiesced in the decision of the Tax

Court in Lake Frrie. C. B. 1945, 5. In 1965, liowever, the

Commissioner withdrew the prior acquiescence and sub-

stituted nonacquiescence. Rev. Rul. 65-142, 1965-1- Cum.

Bull. 223.

The declared purpose of section 482 is “to prevent eva-

sion of taxes or clearly to reflect the income of . . . organi-

zations . . . owned or controlled directly or indirectly by

the same interests.” This legislative purpose is reflected

_in the Treasury Regulations where it is stated that:

“The purpose of section 482 is to place a controlled

taxpayer on a tax parity with an uncontrolled tax-

payer, by determining, according to the standard of

an-uncontrolled taxpayer, the true taxable income from

the property and business of a controlled taxpayer . . .

The standard to be applied in every case is that of an

uncontrolled taxpayer dealing at aftm’s length with

another uncontrolled taxpayer . . . Transactions ‘he-

tween one controlled taxpayer dnd another will be

subjected to special scrutiny to ascertain whether the

common control is being used to reduce, aveid, or es-

cape taxes.”’

‘Treas. Reg. § 1.482(b) (¢)

The courts recognize the congressional purpose of sec-

tion 482 to prevent evasion or avoidance of otherwise pay-

able taxes by means of shifting profits or by other financial

- devices and have. given broad scope to the Commissioner’s

- diseretion in making reallocations of income, where the

exercise of this power is not unreasonable or arbitrary...

W. Braun Co. v. C. 1. R., 396 F. 2d 264, 266 (2d Cir. 1968).

Similar recognition was given to, section 45 of the Rev-

enue Act of 1928. Central Cuba Sugar Co. v. Commissioner,.

198 F. 2d 214, 216 (2d Cir.), cert. denied, 344 U. S. 874, 73

S.: Ct. 167 (1952). The courts have also construed this

statute liberally in order to achieve the declared purpose

—A53

of Congress. In Asiatic Petroleum ‘Co. v. Commissioner,

79 F. 2d 234 (2d Cir:), cert. denied, 296 U. S. 645, 56 S. Ct.

248, 80 L. Ed. 459 (1935), it was held that the phrase

“evasion of taxes” in section 45 of the Reveriue Act of

"1928 “is bread enough to include the avoidance of the

realization for taxation of such a-profit through its trans-

fer to another branch of the same business enterprise in

a way which only changes its’ place in the business set

up.” 79 F. 2d at 236. The court also gave a broad meaning

to the term “gross income” in section 45. It referred to

the progress of section 45 of the Revenue Act of 1928in

support of its liberal interpretation of that statute. 79

F. 2d at 236. See also, Advance Machinery Exchange 1

Commissioner, 196 F. 2d 1006 (2d Cir.), cert. denied, 344

U.S. 835, 73 S. Ct. 45 (1952).

Whether the Commissioner was a in allocating to

McCurdy and Forman interest on their respective loans of

$1,000,000.00 each is essentially one of fact, and his deci-

sion must be affirmed if supported by substantial evidence.

Advance Machinery Exchange, supra, at 1007. Whiere, as

here however, the Tax Court-has reversed the Commis-

‘sioner, the decision of the Tax Court must be affirmed un-

less clearly erroneots. Commissioner v. Duberstein, 363

U. S. 278, 80 S. Ct. 1190 (1960); Schley v. Commissioner,

375 F. 2d 747 (2d Cir. 1967) ; LaMont.v. Commissioner, 339

F. 2d 377 (2d Cir. 1964). In order to justify an allocating

of income pursuant to section 482, the Commissioner must

find that (1) there are two or more trades, businesses or

organizations (2) owned-or controlled by the same inter-

ests and (3) that it is necessary to allocate gross income,

deductions, credits, or allowances among them in order to

prevent evasion of taxes or in order to clearly reflect their —

income. . .

A54

Treasury Regulations

Treasury regulations must be sustained unless unreason-

able and plainly inconsistent with the revenue statutes.

Commissioner v. South Texas Lumber ‘Co., 333 U. S. 496,

501, 68 S. Ct. 695, 698 (1948); Sanford v. Commissioner,

412 F. 2d 201, 202 (2d Cir.), cert. denied, 396 U.S. 841, 90

S. Ct. 104 (1969).

Organization

The terms “organization,” “trade,” “business” are broad-

ly defined in Treas. Reg. § 1.482-1(a)(1) and (2). In Borge

-v. Commisstoner, 405 F. 2d 673 (2d Cir. 1968), cert. denied,

sub nom., Danica Enterprises, Inc. v. Commissioner, 395

U. S. 933, 89 S. Ct. 1994 (1969), this court found that an

individual stockholder and his wholly owned corporation

satisfied the two or more business prerequisite of .section

482. Certainly, Midtown, McCurdy and Forman satisfy

this prerequisite.

Control

No definition of “control” is contained in section 482. It

has been opined that this omission was intentional in order

to allow for flexibility of administration. Plumb and Kapp,

Reallocation of Income and Deductions Under Section 482,

41 Taxes 808, 811 (1963). :

Guidelines for determining control are contained in’

Treas. Reg. 1.482-1(a) (3): :

“The term ‘controlled’ includes any kind of control, di-

rect or indirect, whether legally enforceable, and how-

ever exercisable or exercised. It is the reality of the

control which is decisive, not its form or the mode of

its exercise. A presumption of control arises if income

or deductions have been arbitrarily shifted.”

A55d

To the same effect see Treas. Regs. 39.45-1(a)(3) and

annual Treasury regulations thereafter.

As to “same interests,” there is no statutory definition

and no Treasury regulations guidelines.

In order to find control,-no percentage requirements are

specified nor are any preeise requirements necessary. The

trend:-in the recent ease law is to apply the realistic ap-

proach. Borge v. Commissioner, supra; Hall v. Commis-

stoner, 32 T. C. 390 (1959), aff’d., 294 F. 2d 82 (5th Cir.

1961); Grenada Industries, Inc. v..Commissioner, 17 T. C.

231 (1951), af?d., 202 F. 2d 873 (5th Cir.), cert. denied,

346 U.S. 819, 74S. Ct. 32 (1953). Despite the fact that

these cases are all distinguishable on their facts, they lend

support to the view that the Commissioner urges here.

‘In Borge v. Commissioner, supra, this Court held that an

individual (the entertainer Victor Borge) and his wholly

owned corporation, conducting a poultry business, were

commonly controlled within the purview of § 482 and that

the Commissioner was justified in allocating income from

the corporation to Victor Borge, because the contract he-

tween him and his wholly owned corporation would never

have been made -between two unrelated parties dealing at

arm’s length.

In //all v. Commissioner, supra, the taxpayer (Hall)

conducted a business indiyidually. Thereafter he formed

a corporation and transferred nearly all of his shares of »

stock of that corporation to his son. ‘The court upheld the

allocation of income between Hall and the corporation

under § 45 of the 1939 Code. It disregarded the issue of

who actually owned the stock, holding that Hall, in fact,

actively controlled the corporation, despite his contention

that he had transferred ownership of the steck. The Tax

A56

Court, in Ach v. Commissioner, 42 T. C. 114 (1964), aff’d.,

358 F. 2d 342 (6th Cir.), cert. denied, 385 U. S. 899, 87 S.

Ct. 205 (1966), restated its view that it is not the record

ownership of stock which determines control; that control

is to be determined by ascertaining who, in fact, has con-

trol.

In Grenada Industries, Inc. v. Commissioner, supra, two

corporations and two partnerships were owned by four

families in identical 35%-355-20%-10% proportions. In

upholding an allocation of income among the four organi-

zations, the court noted that it was immaterial that the

record ownership of the ¢tock and the partnership inter.

ests may not have been in the identical persons at the same

time. Control was inferred from the actrons of the parties.

If Midtown was the ereature of only one of the tax-

payers, and all of its stock were owned by that single

parent, ir., if Midtown were a strange creature having a

father but no mother, the most rigid, literal wooden inter-

pretation of section 482 woukl bring Miltown within the

ambit of that section. It is the contention of the taxpayers.

however, that section 482 is not applicable because Mil

town is the normal chikl of a father and a mother, the

product of an earthy relationship between MeCuniy and

Forman, twentieth century parents exercising no control

over their progeny.

Midtown is the creation of a union of MeCunly and

‘Forman—not in holy matrimony but in a legitimate bes

ness enterprise. Their interests in the existence and career

of Midtown and the interests of Midtown are identical.

To contend that these parents do not control their child

is to fly in the face of reality. They have had complete

control of Midtown from the day of conception (its in. |

corporation) throughout the years relevant to this caer.

A57

Every act of Midtown has been dictated by papa and

momma who, directly or indirectly, have financed its ca- +

reer and controlled its every move.

In apparent disregard of the reality of the circumstances,

the Tax Court helow looked only to the record ownership

of Midtown. + Ignored was reality of the control of Mid-

town. in withdrawing his acquiescence in Lake Erie, the

Commissioner concluded that Lake Eric was inconsistent

with the broad language of §482 and the trend of cases

‘liseussed supra, and noted that Lake Erie ignored the

reality of the control in that case.

Persil

“This seems to be fallacious reasoning. One can \ardly maintain

that the two railroads were competing with regarl to the arteies

( Fontmote comtumer! <- tollowmg page)

A5S

The loans by taxpayers to Midtown, without interest,

affected the incomes of taxpayers and of Midtown. By

not reporting interests on these loans, taxpayers reported

lower earnings and, in turn, lower taxes. Midtown, in

not paxing interest, eliminated a business expense which

would have further inereased its Yearly losses. Because

of Midtown’s unfavorable financial condition, it was en-

countering difficulty in the rental of stores, a matter of

concern to MeCurdy and Forman, the actual owners of

Midtown. Midtown, MeCurdy and Forman were loathe

to show as further loxxes annual interest payments on

payments of $150,000.00, said that ther definitely helped

to narrow Midtown’'s deficit: that without these paviments

Foutnute continued frum preceding page }

of the taxpaver since they were. in comer ereriperlating the pric

charged for the taxpayer's facilities. PO jt would som lis.

feult to apply on a mevhanixtic haste ans Perrentage ter be termin:

if contrel exits, Control may te termined tu he the of in

diteet operations of the- empeNT. oF rStah'ich peliew for the aroun.

aaten . . . that any perentase app eatign weakl be jee.

“ete nt with She: he-finit yon of eater! * Hewitt, Aves s-.

Up to Date, SNM. 288 Wnt. om Feel. Tos. 381. 28m (poe.

The authors of an Stticle, “Rrallarstion of Larwme and Vreduct, -

Under Section $82." in U1 Tax OP, AES (1963). commented om the

“Lake Eric A Vit teharg Rav way Ce. t. Commicnionor tutd ¢ a

contred | the same interests did mot exit se cach parent wax

by ite own «+ of tettheldere which was met the «ene

as the combined «t of stackheldess whe indirect 'y cont relied ti.

et, when ther at in comert. for tetr tenteal in.

terest to camer the subsidiary to provide seeds ot eervtive at othe

than arm's length prices, the reality of rontrnl eciste te at best

Stent as it did in the, Mel! caw”

A599.

Midtown would have had to get that money from some

place. Appendix p. 280a. This explanation is equally ap-

plicable to the waiver of interest on the loans aggregating

$2,(.00,000.00. ; .

Whether McCurdy and Forman are regarded as a

partnership or joint venture, de facto, in forming Mid-

town, the conclusion is inescapable that they acted in

concert in making loans without interest to a corporation,

all of whose stock they owned and all of whose directors

and officers were their alter egos. They were not competi-

tors in their dealings with one another or with Midtown

as to Midtown. Their interests in Midtown were identical.

When the Commissioner withdrew his acquiescence in Lake

Erie, he gave reality control as one of the reasons for

doing so. “[T]he reality of control by the same interests

is present no less than if they [the two parent railroads]

had formed a partnership . . . to deal with the petitioner

[Lake Erie Railway Company] or had formed another

corporation to deal with petitioner.” Rev. Rul. 64-142. We

agree.

We find clearly erroneous the holding of the Tax Court

that the requisite control of Midtown by the taxpapers

was not present and find further that MeCurdy and For-

man had the same interests in Midtown.

Having found two businesses under common control, we

reach the question as to whether the Commissioner prop-

erly allocated interest on the two loans of $1,000,.000,00

each as income to the taxpavers.

“Transactions between one controlled taxpayer and

another will he subjectal to special scrutiny to ascertain

whether the common control is being used to reduce, avoid,

or escape taxes.” Treas. Reg. 1.482-1(c). To same effect,

A60

see Local Finance Corporation v. Commissioner, 407 F. 2d

629, 632 (7th Cir.), cert. denied, 396 U. S. 956, 90 S. Ct. 428

(1969). To justify the allocation as income to MeCurdy and

Forman of interest on their loans, it must be found that

their waiver of interest “is other than it wauld have been

had the taxpayer in the conduct of his affairs been an un-

controlled taxpayer dealing at arm's length with another

controlled taxpayer.” Treas. Reg. 1.482-1(¢). See also,

Local Finance Corp. v. Commissioner, supra, at 632; Lilly

and Co. v. United States, 372 F. 2d 990, 1000 (Ct. Cl. 1967):

Oil Base, Ine. v. Commissioner, 362 F. 2d 212, 214 (9th Cir.).

cert. denied, 385 U.S. 928, 87 S. Ct. 287 (1966). “In deter-

mining the true taxable income of a controlled taxpayer,

the district director is not restricted to the case of improper

accounting, to the case of a fraudulent, colorable, or sham

transaction, or to the case of a device designed to reduce or

avoid tax by shifting or distorting income, deductions,

eredits, or allowances.” Treas Reg. 1.482-1(c).

Reallocation is necessary here in order to properly reflect

the income of taxpayers and Midtown. Taxpayers have

advanced an argument, supported by case law, that the

Commissioner may not create income where none actually

existed. In Tennessee-Arkansas Grarel Co. +. Commiis-

stoner, 112 F. 2d 508 (6th Cir. 1940), the court held that

the Commissioner could not increase the income of a tax-

payer whose property had been used by a related corpora-

tion without the payment of rent. The court concluded that.

since no rent was called for, none could he created. In

Smith-Bridgman & Co. rv. Commissioner, 16 T. C. 287 (1951),

the Commissioner had added interest to the taxable income

of Smith-Bridgman & Co., as allegedly constituting interest

which should have been charged by it on non-interest bear-

ing loans to its parent corporation, Continental Department

AGL.

Stores (Continental). Taxpayer did not report as income.

any interest on these loans. The Tax: Court, in overruling

the Commissioner, who had allocated interest to Smith-

Dridgman, refused to authorize the creation of income.

wheré no income was realized. This decision was thought

to rest on the fact that the Commissioner had added interest

to taxpayer, but had failed to make an adjustment to the

income of Continental. llowever, the rationale of Smith-

Bridgman was clarified in Huber Homes, Inc. v. Commis-

sioner, 5 'T. C. 598 (1971), where it was held that the failure

to make the adjustment was only a possible supporting

factor, not a controlling factor. Smith was reaffirmed ini

PPG, Industries, Inc. +. Commissioner, 55 T. C. 928 °¢1970),

where the Tax Court held that § 482 did not authorize the

Commissioner to impute interest on non-interest hearing ~

loans where in fact no interest was created.

Several cases have held that one related party is not

required to charge another related party interest on a loan;

that the lender is net to be taxed on interest, with respect

to a loan, where it was not intended that interest he col-

lected. In Combs Lumber Co. vr. Commissioner, 41 B. T. A.

339 (1940), it was the practice of the corporation to lend

money to its stockholders without interest. The Board of

Tax Appeals ruled that, under the eireumstances, no lia-

bility for interest was created and, thus, the Commissioner

could not impute interest to the lender. In Society Brand

Clothes, luc. +. Commissioner, 18 T. C. 304 (1952), a corpo-

ration held a ten vear note of its wholly owned subsidiary.

The note provided for the payment of interest, but it was

executed with the understanding that no interest would be

charged until some date in the future. The Tax Court

held that the corporation was not required to report any

interest not received by it. A similar result was reached in

A62

Atchison, Topeka & Santa Fe Railway Co. v. Commissioner,

36 T. C. 584 (1961).

To the extent that the above cases cited by taxpayers may

be read as holding that no interest can be allocated under

§ 482 under the facts of this case, they are not in accord

with either economic reality, or with the declared purpose

of section 482. They seriously impair the usefulness of

§ 482. Those cases may be correct from a pure accounting

standpoint. Nevertheless, interest income may be added

to taxpayers’ incomes, as long as a correlative adjustment

is made to Midtown, for then the true taxable income of

all involved will be properly reflected. Treas. Reg. 4 1.482-

1(a)(6) provides:

“The term ‘true taxable income’ means . . . the tax-

able income . . . which would have resulted to the con-

trolled taxpayer, had it in the conduct of its affairs . . .

dealt with the other member . . . at arm’s length. It

does not mean the income . . . or allowances, result-

-ing to the controlled taxpayer by reason of the par-

ticular . . . transaction . . . the controlled taxpayer

. . chose to make (even though such . . . transaction

.. . may be legally binding upon the parties there-

to).” ;

‘Treas. Reg. § 1.482-2(a) provides:

“Where one member of a group of controlled entities

makes a loan or advance directly or indirectly to, or

otherwise becomes a creditor of, another member of

such group, and charges no interest . . . the district

director may make appropriate allocations to reflect

an arm’s length interest rate for the use of such

ar .

These regulations must prevail, for they are entirely con-

sistent with the scope and purpose of § 482. The instant

loans without interest are obviously not at arm’s fength,

since no unrelated parties would loan such large sums

without interest. The allocation of the interest income to

A63

taxpayers was necessar y in order to properly reflect their

taxable incomes.

Taxpayers contend that the $1,000,000.00 loans were not

in fact loans; that they were contributions to capital. This

argument is completely without merit. The terms of the

loans plus the terms of the 1959 Agreement, specifying

the creation of $1.000,000,00 loans, leave no doubt that the

parties intended to and did treat these transactions as

loans. Further, there is no evidence in the record that

the taxpayers received additional stock of Midtown for

these alleged capital contributions.

Gur remaining concern is with whether the allocation

of interest at 5 percent was proper. The Tax Court ‘in

its decision did not reach this issue. A remand is not nee-

essary because, under both the regulations and the ¢ir-

cumstances of this case, the 5% interest charge was em-

inently reasonable. Treas. Reg. 1.482-2(a)(2) provides the

standard for determining the appropriate interest to be

‘charged:

“For the purposes of this paragraph, the arm's length

interest rate shall be the rate of interest which .

would have been charged at the time the indebtedness

arose, in independent transactions with or hetween un-

related parties under similar cireumstances. . . . Hf

the creditor was not regularly engaged in the business

of making loans or advances of the same general type

as thie los an or advance in question to unrelated parties,

the arm's length rate for purposes of this paragraph

shall he—

(i) The rate of interest actually charged of at least 4

but not in excess of 6 percent per annum simple in-

terest,

(ii) 5 percent per annum simple interest if no interest

was charged or if the rate of interest charged was

atl ill tie)

A64

less than 4, or in excess of 6 per cent per annum

* - simple interest,

unless the taxpayer establishes a more appropriate

Ces seer

Midtown’s balance sheets reveal that it paid interest on

various loans, ranging from 4 and 14% to 6% per annum.

(See for example pp. 97, 106, 109, 112, 133 and 166 of the

Exhibit file.) Midtown had outstanding loans from Lincoln

Rochester Trust Co. payable at 5 and 14% interest; from

Central Trust Co. payable at 5 and 4%4% per annum and

from D. Raffelson payable at 5% per annum. —Consider-

ing the rate of interest Midtown paid on its arm’s length

loans and the Treasury Regulations, 5% i is an appropriate

rate of interest.

‘This Court finds that the reversal by the Tax Court of

the determination of the Commissionér allocating to the

taxpayers interest income at 5% on their respective loans

of $1,000,000.00 to Midtown is clearly erroneous.

The annual payments of $75,000.00 each by

McCurdy and Forman to Midtown

The initial plans for the endosed mall shopping center

(Midtown Plaza) contemplated kiosks in the southern por-

tion of the mall (South Mall) and the northern portion

thereof (North Mall). Midtown constructed and rented

four kiosks in the South Mall. No more than three of these

kiosks were rented and occupied at one time. No kiosks

were erected in the North Mall, although “utility pits” for

future kiosks in the North Mall were completed so that, if

kiosks were erected there in the future, they could be

readily connected to utilities. The Tax Court found that,

at some time after the original plan to erect kiosks in the

North Mall, Midtown decided not to do so but, rather, to

A65

preserve the North Mall space (180 feet by 110 feet with

twice the square footage of the South Mall) for non-com-

mercial events. The record amply supports this finding..

The North Mall, with its fountain and permanent exhibit

known as the “Clock of Nations,” was a focal point of

Midtown Plaza, used for numerous non-commercial activi-

ties which attracted considerable publicity.

At the hearing before the Tax Court, Angelo Chiarella

(Chiarella), employed by Midtown as its General Manager,

pursuant to a written contract of employment, testified that

it was his suggestion that kiosks be erected in the North

Mall. His contract of employment provided that he was

to serve as General Manager of Midtown “under the gen-

eraf supervision and direction of the President of the Cor- .

poration and with such duties as may be reasonably as-

signed to him by the President of the Corporation and by

its Board of Directors . . .” Entrance to the stores of both

taxpayers was available from this mall and display win-

dows of each store were visible from that mall. After

Chiarella had discussed his idea that (kiosks be so erected

and rented) with Gilbert J. C. MeCurdy (President and

Chairman of the Board of Directors of Midtown and also

President and Chairman of the Board of Directors of Me-

(urdy) and with Maurice R. Forman (Vice-President and a

Director of Midtown and also President and Chairman of

the Board of Directors of Forman), Chiarella wrote identi-

eal letters to McCurdy and Forman, each dated May 7, 1964,

which he signed as a Vice-President of Midtown. The gist

of these letters was that Midtown was losing rental income

by complying with the requests of MeCurdy and Forman

that no kiosks be erected in the North Mall: that McCurdy

and Forman derived numerous benefits from the absence of

kiosks in the North Mall: that Midtown could erect and

A66

rent ten kiosks in the North Mall and thereby increase its

annual rental income by $150,000.00;.that in lieu thereof,

MeCurdy and Forman should each pay $75,000.00 per

annum to Midtown for its continued compliance with the

requests of MeCurdy and Forman that no kiosks he erected

in the North Mall. ' .

On October 27, 1964, Midtown (by Chiarella, Vice-Presi- _

dent) made a written offer to Gilbert J. C. MeCurdy, Chair-

. man of the Board of McCurdy, and Maurice R. Forman,

President of Forman, that Midtown would accede to the

said wishes of MeCurdy and Forman and would not con-

duct any promotional events or rent the North Mall for

any events or displays that would be conducted in a manner

‘to distract from the esthetic dignity of MeCurdy and For-

man, in consideration of the payment by each of them of

the sum of $75,000.00 per year commencing February 1,

1964. Each taxpayer accepted this offer on November 6,

1964, McCurdy, by the Chairman of the Board; Forman,

by its President. It would appear that there was a studied

avoidance of any signature to this Midtown offer by any

officer or director holding stock in Midtown. Nevertheless,

it is obvious from the terms of his employment contract

that he signed this Midtown offer pursuant to the direc-

tion of the President of Midtown and that the offer was

made with the knowledge and/or subsequent consent of the’

Board of Directors of -Midtown. In effect, of course, Me-

Curdy and Forman (as owners of Midtown and of the

taxpayer stores) were dealing with one another at less

than an arm’s length transaction. McCurdy and Forman

had the power to prevent the erection of kiosks by Midtown

(its controlled entity) in the North Mall.

MeCurdy and Forman each paid $75,000.00 to Midtown

during their fiseal vears 1965, 1966 and 1967 or a total of

A67

$225,000.00 each. They deducted these annual payments as

ordinary and necessary business expenses paid during each

taxable year in carrying on their respective businesses.

296 U.S. C. §162(a). The taxpayers took the position that

absence of kiosks in the North Mall was responsible for

. substantial benefits which “more than justified the expense

involved”; that kiosks in the North Mall would have ob-

structed the visibility of their display windows; that they

would have siphoned off “impulse shoppers” ; would have

created a “crass eommercial atmosphere” inconsistent with

their status as “quality” stores; that they would have taken

up so much space that it would have been impossible for

Midtown to hold the special events which were held in the

mall, e.g., charity. balls, scientific exhibits, dinners, ete.;

that the holding of such events was a form of advertising

by Forman and MeCurdy, which would have been prevented

if the kiosks were erected; that they regarded these annual

payments of $75,000.00 as rental payments, in the sense

. that these payments insured that the mall area surrounding

their stores would not be used in a “detrimental manner.”

The taxpayers assert that, during the period from the open-

ing of Midtown Plaza through the taxable years at issue,

McCurdy’s annual sales increased by 5.2 million dollars

and Forman’s sales increased by 40% and they attribute

these increases to “the presence of Midtown Plaza and its

Mall.” Thus they took the position that these annual pay-

ments were deductible as ordinary and necessary business

expenses. |

The Commissioner disallowed these deductions. The Tax

Court affirm@d the determinations of the Commissioner. | It

found that these ‘‘Kiosk-Prevention Payments” were not

ordinary and necessary business expenses, but, rather, “dis-

guised capital contributions and therefore not deductible

expenses,” 54 T. C. at 926; that [a]t least by April 10, 1962,

, AS

when Midtown Plaza opened for business, Midtown had

made a firm decision not to construct and rent kiosks on

the North Mall and such decision continved in full force

and effect during all the periods relevant herein,” 4 T. C.

at 921;

thet the arrangements were not what they purport te

HIF

art

ful

32 i

32287

concerne:! it might

he payee.”

The record fully warrants the Tax Court's conclusion

that the annual payments made by the taxpayers to Mid.

town were no

This text is long and has been trimmed here. Open the source document for the complete record.

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