Opposition Brief — Kenco Restaurants, Inc. v. Commissioner

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No. 99-1834 °*

In the Supreme Court of the United States

KENCO RESTAURANTS, INC., ETAL., PETITIONERS

Vv.

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT OF CERTIORARI

TOTHE UNITED STATES COURT OF APPEALS

FOR THE SIXTH CIRCUIT

BRIEF FOR THE RESPONDENT IN OPPOSITION

SETH P. WAXMAN

Solicitor General

Counsel of Record

PAULA M. JUNGHANS

Acting Assistant Attorney

General

TERESA E. MCLAUGHLIN

CHARLES F. MARSHALL

Attorneys

Department of Justice

Washington, D.C. 20530-0001

(202) 514-2217

QUESTION PRESENTED

Whether, pursuant to 26 U.S.C. 482, the Commis-

sioner of Internal Revenue properly reallocated deduc-

tions among commonly controlled corporations to re-

flect arm’s length charges for services performed by a

related corporation.

(I)

TABLE OF CONTENTS

Page

Opinions below 1

Jurisdiction

Statement 1

Argument

Conclusion 12

TABLE OF AUTHORITIES

Cases:

Altama Delta Corp. v. Commissioner, 104 T.C. 424

(1995) 11

Anderson v. City of Bessemer City, 470 U.S. 564

(1985) chai cibaiiedethi 11

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

435 F.2d 182 (7th Cir. 1970) 8

Bausch & Lomb, Inc. v. Commissioner, 933 F.2d

1084 (2d Cir. 1991) 8

Central Bank of the South v. United States, 834

F.2d 990 (11th Cir. 1987) 8

Commisssioner v. First Security Bank of Utah,

405 U.S. 394 (1972) 7

Eli Lilly & Co. v. Commissioner, 856 F.2d 855 (7th

Cir. 1988) < 7, 8, 9, 10

Lufkin Foundry & Mach. Co. v. Commissioner,

468 F.2d 805 (5th Cir. 1972) 8, 10

Rogers v. Lodge, 458 U.S. 613 (1982) oo... .cecccccecececeseceeee fo)

Spicer Theatre, Inc. v. Commissioner, 346 F.2d 704

(6th Cir. 1965) 8

Sunstrand Corp. v. Commissioner, 96 T.C. 226

(1991) 11

Tiffany Fine Arts, Inc. v. United States, 469 U.S.

310 (1985) 9

Welch v. Helvering, 290 U.S. 111 (1933) .ccceccceccsseseseeeee 9

(IID)

IV

Cases—Continued: Page

Wisconsin Big Boy Corp. v. Commissioner, 452

F.2d 137 (7th Cir. 1971) .. 8-9

Statute, regulations and rule:

Internal Revenue Code, 26 U.S.C. 482 3, 6, 7, 8, 10

Treas. Reg. (26 C.F.R.) (1999):

§ 1.482-1A(a)(1) 8

§ 1.482-1A(b)(1) ......... Iniicapraieabendicgbibiaiamteateienitialeih 8,9

§ 1.482-2(b)(3) 8

8

9

§ 1.482-2(b)(7)(ii)

Tax Ct. R. 142(a) ........

Miscellaneous:

B. Bittker & J. Eustice, Federal Income Taxation of

Corporations and Shareholders (3d ed. 1971) ........s00 7-8

H.R. Rep. No. 2, 70th Cong., Ist Sess. (1928) 8

In the Supreme Court of the Gnited States

No. 99-1834

KENCO RESTAURANTS, 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 SIXTH CIRCUIT

BRIEF FOR THE RESPONDENT IN OPPOSITION

OPINIONS BELOW

The opinion of the court of appeals (Pet. App. 1a-17a)

is reported at 206 F.3d 588. The opinion of the United

States Tax Court (Pet. App. 18a-35a) is unofficially

- reported at 76 T.C.M. (CCH) 512.

JURISDICTION

The judgment of the court of appeals was entered on

February 16, 2000. The petition for a writ of certiorari

was filed on May 16, 2000. The jurisdiction of this

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

STATEMENT

1. Petitioners Kenco Restaurants, Inc., K-K Restau-

rants, Inc., Tiffin Avenue Realty Co., Inc., and Bryan

(1)

2

Realty, Inc., are members of a group of 14 corporations

that are owned in equal shares by three shareholders

(individually or together with their wives). Those

shareholders are George Kentris, his father, Mike

Kentris, and Ken Baerwaldt. Pet. App. 2a-3a. Seven of

the corporations (the restaurant corporations) own and

operate Taco Bell restaurants. Six of the corporations

(the realty corporations) own the real estate where the

restaurants are located. Jd. at 3a; C.A. App. 51-53. The

fourteenth corporation, BKK Management, Inc., pro-

vided management and administrative services to the

other 13 corporations during 1990, 1991 and 1992. Pet.

App. 3a, 20a. The services provided by BKK Manage-

ment were performed by the three owners and by

additional employees, all of whom received salaries

from BKK. Jd. at 4a. BKK Management provided simi-

lar services to each corporation—accounting and

administrative services, operational oversight, product

pricing, advertising and training. Jd. at 3a, 20a.

BKK Management charged each of the 13 related

corporations a “management cost share” fee for its ser-

vices. These fees ranged from a high of $413,000

charged to Kenco in 1991 (more than 42% of the total

fees for that year) to zero for the Wapak restaurant in

1990. Pet. App. 4a. Petitioners claim that the fee al-

locations for management services were based on the

number of hours the owners devoted to each corpora-

tion. The owners did not, however, maintain records of

the number of hours actually spent on each corporation

during any given year. The owners instead projected

the number of hours they would spend on each corpora-

tion for the next year, based on the number of hours

allegedly devoted to each corporation during the

previous year, and made adjustments to those esti-

3

mates for any specific projects contemplated for the

coming year. Jbid.

Upon audit of petitioners’ returns for 1990, 1991 and

1992, the Commissioner of Internal Revenue deter-

mined that the fees paid to BKK Management did not

reflect an arm’s length charge for its services. In cases

involving commonly controlled corporations, the Com-

missioner is authorized by Section 482 of the Internal

Revenue Code to make such allocations or distributions

of income and deductions among such corporations as

he determines “is necessary in order to prevent evasion

of taxes or clearly to reflect the income of any such

organizations * * *.” 26 U.S.C. 482. Invoking that

authority, the Commissioner reallocated the manage-

ment fees among the various commonly controlled cor-

porations to reflect arm’s length charges in their

dealings with one another. This reallocation of deduc-

tions and income resulted in tax deficiencies for some of

the corporations. Petitioners filed petitions in Tax

Court seeking review of the deficiency determinations.

Pet. App. 27a-28a.

2. In the Tax Court proceedings, petitioners en-

gaged an accounting expert to render an opinion on the

reasonableness of the management fee allocations. The

Tax Court refused to admit the accountant’s report,

however, because he was not qualified as an expert in

the field of determining reasonable management fees.

C.A. App. 593.

At trial, the government introduced the testimony of

the revenue agent who had conducted the audit. The

agent had reallocated BKK’s management fees among

the restaurant corporations primarily based upon the

gross sales of each corporation. Adjustments were

made in that allocation formula for the realty cor-

porations that made no sales. Pet. App. 6a. The agent

4

used a gross sales reallocation method because peti-

tioners did not provide time logs or any other documen-

tary basis for calculating the actual number of-hours

devoted by the owners to each corporation. Jd. at 6a,

17a, 29a. The agent testified that petitioners’ account-

ant had stated that her allocation of the payments made

by the corporations to BKK for management services

was based on the “cash flows” of each corporation. C.A.

App. 596, 611. Petitioners’ accountant, however, testi-

fied that the agent’s recollection was a “misunder-

standing” and that the allocation was based on the costs

of providing the management services, not on the in-

come of the client corporations. Jd. at 708.

The government also called a business valuation ex-

pert whose allocations of the management fees were

based on a different method than that reflected in the

notice of deficiency.’ In the opinion of that expert, the

fee allocations made by petitioners were not consistent

with the fees that each corporation would have paid for

management services in an arm’s-length transaction.

She devised arm’s length allocations by calculating the

amount of time each owner and employee of BKK spent

performing particular services at each restaurant. She

obtained data for these calculations from interviews

with the owners and employees regarding their parti-

cular duties and responsibilities. She did not accord

greater weight to the owner hours than the employee

hours because owners and employees often spent time

performing similar tasks. She concluded that this

allocation of management fees based on the total hours

! This expert witness did not analyze or reallocate any portion

of the fees attributable to the realty corporations, nor did she

reallocate any portion of the fees to Bryan Restaurants, Inc., which

was created during 1992. Pet. App. 7a-8a. ’

5

of services provided to each corporation more clearly

reflected the arm’s-length charges attributable to such

services than was yielded by petitioners’ original alloca-

tion method. Pet. App. 7a.

3. The Tax Court found that petitioners failed to

prove that the Commissioner’s reallocation of the

management charges was arbitrary, capricious or

unreasonable. Pet. App. 29a-3la. The court noted that,

although petitioners contended that their own method

of allocating management fees among the corporations

was reasonable, “they have not directed any of their

argument to proving that [the revenue agent’s] method

produces an arbitrary, capricious, or unreasonable re-

sult, to wit, that gross sales is not indicative of manage-

ment and administrative services provided.” Id. at 29a.

Although petitioners criticized the agent for failing to

take into account “certain unusual events” that re-

quired BKK to provide “unusual types and amounts of

services” to the affected corporations, the Tax Court

concluded that the failure of the owners to maintain

records regarding hours spent “made it impossible for

[the agent] to determine the impact of the unusual

events on the services provided using an hc ur-based

allocation methodology.” Jbid. The Tax Court ob-

served that petitioners’ “principal engagement at trial

and on brief” (id. at 30a) was disputing the management

fee reallocation made by the government’s business

valuation expert, rather than the allocation contained in

the deficiency notices, under a mistaken belief that the

Commissioner had abandoned the notice of deficiency.

The court concluded that the Commissioner had not

abandoned the deficiency determination but had relied

on the expert’s testimony “only to prove a reasonable

allocation on the contingency that petitioners succeed in

showing the respondent’s allocation to be arbitrary,

6

capricious, or unreasonable.” Jd. at 30a-3la. The court

held that the Commissioner’s reallocation of these costs

was an appropriate exercise of his authority under Sec-

tion 482 clearly to reflect the income of the controlled

corporations because petitioners had impermissibly al-

located the management fees on the basis of ability to

pay, rather than on the basis’ of the costs of services

provided. Jd. at 3la-34a.

4. The court of appeals affirmed. The court first

rejected petitioners’ contention that they had been

relieved of their initial burden of demonstrating that

the reallocations in the notice of deficiency were arbi-

trary, capricious, or unreasonable by the government’s

supposed abandonment of the allocations contained in

the notices of deficiency in favor of the expert witness’s

reallocations at trial. Pet. App. 9a-10a. The court held

that the government “may rely on alternative theories

supported by a different methodology than that used in

the notice of deficiency” and that such reliance “does

not * * * render the notice of deficiency arbitrary,

capricious, or unreasonable.” Jd. at 9a. The court also

agreed with the Tax Court’s finding that respondent

had not, in fact, ever abandoned the reallocations

coritained in the notice of deficiency but had instead

relied upon the expert’s testimony as an alternative

allocation in the event that petitioners met the

threshold burden of establishing that the reallocations

in the notice of deficiency were wrong. /d. at 10a. The

court noted that the government “had no reason to

establish an arm’s-length charge other than as a

contingency argument in case Petitioners overcame the

initial presumption.” [bid.

The court of appeals concluded that petitioners had

failed to meet their burden of proving that the realloca-

tions in the notice of deficiency were arbitrary, capri-

7

cious or erroneous. The court explained that “(pleti-

tioners provide[d] no evidence of an independent trans-

action between unrelated parties in similar circum-

stances,” and “the facts support our conclusion that

Petitioners were not dealing at arm’s length but were,

instead, allocating their costs based on an ability to

pay.” Pet. App. 15a. The court noted that, although

one of the restaurant corporations paid no management

fee in 1990, its fee increased in 1991 and 1992 as its

income rose during those years. Ibid. Similarly, the

fees charged to another of the corporations increased

more than ninefold between 1990 and 1992, and its

share of the total fees increased by a factor of seven,

without any evidence of “a corresponding increase in

Owner hours.” Jd. at 16a.

ARGUMENT

The fact-bound decision of the court of appeals is

correct and does not conflict with any decision of this

Court or of any other court of appeals. Further review

is therefore not warranted.

1. Section 482 of the Internal Revenue Code autho-

rizes the Commissioner to reallocate income or

deductions among commonly controlled businesses if he

determines that such a reallocation “is necessary in

order to prevent evasion of taxes or clearly to reflect

the income of any such * * * businesses.” 26 U.S.C.

482; see Eli Lilly & Co. v. Commissioner, 856 F.2d 855,

859 (7th Cir. 1988). The purpose of this statute is to

place a controlled taxpayer on a tax parity with an un-

controlled taxpayer and to “prevent artificial shifting,

milking, or distorting of the true net incomes of com-

monly controlled enterprises.” Commissioner v. First

Security Bank of Utah, 405 U.S. 394, 400 (1972) (quot-

ing B. Bittker & J. Eustice, Federal Income Taxation

8

of Corporations and Shareholders at 15-21 (3d ed.

1971)); see also 26 C.F.R. 1.482-1A(a)(1); H.R. Rep. No.

2, 70th Cong., Ist Sess. 16-17 (1928).

In testing dealings between commonly controlled

taxpayers under Section 482, the touchstone is that of

“an uncontrolled taxpayer dealing at arm’s length with

another uncontrolled taxpayer.” 26 C.F.R. 1.482-

1A(b)(1); Bausch & Lomb, Inc. v. Commissioner, 933

F.2d 1084, 1089 (2d Cir. 1991); Baldwin-Lima-Hamilton

Corp. v. United States, 435 F.2d 182, 185 (7th Cir. 1970).

When a corporation (such as BKK) renders manage-

ment or administrative services to related corporations

as an “integral part of the business activity,” i.e., as

“one of its principal activities,” 26 C.F.R. 1.482-

2(b)(7)(ii), an arm’s length charge is “the amount which

was charged or would have been charged for the same

or similar services in independent transactions-with or

between unrelated parties under similar circumstances

considering all relevant facts.” 26 C.F.R. 1.482-2(b)(3).

Recognizing the broad discretion that Congress con-

ferred on the Commissioner to appraise particular fact

situations in making a Section 482 allocation, the courts

have held that such allocation determinations are not to

be set aside unless clearly shown to be arbitrary,

capricious or unreasonable. Eli Lilly & Co. v. Com-

missioner, 856 F.2d at 860; Spicer Theatre, Inc. v. Com-

missioner, 346 F.2d 704, 706 (6th Cir. 1965). To meet

this burden, the taxpayer ordinarily produces evidence

showing that its dealings are consistent with those

entered into by other parties at arm’s length. See, e.g.,

Central Bank of the South v. United States, 834 F.2d

990, 993-994 (11th Cir. 1987); Lufkin Foundry & Mach.

Co. v. Commissioner, 468 F.2d 805, 807 (5th Cir. 1972);

Wisconsin Big Boy Corp. v. Commissioner, 452 F.2d

9

137, 139-141 (7th Cir. 1971); see also 26 C.F.R. 1.482-

1A(b)(1).

Even if the taxpayer were to prove that the Com-

missioner’s reallocations were arbitrary, capricious or

unreasonable, the taxpayer would still bear the ulti-

mate burden of proving that its own allocations reflect

arm’s length charges. See Welch v. Helvering, 290 U.S.

111 (1933); Tax Ct. R. 142(a). In-that situation, the

government would be entitled to provide the court with

alternative evidence of arm’s length charges to rebut

the evidence offered by the taxpayer. Eli Lilly & Co. v.

Commissioner, 856 F.2d at 860. The court would then

be able to accept either the evidence offered by the tax-

payer, the evidence offered by the government, or

instead make its own allocation of the charges. Id. at

859-860.

2. The Tax Court and the court of appeals both

determined that, on the record of this case, petitioners

have failed to satisfy their burden of proving that the

Commissioner’s reallocation of management fees in the

notices of deficiency was arbitrary, capricious or un-

reasonable. In particular, both courts correctly con-

cluded that petitioners failed to establish the amount of

fees that would have been charged for similar manage-

ment services rendered at arm’s length to unrelated

corporations. Pet. App. 14a-15a, 29a-30a. There is no

basis to disturb these factual conclusions “concurred in

by two lower courts” (Rogers v. Lodge, 458 U.S. 613,

623 (1982)). See Tiffany Fine Arts, Inc. v. United

States, 469 U.S. 310, 317-318 n.5 (1985).

Petitioners err in contending (Pet. 11-15) that the

allocation of the burden of proof in this case conflicts

with the allocation described by the Seventh Circuit in

Eli Lilly & Co. v. Commissioner, 856 F.2d at 860. Like

the court of appeals in this case (Pet. App. 14a), the

10

Seventh Circuit in Eli Lilly held that the taxpayer

must first rebut the presumptive validity of the Com-

missioner’s determinations under Section 482 by esta-

blishing that the Commissioner’s allocations are arbi-

trary, capricious or unreasonable. 856 F.2d at 860. In

order to show that the Commissioner abused his discre-

tion under Section 482, the taxpayer must show that

arm’s length transactions among uncontrolled parties

are inconsistent with the Commissioner’s determina-

tions. A taxpayer challenging a Section 482 allocation is

required to “present evidence sufficient to establish

that the discounts and commissions it gave would not

have varied had one uncontrolled taxpayer dealt at

arm’s length with another uncontrolled taxpayer” and

such proof “is the generally accepted standard of evi-

dence necessary to overcome the presumption of cor-

rectness and to establish the arbitrariness of the Com-

missioner’s allocations.” Lufkin Foundry & Mach. Co.

v. Commissioner, 468 F.2d at 807 (citing cases).

Because petitioners presented no such evidence, they

failed to acquit their initial burden of proof in this case.”

3. There is also no merit to petitioners’ contention

(Pet.‘17-24) that the Commissioner abandoned the allo-

2 “Petitioners’ allocations are not an arm’s-length charge

because Petitioners provide no evidence of an independent tran-

saction between unrelated parties in similar circumstances.” Pet.

App. 15a. Petitioners contend (Pet. 13) that when a taxpayer has

rebutted the Commissioner’s determinations, the Tax Court could

then make a determination of the proper allocation of such charges

based upon the totality of the evidence in the record. Since

petitioners failed to satisfy their initial burden of establishing that

the Commissioner’s determinations were arbitrary and capricious,

however, neither the Tax Court nor the court of appeals had

occasion to attempt a further reallocation of the charges at issue in

this case.

11

cations of management fees that were the basis of the

notices of deficiency. As the courts below correctly

held, the Commissioner presented the testimony of an

expert witness as alternative evidence of an arm’s

length reallocation of such fees in the event that the

taxpayer succeeded in meeting the initial burden of

showing the Commissioner’s determinations to be arbi-

trary and capricious. Such evidence was properly

submitted “as a contingency argument in case Petition-

ers overcame the initial presumption.” Pet. App. 10a;

see also id. at 30a-31a. Proffering such alternative

evidence of the taxpayer’s liability does not constitute

an abandonment of notice of deficiency and does not

render the notice of deficiency arbitrary, capricious, or

unreasonable. Altama Delta Corp. v. Commissioner,

104 T.C. 424, 458 (1995). See also Sunstrand Corp. v.

Commissioner, 96 T.C. 226, 354-355 (1991).

Petitioners point to selected portions of the trial

transcript where the Commissioner’s counsel or the

Tax Court referred to the evidence provided by the ex-

pert witness (Pet. 18-21). At no point, however, did the

Commissioner or his counsel state that the government

was abandoning the notice of deficiency. Moreover, the

question whether an abandonment occurred is inher-

ently a factual matter that the Tax Court was in the

best position to evaluate as the events transpired dur-

ing the course of the trial. See Anderson v. City of

Bessemer City, 470 U.S. 564, 575 (1985). Based upon

the record before it, the Tax Court correctly

determined that the Commissioner did not abandon the

notice of deficiency by presenting an alternative

method for allocating these management fees. That

factbound determination, concurred in by the court of

appeals, does not warrant review by this Court.

12

CONCLUSION

The petition for a writ of certiorari should be denied.

Respectfully submitted.

SETH P. WAXMAN

Solicitor General

PAULA M. JUNGHANS

Acting Assistant Attorney

General

TERESA E. MCLAUGHLIN

CHARLES F. MARSHALL

_ Attorneys

JULY 2000