Appendix — Liberty Loan Corp. v. United States

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APPENDIX A

Liberty Loan Corporation,

Plaintiff,

V.

United States of America,

Defendant,

No. 70 C 660(3).

United States District Court,

E.D. Missouri, E.D.

April 13, 1973.

Parent corporation brought tax refund suit seeking recovery

of amounts paid pursuant to an assessed deficiency resulting

from the reallocation of taxable income between parent corpora-

tion and some of its subsidiaries which were engaged in the

consumer finance business. The District Court, Webster, J., held

that where income distortion, which occurred because of parent

corporation's practice of borrowing funds for its group of sub-

sidiaries, charging those subsidiaries without impaired capital

more than interest rate charged parent corporation and not

charging interest to those subsidiaries with impaired capital,

occurred among income of subsidiary corporations and not in-

come of parent corporation as parent corporation charged group

as a whole, and recovered from the group as a whole, all interest

charges which it paid on behalf of the group, imputing interest

income of subsidiaries with impaired income to parent corpora-

tion rather than readjusting interest income and expense among

subsidiaries participating in the group borrowing was unreason-

able, arbitrary and capricious.

Judgment in favor of plaintiff.

een © Tae

William D. Crampton, St. Louis, Mo., Bryan, Cave, Mc-

Pheeters & McRoberts, St. Louis, Mo., for piaintiff.

Daniel Bartlett, Jr., U. S. Atty., St. Louis, Mo., Michael C.

Durney, Tax Div., Dept. of Justice, Washington, D. C., for de-

fendant.

MEMORANDUM OPINION

Webster, District Judge.

In this tax refund suit, plaintiff Liberty Loan Corporation

seeks recovery of amounts paid as an assessed deficiency result-

ing from the “reallocation” by the Commissioner of Internal

Revenue of taxable income between plaintiff and some, but not

all, of its subsidiaries. See 26 U.S.C. § 482.

The jurisdictional facts are not in dispute. Plaintiff timely

filed its 1961 corporate federal income tax return and paid the

amount shown as due thereon. An audit resulted in the assess-

ment of a deficiency in the amount of $246,292.28 together

with interest of $87,173.97, which was paid in full on March

15, 1968. A timely claim for refund was formally disallowed

November 2, 1970, and on December 28, 1970, plaintiff filed

this refund action pursuant to 28 U.S.C. § 1346(a)(1). The

case was ultimately tried to the court upon stipulated facts and

exhibits. The somewhat novel but important issue of law was ex-

tensively briefed and argued.

Facts

Plaintiff, Liberty Loan Corporation, is a Delaware corpora-

tion with its principal executive office and place of business in

St. Louis County, Missouri. Plaintiff was incorporated in 1932

under the laws of Delaware, and has at all times pertinent

been engaged in the consumer finance and related businesses,

PAST OEE TE LONI LEE RY LT TE LE LV ST LNT NTE BE TNL LLANE OS Oe OE IE

—"

directly through its branch offices and indirectly through its

ownership of subsidiaries engaged in such business.

Plaintiff operated 40 branch _ offices and owned 399 sub-

sidiaries during 1961, all actively engaged in the consumer

credit and related businesses. The consumer finance operations

of plaintiff's branch offices and subsidiaries consisted.of making

installment loans directly to borrowers and purchasing (usually

at a discount) installment notes receivable issued to dealers by

purchasers of goods and services.

Plaintiff was licensed to conduct a small loan business only

in Illinois and Wisconsin (that is, only in those states in which

‘it conducted such business in 1961). Plaintiff was not prohibited

by contract, by local law or by any other provision from seek-

ing such a license in other states but chose not to do so. Plaintiff

could not legally have carried on a small loan business, in any

state in which it was not properly licensed.

It is the practice of finance companies to borrow funds to

lend to customers ard for other corporate purposes. Where there

is an affiliated group of finance companies (as here), and large

sums of borrowed funds are equired, in lending such funds

at the most favorable rates, lending institutions (e. g. banks,

insurance companies) require that such borrowings be made by

the parent corporation for the group, and not by the subsidiaries

on an individual basis, because the subsidiaries are not «accept-

able credit risks at these rates on an individual basis, but are

so on a collective, or group, basis.

For the year 1961, plaintiff's borrowings (outstanding debt)

amounted to $110,547,621 (computed on the basis of a monthly

average), for which plaintiff paid an effective interest rate of

5.55 percent. Plaintiff incurred interest expense on these bor-

rowings for the year 1961 in the amount of $5,582,750.65.

The borrowings of the plaintiff were then advanced to its

branch offices and loaned to its subsidiaries. Interest, at the

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rate of 5.75 percent, was charged all branch offices and all

subsidiaries, except those subsidiaries whose capital the plaintiff

regarded as impaired (i. e., those companies which had earned

surplus deficits or whose surplus was less than two months inter-

est on its notes payable to the plaintiff). Such subsidiaries were

charged no irterest. The funds thus loaned the subsidiaries (and

advanced to the branch offices) were in turn loaned by them

to consumers at substantially higher rates than 5.75 percent.

The determination of which subsidiaries were not to be

charged interest was made as of January Ist and July Ist of

1961. Fifteen of plaintiff's subsidiaries were not charged inter-

| est for the first six months of 1961 only. These subsidiaries,

along with the interest income received from consumers by

each subsidiary and the taxable income (Form 1120, Line 30)

of each subsidiary, are as follows:

Taxable Income

Interest Income (Form 1120,

Exhibit Corp.No. Name From Consumers Line 30)

7-G-1 176 Auburn $ 46,954 $ (2,111)

7-G-2. 221 Chula Vista 54,401 0

7-G-3 222 Lemon Grove 59,267 (1,305)

7-G-4 227 Long Beach 81,055 (1,858)

7-G-5 232 Eighth Lib. Loan 46,088 1,995

7-G-6 233 Kentucky 81,575 17,032

7-G-7 240 Helena 29,605 (3,384)

7-G-8 242 Missoula 30,900 0

7-G-9 245 Butte 40,309 0

7-G-10 257 Kalispell 47,828 2,916

7-G-11 309 S. Carolina Dom. 52,372 5,015

7-G-12 325. Pueblo. 67,780 (5,402)

7-G-13 353 Livonia 54,490 4,880

7-G-14. 370 Madison 70,865 (2,300)

7-G-15 420 . Beaumont 43,005 7,102

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Thirteen of plaintiff's subsidiaries were not charged interest

for the /ast six months of 1961 only. These subsidiaries, along

with the interest income received from consumers by each sub-

sidiary and the taxable income (Form 1120, Line 30) of each

subsidiary, are as follows:

Taxable Income

Interest Income (Form 1120,

Exhibit Corp. No. Name From Consumers Line 30)

8-H-1 132 Mass. Trust $ 75,550 $ 14

8-H-2 214 Bay 57,229 0

8-H-3 215 California 112,368 (19,267)

8-H-4 267 Montgomery 51,883 0

8-H-5 268 Alabama Dom. 52,372 0

8-H-6 272 Fairfield 30,108 0

8-H-7 277 Florence 23,867 (811)

8-H-8 282 Sioux City 21,257 (7,942)

8-H-9 285 Dubuque 21,788 (3,116)

8-H-10 286 Georgia 51,982 (1,767)

8-H-11 360 South Penn. 40,346 (52,690)

8-H-12 361 Twelfth Lib. Loan 111,829 (25,787)

8-H-13 364 Fifteenth Lib. Loan 156,476 (2,300)

Twenty-seven of plaintiff's subsidiaries were not charged in-

terest for the entire twelve months of 1961. These subsidiaries,

along with the interest income received from consumers by each

subsidiary and the taxable income of each subsidiary, are as

follows:

sn sett aR ORE: = |

Exhibit Corp.

9-1-1

9-I-2

9-1-3

9-I-4

9-1-5

9-1-6

9-1-7

9-1-8

9-1-9

9-1-10

9-I-11

9-I-12

9-I-13

9-1-14

9-1-15

9-1-16

9-I-17

9-1-18

9-1-19

9-1-20

9-1-2]

9-1-22

9-1-23

9-1-24

9-1-25

9-1-26

9-1-27

120

136

142

187

188

200

197

206

211

212

219

223

235

239

241

243

246

247

248

249

250

251

252

254

255

412

416

ws: i ii

No. Name

Glen Burnie

Cambridge

Allston

Westfield

Summit

Old South

Boston

Roslindale

Los Altos

San Jose

Elcajon

Clairemont

Rome

Montana Dom.

Great Falls

Bozeman

Anaheim

Santa Ana

Garden Grove

Pomona

Riverside

San Bernardino

Redondo

Tucson

Van Nuys

Mt. Rainier

Rosslyn

Taxable Income

Interest Income (Form 1120,

From Consumers Line 30)

$ 60,833 $ 0

71,758 0

49,893 (17,469)

35,078 0

61,163 3,804

33,252 (8,298)

120,080 0

48,266 5,949

45,047 0

"102,990 (7,057)

58,086 0

51,034 0

36,737 0

34,970 0

40,129 0

21,874 0

44,037 0

37,827 0

45,254 0

39,440 0

46,836 0

39,831 0

38,371 (3,815)

33,882 0

34,387 0

65,721 19,989

86,041 10,744

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Three hundred and seventy-two of plaintiff's subsidiaries were

charged interest for all of the year 1961 at the rate of 5.75 per-

cent in the total amount of $5,313,749. The amount of $5,-

313,749 (after reduction for interest in the amount of $6,075

paid by plaintiff to an. insurance company subsidiary) was re-

ported by the plaintiff as “interest from subsidiaries” income on

line 7 of its federal income tax return (Form 1120) for 1961.

All of plaintiff's forty branch offices were charged interest for

all of the year 1961 at the rate of 5.75 percent in the total

amount of $515,221.

The total interest received from consumers by the 54 insolvent

subsidiaries with impaired capital amounts to $2,996,965.22.

The average notes payable from the 54 insolvent subsidiaries to

the plaintiff for the year 1961 amounted to $13,444,634. Had

plaintiff charged the 54 insolvent subsidiaries interest at the rate

of 5.75 percent for the full year 1961, the total interest would

have amounted to $773,066. The total interest actually charged

the 54 insolvent subsidiaries by plaintiff amounted to $198,542,

or an approximate average interest rate of 1.48 percent.

On audit of plaintiff's federal income tax return for the year

1961, the Commissioner of Internal Revenue allocated the sum

of $473,639 in interest income from the 54 subsidiaries with

impaired capital to the plaintiff, thereby increasing plaintiff's

income by that amount. This increase in plaintiff's income re-

sulted in the $246,292.28 income tax deficiency which was

- assessed against plaintiff. The provisions of Treasury Regula-

tions § 1.482-1(2) applicable to the instant suit have been

complied with by the Commissioner.

Plaintiff was fully reimbursed for all but its own share of

the borrowing costs it incurred on behalf of the group. Plain-

tiff’s expenses on behalf of the group totalled $5,582,750.65.

1 This was an internal control procedure and resulted in no sepa-

rate tax consequence.

— yess

It received in reimbursement from its subsidiaries a total of

$5,319,824. Both income interest and income expense were

reflected in its federal income tax return, and the net effect was

interest expense of $262,927.

The federal income tax return of plaintiff for 1961 clearly

reflects its income and there has been no tax evasion on its

part. Plaintiff paid federal income taxes in 1961 at the highest

rate (52%) on the amount of the interest reimbursement re-

ceived from its subsidiaries, and no higher rate was effective

for that year with respect to the interest deductions allowed

to various of its subsidiaries. Plaintiff, and the group taken as

a whole, thus paid more taxes than would have been due if each

corporation had paid only its pro rata share.

The issue of law to be determined in this case is whether

the defendant properly allocated the amount of $473,639 as

interest income in 1961 to the plaintiff from 54 of its sub-

sidiaries on the grounds that plaintiff did not loan funds to the

54 subsidiaries (whose capital the plaintiff regarded as being

impaired) at an arms length interest rate (as defined by Section

482 of the Internal Revenue Code of 1954 and the applicable

Treasury Regulations).

Opinion

Plaintiff recovered from the group all of the interest expense

incurred on behalf of the group and reported that recovery as

an income item in its return. The vice, if any, was in the method

of allocating this charge (for income expense) among the 399

individual members of the group. As noted, supra, the plaintiff

took into account the solvency of each subsidiary, and, apply-

ing its own internal family standards, exempted, pro tanto,

those members of the group whose capital would thereby be

“impaired”. The burden was shifted and reallocated among the

a

more solvent members of the group. Plaintiff charged and re-

ceived from the group no more and no less than it would have

zeceived without such internal family allocation.

The defendant, however, contends that such arbitrary ap-

portionment of subsidiary expense resulted in an overall dis-

tortion of the taxable income of the several subsidiary corpora-

tions. This is a meritorious contention. Low or no income sub-

sidiaries would have significantly less use for an interest expense

deduction, whereas a subsidiary corporation in a surtax bracket

would be able to utilize the deduction against higher tax rates.

The internal apportionment undoubtedly led to substantial over-

all savings in taxes to the group, taken as a whole.

To meet this distortion, defendant drew upon Section 482

of the Internal Revenue Code of 1954, which, in general terms,

authorized the Commissioner to allocate income or deductions

between related taxpayers to more clearly reflect their true

liability and to prevent tax evasion.” In reliance thereon, de-

fendant imputed to plaintiff all of the interest income earned

by the 54 subsidiaries who were not charged by plaintiff with

interest expense because of “impaired capital”. The allocation

of an additional $473,639 on this account resulted in the $246,-

292.28 tax deficiency which is the subject of this refund suit.

Plaintiff contends that its actions in relation to its subsidiaries

meet the required standards of “an uncontrolled taxpayer deal-

ing at arm’s length with another uncontrolled taxpayer.” Regs.

§ 1.482-1(b)(1). Plaintiff further contends that in selecting for

reallocation only the 54 impaired subsidiaries, defendant has

2 Section 482 provides in part:

“In any case of two or more . . . businesses . . . owned or con-

trolled directly or indirectly by the same interests . . . {the Com-

missioner] may . . . allocate gross income . . . between or

among such . . . businesses, if he determines that such... .

allocation is necessary in order to prevent evasion of taxes

or clearly to reflect the income of any of such... businesses.”

itu ot al bela RE MS

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aggravated, rather than cured any distortion of plaintiff's in-

come. Finally, plaintiff challenges the validity of the regulations.

Plaintiff stresses the business purpose and industry practice

behind group borrowing of the subsidiaries, in the name of the

parent. As the court has found no purpose of evasion, the conse-

quence, rather than the justification, of such activity becomes of

greater significance. The reallocation of interest expense among

members of the group plainly distorted the taxable income of

the respective subsidiaries. The question is, however, did it dis-

tort plaintiff's income?

Plaintiff charged the group and recovered from the group as

a whole all of the interest charges it paid on behalf of the group.

Plaintiff's income and expenses, for tax purposes, were thus no

different in amount than they would have been had an exact

proration been made according to amounts separately loaned

to the members of the group.

Defendant places reliance upon Regs. § 1.482-2(a), which

authorizes the district director to make appropriate allocations

where loans are made by one member of a controlled group

to another member at less than arm’s length interest rates. Sub-

paragraph (a) thereof provides:

“(a) Loans or advances—(1) In general. 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, 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

allocations to reflect an arm’s length interest rate for the

use of such loan or advance.”

In making the allocation, defendant isolated from the group

those subsidiaries who had paid no interest to plaintiff or had

paid interest for only six months in 1961. Defendant then

—A-11l —

calculated imputed interest at 5% on loans to each such sub-

sidiary [See Regs. § 1.482-2(a)(2)(ii)], giving credit for any

interest actually paid. In so doing, defendant ignored, for pur-

poses of this §482 allocation, the 5.75 per cent interest paid

by the other 372 subsidiaries and 40 branch offices of plaintiff

to offset plaiatitf's effective cost (5.55 per cent) on all loans.

Plaintiff challenges this procedure, and this, in substance, is the

central issue to be determined in this case.

The 5 per cent rate is subject to one significant qualification

which appears to be applicable under the facts in this case:

“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 incurred by the lender in borrowing

such amounts and making such loans, unless the taxpayer

establishes a more appropriate rate under the standards

set forth in the first sentence of this subparagraph.” Regs.

1.482-2(a) (2) (ii).

[1] Three essential findings are necessary prerequisites to a

§ 482 allocation: (1) there must be two or more trades, busi-

nesses or organizations; (2) these must be owned or controlled

by the same interests; and (3) it must be 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. Forman Co. v. Commissioner, 453 F.2d 1144

(2nd Cir. 1972). The first two elements are not disputed. Plain-

tiff contends there was no necessity for allocation where the

group as a whole paid enough interest to recover plaintiff's cost

and the effective rate was in excess of 5 per cent, taken together.

Defendant asserts that the Commissioner is impowered to make

the allocation of individual members even though it results in

generating income to plaintiff, and notwithstanding the effective

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er

— A-12 —

rate of the group as a whole was not subject to allocation as

insufficient in amount to be at arm’s length.

Prior to the promulgation of Regs. § 1.482-2 in 1968, the

courts had uniformly held that Section 482 did not authorize

the creation of income where none existed. Tennessee-Arkansas

Gravel Co. v. Comm., 112 F.2d 508 (6th Cir. 1940). Smith-

Bridgman & Co., 16 T.C. 287. An attempt by the I.R.S. to dis-

tinguish Smith-Bridgman because no corresponding redirection

in income had been extended to the other member was rejected

by the Tax Court in Huber Homes, Inc., 55 T.C. 598 (1971),

which held that “essential to the application of Section 482 is

the distribution, apportionment, or alteration of income realized

at some time by the controlled group.” /d. 607.

[2] While the regulations now permit the Commission to

impute interest on intercompany loans if too little or too much

is charged, this power should not be exercised in the face of

known multiple relations to produce a wholly fictitious result

which does not “clearly reflect the income of any * * * busi-

nesses.” I.R.C. § 482.

“Plainly, section 482 was not intended to produce a dif-

ferent result; it was designed merely to ‘unscramble’. . . a

situation where income realized by the controlled group

and earned by one member of the group is diverted to

another group member by means of transactions not car-

ried out at arm's length.” Huber Homes, Inc., supra at 609.

It is undisputed in this case that all of the members of the

controlled group were acting as a group for purposes of borrow-

ing working capital, and that the interest burden was shared ac-

cording to a pre-established formula.

{3] First, there is nothing in the record to indicate that had

plaintiff been acting on behalf of an uncontrolled group of

which it was a member its true taxable income (Regs. § 1.482-1

(a)(6)) would have been any greater. The record shows clearly

— A-13 —

that the distortion occurred among the subsidiary corporations.

Second, the regulations direct that the method of allocating,

apportioning or distributing income “shall be determined with

reference to the substance of the particular transactions or ar-

rangements which result in the avoidance of taxes or the failure

to clearly reflect income.” Regs. § 1.482-1(d)(1) (Emphasis

added). The district director is further directed to make “appro-

priate correlative adjustments to the income of any other mem-

ber of the group involved in the allocation.” Regs. § 1.482-1]

(d)(2). i

The court finds and concludes that allocating part of the

interest income of the impaired subsidiaries to plaintiff as im-

puted interest was unreasonable, arbitrary and Capricious. De-

fendant had the power and discretion under Section 482 to re-

allocate the interest charges among all the subsidiaries, and

thereby effectively unscramble the distortion created among

them by the group's internal procedures (which have since been

abandoned). Where the controlling interest ( plaintiff) causes

the controlled members to operate so that their taxable incomes

are understated, the district director is mandated to intervene

and, by making apportionments or allocations “between or

among the controlled taxpayers constituting the group”, deter-

mine “the true taxable income of each controlled taxpayer.”

Regs. § 1.482-1(b)(1). (Emphasis supplied ).

It would appear that the method used by defendant—that of

imputing the income to plaintiff instead of readjusting the in-

terest income and interest expense among the subsidiaries par-

ticipating in group borrowing—was intended to produce a higher

harvest of revenue. That is not the purpose of Section 482. De-

fendant ignored the substance of the group relationship and im-

puted income where an objective analysis of the group business

discloses that none had been realized.*

* The courts continue to differ as to the need to prove that the

borrower under an interest free arrangement between controlled

| J A arts 8

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The Clerk will enter judgment in favor of plaintiff and against

defendant in the sum of $246,292.28, together with interest as

provided by law including the interest of $87,173.97 previously

paid by plaintiff. Costs are assessed against defendant.

So ordered.

members realized gross income from the borrowed funds. In Forman,

supra, the Second Circuit seemed to indicate Section 482 could be

applied without reference to whether the borrower had income dur-

men Soe rege In refusing to adopt this position, the Tax Court ob-

served borrower in Forman did in fact —— receive

Kerry Investment Co., 58 T.C. 479, 6/20/72.

“[Bjased u {Huber Homes, Inc.] we hold that the [Commis-

sioner] lacked legal authority to make an adjustment under Section

482 as to funds which did not produce income during the year [in

question].” /d. ;

We need not make such a determination here, in view of our hold-

ing that income earned and interest paid by the borrowing group as a

whole must be considered, under the facts in this case, in determining

the true taxable income to plaintiff (as lender) under Section 482.

— A-15 —

APPENDIX B

Liberty Loan Corporation,

Appellee,

Vv.

United States of America,

Appellant.

No. 73-1389.

United States Court of Appeals,

Eighth Circuit.

Submitted Nov. 14, 1973.

Decided May 31, 1974.

Rehearing En Banc Denied July 19, 1974.

Suit by corporate taxpayer for refund of income taxes al-

leged to have been wrongfully assessed and paid. The United

States District Court for the Eastern District of Missouri, Wil-

liam H. Webster, U. S. Circuit Judge (former U. S. D. C.

Judge), 359 F.Supp. 158, entered judgment for taxpayer, and

the United States appealed. The Court of Appeals, Lay, Circuit

Judge, held that where corporate taxpayer, engaged in con-

sumer finance business, borrowed substantial sums at an effective

interest rate of 5.55% which it then loaned to its subsidiaries

and, rather than charge each subsidiary 5.55% interest, charged

its solvent companies 5.75% and its insolvent enterprises little

or no interest, which resulted in interest income to taxpayer just

sufficient to cover its own interest expense on total amount bor-

rowed, but savings and taxes realized by subsidiaries due to

interest expense deduction had effect of increasing taxpayer's

ro

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coon i AG ame

net worth and distorting its true income, Commissioner acted

within his discretion in allocating to taxpayer interest income of

5% to bring no-interest loans more closely into conformity with

arm’s length standard of statute governing income allocation.

Reversed and remanded with directions.

Van Oosterhout, Senior Circuit Judge, dissented and filed

opinion.

John A. Townsend, Atty., Tax Div., Dept. of Justice, Wash-

ington, D. C., for appellant.

William D. Crampton, St. Louis, Mo., for appellee.

Before Van Oosterhout, Senior Circuit Judge, and Lay and

Heaney, Circuit Judges.

Lay, Circuit Judge.

The United States appeals from a judgment of the district

court granting Liberty Loan Corporation (hereinafter taxpayer )

a refund of $246,292.28 plus interest for 1961 income taxes

alleged to have been wrongfully assessed and paid. The trial

court's opinion is reported at 359 F.Supp. 158 (E.D.Mo. 1973).

We reverse the judgment for the taxpayer and remand with di-

rections to enter judgment in favor of the government.

The fundamental issue is whether the Commissioner of In-

ternal Revenue properly exercised his discretion under 26 U.S.C.

§ 482! and the regulations promulgated thereunder in allocating _

? Section 482 of the Internal Revenue Code provides:

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

nesses (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 Secre-

tary or his delegate may distribute, apportion, or allocate gross

income, deductions, credits, or allowances between or among

such organizations, trades, or businesses, if he determines that

such distributions, apportionment, or allocation is necessary in

order to prevent evasion of taxes or clearly to reflect the in-

come of any of such organizations, trades, or businesses.

es Met coc

to taxpayer the amount of $473,639 as interest income from

certain of its wholly-owned subsidiaries.

Taxpayer is engaged in the consumer finance business, oper-

ating through 40 branch offices and 399 subsidiaries in several

states. In 1961, taxpayer borrowed substantial sums which it

then loaned to its 399 subsidiaries. The subsidiaries in’ turn

loaned the monies to consumers. This procedure of borrowing

by the parent was employed because of the parent’s higher

credit rating, which enabled it to borrow at a lower rate of inter-

est than would have been available to the subsidiaries acting

independently.* In 1961, taxpayer was able to borrow the

amount involved, over $110,547,000, at an effective interest

rate of 5.55%. The ultimate consumers were charged consider-

ably higher interest rates by the subsidiaries.*

Rather than charge each subsidiary 5.55% interest, taxpayer

_ charged its solvent companies 5.75%, while its 55 insolvent

* The facts were stipulated in the district court. Paragraph 3 of

the stipulation reads in part:

It is the practice of finance companies to borrow funds to

lend to customers and for other corporate purposes. Where

there is an affiliated group of finance companies, and large sums

of borrowed funds are so required, in lending such funds at the

most favorable rates, lending institutions (e. g., banks, insurance

companies) require that such borrowings be made by the parent

corporation for the group and not by the subsidiaries on an

individual basis because the subsidiaries are not acceptable

credit risks at these rates on an individual basis, but are so on

a collective, or group, basis. The affiliated group determined to

have the borrowings nfade by the plaintiff on the group’s behalf

because, in addition to the lower rates of interest thus available,

this permitted greater flexibility in the use of funds within the

8rOUp SO as to minimize the total borrowings of the group. The

lending institutions, accordingly, required financial information

to be submitted solely on a consolidated (or group) basis.

* Thus, this case does not involve the “creation of income” prob-

lem presented in Kahler Corp. v. Commissioner, 486 F.2d 1 (8th

Cir. 1973), and B. Forman Co. v. Commissioner, 453 F.2d 1144

(2d Cir.), cert. denied, 407 U.S. 934, 92 S.Ct. 2458, 32 L.Ed.2d

817, rehearing denied, 409 U.S. 899, 93 S.Ct. 102, 34 L.Ed.2d 158

(1972). Those two cases reversed prior Tax Court decisions which

had held that a § 482 adjustment could not be made to a transaction

from which income had not been realized.

- aie hie

enterprises were charged little or no interest.‘ This system re-

sulted in interest income to taxpayer just sufficient to cover its

own interest expense on the total amount borrowed, i. e., 5.55%.

The Commissioner determined that taxpayer's 1961 income

had not been clearly reflected due to the no-interest loans.®

Acting pursuant to § 482 and the regulations thereunder, the

Commissioner therefore increased taxpayer's income to reflect

interest payments of 5% from the insolvent subsidiaries. No

adjustment was made to the 5.75% interest income received

from the solvent subsidiaries.

Upon Liberty Loan’s suit for a refund, the district court found

no distortion in taxpayer’s income, since taxpayer had received

the actual costs of its borrowing from the overall group of sub-

sidiaries. Hence, the court held that § 482 and its regulations

had been improperly applied. The court recognized that the

income of the subsidiaries had been distorted; however, it held

| the Commissioner erred in attempting to adjust the income of

the taxpayer, rather than unscrambling the distortion among the

subsidiaries.

The regulations under § 482 specifically require that the

method of allocating and apportioning income “shall be deter-

' 4 Taxpayer made an evaluation of each of its subsidiary’s surplus

condition every six months. As a result, 28 subsidiaries whose sur-

plus condition changed during the year were charged no interest for

one six-month period and were charged the regular 5.75% rate for

the other six months of the year. Twenty-seven companies were

charged no interest for the entire year. The actual interest rate paid

by these 55 subsidiaries averaged out at a rate of 1.48%.

5 The existence of two or more or ganizations, trades, or busi-

nesses, owned or controlled directly or lodiecety by the same inter-

ests, is not contested in this case. us, the only issues are whether

a § 482 allocation was necessary and, if so, whether the’ Commis-

sioner made the proper allocation.

6 Taxpayer was given credit for the 1.48% interest income al-

ready received from the insolvent companies. See note 4, supra.

— le —

mined with reference to the substance of the particular trans-

actions . . .” Regs. § 1.482-1(d)(1) (emphasis added). We

find the “group loan” theory of the trial court ignores the actual

substance of the transactions under scrutiny here. It is clear that

the loans by the taxpayer were not made to a single entity or

group. The facts stipulated show that the loans were made indi-

vidually to each subsidiary; the interest rates charged the indi-

vidual subsidiaries ranged from 0 to 5.75%, depending on the

capital status of each company; each subsidiary carried on its

balance sheets a note payable to its parent; and each subsidiary

filed a separate income tax return, reflecting the individual loan

from the parent. Although the parent, for admittedly sound

business reasons, may have borrowed a lump sum, nevertheless

when it came to relending the monies to the subsidiaries, it is

evident that each loan was a separate transaction requiring in-

dependent scrutiny by the Commissioner.

The individual nature of taxpayer's loans to its controlled

interests is not altered in any way by the references to “group

borrowing” contained in Paragraph 3 of the Stipulation. As the

government notes in its brief:

This label is in itself meaningless; here it can signify no

more than that the assets of the entire group of corpora-

tions were made subject to the lender's debt claim in order

to achieve more favorable interest rates. But this is a for-

tiori true of any loan to a parent corporation since the

assets of its subsidiaries can be reached by its creditlrs.

Hence, the parent is likely to be in a better credit position

than the individual subsidiaries.

Equally unsupported by the facts is taxpayer's argument that

the solvent subsidiaries, rather than the parent, were actually

the creditors of the insolvent concerns to the extent the insolvent

companies failed to pay their full share of the interest costs.

There is no evidence that the insolvent subsidiaries had any

obligation to pay the “gain” subsidiaries any amounts whatso-

a eee Ts |

He tN

— A-20 —

ever. The balance sheets of the gain subsidiaries do not reflect

any amounts due from the “loss” subsidiaries. Particularly note-

worthy in this regard is the fact that some of the insolvent sub-

sidiaries paid the parent 5.75% interest for six months of the

year. See note 4, supra. If the taxpayer's theory were true,

these amounts would have been paid to the gain subsidiaries, not

to the parent.

Moreover, the stipulated fact that the gain subsidiaries paid

5.75% interest, while the loss subsidiaries paid little or no

interest, is totally inconsistent with taxpayer's assertion that all

of the subsidiaries actually paid 5.55%, with the gain subsidi-

aries loaning the necessary interest amounts to the loss subsidi-

aries.

Viewed as a number of independent transactions, it is readily

apparent that the no-interest loans to the insolvent subsidiaries

distorted taxpayer's 1961 taxable income. As the Second Circuit

has observed, in construing § 482:

The instant loans without interest are obviously not at arm’s

length, since no unrelated parties would loan such large

sums without interest. The allocation of the interest in-

come to taxpayers was necessary in order to properly re-

flect their taxable incomes.

B. Forman Co. v. Commissioner, 453 F.2d 1144, 1156 (2d

Cir.), cert. denied, 407 U.S. 934, 92 S.Ct. 2458, 32 L.Ed.2d

817, rehearing denied, 409 U.S. 899, 93 S.Ct. 102, 34 L.Ed.2d

158 (1972).

We note also that even if one were to accept the “group loan”

premise of the trial court, there is nevertheless a distortion in

taxpayer's income. As the trial court recognized:

Low or no income subsidiaries would have significantly less

use for an interest expense deduction, whereas a subsidi-

ary corporation in a surtax bracket would be able to utilize

— A-21 —

the deduction against higher tax rates. The internal ap-

portionment undoubtedly led to substantial overall savings

in taxes to the group, taken as a whole. (emphasis addeg).

359 F.Supp. at 162-163.

We think it obvious that any savings in taxes realized by the sub-

sidiaries has the effect of increasing the parent's net worth and

hence distorting its true income. And, as one commentator has

observed, “[t]he purpose of the section is to prevent corporations

within the same corporate family from utilizing their separate

corporate structures to diminish the overall tax liability of the

corporate family.” Note, 6 N.Y.U.J.Int.L. & Politics 169, 171

(1973). Thus, any distortion in the income of the subsidiaries

is necessarily a distortion of the parent’s income as well.

Contrary to the district court's holding, it makes no difference

whether the Commissioner first adjusts the income of the sub-

sidiaries or that of the parent. Regs. § 1.482-1(d)(2) requires

the Commissioner to make appropriate correlative adjustments

to the income of any other member of the group involved in

the allocation. In other words, when the Commissioner in-

creased taxpayer's income, he was also required to give the

insolvent subsidiaries correspondingly increased interest deduc-

tions. Whether the Commissioner starts by increasing the in-

come of the parent or, instead, by increasing the deductions of

the insolvent subsidiaries should have no effect on the ultimate

tax consequences.

[1] Having determined that there exists a § 482 distortion in

taxpayer's income, it remains to be seen whether the Commis-

sioner’s adjustment was a proper application of the regulations.

We note at the outset that the Commissioner has broad discre-

tion under § 482 and his determination will not be upset unless

proven by the taxpayer to be arbitrary and capricious. See, e. g.,

Ballentine Motor Co. v. Commissioner, 321 F.2d 796, 800 (4th

Cir. 1963); Grenada Industries, Inc. v. Commissioner, 17 T.C.

Fe ee

ee ee BB, SE |

— A-22 —

231, 255 (1951), aff'd, 202 F.2d 873 (Sth Cir.), cert. denied,

346 U.S. 819, 74 S.Ct. 32, 98 L.Ed. 345 (1953). As the Tax

Court has recognized:

The legislative history of section 482 indicates that it was

designed to prevent evasion of taxes by the arbitrary shift-

ing of profits, the making of fictitious sales, and other such

methods used to “milk” a taxable entity. * * * The Com-

missioner has considerable discretion in applying this sec-

tion and his determinations must be sustained unless he has

abused his discretion. We may reverse his determinations

only where the taxpayer proves them to be unreasonable,

arbitrary, or capricious.

Pauline W. Ach, 42 T.C. 114, 125-126 (1964), affd, 358

F.2d 342 (6th Cir.), cert. denied, 385 U.S. 899, 87 S.Ct. 205,

17 L.Ed.2d 131 (1966).

[2] Regs. § 1.482-1(b)(1) provides that the “purpose of

section 482 is to place a controlled taxpayer on a tax parity

with an uncontrolled taxpayer . . .” In the case of loans or

advances from one controlled entity to another, the regulations

provide that tax parity with uncontrolled taxpayers is to be

achieved through application of an arm's length standard. Regs.

§ 1.482-2(a)(1).?

Regs. § 1.482-2(a)(2) sets up standards for determination

of the appropriate arm's length interest rate.* The regulation

7 Regs. § 1.482-2(a)(1) reads:

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

arm’s length rate as defined in subparagraph (2) of this para-

graph, the district director may make ag ny ge allocations to

reflect an arm’s length interest rate for the use of such loan or

advance.

* Regs. § 1.482-2(a)(2) reads:

For the purposes of this parneraph, the arm’s length interest rate

shall be the rate of interest which was charged, or would have been

my: eo

first requires that the arm’s length rate shall be the rate which

would have prevailed between unrelated parties under similar

circumstances. However, the regulation then creates certain

“safe haven” rates which, even though not the prevailing arm’s

length rate, will be allowed to stand unadjusted. The govern-

ment calls these rates “deemed arm's length rates,” since they

may be substituted for the prevailing arm's length rate. One

commentator explains the operation of the deemed rate pro-

visions as follows:

Thus, if a taxpayer (not in the business of making loans)

lends money to an affiliate at an interest rate between 4

and 6 per cent no allocation will be made; if the arm’s

length rate is greater than 6 per cent or less than 4 per

cent, and the actual rate charged falls between the arm’s

length rate and the safe haven rate, the actual rate charged

similarly will be allowed to stand; if the actual rate falls

outside of this zone, however, a rate of 5 per cent simple

interest will be imputed to the loan for allocation purposes.

Eustice, Affiliated Corporations Revisited: Recent Developments

Under Sections 482 and 367, 24 Tax L.Rev. 101, 105 (1968).

charged at the time the indebtedness arose, in independent transac-

tions with or between unrelated parties under similar circumstances.

All relevant factors will be considered, including the amount and

duration of the loan, the security involved, the credit standing of the

borrower, and the interest rate prevailing at the situs of the lender

or creditor 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 but not

in excess of 6 percent per annum simple interest.

(ii) 5 percent 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 interest,

unless the taxpayer establishes a more appropriate rate under

the standards set forth in the first sentence of this subparagraph.

For pu s of the preceding sentence if the rate actually

charged is greater than 6 percent per annum simple interest and

ek hh as is an ee ae se |

Siren ah

PROP |

berth hee WN) OW

si ll a

In the present case, the Commissioner adjusted taxpayer's in-

come upward to reflect interest income of 5% from the insolvent

subsidiaries. This adjustment was made pursuant to Regs.

§ 1.482-2(a) (2) (ii), applicable in the case of no-interest loans.®

The Commissioner made no adjustment to the 5.75% interest

rates charged the solvent subsidiaries because, in his view,

5.75% was within the safe haven provision of Regs. § 1.482-2

(a) (2) (i).

Because the district court viewed the subsidiaries as a single

entity, it in effect required the Commissioner to offset the

5.75% interest paid by the solvent subsidiaries against the no-

interest loans to the insolvent subsidiaries. It is clear, however,

that the regulations do not permit an offset under the factual

circumstances of this case. Regs. 1.482-1(d)(3) limits offsets

to transactions between the same two members of the controlled

less than the rate determined 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 subpara-

graph. Notwithstanding the other provisions of this subpara-

graph 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

incurred by the lender in borrowing such amounts and making

such loans, unless the taxpayer establishes a more appropriate

rate under the standards set forth in the first sentence of this

subparagraph.

® The trial court’s opinion indicates that had it felt an adjustment

was called for, it would have relied on the last sentence of Regs. §

1.482-2(a)(2) to apply an interest rate of 5.55% —the cost the

parent incurred when it borrowed the money to relend to the sub-

sidiaries. The Commissioner persuasively argues, however, that the

“situs of the borrower” test in that sentence has not been met in this

case. Thus, the Commissioner has used the appropriate deemed

arm’s length rate of 5%, as proviged in Regs. § 1.482-2(a)(2) (ii).

— A-25 —

group.’” Thus, if the parent loaned one of its subsidiaries monies

at no interest, but received in exchange services equivalent to

an arm’s length interest charge, an offset would be permitted.

But the regulations do not contemplate offsets involving bene-

fits flowing to other members of the group. As one commen-

tator has observed:!!

In a sense, the allowance of any offset to a section 482

adjustment represents a retreat from the Service's historical

position that section 482 is a “one-way street” which may

not be invoked by the taxpayer. On the other hand, multi-

national corporations with many foreign subsidiaries prob-

ably would have preferred an approach which permitted

netting not only “vertically” (that is, between two mem-

bers of a controlled group) but also “horizontally” (that

is, among all members of the group) . . . The Treasury,

however, rejected the “horizontal netting” principle, pre-

™ Regs. § 1.482-1(d)(3) provides in part:

The district director ‘ah also consider the effect of any other

nonarm’s length transaction between them in the taxable year

which, if taken into account, would result in a set off against

any allocation which would otherwise be made, provided the

taxpayer is able to establish with reasonable specificity that the

transaction was not at arm's length and the amount of the ap-

propriate 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 circumstances

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. . . . In order to establish that a set-off to

the adjustments proposed by the district director is appropriate,

the taxpayer must notify the district director of the basis of any

claimed set-off at any time before the 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

= Proposed adjustments or before July 16, 1968. whichever is

ater.

"t Mr. Jenks’ remarks concern multinational corporations with

numerous foreign subsidiaries; however, they are equally applicable

to corporations such as taxpayer with many domestic subsidiaries.

‘

ches &

eB Seva Sash, Ad See pul ed beth pdcanaae

— A-26 —

sumably because of administrative difficulties and the pos-

sibilities of manipulation.

It must be recognized, however, that there would be an

obvious temptation under horizontal netting to overcharge

profitable subsidiaries in high-tax countries and to under-

charge those operating at a loss or in low-tax countries. The

reservation of authority to deny offset and to make indi-

vidual allocations, where United States tax liabilities are

thus distorted might be sufficient to control such tax-moti-

vated operations. However, there is a marked reluctance

in this, as in other areas of the section 482 regulations, to

depart from the concept of allocation in individual trans-

actions or to judge compliance on the basis of overall re-

sults. Taxpayers had to settle for the proverbial half a

loaf.

Jenks, Treasury Regulations Under Section 482, 23 Tax Lawyer

279, 285-286 (1970).*?

In addition to the above limitation on the offset regulations,

Regs. § 1.482-1(d)(3) requires a taxpayer desiring to utilize

the offset provision to notify the IRS of that fact within 30 days

of the date of the examination report advising taxpayer of the

12 The government explains the restricted basis of the offset regu-

lation as follows:

The reason is that offsetting transactions between the same two

entities do not alter their combined taxable income and there is

thus no need to adjust cither or both in order to clearly reflect

income. On the other hand, where, as here, an unduly high

rate is charged to one member and a purportedly offsetting low

rate is charged to a different member, the aggregate taxable

income of the three part .ipating entities may be altered ma-

terially because of the diifering impact which the thus shifted

income or deductions will have in the hands of the two members

affected by the shift. Untangling the resulting complications

and distortions deliberaicly created by the taxpayers could prove

to be an administrative task of considerable proportions and

place an undue strain upon the administrative resources of the

Internal Revenue Service.

— ; om

proposed § 482 adjusiment. Taxpayer made no attempt here

to so notify the Commissioner.

Finally, the taxpayer may not assert an offset in which a

deemed arm's length rate (here 5% ), as opposed to the actual

arm’s length rate (stipulated to be in excess of 5.75% ), is used

as the balance point. Regs. § 1.482-1(d)(3) provides that for

purposes of an offset:

[T]he term arm's length refers to the amount which was

charged or would have been charged in independent trans-

actions with unrelated parties under the same or similar

circumstances 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. (emphasis

added. )

Thus, it would have been contrary to the regulations for the

Commissioner to balance out the transactions at 5% (or 5.55% )

when the stipulated arm's length rate was in excess of 5.75%.

This limitation on the offset provision logically follows when

one remembers that the purpose of a § 482 adjustment is to

more clearly reflect income. The upward adjustments to the no-

interest loans do just that. Downward adjustments to the 5.75%

loans, however, would have the effect of moving those loans

even further away from the actual arm’s length rate. In adjust-

ing the no-interest loans upwards to 5%, the Commissioner

therefore made the only adjustment he could.!3

-

In sum, we conclude that the Commissioner acted within his

discretion in allocating to the taxpayer interest income of 5%

_ 1% Even with the adjustment made by the Commissioner, taxpayer

is still receiving the benefit of the safe haven rates. As the govern-

ment states:

By providing the safe harbors, the Commissioner has allowed

taxpayer to save substantially on its taxes, in that the 5.75

percent loans stood unadjusted and the no-interest loans were

adjusted only up to 5 percent.

te ee tr ees ia atts ta ee a

Tw? on

— A-28 —

to bring the no-interest loans more closely into conformity with

the arm’s length standard of § 482.

Judgment reversed and remanded with directions to the dis-

trict court to enter judgment for the United States.

Van Oosterhout, Senior Circuit Judge (dissenting).

I would affirm the trial court’s decision, principally upon the

basis of Judge Webster’s well-reasoned opinion, reported at 359

F.Supp. 158 (E.D.Mo. 1973). Judge Webster makes the fol-

lowing critical findings:

It is undisputed . . . that all of the members of the

controlled group were acting as a group for purposes of

borrowing working capital, and that the interest burden

was shared according to a pre-established formula. 359

F.Supp. at 164.

* * - 7. 7 * *

Plaintiff charged the group and recovered from the group

as a whole all of the interest charges it paid on behalf of

the group. Plaintiff's income and expenses, for tax pur-

poses, were thus no different in amount than they would

have been had an exact proration been made according to

amounts separately loaned to the members of the group.

Id. at 163.

* 7 * * * * *

Plaintiff was fully reimbursed for all but its own share

of the borrowing costs it incurred on behalf of the group.

Id. at 162.

The federal income tax return of plaintiff for 1961

clearly reflects its income and there has been no tax eva-

sion on its part. /d. at 162.

Upon the basis of such findings, Judge Webster determined:

—* yo

The court finds and concludes that allocating part of the

interest income of the impaired subsidiaries to plaintiff as

imputed interest was unreasonable, arbitrary and capri-

cious. /d. at 165.

In my view, such findings are supported by substantial evi-

dence, are not induced by any erroneous view of the law, and

are not clearly erroneous, and afford a sound basis for the judg-

ment entered by Judge Webster. This case differs factually from

B. Forman Co. v. Commissioner, 453 F.2d 1144 (2d Cir.

1972), and Kahler Corp. v. Commissioner, 486 F.2d 1 (8th

Cir. 1973), in a number of significant respects. In those cases

no subsidiaries paid any interest; no showing of subsidiary par-

ticipation in the loans obtained from the financial institutions

was made, and no business purpose in making the interest-free

loans was established. In our present case, the court found upon

the basis of the parties’ stipulation, particularly paragraph 3

thereof, that the subsidiaries participated in making the loans

and that the subsidiaries as a group agreed to reimburse the

parent corporation for all interest and other expense arising out

of the borrowing. It is undisputed that the group as a whole

reimbursed the parent for all interest and incidental expense in-

curred as a result of the loans, and that the interest paid by the

group as a whole fell well within the safe harbor provisions. '

Such interest was reported as income by taxpayer.

1 The Government in its brief states:

Here, taxpayer, a parent corporation, lent substantial sums of

money to its numerous subsidiaries, having itself borrowed the sums

in question at an interest rate of 5.55 percent. Under one of the

safe harbor rates — out in the Regulations the rate paid 7 the

taxpayer is deemed the arm’s length rate for purposes of the reloans

to the subsidiaries. Thus, had the taxpayer charged each subsidiary

interest at 5.55 percent, there would have been no basis for adjust-

ment by the Commissioner. However, the taxpayer charged no inter-

est to some of the subsidiaries which were in poor financial condition

and charged the balance the rate of 5.75 percent—the latter rate

being at the level which would provide the taxpayer with interest

income in the same aggregate amount which it had to pay on its own

borrowing and which would net out at an average rate of 5.55 per-

cent to all subsidiaries.

i

4

5

7

aA

i

— A-30 —

The court on the present record was also warranted in finding

that a legitimate business purpose existed for shifting the interest

burden from the loss subsidiaries to the gain subsidiaries, and

that no tax evasion was established.

The parent company is the only entity whose tax liability is

directly involved in this case. The Government has instituted no

timely proceedings under § 482 or otherwise to increase the tax

liability of any subsidiary.

I recognize that § 482 confers considerable discretion upon

the Commissioner to allocate income. Under the peculiar facts

of this case, I agree with the trial court that the Commissioner

has abus«. his discretion in making the allocation that he made.

I would affirm the judgment entered by the trial court.

— A-31 —

APPENDIX C

United States Court of Appeals

7 for the Eighth Circuit

No. 73-1389 September Term, 1973

Liberty Loan Corporation,

— Appeal from the United

States District Court

( for the Eastern Dis-

trict of Missouri.

Appellee,

vs.

United States of America, °

Appellant. |

(Filed July 19, 1974)

This Court having considered petition for rehearing en banc

filed by counsel for appellee and, being fully advised in the

premises, it is ordered that the petition for rehearing en banc be,

and it is hereby, denied.

Considering the petition for rehearing en banc as a petition

for rehearing, it is ordered that the petition for rehearing also

be, and it is hereby, denied.

July 19, 1974

PROM A Kee 2a ed ae, & vipat

— A-32 —

APPENDIX D

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

SEC. 482. ALLOCATION OF INCOME AND ee

TIONS 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 af-

filiated) 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,

or businesses, if he determines that such distribution, ap-

portionment, 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.

Treasury Regulations on Income Tax (1954 Code) (26 C.F.R.):

§ 1.482-1 Allocation of income and deductions among tax-

payers.

; * * * * * * *

(a). Definitions. When used in this section and in §

1.482-2—

- * . * - . -

(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 be, 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 deduc-

— A-33 —

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 con-

tract, 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

422 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

taxpayer. 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, this has not been

done, and 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 income.

between 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

case is that of an uncontrolled taxpayer dealing at arm's

length with another uncontrolled taxpayer.

* * = * * * of

(d) Method of Allocation. (1) The method of allocat-

ing, apportioning, or distributing income, deductions,

credits, and allowances to be used by the district director

in any case, including the form cf the adjustments and the

character and source of amounts allocated. shall be deter-

eco e e |

a v” on

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 ap-

propriate adjustments may take the form of an increase or

decrease in gross income, increase or decrease in deduc-

tions (including depreciation), increase or decrease in

basis of assets (including inventory), or any other adjust-

ment which may be appropriate under the circumstances.

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

allocation in the case of several types of business transac-

tions.

$ 1.482-2 Determination of taxable income in specific situa-

tions

(a) Loans or advances—(1) In general. 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, or charges in-

terest at a rate which is not equal to an arm’s length rate as de-

fined in subparagraph (2) of this paragraph, the district director

may make appropriate allocations to reflect an arm’s length in-

terest rate for the use of such loan or advance.

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

graph, 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 similar circumstances. All relevant factors

will be considered, including the amount and duration of the

loan, the security involved, the credit standing of the borrower,

and the interest rate prevailing at the situs of the lender or

creditor 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 un-

— A-35 —

related parties, the arm’s length rate for purposes of this para-

graph shall be—

(i) The rate of interest actually charged if at least 4 but not

in excess of 6 percent per annum simple interest,

(ii) 5 percent 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 interest,

unless the taxpayer establishes a more appropriate rate under

the standards 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 annum simple interest

and less than the rate determined 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 incurred

by the lender in borrowing such amounts and making such

loans, unless the taxpayer establishes a more appropriate rate

under the standards set forth in the first sentence of this sub-

paragraph.