Brief for the Respondents in Opposition — Your Host, Inc. v. Commissioner

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CITATIONS

Advance Machinery Exch. v. Commissioner, 196

F. 2d 1006, certiorari denied, 344 U.S. 835

Automobile Club v. Commissioner, 353 U.S.

BERETA Ot try ee GOES ewe

Baldwin-Lima-Hamilton Corp. v. United States,

eal A ie | LR Sibi ASE ORR Be Bae UE

of ON ERIE EELS PN CI IO EE TO LEN

Commissioner v. First Security Bank of Utah,

RUE SEEK: SOMO “asndiknstiieccen nts nenaantnbesocanseasaienicic

Grenada Industries, Inc. vy. Commissioner, 17

T.C. 231, affirmed 202 F. 2d 873 ..................

Hamburger’s York Road, Inc. v. Commissioner,

GB ees ME cuba addenda bigtpubcintcchcstor teesoneks

Helvering v. Taylor, 293 U.S. 507 ...................-. 10

Lufkin Foundry & Machine Co. v. Commissioner,

Philipp Brothers Chenicals, Inc. (N.Y.) v. Com-

i ee ee 5, 10

W. Braun Co., Inc. ». Commissioner, 396 F. 2d

a aeaiinpaore 8

Wisconsin Big Boy Corp. v. Commissioner, 452

SE i a 6,9

Statutes and regulations:

Internal Revenue Code of 1954 (26 U.S.C.):

8 ENC a a oe 5

Sa TRE a 2, 4, 5, 11, 12

| See "RRL Le PM 2

Re. LS aCe 2

|S) eee 3, 5, 6, 8, 9, 10, 11,12

Fe nennicnnienemedetn 11

2 ER ek Se 11

*-Revenue Act of 1928, Section 45, 45 Stat. 791 5

Treasury Regulations:

Sec. 4452-1 )) .....<....:..:...... aealeaatineceiiebatie 6,9

a cceticnpeneniniirinesnenee 38

Miscellaneous:

H. Rep. No. 2, 70th Cong., Ist Sess. ..............-- 5

S. Rep. No. 2375, 81st Cong., 2d Sess. ............. 12

468 F. 2d 805 .. EE =

In the Supreme Court of the United States

OcToBER TERM, 1974

No. 73-1652

Your Host, INC., ET AL., PETITIONERS

Vv.

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPEALS FOR

THE SECOND CIRCUIT

BRIEF FOR THE RESPONDENT IN OPPOSITION

OPINIONS BELOW

The findings of fact and opinion of the Tax Court

(Pet. App. A 16-51) are reported at 58 T.C. 10. The

opinion of the court of appeals (Pet. App. B 52-67)

is reported at 489 F. 2d 957.

JURISDICTION

The judgment of the court of appeals was entered*on

December 11, 1973 (Pet. App. C 68-69). A petition for

rehearing was denied on February 6, 1974 (Pet. App.

C 69). The petition for a writ of certiorari was filed

on May 7, 1974. The jurisdiction of this Court is invoked

under 28 U.S.C. 1254(1).

QUESTIONS PRESENTED

1. Whether Section 482 of the Internal Revenue Code

of 1954 empowers the Commissioner to reallocate all of

(1)

PLA OT ELE AE OPT RET BE SF Te

2

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the income reported by one commonly controlled cor-_

poration to another such corporation.

2. Whether Section 482 empowers the Commissioner to

reallocate income from one commonly controlled cor-

poration to another, even though the tax result achieved

is the same as a disallowance of the Section 11(d)

$25,000 corporate surtax exemption of the corporation

from which the income is reallocated.

3. Whether the Commissioner’s determination, that the

acquisition of a corporation was for the principal purpose

of tax evasion or avoidance within the meaning of

Section 269 of the Code and that the acquired corporation

therefore was not entitled to the corporate surtax ex- —

emption, constitutes a denial of due process because

previous audits had not resulted in such a determination.

STATUTES INVOLVED

Internal Revenue Code of 1954 (26 U.S.C.):

Sec. 269. ACQUISITIONS MADE TO EVADE OR

AVOID INDOME TAX.

(a) In General. If—

(1) any person or persons acquire, or acquired

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

control of a corporation, or

(2) any corporation acquires, or acquired on or

after October 8, 1940, directly or indirectly, property

of another corporation, not controlled, directly or

indirectly, immediately before such acquisition,

by such acquiring corporation or its stockholders,

the basis of which property, in the hands of the

acquiring corporation, is determined by reference to

the basis in the hands of ihe transferor corporation,

U

3

and the principal purpose for which such acquisition

was made is evasion or avoidance of Federal income

tax by securing the benefit of a deduction, credit,

or other allowance which such person or corporation

would not otherwise enjoy, then the Secretary or his

delegate may disallow such deduction, credit, or other

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

control means the ownership of stock possessing at

least 50 percent of the total combined voting power

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

percent of the total value of shares of all classes of

stock of the corporation.

Sec. 482. ALLOCATION 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 directly or

indirectly by the same interests, the Secretary or

his delegate may distribute, apportion, or allocate

gross income, deductions, credits, or allowances

between, or among such organizations, trades, cr bus-

inesses, 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. -

STATEMENT

Petitioner and its affiliates operate a restaurant chain

and food business in the Buffalo, New York, area. The

business began in 1944 as a single-restaurant partnership

between A. J. Durrenberger and R. T. Wesson. During the

4

period 1947 through 1958, the business expanded and

a group of corporations under common control was organ-

ized to engage in the operation of restaurants, a food

supply commissary (Sher-Del-Foods, Inc.), a bakery (Your

Host Bakery, Inc.), a real estate holding company

(Alro, Inc.), and vending machine and leasehold operations.

Petitioner Your Host, Inc., the first and principal

corporation of the group, owns and operates fifteen “Your

Host” restaurants. The other restaurants are owned by ten

different corporations, none of which have more than four

restaurants. All of these enterprises remained under the

control of the two original partners and later, after

Wesson’s death in 1956, under the control of Durrenberger

alone (Pet. App. B 54-55 and n. 3).

Pursuant to the Commissioner’s authority under Section

482 of the Code to allocate income between commonly

controlled corporations, if he determines that such allo-

cation is necessary in order to prevent evasion of taxes

or clearly to reflect their income, all of the income

reported by the ten restaurant corporations and by Chef

Foods, Inc., for their taxable years ending in 1965

through 1968, was allocated to petitioner Your Host, Inc.

The Commissioner further allocated for these years

all of the income reported by Your Host Bakery, Inc.,

to Sher-Del-Foods, Inc. The Tax Court sustained the allo-

cations of the income of Chef Foods and Your Host Bakery

but not of the ten restaurant corporations (Pet. App. A 45-

46). However, the Tax Court sustained the Commissioner’s

alternative position under Section 269 of the Code dis-

allowing the $25,000 corporate surtax exemptions of four

of the restaurant corporations and of Alro, the real

€state corporation, on the ground that the principal pur-

pose for the formation of these corporations was the

-

avoidance of taxes (Pet. App. A 46).' The court of appeals

affirmed, with one judge dissenting in part.

ARGUMENT

1. Section 482 of the Internal Revenue Code of 1954

empowers the. Commissioner to “allocate gross income”

among commonly controlled business entities, if he deter-

mines that such allocation is necessary in order toprevent

evasion of taxes or clearly to reflect the income of such

business entities. The statute is based upon the “well-

settled policy that income is taxable under Section 61 of

the 1954 Code to the party who earns it and that it is eco-

nomic reality rather than legal formality which determines

who earns income.” Philipp Brothers Chenicals, Inc. (N.Y.)

v. Commissioner, 435 F. 2d 53, 57 (C.A. 2). At the time of

its original enactment as Section 45 of the Revenue Act

of 1928 the scope of the provision was explained in H. Rep.

No. 2, 70th Cong., Ist Sess., pp. 16-17, as follows:

The section of the new bill provides that the Commis-

sioner may, in the case of two or more trades or busi-

nesses owned or controlled by the same interests,

apportion, allocate, or distribute the income or de-

ductions between or among them, as may be neces-

sary in order to prevent evasion (by the shifting of

profits, the making of fictitious sales, and other methods

' Because the Tax Court sustained the Commissioner’s primary

Section 482 allocation of the income of Chef Foods and Your Host

Bakery to Your Host and Sher-Del-Foods, it did not have to reach

the alternative Section 269 issue concerning disallowance of the

corporate surtax exemptions of Chef Foods and Your Host Bakery.

We have accordingly filed a petition for a writ of certiorari

(No. 73-1687) in order to protect the revenue by preserving

this alternative position. The petition in No. 73-1687 should be granted

only if the Court grants this petition.

6

frequently adopted for the purpose of “milking”),

and in order clearly to reflect their true tax liability.

As this Court recognized in Commissioner v. First

Security Bank of Utah, 405 U.S. 394, 400, the relevant

Treasury Regulation (Section' 1.482-1(b)(1)), provides that

the standard to be applied under Section 482 is “‘that of

an uncontrolled taxpayer dealing at arm's length with

another uncontrolled taxpayer.’” Thus, Section 482 em-

powers the Commissioner to examine transactions between

controlled taxable entities in order to determine whether

they would have been concluded in an arm’s-lenth nego-

tiation between strangers, and to make a reallocation .

when they fail to meet that standard. It is firmly established

that such determinations can be set aside only if unreason-

able, arbirary, or capricious. See, e.g., Wisconsin Big Boy

Corp. v. Commissioner, 452 F. 2d 137, 140 (C.A. 7), and

cases cited therein.

Petitioners principally argue (Pet. 10-12) that there is a

fundamental conflict among the circuits as to the scope of

the Commissioner’s authority under Section 482. They

urge that the Commissioner is never autnorized to allocate

all of the income of one corporation to another because the

result would be equivalent to the result achieved by the

filing of a consolidated return. In support of their position,

petitioners cite Commissioner v. Chelsea Products, Inc.,

197 F. 2d 620 (C.A. 3), and assert a conflict between that

case and the decision below and Wisconsin Big Boy Corp. .

v. Commissioner, supra.

This position, however, was rejected long ago by the

Second Circuit in Advance Machinery Exch. v. Commis-

sioner, 196 F. 2d 1006, certiorari denied, 344 U.S. 835,

which upheld an allocation of all of the income of several

-_-.

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controlled entities to another.? In rejecting the contention

that the statute did not authorize a total allocation, the

court noted that such a rule “would exclude from the

‘policing’ provisions of § [482] the most flagrant evasion

by arbitrary shifting of income.” The court further obseryed

that if such a limitation were imposed upon the Commis-

sioner’s authority, “tax evasion cauld be so complete as

to make itself invulnerable, a proposition whose statement

discloses its fallacy” (196 F. 2d at 1009). And, contrary

to petitioner’s argument, Chelsea Products did not hold

that the Commissioner cannot as a matter of law allocate

all of a corporation’s income under Section 482. While

there is dictum in Chelsea Products suggesting that the

Commissioner’s allocation “proceeded beyond his statutory

bounds” (197 F. 2d at 623), the Third Circuit emphasized

that the basis of its decision was the Tax Court’s finding

that the corporations involved each conducted a business

enterprise separate from the taxpayer and that their in-

come was not earned by the taxpayer. The court distin-

guished the Second Circuit’s Advance Machinery decision

(rendered one month before) on this ground (197 F. 2d

at 623-624, n. 6), and this Court denied a petition for a writ

of certiorari in Advance Machinery which had urged the

same alleged conflict with Chelsea Products urged by

petitioners here, Significantly, no case since Chelsea

Products has even suggested that the Commissioner cannot

allocate all of a corporation’s income merely because

2Thus, petitioners’ contention (Pet. 10-11) that the courts did

not permit total allocations until the 1964 decision of the Tax

Court in Hamburger’s York Road, Inc. v. Commissioner, 41 T.C.

821, is refuted by the Advance Machinery Exchange decision

which was rendered in 1952.

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the result achieved is similar to that under a consolidated

return. ;

3. Petitioners further contend (Pet. 9) that the total

allocation of the income of Chef Foods and Your Host

Bakery cannot stand because a lesser allocation was more

appropriate. But as the court of appeals observed with

respect to Chef Foods, “the actual scope of its operations,

in terms of its labor force, capitalization, work site, and so

forth, suggests that the firm was kindred in nature to the

kind of sham enterprise which [that] court held properly

subject to income allocation in Philipp Bros. Chemicals,

Inc. v. C.I.R. [435 F. 2d 53]” (Pet. App. B 58). Indeed,

petitioners have pointed to nothing in the record which

suggests that Chef Foods earned any of the income it 1e-

ported. Thus, while purchases and sales of cigarettes in

vending machines located in “Your Host” restaurants and

rental of refrigeration and storage facilities were con-

ducted in the name of Chef Foods, the record indicates

that it incurred no office, telephone, or automobile expenses,

sustained $179 of repair expenses, and purchased $160 of

operating supplies during the four years at issue (Pet. App.

B 57; R. 277-282, Exs. 79-CA through 82-CD).‘ In light

?>W. Braun Co., inc. v. Commissioner, 396 F. 2d 264 (C.A. 2),

cited by petitioners (Pet. 7-10), is not to the contrary. Apart

from the fact that it does not establish an inter-circuit conflict, the

court there rejected a Section 482 allocation of all of a corporation's

income because it conducted substantial business activities and earned

its own income.

Nor does Section 1.482-1(b)3) of the Treasury Regulations

(Pet. 7) prevent the Commissioner from making a total allocation

under Section 482. As the Second Circuit explained in Advance

Machinery, that provision simpy means that the Commissioner is

not free to compel affiliated corporations to file a consolidated return

(196 F. 2d at 1009).

*R.” and “Ex.” references are respectively to the joint appendix

filed in the court of appeals and the trial exhibits.

ae

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of this gross imbalance between Chef Foods’ annual re-

ceipts ($160,000) and its virtually non-existent expenses,

both courts below were amply justified in concluding that

the Commissioner's allocation of all of its income was

neither arbitrary nor unreasunable.

Petitioners have likewise failed to show that the Commis-

sioner’s allocation of all of Your Host Bakery’s income to

Sher-Del-Foods was arbitrary or unreasonable. It is un-

disputed that the bakery soid virtually all of its products

to Sher-Del-Foods, which in turn sold them at its cost to

the various “Your Host” restaurants. Thus, the entire

profit of the baking part of the enterprise was shifted to

Your Host Bakery despite the fact that Sher-Del-Foods

would have received part of the profit if sales of the baked

goods had been made to an unrelated third party. It is there-

fore beyond doubt that these sales did not meet the standard

prescribed by Treasury Regulations, Section 1.482-1(b) (1)

of “an uncontrolled taxpayer dealing at arms’s length with

another uncontrolled taxpayer.”

Although petitioners appear to acknowledge (Pet. 9)

that some allocation of income from Your Host Bakery to

Sher-Del-Foods would be proper, they claim to have proved

that an allocation of less than 100 percent is required.

They urge that they are entitled to a remand to the Tax

Court in order to prove the exact amount of the correct

allocation. But it is well settled that a taxpayer seeking

to overcome a Section 482 allocation has the burden of prov-

ing more than simply that the allocation may be erroneous.

The burden of proving that a Section 482 determination by

the Commissioner is arbitrary requires a showing as to

what other allocation would have been more appropriate

under the “arm’s length” standard of the statute. See

Grenada Industries, Inc. vy. Commissioner, 17 T.C. 231,

258-259, affirmed, 202 F. 2d 873 (C.A. 5); Wisconsin

Big Boy Corp. v. Commissioner, supra, 452 F. 2d at 140.

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Thus, a generalized claim that a total allocation is inap-

propriate, without more, is insufficient to overturn a Section

482 allocation. In order to demonstrate that such an allo-

cation is arbitrary or unreasonable, the taxpayer must

come forward with proof of what allocation, if any,

would be proper. Here, the only evidence petitioners

submitted was the gross income and expenses as report-

ed by Your Host Bakery and the number of its employees.

Petitioners claim that a total allocation cannot be sustained

in light of those facts. But petitioners introduced

no evidence to show what profits a bakery enterprise

comparable to Your Host Bakery should have earned or

what profits Sher-Del-Foods earned prior to the formation

of Your Host Bakery when it dealt with an uncontrolled

bakery. Thus, on this record, the Tax Court had no basis

upon which to approve a lesser allocation of income from

Your Host Bakery to Sher-Del-Foods. In these circum-

stances, the courts below had little alternative other than

to sustain the Commissioner’s allocation as neither arbi-

trary nor unreasonable. As the Second Circuit stated in

Philipp Brothers Chemicals, Inc. (N. Y.) v. Commissioner,

supra, 435 F. 2d at 59, in a passage the court of appea!s

found equally appropriate here (Pet. App. B 59):

[TJhe taxpayer had the burden of showing that the

100% allocation of income to the [parent] corporation

was unjustified. Taxpayers ask us to remand the case in

order to allow them an opportunity to establish that the

100 percent allocation was unreasonable and to show what

a reasonabie allocation would be. We see no reason for

according them another chance. * * *

Contrary to petitioner’s assertion (Pet. 9), the decision

below does not conflict with Helvering v. Taylor, 293 U.S.

507. In that case, which did not involve Section 482, this

Court held that where specific valuation evidence sub-

ee a

mitted by the taxpayer to the Board of Tax Appeals

demonstrated that the Commissioner's apportionment

of cost between two kinds of stock was arbitrary and ex-

cessive, it could not sustain the Commissioner’s determina-

tion on the ground that the taxpayer did not introduce

any evidence showing the correct amount of the tax. Under

those circumstances, the Court declared that the Board

should have held a further hearing to receive additional

evidence in accordance with its statutory obligation under

the predecessor of Section 6213(a) to conduct “a redeter-

mination of the deficiency.” See also Section 7459. Here,

however, the Tax Court did not sustain the Commissioner’s

Section 482 determination in the face of any cogent evi-

dence that it was either arbitary or unreasonable. Indeed,

no such finding could have been made in light of peti-

tioner’s utter failure to meet its special burden of proving

the allocation arbitrary or unreasonable by showing what

the correct allocation would be under the “arm’s length”

standard of Section 482.5

SNor do Baldwin-Lima-Hamilton Corp. v. United States, 435 F. 2d

182 (C.A. 7) or Lufkin Foundry & Machine Co. v. Commissioner, 468

F. 2d 805 (C.A. 5)(Pet. 9), conflict with the decision below. In the former

case, the district court concluded that the Commissioner’s allocation

of total income was arbitrary and unreasonable. The court of appeals

found that certain evidence submitted by the taxpayer contained erro-

neous assumptions which would unquestionably require a modifica-

tion of the district court’s decision. Accordingly, it remanded the

case for recomputation of the allocation in light of its opinion.

Lufkin does not involve a total allocation. There the Tax Court held

that the evidence submitted by the taxpayer was sufficient to set aside

the Commissioner’s Section 482 allocation of 50 percent of two corpo-

rations’ income. The court of appeals held, however, that the Tax

Court erred in reaching this conclusion on the basis of analyses of the

taxpayer's marketing arrangements rather than on proof of prices

charged between similar uncontrolled taxpayers. Under these circum-

stances, where the Tax Court employed an erroneous standard of the

taxpayer's burden of proof, the government conceded that it was

appropriate to permit the taxpayer an opportunity to adduce addi-

tional evidence on a remand where the correct standard would be em-

ployed. Here, however, the Tax Court applied the correct burden of

proof standard and petitioners failed to meet that burden.

DOT-1974-0s

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4. Petitioners renew their suggestion (Pet. 11-12),

advanced in the courts below, that the Commissioner's

allocations were inproper because the result achieved is

the same as would have followed from disallowance under

Section 269 of the surtax exemptions of the corporations

from which the income was reallocated to petitioners. But

Congress specifically contemplated the possibility that

Sections 269 and 482 would be alternative means for com-

batting the use of multiple corporations for the purpose of

gaining additional surtax exemptions. Thus, S. Rep. No.

2375, 81st Cong., 2d Sess., p. 70, states:

It is not intended, however, that the exemption of the

first $25,000 of a corporation’s surtax net income

from the surtax shall be abused by the splitting up,

directly or indirectly, of a business enterprise

into two or more corporations oz the forming of two

or more corporations to carry on an integrated bus-

iness enterprise. It is believed that sections 45 [now

Section 482] and 129 [now Section 269] will prevent

this form of tax avoidance. [Emphasis supplied.]

5. Finally, petitioners urge (Pet. 12-13) that the dis-

allowance by the Commissioner of the surtax exemptions

under Section 269 after taking no such action in prior

audits is a violation of their rights to due process. The

Commissioner, however, is not estopped from correcting

past errors of his agents in auditing returns for earlier

years. Automobile Club v. Commissioner, 353 U.S. 180.

The only proper question is whether the action taken for

the year in issue is correct. The courts below correctly held

that it was, and there is no reason for further review by

this Court.

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CONCLUSION |

For the reasons stated, it is respectfully submitted thai

the petition for a writ of certiorari should be denied.

RoBerT H. Bork,

Solicitor General.

Scott P. CRAMPTON,

Assistant Attorney General.

STUART A. SMITH,

Assistant to the Solicitor General.

WILLIAM A. FRIEDLANDER,

Altorney.

AuGustT 1974. a

DOJ-1974-08