Norwest Corporation and Subsidiaries v. Commissioner , 108 T.C. No. 15 ( 1997 )

108 T.C. No. 15UNITED STATES TAX COURT
NORWEST CORPORATION AND SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 20567-93, 26213-93. Filed April 28, 1997.
I.
Norwest Bank Nebraska, N.A., a subsidiary of
petitioner, removed asbestos-containing materials from
its Douglas Street building in connection with the
building's renovation and remodeling. On its 1989
return, petitioner claimed a $902,206 ordinary and
necessary business deduction with respect to the
asbestos-removal expenditures. In the notice of
deficiency, respondent disallowed the deduction.
Held: The costs of removing the asbestos-containing
materials must be capitalized because they were part of
a general plan of rehabilitation and renovation that
improved the Douglas Street building.
II.
Petitioner's subsidiary Norwest Bank Minneapolis
(NBM) owned "blocked deposits" at the Central Bank of
Brazil (Central Bank) consisting of principal repayments
of dollar-denominated loans previously made to Brazil in
the ordinary course of NBM's banking business. The
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Central Bank prevented petitioner from repatriating these
deposits because Brazil had insufficient hard currency
(U.S. dollars) to make payments on the loans. In order
to reduce petitioner's blocked deposit holdings and
decrease its foreign debt exposure, petitioner entered
into a debt-equity conversion transaction in 1987 as
follows: $12,577,136 of petitioner's blocked deposits
was exchanged for a 14.361-percent interest in a
Brazilian company. Petitioner agreed to maintain the
invested funds in Brazil for 12 years.
On its consolidated 1987 return, P claimed a
$4,577,136 loss with regard to the debt-equity conversion
transaction. In the notice of deficiency, respondent
disallowed petitioner's claimed loss on the grounds that
petitioner did not establish that any deductible loss was
sustained in 1987.
1. Held: The step transaction doctrine is not
applicable. The Central Bank converted the full face
value of petitioner's blocked deposits, plus accrued
interest, at the official exchange rate without
diminution or discount into cruzados, which were used to
pay a third party in exchange for its 14.361-percent
interest in the Brazilian company. The exchange of the
blocked deposits for the cruzados and the conversion of
the cruzados into stock was not a transitory step but
rather a substantive and significant element of the
conversion. Petitioner's loss, if any, is measured by
the difference between its basis in the blocked deposits
and the fair market value of the cruzados it received.
G.M. Trading Corp. v. Commissioner, 103 T.C. 59 (1994),
supplemented by 106 T.C. 257 (1996), on appeal (5th Cir.,
Oct. 4, 1996), followed. Petitioner did not realize a
loss because the basis of the blocked deposits and the
fair market value of the cruzados were identical on the
date of the transaction.
2. Held, further: The 12-year repatriation
restriction imposed on petitioner's invested funds
warrants a 15-percent discount on the fair market value
of the cruzados P received, rendering a $1,886,570 loss
for petitioner's 1987 tax year.
III.
In 1989, Norwest Financial Resources, one of
petitioner's affiliates, acquired the lease portfolio and
other assets of Financial Investment Associates, Inc.,
for $141,456,620. On its 1989 return, petitioner
allocated $131,513,038 of the $141,456,620 purchase price
to the lease portfolio. The purchase agreement provided
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that no part of the purchase price is attributable to
goodwill. In the notice of deficiency, respondent
determined that petitioner overstated the fair market
value of the lease portfolio by $1,328,618, which amount
should be allocated to goodwill, going-concern value, or
other nonamortizable intangible assets.
The parties presented experts who valued
petitioner's lease portfolio. The difference between the
experts' valuations centers around the different discount
rates they used (respondent's expert used a 15.6-percent
discount rate, while petitioner's expert used an 11.5-
percent discount rate).
Held: Giving consideration to all the evidence
presented, 13 percent is determined to be the appropriate
discount rate.
Mark Alan Hager, Joseph Robert Goeke, Thomas C. Durham, David
Farrington Abbott, William Albert Schmalzl, Glenn A. Graff, Daniel
A. Dumezich, and Scott Gerald Husaby, for petitioner.
Lawrence C. Letkewicz, Dana Hundrieser, and Gary J. Merken,
for respondent.
CONTENTS
Page
General Findings ......................................... 6
Issue I. Removal of Asbestos-Containing Materials ..... 6
A. The Douglas Street Building ............... 7
B. Remodeling Plans .......................... 7
C. Use of Asbestos-Containing Materials in
the Douglas Street Building ............... 8
D. Federal Asbestos Guidelines ............... 8
E. Testing at the Douglas Street Building and
Decision To Remove Asbestos-Containing
Materials ................................. 10
F. Contractors and Work Performed ............ 13
G. Health Concerns ........................... 15
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H. Liability Issues .......................... 16
I. Tax and Accounting Matters ................ 17
J. Petitioner's Returns and Petitions ........ 18
K. Notice of Deficiency ...................... 19
Discussion.................................... 19
L. Capital Expenditures vs. Current
Deductions ................................ 19
M. General Plan of Rehabilitation Doctrine ... 21
N. The Parties' Arguments .................... 23
O. Analysis .................................. 27
Issue II. Brazilian Debt-Equity Conversion ............. 29
A. The Brazilian Debt Crisis ................. 31
1. Deposit Facility Agreements and
Blocked Deposits ....................... 31
2. The Cruzado Plan ....................... 33
3. Moratorium on Interest ................. 34
B. Petitioner's Blocked Deposits ............. 34
C. Papel e Celulose Catarinense, S.A. ........ 36
1. PCC's Expansion Plans .................. 38
2. Petitioner's Internal Analysis of a PCC
Investment ............................. 39
3. Petitioner's Conclusions About the PCC
Investment ............................. 40
D. Steps Leading Up to the Conversion ........ 41
E. The Conversion Transaction ................ 42
F. Petitioner's Tax and Accounting Treatment
of the Conversion ...................... 45
G. Petitioner's Return and Petition .......... 46
H. Notice of Deficiency ...................... 47
I. Subsequent Events ......................... 47
Discussion ................................... 47
J. Respondent's Arguments .................... 47
K. Petitioner's Arguments .................... 50
L. Law and Analysis .......................... 52
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Issue III. Allocation of Purchase Price ................. 64
A. FIA ....................................... 64
B. Federal's Acquisition of FIA .............. 66
C. Petitioner's Acquisition of FIA ........... 67
D. Petitioner's 1989 Return .................. 71
E. Notice of Deficiency ...................... 71
Discussion ................................... 71
F. Residual Value ............................ 72
G. Expert Witnesses .......................... 73
1. Petitioner's Expert .................... 74
2. Respondent's Expert .................... 75
3. Critique of Experts .................... 77
H. Conclusion ................................ 80
OPINION
JACOBS, Judge: In docket No. 20567-93, respondent determined
deficiencies in petitioner's 1987 and 1988 Federal income taxes in
the respective amounts of $93,413 and $3,999,398, as well as
additional interest under section 6621(c) for 1988. Pursuant to an
amended answer filed on September 23, 1994, respondent increased
the amount of the 1988 deficiency to $4,644,201.
In docket No. 26213-93, respondent determined a deficiency in
petitioner's 1989 Federal income tax in the amount of $10,532,064.
Respondent increased the amount of the 1989 deficiency to
$22,757,717 pursuant to an answer filed on February 14, 1994, and
further increased the deficiency amount to $22,791,923 pursuant to
a September 22, 1994, amendment to answer.
These cases were consolidated for trial, briefing, and
opinion.
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The issues for decisions are:1 (1) Whether petitioner is
entitled to deduct the costs of removing asbestos-containing
materials from its Douglas Street bank building; (2) whether
petitioner realized a loss on a Brazilian debt-equity conversion;
and (3) whether any portion of the $141,456,620 petitioner paid to
acquire the assets of Financial Investment Associates, Inc., should
be allocated to goodwill, going-concern value, or other
nonamortizable intangible assets.
All section references are to the Internal Revenue Code in
effect for the years under consideration. All Rule references are
to the Tax Court Rules of Practice and Procedure.
For convenience and clarity, we have combined our findings of
fact and opinion with respect to each issue. Some of the facts
have been stipulated and are found accordingly. The stipulations
of facts and the attached exhibits are incorporated herein by this
reference.
General Findings
Norwest Corporation (hereinafter petitioner or Norwest), a
Delaware corporation, had its principal place of business in
Minneapolis, Minnesota, at the time the petitions were filed.
Norwest is the parent company of a group of corporations that filed
1
With the exception of certain issues relating to
foreign tax credits and petitioner's claim for additional
research credits, all other issues have been resolved.
The increased deficiencies asserted in the answers and
amended answers are not attributable to any issues before this
Court.
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consolidated corporate income tax returns for the years under
consideration (1987 through 1989). Petitioner reports its income on
a calendar-year basis, employing the accrual method of accounting.
Petitioner timely filed its U.S. Corporation Income Tax Returns for
1987, 1988, and 1989.
Issue I. Removal of Asbestos-Containing Materials
The first issue is whether petitioner is entitled to deduct
the costs of removing asbestos-containing materials from its
Douglas Street bank building. Petitioner argues that the
expenditures constitute section 162(a) ordinary and necessary
expenses. Respondent, on the other hand, contends that the
expenditures must be capitalized pursuant to section 263(a)(1).
Alternatively, respondent contends that the expenditures must be
capitalized pursuant to the "general plan of rehabilitation"
doctrine.
A. The Douglas Street Building
One of petitioner's subsidiaries, Norwest Bank Nebraska, N.A.
(Norwest Nebraska), owns a building at 1919 Douglas Street in
Omaha, Nebraska (the Douglas Street building or building). The
Douglas Street building is a three-story commercial office building
that occupies half a square block and has a lower level parking
garage. Norwest Nebraska constructed the building in 1969 at a
$4,883,232 cost. During all relevant periods, Norwest Nebraska
used the Douglas Street building as an operations center as well as
a branch for serving customers.
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B. Remodeling Plans
In 1985 and 1986, Norwest Nebraska consolidated its "back
room" operations at the Douglas Street building. Pursuant to that
process, Norwest Nebraska undertook to determine the most efficient
means for providing more space to accommodate the additional
operations personnel within the building. The planning process
indicated that the building needed a major remodeling. (The
building had not been remodeled since its construction; Norwest
Nebraska usually remodels its banks every 10 to 15 years.) Thus, by
the end of 1986, petitioner and Norwest Nebraska had decided to
completely remodel the Douglas Street building. In December 1986,
both petitioner and Norwest Nebraska approved a preliminary budget
of $2,738,000 for carpet, furniture, and improvements.
C. Use of Asbestos-Containing Materials in the Douglas Street
Building
The Douglas Street building was constructed with asbestos-
containing materials as its main fire-retardant material. (The
local fire code required that buildings contain fireproofing
material.) Asbestos-containing materials were sprayed on all
columns, steel I-beams, and decking between floors. The health
dangers of asbestos were not widely known when the Douglas Street
building was constructed in 1969, and asbestos-containing materials
were generally used in building construction in Omaha, Nebraska.
A commercial office building's ventilation system removes
existing air from a room through a return air plenum as new air is
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introduced. The returned air is subsequently recycled through the
building. The area between the decking and the suspended ceiling
in the Douglas Street building functioned as the return air plenum.
The top part of the return air plenum, the decking, was one of the
components of the building where asbestos-containing materials had
been sprayed during construction.
Over time, the decking, suspended ceiling tiles, and light
fixtures throughout the building became contaminated. This
contamination occurred because the asbestos-containing fireproofing
had begun to delaminate, and pieces of this material reached the
top of the suspended ceiling.
D. Federal Asbestos Guidelines
In the 1970's and 1980's, research confirmed that asbestos-
containing materials can release fibers that cause serious diseases
when inhaled or swallowed. Diseases resulting from exposure to
asbestos can reach the incurable stage before detection and can
cause severe disability or death. Asbestosis is a progressive and
disabling lung disease caused by inhaling asbestos fibers that
become lodged in the lungs. Persons exposed to asbestos may
develop lung cancer or mesothelioma, an extremely rare form of
cancer.
On March 29, 1971, the Environmental Protection Agency (EPA)
designated asbestos a hazardous substance. The parties have
stipulated that Federal, State, and local laws and regulations at
all relevant times did not require asbestos-containing materials to
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be removed from commercial office buildings if they could be
controlled in place. Nevertheless, building owners had to take
precautions against the release of asbestos fibers.
The presence of asbestos in a building does not necessarily
endanger the health of building occupants. The danger arises when
asbestos-containing materials are damaged or disturbed, thereby
releasing asbestos fibers into the air (when they can be inhaled).
The Department of Labor, Occupational Safety and Health
Administration (OSHA), has established standards and guidelines for
permissible levels of employee exposure to asbestos. Effective
July 21, 1986, the permissible exposure limit for employees was 0.2
fiber (longer than 5 micrometers) per cubic centimeter of air,
determined on the basis of an 8-hour time-weighted average. At
half of the permissible exposure limit (0.1 fiber per cubic
centimeter of air), employers are required to begin compliance
activities such as air monitoring, employee training, and medical
surveillance.
Moreover, the EPA has established standards and guidelines for
the general public's exposure to asbestos.2 The EPA-recommended
guideline for general occupancy and clearance of a building after
2
In assessing the potential for fiber release, the EPA
in 1985 recommended evaluating the current condition of asbestos-
containing materials based on evidence of: (1) Deterioration or
delamination; (2) physical damage (e.g., the presence of debris);
and (3) water damage as well as the potential for future
disturbance (based on proximity to air plenum or direct air
stream, visibility, accessibility and degree of activity, as well
as change in building use).
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construction activities involving asbestos-containing materials is
0.01 fiber per cubic centimeter of air.
Asbestos removal must be performed by specially trained
professionals wearing protective clothing and respirators. The
work area must be properly contained to prevent release of fibers
into other areas. Containment typically requires barriers of
polyethylene plastic sheets with folded seams, complete with air
locks and negative air pressure systems. Asbestos-containing
materials that are removed must be wetted to reduce fiber release.
Once removed, the materials must be disposed of in leak-tight
containers in special landfills.
E. Testing at the Douglas Street Building and Decision To
Remove Asbestos-Containing Materials
In October 1985, petitioner's general liability and property
damage insurer, the St. Paul Property and Liability Insurance Co.
(St. Paul), tested a bulk sample of fire-retardant material from
the Douglas Street building's steel I-beams to determine whether
the building contained asbestos. The results indicated that the
material contained 8 to 10 percent chrysotile asbestos, the most
common type of asbestos.
Petitioner obtained its umbrella insurance policies through
Marsh & McLennan, which provided coverage over and above the St.
Paul policies. In January 1987, at Marsh & McLennan's request,
Clayton Environmental Consultants, Inc. (Clayton), conducted more
extensive testing for the presence of asbestos at Norwest
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facilities in South Dakota and Nebraska, including the Douglas
Street building. On February 9, 1987, petitioner received
notification that the January testing indicated that the sprayed-on
fireproofing contained 8 to 10 percent chrysotile asbestos and the
ceiling tiles on the parking level contained 26-percent chrysotile
asbestos. This confirmed the St. Paul results.
At the request of Marsh & McLennan, Clayton conducted
extensive additional testing for airborne asbestos-fiber
concentrations in the Douglas Street building. On February 25,
1987, Clayton collected air samples from the building. On April
14, 1987, it issued the results of its survey, which indicated that
the airborne asbestos fiber concentrations present during normal
occupancy of the Douglas Street building ranged from 0.0002 to
0.006 fiber per cubic centimeter of air. The highest level of
airborne fiber concentration at the Douglas Street building (0.006
fiber per cubic centimeter of air) did not exceed either the EPA or
OSHA guidelines. There was, however, the expectation that the
airborne asbestos-fiber concentrations would continue to increase.
Moreover, the asbestos-containing fireproofing at the Douglas
Street Building had characteristics that the EPA had identified as
warranting removal of the material, such as evidence of
delamination, presence of debris, proximity to an air plenum, and
necessity of access for maintenance.
After considering the circumstances, petitioner decided to
remove the asbestos-containing materials from the Douglas Street
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building (other than the parking garage) in coordination with the
overall remodeling project. Indeed, the remodeling could not have
been undertaken without disturbing the asbestos-containing
fireproofing. Thus, because petitioner and Norwest Nebraska chose
to remodel, it became a matter of necessity to remove the asbestos-
containing materials. Petitioner essentially decided that
"managing the asbestos in place" was not a viable option, given the
extent of remodeling that would disturb the asbestos.
Removing the asbestos-containing materials from the Douglas
Street building at the same time as, and in connection with, the
remodeling was more cost efficient than conducting the removal and
renovations as two separate projects at different times. It also
minimized the amount of inconvenience to building employees and
customers.
As late as May 1988 (approximately 6 months after asbestos
removal began) petitioner and Norwest Nebraska did not intend to
remove the parking garage asbestos-containing materials. No
remodeling was planned for the garage, and the materials were in
sound condition. However, petitioner and Norwest Nebraska
subsequently decided to remove the garage asbestos-containing
materials as well, on the basis of their expectation that the
garage tiles would eventually deteriorate, as well as the fact that
it was financially advantageous to conduct this removal in
connection with the ongoing abatement activity.
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F. Contractors and Work Performed
On August 4, 1987, Norwest Nebraska hired Hawkins Construction
Co. (Hawkins), as general contractor, to perform the remodeling
work at the Douglas Street building. On November 30, 1987, Norwest
Nebraska hired Waste Environmental Technology (WET) to remove the
asbestos-containing materials from the building. Norwest Nebraska
also hired ATC Environmental, Inc., to perform on-site air
monitoring during all asbestos-abatement activities at the
building.
WET declared bankruptcy in 1988 and could not complete the
project. On December 5, 1988, Norwest Nebraska hired Michael T.
Robinson Associates, Inc. (Robinson), to replace WET and complete
removal of the asbestos-containing materials from the Douglas
Street building. At that time, Norwest Nebraska also replaced ATC
Environmental, Inc., with Chart Services, Ltd.
The asbestos removal and remodeling were basically performed
in 13 phases; each phase involved a defined area of the Douglas
Street building. For each phase, the asbestos-removal contractor
removed the asbestos-containing materials before the general
contractor began remodeling. After setting up a containment area,
the asbestos removal contractor physically removed the walls,
floors, ceilings, and light fixtures, where necessary, to reach and
remove the asbestos-containing materials. Once all the asbestos-
containing materials had been removed from an area, the air was
tested for airborne-fiber concentration before the containment
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could be taken down and the general contractor could begin
remodeling.
Removing all the asbestos-containing materials from the
Douglas Street building was a large project, entailing an enormous
amount of work. Nearly every suspended ceiling and light fixture
on all four levels of the building had to be taken down. Asbestos-
containing materials were removed from the entire building.
The asbestos fireproofing in the Douglas Street building was
replaced with Cafco,3 a mineral wool material. The ceiling tiles
on the Farnam4 parking level, as well as the floor tiles in the
customer lobbies, were replaced with new, asbestos-free materials.
Hawkins' subcontractors installed the replacement fireproofing and
tiling.
Norwest Nebraska representatives, the asbestos-removal
contractor, Hawkins, and Hawkins' subcontractors held meetings on
a regular basis to coordinate the schedule for the remodeling work
with the asbestos removal work. Petitioner had a financial interest
in ensuring that the asbestos removal work was performed in a
timely fashion and was properly coordinated with the remodeling
work. (Delays caused by the asbestos-removal contractor resulted
3
At all relevant times, Cafco was not known to present
any health hazards.
4
Farnam is one of the streets adjacent to the Douglas
Street building.
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in additional costs to Hawkins, which passed those costs on to
petitioner.)
The removal of the asbestos-containing materials from the
Douglas Street building was substantially completed by the end of
May 1989. Following completion, Norwest Nebraska learned that the
two elevator lobbies in the parking garage contained vinyl asbestos
floor tile. Petitioner hired Technical Asbestos Control to remove
and replace these tiles.
The removal of the asbestos-containing materials from the
Douglas Street building did not extend the building's useful life.
G. Health Concerns
In addition to removing the asbestos-containing materials on
account of the remodeling, petitioner also considered the health
and welfare of its employees and customers. Even though the level
of airborne asbestos fiber concentrations in the Douglas Street
building did not exceed OSHA or EPA standards for exposure, the
presence of asbestos-containing materials in the return air plenum
nonetheless increased the possibility for release of asbestos
fibers into the air: (1) The flow of air through the return air
plenum made surface erosion of the asbestos-containing materials
more likely; (2) the asbestos-containing materials had already
started to delaminate or flake off, which was almost certain to
become progressively worse; and (3) the necessity for working above
the suspended ceiling in the return air plenum to replace light
fixtures or computer cables created greater chances for disturbance
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of the asbestos-containing materials, and made routine maintenance
more expensive.
Petitioner intended to create a safer and healthier
environment for the building employees by removing the asbestos-
containing materials.5 The building indeed became safer after the
asbestos-containing materials were removed.
H. Liability Issues
By removing the asbestos-containing materials from the Douglas
Street building, petitioner also intended to avoid or minimize its
potential liability for damages from injuries to employees,
customers, and workers resulting from asbestos exposure.
Petitioner's general liability insurance policies in effect at all
relevant times contained an exclusion for damages attributable to
the discharge of pollutants. Such exclusion would include the
circulation of asbestos fibers through the Douglas Street
building's ventilation system. Some of petitioner's umbrella
insurance policies contained an additional endorsement specifically
excluding liability for damages caused by asbestos exposure.
Injuries to Douglas Street building employees arising out of,
and in the course of, their employment are not covered under
petitioner's general liability or umbrella insurance policies.
5
Before the asbestos removal and remodeling work began,
John Cochran, president of Norwest Nebraska, wrote a memorandum
dated Oct. 28, 1987, to the Douglas Street building employees,
assuring them that Norwest Nebraska wanted their work environment
to be safe.
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Workmen's compensation insurance is the only coverage available for
such injuries. It is unclear whether damages for injuries to the
employees resulting from exposure to asbestos would be covered by
workmen's compensation insurance. Nevertheless, petitioner was,
and continues to be, at risk with respect to asbestos damage claims
brought by Douglas Street building employees.
Furthermore, by removing the asbestos-containing materials
from the building, petitioner intended to avoid or minimize a
potential increase in its premiums for workmen's compensation
insurance. If asbestos damage claims filed by Douglas Street
building employees were, in fact, covered by workmen's compensation
insurance, the increase in petitioner's premiums could be sizable,
depending on the volume and magnitude of such claims.
I. Tax and Accounting Matters
The total cost of renovating the Douglas Street building was
close to $7 million, comprising nearly $4,998,749 in remodeling
costs and approximately $1.9 million6 in asbestos removal costs.
6
According to a schedule petitioner prepared, entitled
"Norwest Bank Nebraska N.A.--Payments Related to the Asbestos
Abatement", petitioner's costs of removing the asbestos-
containing materials from the Douglas Street building were as
follows:
Year Amount
1987 $ 175,095.00
1988 861,471.30
1989 881,769.77
Total 1,918,336.07
(continued...)
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Petitioner considered the cost of all demolition done by the
asbestos removal contractors (including the cost of removing the
asbestos tiles) as a removal cost for both book and tax purposes.
Petitioner considered the cost of any demolition done by the
general contractor or one of the subcontractors a remodeling cost
for both book and tax purposes.
All construction-related remodeling costs were added to the
basis of the building and depreciated on a straight-line basis over
31.5 years. The portion of the remodeling costs for furniture and
fixtures was written off over 7 years.
J. Petitioner's Returns and Petitions
On its 1987 and 1988 returns, petitioner claimed neither
depreciation nor ordinary deductions with respect to the costs of
removing the asbestos-containing materials from the Douglas Street
building. On its 1989 return, however, petitioner claimed a $7,696
depreciation deduction and a $902,206 ordinary and necessary
business deduction with respect to such expenditures.
Petitioner asserts in its petitions that it properly deducted
the $902,206 on its 1989 return. In addition, petitioner claims
6
(...continued)
Respondent agrees that these amounts properly represent the
asbestos removal costs, except for $2,836.61 paid on Apr. 7,
1989, in settlement of a lien filed by a materialman.
We note, however, that petitioner's general ledger reflects
a $1,945,816 total incurred for the asbestos removal between 1987
and 1989. This amount does not include the cost of replacing the
asbestos-containing materials with asbestos-free materials.
There is no explanation in the record for the discrepancy between
the $1,918,336.07 and the $1,945,816.
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that it is also entitled to ordinary and necessary business
deductions for the costs of removing the asbestos-containing
materials from the Douglas Street building for tax years 1987 and
1988 in the respective amounts of $175,095 and $863,764 (which
amounts, petitioner claims, were inadvertently omitted from its
1987 and 1988 returns).
K. Notice of Deficiency
In the notice of deficiency, respondent disallowed
petitioner's $902,206 ordinary and necessary deduction for
asbestos-removal expenditures.
Discussion
At issue is whether petitioner's costs of removing the
asbestos-containing materials are currently deductible pursuant to
section 162 or must be capitalized pursuant to section 263 or as
part of a general plan of rehabilitation.
L. Capital Expenditures vs. Current Deductions
Section 263 requires taxpayers to capitalize costs incurred
for permanent improvements, betterments, or restorations to
property. In general, these costs include expenditures that add to
the value or substantially prolong the life of the property or
adapt such property to a new or different use. Sec. 1.263(a)-1(b),
Income Tax Regs. In contrast, section 162 permits taxpayers to
currently deduct the costs of ordinary and necessary expenses
(including incidental repairs) that neither materially add to the
value of property nor appreciably prolong its life but keep the
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property in an ordinarily efficient operating condition. See sec.
1.162-4, Income Tax Regs.
Deductions are exceptions to the norm of capitalization.
INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). An income
tax deduction is a matter of legislative grace; the taxpayer bears
the burden of proving its right to a claimed deduction. Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
In Illinois Merchants Trust Co. v. Commissioner, 4 B.T.A. 103,
106 (1926), which involved the cost of shoring up a wall and
repairing a foundation needed to prevent a building from
collapsing, the Board of Tax Appeals drew the following
distinctions:
To repair is to restore to a sound state or to
mend, while a replacement connotes a
substitution. A repair is an expenditure for
the purpose of keeping the property in an
ordinarily efficient operating condition. * *
* Expenditures for that purpose are
distinguishable from those for replacements,
alterations, improvements or additions which
prolong the life of the property, increase its
value, or make it adaptable to a different use.
The one is a maintenance charge, while the
others are additions to capital investment
which should not be applied against current
earnings. * * *
The distinction between repairs and capital improvements has also
been characterized as follows:
"The test which normally is to be applied
is that if the improvements were made to 'put'
the particular capital asset in efficient
operating condition, then they are capital in
nature. If, however, they were made merely to
'keep' the asset in efficient operating
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condition, then they are repairs and are
deductible."
Moss v. Commissioner, 831 F.2d 833, 835 (9th Cir. 1987), revg. T.C.
Memo. 1986-128 (quoting Estate of Walling v. Commissioner, 373 F.2d
190, 192-193 (3d Cir. 1967), revg. and remanding 45 T.C. 111(1965)).
The Court in Plainfield-Union Water Co. v. Commissioner, 39
T.C. 333, 338 (1962), articulated a test for determining whether an
expenditure is capital by comparing the value, use, life expectancy,
strength, or capacity of the property after the expenditure with the
status of the property before the condition necessitating the
expenditure arose (the Plainfield-Union test). Moreover, the
Internal Revenue Code's capitalization provision envisions an
inquiry into the duration and extent of the benefits realized by the
taxpayer. See INDOPCO, Inc. v. Commissioner, supra at 88.
Whether an expense is deductible or must be capitalized is a
factual determination. Plainfield-Union Water Co. v. Commissioner,
supra at 337-338. Courts have adopted a practical case-by-case
approach in applying the principles of capitalization and
deductibility. Wolfsen Land & Cattle Co. v. Commissioner, 72 T.C.
1, 14 (1979). The decisive distinctions between current expenses and
capital expenditures "are those of degree and not of kind." Welch
v. Helvering, supra at 114.
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M. General Plan of Rehabilitation Doctrine
Expenses incurred as part of a plan of rehabilitation or
improvement must be capitalized even though the same expenses if
incurred separately would be deductible as ordinary and necessary.
United States v. Wehrli, 400 F.2d 686, 689 (10th Cir. 1968);
Stoeltzing v. Commissioner, 266 F.2d 374 (3d Cir. 1959), affg. T.C.
Memo. 1958-111; Jones v. Commissioner, 242 F.2d 616 (5th Cir. 1957),
affg. 24 T.C. 563 (1955); Cowell v. Commissioner, 18 B.T.A. 997(1930). Unanticipated expenses that would be deductible as
business expenses if incurred in isolation must be capitalized when
incurred pursuant to a plan of rehabilitation. California Casket
Co. v. Commissioner, 19 T.C. 32 (1952). Whether a plan of capital
improvement exists is a factual question "based upon a realistic
appraisal of all the surrounding facts and circumstances, including,
but not limited to, the purpose, nature, extent, and value of the
work done". United States v. Wehrli, supra at 689-690.
An asset need not be completely out of service or in total
disrepair for the general plan of rehabilitation doctrine to apply.
For example, in Bank of Houston v. Commissioner, T.C. Memo. 1960-
110, the taxpayer's 50-year-old building was in "a general state of
disrepair" but still serviceable for the purposes used (before,
during, and after the work) and was in good structural condition.
The taxpayer hired a contractor to perform the renovation (which
included nonstructural repairs to flooring, electrical wiring,
-24-
plaster, window frames, patched brick, and paint, as well as
plumbing repairs, demolition, and cleanup). Temporary barriers and
closures were erected during work in progress. The Court recognized
that each phase of the remodeling project, removed in time and
context, might be considered a repair item, but stated that "The
Code, however, does not envision the fragmentation of an over-all
project for deduction or capitalization purposes." The Court held
that the expenditures were not made for incidental repairs but were
part of an overall plan of rehabilitation, restoration, and
improvement of the building.
N. The Parties' Arguments
Petitioner contends that the costs of removing the asbestos-
containing materials are deductible as ordinary and necessary
business expenses because: (1) The asbestos removal constitutes
"repairs"7 within the meaning of section 1.162-4, Income Tax Regs.;
(2) the asbestos removal did not increase the value of the Douglas
Street building when compared to its value before it was known to
contain a hazardous substance--a hazard was essentially removed and
the building's value was restored to the value existing prior to the
discovery of the concealed hazard;8 (3) although performed
7
Petitioner states in its opening brief that "The law
recognizes that removing an unsafe condition is a repair rather
than an improvement", citing Schmid v. Commissioner, 10 B.T.A.
1152 (1928).
8
Petitioner introduced the reports and testimony of two
expert witnesses concerning the impact of the asbestos removal
(continued...)
-25-
concurrently, the asbestos removal and remodeling were not part of
a general plan of rehabilitation because they were separate and
distinct projects, conceived of independently, undertaken for
different purposes, and performed by separate contractors; and (4)
using the principles of section 213 (which allows individuals to
deduct certain personal medical expenses that are capital in nature)
and section 1.162-10, Income Tax Regs. (which allows a trade or
business to deduct medical expenses paid to employees on account of
sickness), the cost of removing a health hazard is deductible under
section 162.9
Respondent, on the other hand, contends that the costs of
removing the asbestos-containing materials must be capitalized
because: (1) The removal was neither incidental nor a repair;10 (2)
8
(...continued)
costs on the value of the Douglas Street building. These experts
opined that the discovery of asbestos as a health hazard in
combination with the extent of asbestos present in the building
resulted in an immediate diminution in the value of the building.
(One of the experts testified that the building would be
appraised as if it did not contain asbestos, and then the amount
it would cost to repair the condition would be deducted from the
appraisal.) The expert testimony supports petitioner's argument
that the asbestos removal merely restored the original value of
the building (i.e., without hazardous fireproofing) but did not
enhance its value.
9
Petitioner also relies on Rev. Rul. 79-66, 1979-1 C.B.
114, which allows, under limited circumstances, a sec. 213
deduction for an individual taxpayer's costs of removing and
covering lead-based paint in a personal residence, to the extent
the costs exceed the increase in the residence's value.
10
Respondent contends that petitioner's reliance on
Schmid v. Commissioner, supra, is misplaced. The Board of Tax
(continued...)
-26-
petitioner made permanent improvements that increased the value of
the property11 by removing a major building component and replacing
it with a new and safer component, thereby improving the original
condition of the building; (3) petitioner permanently eliminated the
asbestos hazard that was present when it built the building,
creating safer and more efficient operating conditions and reducing
the risk of future asbestos-related damage claims and potentially
higher insurance premiums; (4) the asbestos removal and the
remodeling were part of a single project to rehabilitate and improve
the building; (5) the purpose of the expenditure was not to keep the
property in ordinarily efficient operating condition, but to effect
a general restoration of the property as part of the remodeling; and
(6) section 213 and section 1.162-10, Income Tax Regs., are not
analogous to the present case.
The parties also disagree as to whether the Plainfield-Union
test is appropriate for determining whether petitioner's asbestos
removal expenditures are capital. Petitioner contends that it is
the appropriate test because the condition necessitating the
10
(...continued)
Appeals held that the funds expended by the taxpayer in that case
were to "maintain * * * [a store] in a safe condition and may be
properly classified as repairs and deductible as an expense." 10
B.T.A. at 1152. Respondent posits that the operative word
leading to the Board of Tax Appeals' classification of the
taxpayer's expenditures as deductible repair expenses was
"maintain", and not the words "safe condition", as petitioner
suggests.
11
Respondent did not introduce any expert testimony
concerning the value of the Douglas Street building.
-27-
asbestos removal was the discovery that asbestos is hazardous to
human health. Accordingly, until the danger was discovered,
petitioner argues that the physical presence of the asbestos had no
effect on the building's value. Only after the danger was perceived
could the contamination affect the building's operations and reduce
its value.12
Petitioner points to Rev. Rul. 94-38, 1994-1 C.B. 35, which
cites Plainfield-Union in addressing the proper treatment of costs
to remediate soil and treat groundwater that a taxpayer had
contaminated with hazardous waste from its business. The ruling
treats such costs (other than those attributable to the construction
of groundwater treatment facilities) as currently deductible.
Respondent, on the other hand, argues that the discovery that
asbestos is hazardous and that the Douglas Street building contained
that substance is not a relevant or satisfactory reference point.
Respondent contends that the Plainfield-Union test does not apply
herein because a comparison cannot be made between the status of the
building before it contained asbestos and after the asbestos was
removed; since construction, the building has always contained
asbestos. In cases where the Plainfield-Union test has been applied
(such as Oberman Manufacturing Co. v. Commissioner, 47 T.C. 471, 483
(1967); American Bemberg Corp. v. Commissioner, 10 T.C. 361, 370
12
In its reply brief, petitioner states: "While in a
metaphysical sense the Douglas Street Building may have been
contaminated in 1970, such contamination had no discernable
impact until the hazard became known."
-28-
(1948), affd. 177 F.2d 200 (6th Cir. 1949); and Illinois Merchants
Trust Co. v. Commissioner, 4 B.T.A. 103 (1926)), respondent
continues, the condition necessitating the repair resulted from a
physical change in the property's condition. In this case, no
change occurred to the building's physical condition that
necessitated the removal expenditures. The only change was in
petitioner's awareness of the dangers of asbestos. Accordingly,
respondent argues that the Plainfield-Union test is inapplicable,
and the Court must examine other factors to determine whether an
increase in the building's value occurred.
Respondent also disagrees with petitioner's reliance on Rev.
Rul. 94-38, supra, arguing that the present facts are
distinguishable. The remediated property addressed in the ruling
was not contaminated by hazardous waste when the taxpayer acquired
it. The ruling permits a deduction only for the costs of
remediating soil and water whose physical condition has changed
during the taxpayer's ownership of the property. Under this
analysis, the taxpayer is viewed as restoring the property to the
condition existing before its contamination. Thus, respondent
contends, unlike Rev. Rul. 94-38, petitioner's expenditures did not
return the property to the same state that existed when the property
was constructed because there was never a time when the building was
asbestos free. Rather, the asbestos-abatement costs improved the
property beyond its original, unsafe condition.
-29-
O. Analysis
We believe that petitioner decided to remove the asbestos-
containing materials from the Douglas Street building beginning in
1987 primarily because their removal was essential before the
remodeling work could begin. The extent of the asbestos-containing
materials in the building or the concentration of airborne asbestos
fibers was not discovered until after petitioner decided to remodel
the building and a budget for the remodeling had been approved.
Because petitioner's extensive remodeling work would, of necessity,
disturb the asbestos fireproofing, petitioner had no practical
alternative but to remove the fireproofing. Performing the asbestos
removal in connection with the remodeling was more cost effective
than performing the same work as two separate projects at different
times. (Had petitioner remodeled without removing the asbestos
first, the remodeling would have been damaged by subsequent asbestos
removal, thereby creating additional costs to petitioner.) We
believe that petitioner's separation of the removal and remodeling
work is artificial and does not properly reflect the record before
us.
The parties have stipulated that the asbestos removal did not
increase the useful life of the Douglas Street building. We
recognize (as did petitioner) that removal of the asbestos did
increase the value of the building compared to its value when it was
known to contain a hazard. However, we do not find, as respondent
advocates, that the expenditures for asbestos removal materially
-30-
increased the value of the building so as to require them to be
capitalized. We find, however, that had there been no remodeling,
the asbestos would have remained in place and would not have been
removed until a later date. In other words, but for the remodeling,
the asbestos removal would not have occurred.13
The asbestos removal and remodeling were part of one
intertwined project, entailing a full-blown general plan of
rehabilitation, linked by logistical and economic concerns. "A
remodeling project, taken as a whole, is but the result of various
steps and stages." Bank of Houston v. Commissioner, T.C. Memo.
1960-110.14 In fact, removal of the asbestos fireproofing in the
Douglas Street building was "part of the preparations for the
remodeling project." See id. Before remodeling could begin, nearly
every ceiling light fixture in the building was ripped down and
crews removed all the asbestos-containing materials that had been
sprayed on the columns, I-beams, and decking between floors, as well
as the floor tiles in the customer lobbies. Only then could the
remodeling contractor perform its work. As described above, the
13
While no remodeling was done in the parking garage, the
record indicates that it was financially advantageous to remove
the asbestos-containing materials in the parking garage at the
same time as the abatement activity throughout the building.
14
Petitioner attempts to distinguish Bank of Houston v.
Commissioner, T.C. Memo. 1960-110, from the present case by
arguing that only one contractor was used in Bank of Houston
while it used two. We do not find that distinction to be of any
significance. Two different contractors were necessary in this
case because removing the asbestos-containing materials required
special skills that the remodeling contractor did not possess.
-31-
entire project required close coordination of the asbestos removal
and remodeling work.
Clearly, the purpose of removing the asbestos-containing
materials was first and foremost to effectuate the remodeling and
renovation of the building. Secondarily, petitioner intended to
eliminate health risks posed by the presence of asbestos15 and to
minimize the potential liability for damages arising from injuries
to employees and customers.
In sum, based on our analysis of all the facts and
circumstances, we hold that the costs of removing the asbestos-
containing materials must be capitalized because they were part of
a general plan of rehabilitation and renovation that improved the
Douglas Street building.
Issue II. Brazilian Debt-Equity Conversion
The second issue is whether petitioner realized a loss on a
1987 Brazilian debt-equity conversion.16 According to petitioner,
the debt-equity conversion should be viewed under the step
transaction doctrine as an exchange of petitioner's blocked deposits
at the Central Bank of Brazil (with a basis of $12,577,136) for
15
We reject petitioner's argument regarding sec. 213,
sec. 1.162-10, Income Tax Regs., and Rev. Rul. 79-66, 1979-1 C.B.
114. These provisions and ruling cannot convert the costs of
removing the asbestos-containing materials into current
deductions simply because petitioner's "concerns for the health
and welfare of its employees" partially motivated the removal.
16
A "debt-equity conversion" is also commonly referred to
as a "debt-equity swap".
-32-
stock in a Brazilian company (with a fair market value of
$5,544,000). Consequently, the conversion produces a $7,033,136
loss. By utilizing the step transaction doctrine, petitioner
essentially ignores the conversion of the Brazilian debt into
cruzados and simultaneously the payment of the cruzados for the
stock.
Respondent, on the other hand, asserts that the step
transaction doctrine is inapplicable to petitioner's debt-equity
conversion. According to respondent, we should view the transaction
as an exchange of petitioner's blocked deposits for cruzados, which
were then used to purchase stock in a Brazilian company. Based on
this scenario, petitioner would recognize a loss on the exchange of
the debt for the cruzados only to the extent its adjusted basis in
the debt exceeded the fair market value of the cruzados. Respondent
contends that there was no excess (and thus, no loss) in this case:
petitioner exchanged blocked deposits with a $12,577,136 basis for
cruzados with a $12,577,136 fair market value. As an alternative
position, respondent claims that, assuming arguendo petitioner did
realize a loss, the loss did not exceed 10 percent of the
investment, or approximately $1.25 million.
A. The Brazilian Debt Crisis
In the late 1970's, Latin American countries borrowed heavily
abroad. As part of its response to higher world oil prices, the
Brazilian Government embarked on a major program of import-
substituting industrialization. This development strategy involved
-33-
the potential risk of higher external indebtedness. The extensive
borrowing made Brazil vulnerable when international interest rates
rose sharply in the early 1980's. It was difficult for Brazil to
maintain sufficient foreign currency (such as the U.S. dollar) to
repay its foreign debts.
In 1982, Mexico announced that it could not meet external debt
payments and declared a moratorium on its external indebtedness.
A general cutback in credit to most Latin American nations,
including Brazil, followed.
1. Deposit Facility Agreements and Blocked Deposits
Brazil attempted to deal with its debt problems by negotiating
with its foreign creditors to reschedule its indebtedness. The
negotiations resulted in various agreements including the 1983 and
1984 Deposit Facility Agreements (DFA's), and a 1986 amendment to
the 1984 DFA (the 1986 DFA). Under the terms of these agreements,
the principal amount of the loans made by international banks to
Brazilian financial institutions maturing in 1983, 1984, and 198617
would not be paid to creditors outside Brazil but rather would be
deposited with the Central Bank of Brazil (the Central Bank)18 in
dollar-denominated accounts on behalf of the respective creditors.
17
Despite the lack of a formal renewal, this arrangement
was continued into 1985.
18
The Central Bank is the principal banking regulatory
agency in Brazil, as well as the agency in charge of implementing
and enforcing national monetary policy, regulating money supply,
and controlling foreign exchange.
-34-
These were called "blocked deposits". Under the DFA's and the 1986
DFA, the payment terms of the deposits were also rescheduled.
Moreover, under the terms of these agreements, blocked deposits
relating to loans maturing in 1983, 1984, and 1985 could be re-lent
by the creditors to borrowers in Brazil. Blocked deposits for loans
maturing in 1986 (such as the deposits at issue herein) could not
be re-lent but could be used for equity investments in Brazilian
companies. This type of transaction is called a "debt-equity
conversion". In a debt-equity conversion transaction, non-Brazilian
currency-denominated blocked deposits at the Central Bank are
exchanged for cruzados at the official exchange rate, and thereafter
the cruzados are used as payment for equity interests in Brazilian
companies, subject to Central Bank guidelines and pursuant to the
DFA's and the 1986 DFA. Such a transaction can take place only after
negotiations with and agreement by the Central Bank.
Blocked deposits at the Central Bank were bought and sold on
a secondary market at a discount to their face amounts. This
secondary market originally reflected rates at which banks exchanged
debt of one country against that of another, attempting to diversify
their portfolios. Ultimately, the transactions on the secondary
market involved sales of all types of claims by banks wishing to
clear their portfolios of the specific loans. Throughout most of
1986, Brazilian debt was trading in the secondary market at 75 cents
on the dollar, declining to 63 cents by April 14, 1987 (the date of
-35-
the transaction herein, discussed infra). In April 1987, the
majority of Brazilian debt was not traded on the secondary market.
The Brazilian Government did not have access to the secondary
market because the debt restructuring agreements (such as the DFA's)
had sharing clauses requiring the recipient of any payments to share
the proceeds with all of the other creditors that were parties to
such agreements.
2. The Cruzado Plan
In February 1986, Brazil adopted the "Cruzado Plan" as part of
an economic stabilization program to reduce the country's high
inflation. A price freeze took effect, and the cruzado replaced the
cruzeiro as Brazil's currency on February 28, 1986. The exchange was
made at one cruzado (Cz$) to 1,000 cruzeiros.19 Brazilian currency
was not freely exchangeable through official Brazilian channels into
non-Brazilian currency. The Cruzado Plan was collapsing by late
1986.
3. Moratorium on Interest
On February 20, 1987, Brazil declared a moratorium on the
payment of interest on its external indebtedness. In response to
19
On Feb. 28, 1986, the official exchange rate of
cruzados to U.S. dollars was set at $1 to Cz$13.84. The 1986
average official exchange rate was $1 to Cz$13.654.
The official rate was the dominant exchange rate in Brazil.
A "parallel" rate also existed (which was published in Brazilian
newspapers) but was technically illegal, and none of the hundreds
of Brazil's creditors, including petitioner, could exchange
blocked deposits for cruzados in the parallel market. The spread
between the official rate and parallel rate typically was
approximately 30 percent.
-36-
this declaration, some U.S. banks, including petitioner, announced
that they would place a portion of their Brazilian loans on
nonaccrual status, recording interest income on such loans only as
payments were received. By November 1987, Brazil resumed partial
interest payments on its external indebtedness.
B. Petitioner's Blocked Deposits
Petitioner's subsidiary, Norwest Bank Minneapolis, N.A. (NBM),
owned blocked deposits at the Central Bank in 1986 and 1987.20 As
described above, these deposits consisted of principal repayments
of dollar-denominated loans previously made to Brazil in the
ordinary course of NBM's banking business. The Central Bank
prevented petitioner from repatriating these deposits because Brazil
had insufficient hard currency (U.S. dollars) to make payments on
the loans. At petitioner's election, the blocked deposits accrued
interest at the U.S. domestic rate.
In late 1986, petitioner began investigating the possibility
of using some of its Brazilian blocked deposits to make an equity
investment in a Brazilian company. Darin P. Narayana managed
international banking for Norwest at this time and was in charge of
petitioner's Brazilian blocked deposits. A debt-equity conversion
became attractive to petitioner because it would: (1) Allow
petitioner to regain control over some assets by placing them
20
Because NBM was a subsidiary of petitioner, for
convenience we sometimes refer to petitioner as owner of the
blocked deposits.
-37-
outside of Brazil's debt-restructuring process; (2) increase the
probability of repayment of a portion of its outstanding Brazilian
loans; and (3) reduce petitioner's obligation to make new loans to
Brazil sufficient to pay at least part of the interest due on old
loans.
At this time (and until July 1987), Brazil's policies favored
debt-equity conversion transactions. Creditors were permitted to
use 1986 deposits to invest in Brazilian companies. If a creditor
decided to make such an investment, the Central Bank converted 100
percent of the face value21 of the deposits, plus accrued interest,
into cruzados at the official exchange rate. Pursuant to Central
Bank Circular 1.492 (the implementing measure concerning debt-equity
conversions), the creditor and the company in which it was investing
pledged "to keep the converted sums in Brazil for the minimum period
that may be established." The debt-equity conversion policies
benefited Brazil by allowing it to extinguish its foreign debt by
the amount of the debt converted, thereby eliminating its foreign
exchange obligation with respect to that portion of its debt.
The equity investment acquired as a result of a debt-equity
conversion was registered at the Central Bank as registered foreign
capital in the currency originally brought into Brazil by the
creditor. The amount registered could be increased annually by the
amount of retained earnings. Registration entitled the creditor to
21
In July 1987, the Central Bank ended the practice of
converting blocked deposits at full face value.
-38-
remit profits and capital outside Brazil at the official exchange
rate, avoid or reduce supplementary withholding taxes and, upon the
ultimate sale of the investment, remit the proceeds of the sale free
of tax up to the amount of registered foreign capital. In February
1987, when Brazil declared a temporary moratorium on interest
payments on its debt, foreign investors possessing a certificate of
registration were still able to receive dividends outside Brazil at
the official exchange rate.
Petitioner had several options with respect to its 1986 blocked
deposits:22 (1) Hold the blocked deposits and participate in the
debt restructuring process; (2) sell the deposits on the secondary
market to another party; or (3) convert the deposits into an equity
interest in a Brazilian company pursuant to the Central Bank's debt-
equity conversion program. The only options that would reduce
petitioner's blocked deposit holdings and decrease its foreign debt
exposure were selling the debt on the secondary market for cash or
swapping the debt for equity in a Brazilian company.
C. Papel e Celulose Catarinense, S.A.
Petitioner decided to engage in a debt-equity conversion and
in that regard began examining investment possibilities in Brazilian
companies. In November 1986, petitioner received an Information
22
Petitioner could only use 1986 deposits to participate
in the debt-equity conversion at issue in this case. These
deposits were governed by the 1984 and 1986 DFA's.
-39-
Memorandum23 regarding a Brazilian company, Papel e Celulose
Catarinense, S.A. (PCC), prepared by Banco Bozano, Simonsen de
Investimento, S.A. (Banco Bozano) and Morgan Grenfell & Co., Ltd.24
The International Finance Corporation (IFC),25 a World Bank
affiliate, engaged these firms to market its 28.7-percent interest
in PCC.26 IFC's asking price for its 28.7-percent interest in PCC
was $25 million.
PCC, headquartered in San Paulo, was a subsidiary of Industrias
Klabin Papel e Celulose, S.A. (IKPC), a Brazilian corporation
incorporated in 1934. IKPC was the largest pulp and paper producer
in South America and among the 100 largest in the world. Prior to
the transaction at issue herein, PCC's stock was owned as follows:
IKPC--70.9 percent; IFC--28.7 percent; and PCC's Administration
23
The Information Memorandum did not by its terms limit
the offering to prospective purchasers who intended to engage in
a debt-equity conversion.
24
At the time petitioner was considering an investment in
PCC, it was also reviewing a possible investment in Medtronic do
Brazil, as well as the purchase of Mellon Bank's 12.5-percent
interest in Banco Bozano.
25
IFC aids in the development of private sector projects
in developing countries, such as providing "seed capital" to
private ventures and projects. IFC focuses its assistance on
those projects which, while economically and financially
attractive, cannot by themselves attract enough managerial,
technical, or financial resources to be implemented. Once these
projects reach success and maturity, IFC expects to divest and
redeploy its assets to assist the development of new attractive
ventures.
26
PCC was IFC's oldest equity investment, dating back to
the late 1960's. By 1986, IFC had decided that PCC's operational
and financial maturity warranted the sale of its interest.
-40-
Council--.4 percent. PCC stock was not publicly traded, whereas IKPC
stock was listed on the Brazilian stock exchanges.
PCC was engaged in the production of unbleached and bleached
kraft paper and bleached fluff pulp as well as multiwall paper bags
and envelopes. PCC's management and the management of its principal
subsidiaries were fully integrated with that of its parent, IKPC.
PCC's directors had all been in the Klabin group for more than 30
years.
Paper consumption is closely linked to economic activity.
Consequently, swings in economic activity place pulp and paper
manufacturers at risk. Prior to 1986, PCC had been consistently
profitable. (For example, its 1985 net income was $13,453,000.)
From 1976 through 1985, PCC paid dividends averaging approximately
31 percent of its net profits. In 1986, PCC was cash rich and had
only a small amount of long-term indebtedness. As of December 31,
1985, PCC had cash and short-term financial investments totaling
$11,430,000; long-term loans totaled $2,166,000. PCC's shareholders'
equity at the end of 1985 was approximately $125 million.
1. PCC's Expansion Plans
The Brazilian pulp and paper industry operated at or close to
full capacity in 1985 and 1986. Additional investments in
productive capacity were needed to meet Brazil's 7-percent annual
growth in paper demand. PCC planned to expand its production
capacity from 80,200 to 178,700 tons per year in order to meet
expected demand. By early 1987, the cost of PCC's planned expansion
-41-
was $115 million. PCC intended to finance this expansion with a $55
million loan from the Brazilian National Development Bank, a $30
million loan from IFC, and $30 million from internally generated
cash flow.
On November 19, 1986, PCC acquired 80 percent of Bates' stock,
one of its principal Brazilian competitors. The purchase price was
approximately $9 million. The Bates acquisition enabled PCC to
expand its capacity in the multiwall-paper-bag market.
2. Petitioner's Internal Analysis of a PCC Investment
At the request of NBM's International Department, Norwest
Corporate Finance27 evaluated IFC's 28.7-percent equity interest in
PCC at the beginning of 1987. The evaluation resulted in a February
1987 study (Corporate Finance study). At this time, NBM was
contemplating the acquisition of IFC's entire 28.7-percent interest.
Norwest Corporate Finance reviewed the forecast prepared by
PCC's management and found it reasonable, based on the available
information. It found that the projected level of sales and
profitability from the planned increase in capacity was reasonable
and concluded that PCC was not underperforming in comparison with
its Brazilian competitors.
The Corporate Finance study used both the market and income
approaches to value IFC's interest in PCC. The market approach
27
Norwest Corporate Finance was responsible for the
corporation's policies with regard to the deployment of its
assets and liabilities.
-42-
involved the application of a price/earnings ratio based on U.S.
companies in the pulp and paper industry to a 3-year weighted
average of historical earnings, while the income approach discounted
PCC's expected dividends to present value at a 24-percent rate. The
Corporate Finance study concluded that IFC's 28.7-percent interest
in PCC had a value of $22,783,000 under the market approach and
$16,884,000 under the income approach. In attempting to harmonize
the two methods, the study accorded the income approach twice the
weight of the market approach and concluded that the 28.7-percent
interest in PCC had a $18,850,000 value. The study did not consider
the repatriation restriction or the foreign exchange political risks
associated with owning a Brazilian investment.
As holder of more than 10 percent of PCC's share capital,
petitioner would be entitled, as a matter of Brazilian law, to elect
a representative to each of the two councils responsible for PCC's
management, the Council of Administration and the Fiscal Council.
Petitioner anticipated receiving fees for each of the two seats on
PCC's management councils in the amount of $7,500 per month in
cruzados, or the cruzado equivalent of $180,000 annually. By
February 23, 1987, petitioner had revised its value for IFC's 28.7-
percent interest in PCC to $24 million by adding the director's fees
from one board seat to projected dividends from PCC under the
Corporate Finance study's income approach.
-43-
3. Petitioner's Conclusions About the PCC Investment
Petitioner concluded that the acquisition of a 14.361-percent
equity interest in PCC (rather than the entire 28.7-percent
interest) was an attractive investment. It based its conclusions
on PCC's: (1) Strong professional management; (2) solid financial
condition; (3) history of profitability and dividends; (4) dominant
position in the markets for its products; (5) growth potential; and
(6) relationship with IFC, both past and future. As of April 14,
1987, petitioner could have sold $12,577,136 of its Brazilian debt
on the secondary market for 63 percent of face value and received
$7,923,596 million in return, but it chose not to do so. Petitioner
believed that a 14.361-percent equity interest in PCC through a
debt-equity conversion (in which it would receive 100 cents on the
dollar) was more profitable than the cash it could have received on
the secondary market.
D. Steps Leading Up to the Conversion
On February 24, 1987, NBM sent to Banco Bozano a proposal to
purchase 14.35 percent of PCC's equity for a purchase price not to
exceed $12.5 million.28 The other 14.361 percent was to be acquired
by the Bank of Scotland and its affiliate, Balmoral Industria e
Comercio, Ltda. (Balmoral), as a result of a debt-equity conversion
28
The proposal states that the purchase is to "be
effected by means of a conversion" of blocked deposits with a
$12.5 million face value.
-44-
which would occur simultaneously with petitioner's debt-equity
conversion. Petitioner negotiated the purchase of IFC's PCC stock
at arm's length.
Once the parameters of the acquisition had been established,
NBM wrote to the Central Bank on April 2, 1987, seeking its consent
to engage in a debt-equity conversion (pursuant to Central Bank
Circulars 1.125 and 1.492, Central Bank Resolution 1.189, and the
1986 DFA) that would enable the use of blocked deposits with a face
amount of approximately $12.5 million to acquire 32,524,650 shares
of PCC common stock (the 14.361-percent equity interest).
In order to execute the transaction, on April 7, 1987,
petitioner formed a wholly owned Cayman Islands subsidiary,
Minnetonka Overseas Investment, Ltd. (MOIL), which in turn formed
a wholly owned Brazilian subsidiary, Minnetonka Representacoes
Comerciais, Ltda. (MRC). (MOIL and MRC are controlled foreign
corporations within the meaning of subpart F of the Internal Revenue
Code.) Petitioner chose this arrangement in order to allow it the
maximum flexibility in the future disposition of its investment.
Also on April 7, 1987, MOIL notified the Central Bank that
NBM's blocked deposits would be converted into MRC risk capital.
This capital would be used to purchase the PCC stock. The
conversion was to occur on April 14, 1987. Petitioner, through MRC,
requested that the Central Bank register MRC's investment as
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registered foreign capital within 30 days of the investment.
Moreover, NBM, MOIL, and MRC agreed to maintain the invested funds
in Brazil "for a period of twelve (12) years", which was the "period
to which funds relative to deposits made in 1986" were subject.
On April 10, 1987, NBM and MOIL instructed the Central Bank to
transfer $12,577,13629 of blocked deposits to the "name of MRC".
E. The Conversion Transaction
On April 14, 1987, IFC, NBM, MOIL, MRC, the Bank of Scotland,
and Balmoral executed a Share Purchase Agreement (Purchase
Agreement). In relevant part, the Purchase Agreement states as
follows:
Each of the Purchasers shall pay to the
Seller at the place and to the person or
account in Brazil designated by the Seller
the purchase price for the Relevant
Purchaser's Shares, equal to the Brazilian
Cruzado equivalent of US$12,500,000
without any deduction, setoff or
withholding whatsoever, obtained by
converting into Cruzados Brazilian
Sovereign Debt * * *
Under the Purchase Agreement, IFC was entitled to either the
immediate remittance in dollars in New York of $25 million or the
deposit of the sale proceeds in a dollar-denominated account
satisfactory to IFC at the Central Bank.
29
We note that $77,136 of the $12,577,136 was used to
pay legal expenses and the buy/sell foreign exchange rate
differential.
-46-
As contemplated, petitioner's blocked deposits totaling $12.5
million were converted on April 14, 1987, at the official exchange
rate of 23.616 cruzados to one U.S. dollar, into Cz$295,200,000.
MRC in turn transferred the cruzados to IFC in consideration for 50
percent of IFC's equity interest in PCC, some 32,524,650 shares.
IFC provided MRC a receipt acknowledging this payment.30 This
transaction extinguished the $12.5 million debt; moreover,
petitioner agreed to maintain its equity investment in Brazil for
12 years.
Also on April 14, 1987, IFC and MOIL entered into a
Repatriation Guarantee Agreement, whereby IFC guaranteed that in
the event MOIL sold the PCC stock and was unable to repatriate the
30
The receipt states, in relevant part, as follows:
IN THIS FORM, INTERNATIONAL FINANCE
CORPORATION ("IFC"), * * * acknowledges
receipt of Cz$ 295.200.000,00 (Two
hundred, ninety five million, two
hundred thousand cruzados), equivalent
to US$ 12,500,000 (twelve million five
hundred thousand dollars) as of this
date of April 14 at the exchange rate of
Cz$ 23,616 from MINNETONKA
REPRESENTACOES COMERCIAIS LTDA.
("MINNETONKA"), * * * for the sale to
the latter of 32,524,650 shares from the
capital stock of PAPEL E CELULOSE
CATARINENSE S.A., * * * of which shares
IFC is the legal owner, * * * for which
receipt IFC hereby grants MINNETONKA
total, general and irrevocable quittance
for said sale of shares.
-47-
sale proceeds, IFC would purchase, for U.S. dollars outside of
Brazil, MOIL's share holding in MRC equal to MOIL's remittance
interest, up to $12.5 million. This guaranty would be reduced by
any earlier sale or disposition of any part of the shares and would
apply only during the convertibility period (the 18-month period
beginning on the 12th anniversary of the PCC purchase).
(Petitioner's blocked deposits at the Central Bank had no such
guaranty.)
Following the debt-equity transaction, IKPC held 70.842
percent of PCC's voting capital, and MRC and Balmoral each held
14.361 percent. The three parties entered into a Shareholders
Agreement on April 30, 1987, whereby IKPC and Balmoral had a right
of first refusal with respect to the sale of petitioner's PCC
stock.
Due to the manner in which petitioner arranged the
transaction, it could sell its investment indirectly, through the
sale of MOIL, at any time and without restriction, for U.S. dollars
outside Brazil. The buyer would have to maintain the invested
funds in Brazil for whatever portion of the 12-year waiting period
remained, but it would be free to dispose of the investment
indirectly, in the same manner as petitioner. Moreover, petitioner
could dispose of the investment by causing MOIL to sell the stock
of MRC, without restriction, to a buyer in Brazil for cruzados.
-48-
The cruzado proceeds would remain subject to the same prohibition
on repatriation, until April 14, 1999.
F. Petitioner's Tax and Accounting Treatment of the Conversion
NBM's chief financial officer and comptroller, Phil Williams,
reviewed and analyzed the Corporate Finance study. Two days after
the conversion he concluded that the estimated fair market value of
petitioner's 14.361-percent equity interest in PCC was between
$12.4 million and $12.6 million. Mr. Williams arrived at this
conclusion by using the price/equity ratio and discounted cash-flow
approaches, as well as adding a third approach, based on the net
book value of PCC. He then weighted the three approaches equally.31
Mr. Williams recommended that the investment be recorded at par.
In April 1987, Mr. Narayana (who was in charge of petitioner's
Brazilian blocked deposits) agreed with Mr. Williams' conclusion.
31
Mr. Williams determined the fair market value of
petitioner's interest in PCC as follows (numbers are in
thousands):
Method Total Company Norwest's Share
Price/earnings ratio $ 79,385 x 14.361% = $11,400
Discounted cash-flow 79,790 x 14.361% = 11,459
1
Net book value 100,386 x 14.361% = 14,416
Weighted average $ 86,520 $12,425
1
Discounted 20 percent.
-49-
Norwest's International Department was responsible for
monitoring the value of petitioner's PCC investment on a quarterly
basis. Petitioner periodically reviewed all of its lesser
developed country debt. On July 3, 1987, Mr. Williams wrote a
memorandum, on behalf of International Management, reassessing the
value of petitioner's PCC equity interest. Based on a June 12,
1987, Proposed Practice Bulletin issued by the American Institute
of Certified Public Accountants and its own analysis that the true
fair market value of the debt surrendered would be 85 percent of
par, petitioner decided to write down its PCC investment to
approximately $10.7 million, based on a 15-percent discount.
At the end of 1987, petitioner again reduced the value of the
PCC investment to $8 million for financial purposes. This value
was based on the secondary market value of the $12,577,136 debt and
on petitioner's Tax Department's analysis of the tax implications
resulting from the debt-equity transaction.
G. Petitioner's Return and Petition
On its 1987 Federal income tax return, petitioner claimed a
$4,577,136 loss (the difference between its $12,577,136 of blocked
deposits and $8 million, the secondary market price for the
$12,577,136 of Brazilian debt as well as petitioner's final
valuation for book purposes of the PCC stock received in the debt-
equity conversion). Petitioner asserted in its petition: "Since
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the PCC stock was valued at $8,000,000 when it should have been
valued at $681,099, Petitioner is entitled to an additional loss
deduction of $7,318,901 for 1987."
H. Notice of Deficiency
In the notice of deficiency, respondent disallowed
petitioner's claimed $4,577,136 loss. The notice explains that
petitioner did not establish that any deductible loss was sustained
in 1987.
I. Subsequent Events
Petitioner attempted to sell its interest in PCC several weeks
after the conversion. Then, in 1992 or 1993, petitioner engaged
Eden International to assist in the sale of its PCC stock. On
December 1, 1994, petitioner entered into a Deferred Stock Sale
Agreement with Tiquie, S.A., a subsidiary of IKPC located in
Uruguay, agreeing to sell the MOIL shares to Tiquie for
$10,500,000, consisting of $1,150,000 in cash and a $9,350,000
note, plus interest on the outstanding balance of the purchase
price. By selling its entire interest in MOIL, petitioner
indirectly sold the 14.361-percent equity interest in PCC, as well
as cash equivalents of approximately $658,000. Petitioner incurred
$260,000 in closing costs.
Petitioner sold its remaining blocked deposits for 47 cents on
the dollar in January 1988.
-51-
Discussion
J. Respondent's Arguments
Respondent contends that petitioner did not realize a loss on
the debt-equity conversion because it simply exchanged blocked
deposits in which it had a $12,577,136 basis for cruzados worth the
same amount. Respondent relies upon Rev. Rul. 87-124, 1987-2 C.B.
205, and G.M. Trading Corp. v. Commissioner, 103 T.C. 59 (1994),
supplemented by 106 T.C. 257 (1996), on appeal (5th Cir., Oct. 4,
1996), to support its position.
In Rev. Rul. 87-124, supra, a U.S. commercial bank holds
dollar-denominated debt at the central bank of a foreign country.
The foreign country has a program that allows the commercial bank
to exchange the debt for local currency if it uses the local
currency to invest in a company (the foreign company) organized and
engaged in business in the foreign country. In situation 2, the
commercial bank delivers the dollar-denominated debt to the central
bank. The central bank credits the account of the foreign company
and the foreign company in turn issues its capital stock to the
commercial bank. (Respondent contends that the facts herein are
similar except that petitioner paid the local currency, cruzados,
to a third party, IFC, in exchange for the stock.) The ruling
treats the commercial bank as if it received local currency from
the central bank in exchange for the debt and then contributed the
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local currency to the foreign company in exchange for its stock.
The commercial bank also recognizes a loss on the exchange of the
debt for the local currency to the extent of the excess of its
adjusted basis in the debt over the fair market value of the local
currency. The ruling assumes that the fair market value of the
stock is equal to the fair market value of the foreign currency for
which it was exchanged.
By applying the test enunciated in this ruling, respondent
argues that petitioner did not realize a loss on its exchange of
blocked deposits for cruzados because it received local currency
(cruzados) equal in value to its basis in the blocked deposits.
Moreover, respondent contends that petitioner recognizes no gain or
loss on the exchange of the cruzados for the PCC stock because the
ruling assumes that the value of the cruzados and the value of the
stock are identical.
Respondent also contends that G.M. Trading Corp. v.
Commissioner, supra, supports its position. G.M. Trading involved
a U.S. taxpayer that participated in a Mexican debt-equity swap.
In order to participate in the transaction, the taxpayer, a U.S.
company, formed a Mexican subsidiary, Procesos. The U.S. company
then purchased a previously issued $1.2 million Mexican Government
debt from an unrelated bank for $634,000 (which reflected the
market discount rate of approximately 50 percent of the debt's
-53-
principal face amount). 103 T.C. at 62, 65. The taxpayer
exchanged the $1.2 million debt for 1,736,694,000 pesos (Mex$),32
and the Mexican Government deposited the pesos in Procesos'
restricted bank account. The pesos were to be used to build a
lambskin processing plant. Procesos issued shares of its stock to
the Mexican Government, which in turn transferred the shares to the
taxpayer. The U.S. company surrendered the debt to the Mexican
Government, which then canceled it. Id. at 63-64. The Court
rejected the taxpayer's view that the transaction was a tax-free
contribution to the capital of the Mexican subsidiary. The Court
declined to disregard the taxpayer's exchange of U.S. dollar-
denominated debt for Mexican pesos and held that the taxpayer
realized a $410,000 gain on the exchange, equal to the difference
between the taxpayer's basis in the debt ($634,000) and the fair
market value of the pesos for which the debt was exchanged
(Mex$1,736,694,000 with a fair market value of $1,044,000 on the
date of the transaction). Id. at 68-71.
By analogy to G.M. Trading, respondent asserts that in the
instant situation we should decline to disregard petitioner's
32
The Mex$1,736,694,000 had a $1,044,000 fair market
value at the official exchange rate. The $1.2 million debt had a
fair market value of $1,044,000 because of a 13-percent discount
rate of the debt's face value. G.M. Trading Corp. v.
Commissioner, 103 T.C. 59, 63 (1994), supplemented by 106 T.C.
257 (1996), on appeal (5th Cir., Oct. 4, 1996).
-54-
exchange of blocked deposits for cruzados. Accordingly, respondent
claims we should hold that petitioner's exchange of blocked assets
for cruzados created no loss because the basis of the blocked
assets and the fair market value of the cruzados were identical.
K. Petitioner's Arguments
At trial and on brief, petitioner contends that the conversion
produced a $7,033,136 loss. Petitioner argues that it exchanged
$12,577,136 of blocked deposits, which had a secondary market value
of $7,923,596, for Brazilian stock worth $5,544,000. Petitioner
first argues that Rev. Rul. 87-124, supra, supports its position
rather than that of respondent. Petitioner claims that because the
value of the stock is presumed to equal the value of the local
currency given in exchange, petitioner is justified in looking to
the fair market value of the stock it received in determining the
extent of its loss.
Petitioner also argues that we should not follow the analysis
and reasoning of G.M. Trading because the facts therein are
distinguishable: (1) Petitioner entered into the debt-equity
conversion as a means of cutting its losses on a deteriorating
investment, not as the first step in making a profitable new
investment, as in G.M. Trading; (2) the cruzados petitioner
received were used to acquire stock in a Brazilian company, while
the pesos the taxpayer received in G.M. Trading were used to
-55-
acquire land and construct a plant; and (3) petitioner was
committed to retain the PCC investment for 12 years, while no
similar mandatory holding period existed in G.M. Trading.
Moreover, petitioner contends that unlike G.M. Trading, the
step transaction doctrine applies herein; thus, the exchange of
debt for cruzados and the cruzados conversion into stock should be
ignored. Therefore, according to petitioner, the gain or loss
should be measured by the difference between the basis in the debt
and the fair market value of the stock received. In order to place
a value on the stock, petitioner submitted the expert report of
Nancy Czaplinski, who valued petitioner's interest in the PCC stock
as of the transaction date at $5,544,000. Petitioner also submitted
the expert report and testimony of Steven J. Sherman, who valued
the same interest at approximately $6.77 million.33
Finally, petitioner claims that the value of its blocked
deposits on the secondary market is directly relevant to the value
of its equity interest in PCC. According to petitioner, the
$12,577,136 of blocked deposits had a $7,923,596 value on the
33
Respondent's appraisal experts, Scott Hakala and
William Cline, valued the interest at $12 million and $12.5
million, respectively.
-56-
secondary market, which represents a ceiling on the value of
petitioner's PCC equity interest.34
L. Law and Analysis
The loss from a sale of property is the excess of the
property's adjusted basis over the amount realized. Sec. 1001(a).
An equal exchange results in neither gain nor loss. Because debt
is considered property in the hands of the holder, an exchange of
debt for other property is usually treated as a section 1001
taxable exchange. Cottage Sav. Association v. Commissioner, 499
U.S. 554, 559 (1991); G.M. Trading Corp. v. Commissioner, 103 T.C.
at 67. Federal tax law principles require that foreign currency be
considered property. FNMA v. Commissioner, 100 T.C. 541, 582
(1993); sec. 1.1001-1(a), Income Tax Regs.
The step-transaction doctrine is a rule of substance over form
that treats a series of formally separate "steps" as a single
transaction if they are in substance integrated, interdependent,
and geared toward a specific result. Tandy Corp. v. Commissioner,
92 T.C 1165, 1171 (1989). The step-transaction doctrine is a
manifestation of the more general tax law principle that formal
distinctions cannot obscure the substance of a transaction. Id.34
Respondent counters by arguing that the value of the
blocked deposits on the secondary market is irrelevant because
petitioner chose to partake in a debt-equity conversion rather
than sell the debt on the secondary market.
-57-
Like petitioner herein, the taxpayer in G.M. Trading argued
that its exchange of debt for foreign currency should be ignored
under the step transaction doctrine. The Court in G.M. Trading
rejected the taxpayer's argument in its Supplemental Opinion, as
follows:
a step in a series of transactions or in an
overall transaction that has a discrete
business purpose and a discrete economic
significance, and that appropriately triggers
an incident of Federal taxation, is not to be
disregarded. Further, the simultaneous nature
of a number of steps does not require all but
the first and the last (or "the start and
finish") to be ignored for Federal income tax
purposes. * * *
106 T.C. at 267.
We likewise refuse to apply the step transaction doctrine
herein. We agree with respondent that the substance of
petitioner's transaction was consistent with its form. The
Central Bank converted the full-face value of petitioner's debt,
plus accrued interest, into Cz$295,200,000 at the official
exchange rate without diminution or discount. MRC received the
cruzados from the Central Bank (exchanged at the official exchange
rate) and paid the cruzados to a third party (IFC) in exchange for
its 14.361-percent equity interest in PCC. Contrary to
petitioner's contention, the exchange of the debt for the cruzados
and the conversion of the cruzados into stock did not constitute
a transitory step but rather a substantive and significant element
-58-
of the conversion, having a discrete business purpose and economic
significance: (1) Petitioner needed the cruzados to pay the agreed
purchase price to IFC and pay its other transaction expenses; (2)
the Central Bank was entitled to extinguish approximately $12.5
million of Brazil's foreign debt; (3) the Central Bank did not
need to use its limited supply of U.S. dollars at this time; (4)
the Central Bank received petitioner's assurance that its equity
investment would remain in Brazil for 12 years; and (5) IFC could
use the cruzados without restriction.
Thus, taking into account the cruzados' independent economic
significance, petitioner's exchange of blocked deposits for
cruzados and the conversion of the cruzados into stock cannot be
ignored under the step transaction doctrine. Accordingly, we
follow the analysis in G.M. Trading35 and hold that petitioner's
loss, if any, is measured by the difference between its basis in
the blocked deposits ($12,577,136) and the value of the cruzados
($12,577,136 before any discount, see infra) on the date of the
transaction. Because we hold that the step transaction doctrine is
inapplicable herein, we need not determine the fair market value
35
While we agree with petitioner that the facts in G.M.
Trading Corp. v. Commissioner, 103 T.C. 59 (1994), are not
identical to those herein, the legal propositions stated in G.M.
Trading are nonetheless applicable herein.
-59-
of petitioner's 14.361-percent equity interest in PCC,36 including
any possible marketability discount attributable to that interest.
We reject petitioner's argument that Rev. Rul. 87-124, 1987-2 C.B.
205, supports its position.
At this point, we must address petitioner's argument that the
$12,577,136 of blocked deposits had a secondary market value of
$7,923,596. We agree with respondent that the value of the blocked
deposits on the secondary market is irrelevant to this case.
Petitioner did not engage in a transaction on the secondary
36
Assuming arguendo that the step transaction doctrine
applies, we would hold that the PCC stock had a $12.5 million
fair market value on Apr. 14, 1987, based upon the following:
After considering for several months whether to invest in
PCC, petitioner concluded that the 14.361-percent equity interest
was worth $12.5 million. Petitioner negotiated the purchase of
the PCC stock with IFC (an unrelated party, which has a strong
institutional incentive to charge a fair price) at arm's length,
even though the Latin American debt crisis placed petitioner in a
position with limited options. Petitioner was not under a
compulsion to buy. In fact, two of petitioner's experts
testified that if we find that IFC sold its stock in an arm's-
length transaction and petitioner was not under a compulsion to
buy, the price at which the transaction occurred would provide
the best evidence of fair market value. The amount paid for
property generally is probative evidence of its fair market
value. See, e.g., United States v. Cartwright, 411 U.S. 546, 551
(1973).
Just 2 days after petitioner acquired the interest in PCC,
Phil Williams, NBM's chief financial officer, concluded that the
fair market value of the PCC stock was between $12.4 and $12.6
million. He reached this conclusion after analyzing and revising
the study prepared by Norwest Corporate Finance. We consider
petitioner's subsequent reductions in value for financial
reporting purposes not relevant to the purchase-date fair market
value of the PCC stock.
-60-
market. It chose to participate in the government repurchase
market where the Central Bank paid full face value for the debt.
Our task is to decipher the events that did occur, rather than
those that could have occurred. Mr. Narayana, petitioner's
officer charged with overall responsibility for the debt-equity
conversion, testified that petitioner considered the conversion
more beneficial than a sale of the debt on the secondary market.
Furthermore, as the Court's Supplemental Opinion in G.M. Trading
acknowledges, a creditor is motivated to engage in a debt-equity
conversion by the additional value the transaction creates, above
and beyond the secondary market sale of the debt. If not for this
added value, a creditor would have no reason to spend the time and
resources necessary to complete the transaction. 106 T.C. at 260-
261.
It is clear that petitioner engaged in the debt-equity
conversion because it concluded, after extensive investigation and
analysis of the investment, that a 14.361-percent equity
investment in PCC was worth more than the approximately $8 million
cash petitioner could have received from a secondary market sale.
Contrary to petitioner's argument, the value of the blocked
deposits on the secondary market is not relevant to the value of
petitioner's PCC equity interest and does not represent a ceiling
on that value. While we acknowledge that had petitioner sold the
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blocked deposits on the secondary market, it probably would have
been obligated to make new loans to Brazil, petitioner anticipated
receiving a "better deal" through the debt-equity conversion.
Our analysis does not, however, end here. We must now
determine whether any discount should be applied to the fair
market value of the cruzados petitioner received on account of the
restrictions in this case.
Two restrictions existed with regard to petitioner's debt-
equity conversion. The first required petitioner to invest the
cruzados in a Brazilian company. This restriction has no greater
significance than the restrictions placed upon the taxpayer's use
of the pesos by the Mexican Government in G.M. Trading. The Court
in G.M. Trading declined to discount the value of the pesos
received in exchange for the debt on the grounds that the Mexican
Government restricted their use to the construction of the
processing plant. The Court held that this restriction was
consistent with the parties' purpose and objective and was not
substantially different from disbursements of loan proceeds by
financial institutions. 106 T.C. at 262. In other words, the
restriction only reflected the foreign currency's intended use.
103 T.C. at 70-71. In fact, the restriction served as an
enhancement to the value of the pesos by opening business
opportunities for the taxpayer in Mexico. 106 T.C. at 264.
-62-
We acknowledge that due to the Brazilian debt crisis,
petitioner had limited options with regard to its blocked
deposits. However, once petitioner decided to engage in a debt-
equity transaction, it was free to use its blocked deposits to
invest in any Brazilian company. Moreover, the value of the
cruzados here was enhanced because petitioner's investment was
made at the official exchange rate, entitling it to the benefits
of registered foreign capital. In sum, as in G.M. Trading, we
hold that the restriction on use of the cruzados herein does not
require a discount.
The second restriction involved the 12-year repatriation
restriction. It is clear from the record before us that this
restriction was a preexisting limitation, as articulated in
Central Bank Circular 1.492 and the 1986 DFA. It was not a result
of negotiations or bargaining by the parties. The restriction
reduced the value of petitioner's property right by prohibiting
petitioner from repatriating its capital for 12 years. Despite
the manner in which petitioner arranged the transaction (with the
creation of MOIL and MRC), we believe that the 12-year restriction
warrants a discount on the fair market value of the cruzados
petitioner received, reflecting the preexisting restriction. See,
e.g., Landau v. Commissioner, 7 T.C. 12, 16 (1946) (the Court
imposed a discount on the value of South African pounds,
-63-
reflecting preexisting restrictions imposed upon foreign exchange
by South Africa). Accordingly, we will present the analyses of
the parties' experts regarding the effect of the 12-year
restriction.
Respondent argues that assuming arguendo petitioner realized
a loss as a result of its debt-equity conversion, the loss did not
exceed 10 percent of its investment (approximately $1.25 million)
on account of the 12-year restriction. This argument is based
upon the report and testimony of respondent's expert, Dr. William
R. Cline. Dr. Cline received a Ph.D. in economics from Yale
University in 1969, is a senior fellow at the Institute for
International Economics, and has approximately 25 years'
experience in the area of international debt, particularly Latin
American and Brazilian debt. Dr. Cline concluded that petitioner
realized no loss on its debt-equity conversion. However, he
recognized that petitioner may be entitled to a small discount on
the fair market value of the cruzados it received, attributable to
its agreement to maintain its equity investment in Brazil for 12
years, despite its creation of MOIL and MRC in order to minimize
the effects of the 12-year restriction.
Dr. Cline determined a discount on account of the restriction
by considering the spread between the interest rates on a 3-month
U.S. Treasury bill and a 10-year U.S. Treasury bond between 1964
-64-
and 1987. For this period, the average annual interest rate on
10-year U.S. Treasury bonds exceeded the rate on 3-month U.S.
Treasury bills by 1.1 percent. This is the annual premium for
short-term liquidity versus illiquidity over a 10-year period.
Dr. Cline determined that the differential, if compounded over a
12-year period, amounts to a multiple of 1.14, and that the
general market preference for liquidity means that the 12-year
encumbrance is worth a 12.3-percent discount. He then decreased
the 12.3-percent discount to 10 percent based on his belief that
the spread between the bill and the bond represented not only a
liquidity premium, but also a risk premium for interest rate
fluctuations.
Petitioner introduced a rebuttal witness, Dr. Kenneth Froot,
of the National Economic Research Associates, Inc. Dr. Froot
received a Ph.D. in economics from the University of California at
Berkeley in 1986. He has no direct experience with Brazil.
Petitioner also introduced Nancy Czaplinski, a chartered financial
analyst and an engagement director with American Appraisal
Associates, Inc. Ms. Czaplinski has an M.B.A in finance from the
University of Wisconsin at Milwaukee and is a C.P.A.
Dr. Froot first criticized Dr. Cline's use of U.S. Treasury
bills and bonds because they are both highly liquid instruments.
Ms. Czaplinski also criticized Dr. Cline's use of the interest
-65-
rate spread between the bill and the bond between 1964 and 1987
because it was significantly less than the actual spread at the
valuation date, the average spread for 1987, and the average
spread for 1983 through 1987. After correcting the spread used in
Dr. Cline's analysis, Ms. Czaplinski used Dr. Cline's formula to
arrive at a 25-percent discount solely attributable to liquidity
in the U.S. Treasury market on the valuation date.37
Dr. Froot also insisted that Dr. Cline's 10-percent discount
was too low. Froot concluded that a total 54.5-percent discount
was more appropriate for the following reasons: (1) The "swap
equity" was akin to restricted stock, which trades at 26- to 40-
percent discounts; (2) a significant discount is applicable
because the official and parallel exchange rates could be expected
to merge over a period of time, so that petitioner would not have
the benefit of a favorable cruzado-to-dollar exchange rate at the
end of the 12-year waiting period;38 and (3) a discount rate
37
In response to the criticism of both Dr. Froot and Ms.
Czaplinski, Dr. Cline testified that even though the 10-year bond
is highly liquid, the buyer faces the same waiting period before
maturity as the seller, and his discount represents an inherent
penalty for the waiting period.
38
At the time of the transaction, the official exchange
rate was 23.616 cruzados to one U.S. dollar, while the parallel
rate was 32.250 cruzados to one U.S. dollar.
Dr. Froot opined that if a convergence of the official and
parallel Brazilian exchange rates occurred, petitioner would pay
a 100 million cruzado "penalty" upon entering the debt-equity
(continued...)
-66-
adjustment was necessary for the risk associated with the official
rate premium.
We believe that the 12-year waiting period was not a
restriction on sale but rather a restriction on repatriation of
dollars out of Brazil. Even if petitioner could not take the sale
proceeds out of Brazil in dollars, it could sell MRC at any time
to a buyer in Brazil paying cruzados. Petitioner could also sell
MOIL for dollars outside Brazil. Petitioner's PCC equity
investment was not equivalent to restricted stock.
By focusing on Dr. Froot's opinion that the fair market
value of the cruzados should be determined by reference to the
parallel market exchange rate, petitioner attempts to escape the
tax consequences of its bargain.39 While we agree with Dr. Froot
38
(...continued)
conversion because it was "forced" to use the official exchange
rate and would receive none of this "penalty" back if the
official and parallel rates converged prior to the end of the 12-
year period. Dr. Froot believed that the spread was likely to
narrow.
In April 1987, Dr. Cline would have predicted that the
spread between the official exchange and parallel rates was
likely to continue for a considerable period of time because
Brazil had imbedded indexation as a result of chronic inflation.
Also, Mr. Narayana believed that a spread would persist for a
long time in the absence of drastic action by the Brazilian
Government. In fact, a spread still existed in 1995.
39
See G.M. Trading Corp. v. Commissioner, 106 T.C. at
263-264 (where the taxpayer was unsuccessful in attempting to
disavow the price that the Mexican Government had agreed to pay
and the taxpayer had agreed to accept in exchange for the debt).
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that petitioner could have obtained more cruzados at the parallel
market rate than at the official rate, the Central Bank required
that the conversion take place at the official exchange rate.
This was not a penalty; it was a requirement of engaging in the
debt-equity conversion. As part of the conversion terms,
petitioner agreed that blocked deposits would be converted into
cruzados at the official exchange rate on April 14, 1987.
Petitioner also agreed, as part of the Purchase Agreement, that it
would pay IFC, in exchange for the PCC stock, the cruzados
equivalent of $12.5 million, without any deduction, setoff, or
withholding whatsoever, obtained by converting Brazilian blocked
deposits into cruzados at the official exchange rate. IFC
acknowledged receipt of this cruzado payment and the fact that it
was the equivalent of $12.5 million at the official exchange rate
on April 14, 1987. Thus, we reject Dr. Froot's recommendation of
a discount on account of the official and parallel rate
differentials as an after-the-fact attempt to revalue a
transaction contrary to its agreed-upon terms.
Moreover, investments made in Brazil at the official exchange
rate were entitled to the benefits of registered foreign capital
status; investments made at the parallel rate were not. In this
sense, the Cz$295,200,000 that petitioner obtained by converting
its blocked deposits could easily have the same, if not greater,
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value than an identical amount of cruzados obtained on the
parallel market for fewer U.S. dollars.
Finally, we agree with Dr. Cline that no discount should be
applied for the possible elimination of the official rate premium
at the end of the 12-year waiting period. Foreign investors, such
as petitioner, who received dividends from their registered
investments would continue to receive the benefits of a favorable
cruzado-to-dollar exchange rate during the years that the official
rate premium was shrinking. Dr. Cline believed that a narrowing
of the spread between the official and parallel market rates would
likely be accompanied by an overall improvement in economic
conditions, which would have a positive impact on the value of
equity investments. In this regard, Dr. Cline testified that he
would forgo a 25-percent exchange rate premium for a 100-percent
increase in the value of his investment.
Determining an appropriate discount rate with mathematical
precision is impossible. "Valuation is * * * necessarily an
approximation * * *. It is not necessary that the value arrived
at * * * be a figure as to which there is specific testimony, if
it is within the range of figures that may properly be deduced
from the evidence." Anderson v. Commissioner, 250 F.2d 242, 249
(5th Cir. 1957), affg. in part and remanding in part T.C. Memo.
1956-178; see also Estate of Barudin v. Commissioner, T.C. Memo.
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1996-395. While we find Dr. Cline's analysis generally sound,
based on all of the evidence before us, we believe, and
accordingly hold, that the 12-year repatriation restriction
warrants a 15-percent discount, rendering a $1,886,570 loss for
petitioner's 1987 tax year.
Issue III. Allocation of Purchase Price
The final issue concerns the value of a lease portfolio
petitioner acquired from Financial Investment Associates, Inc.
(FIA). In this regard, we must determine whether any portion of
the $141,456,620 petitioner paid in 1989 to acquire the assets of
FIA should be attributed to goodwill, going-concern value, or
other nonamortizable intangible assets. Petitioner contends that
none of the $141,456,620 it paid for FIA's assets should be
allocated to goodwill, going-concern value, or other
nonamortizable intangible assets. Respondent, on the other hand,
contends that $1,328,618 of the $141,456,620 should be allocated
to nonamortizable intangible assets.
A. FIA
FIA, a medical equipment leasing company, was founded by Fred
Rafanello in 1977. At FIA's incorporation, Mr. Rafanello was its
sole owner, president, and chief executive officer (CEO). FIA's
principal executive offices were located in Northfield, Illinois.
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FIA specialized in the leveraged purchase and leasing of high-tech
diagnostic medical equipment to hospitals and clinics.
FIA's leases typically ran for 60 months, which was less than
the estimated useful life of the leased equipment. FIA financed
its equipment purchases using a combination of debt and equity.
Debt (which generally represented approximately 90 percent of the
cost of equipment) was typically in the form of a 60-month,
nonrecourse loan from a money-center bank. Prior to FIA's
acquisition by Commercial Federal Corp., discussed infra, FIA
obtained equity financing from syndications,40 assembled by
investment bankers.
FIA customarily received an up-front fee or commission from
the syndications, out of which the investment bankers received
their fee. At the expiration of the lease term, the debt incurred
to acquire the equipment being leased was retired, and the
syndications' investors owned the equipment outright.
High-tech medical diagnostic equipment, particularly of the
type leased by FIA, tends to have higher residual values than most
other kinds of leased equipment. FIA projected the residual value
of the equipment it leased to be in the range of 20 to 35 percent
40
FIA was a general partner in the syndications and
received additional remuneration by sharing in the residual value
of the leased equipment with the syndications' investors.
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of the equipment's cost. But, in fact, the equipment's residual
values generally exceeded the amounts projected.41
FIA converted the equipment's residual value into cash at the
end of the lease in a number of ways: Sale or renewal of the
lease to the original lessee; sale or lease to another, generally
smaller, hospital; or return of the equipment to the manufacturer
as a trade-in. FIA's experience was that 85 to 90 percent of the
equipment was purchased or released by the original lessee. In
this regard, approximately 70 to 80 percent of the leases were
renewed, which was more profitable for FIA than a sale of the
equipment to the original lessee or a sale or lease to another
hospital.
The amount of revenue that FIA could earn after the lease
expiration depended largely on the residual value of the
equipment. The residual value of the equipment was the source for
over two-thirds of FIA's cash-flow before expenses and represented
the principal source of FIA's profit. Thus, the equipment's
residual value was the key to FIA's business.
B. Federal's Acquisition of FIA
Commercial Federal Corp. (Federal), the holding company of
Commercial Federal Savings & Loan Association (CFSLA), was one of
41
Through Dec. 31, 1987, FIA achieved gains of 29 percent
over book residual values.
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the largest retail financial institutions in the Midwest. On
November 7, 1986, Federal, through another of its subsidiaries,
Commercial Federal Investment Associates, Inc. (Commercial),
acquired all of FIA's outstanding stock from Mr. Rafanello. The
purchase price, approximately $5.3 million, included a 25-percent
premium over FIA's book value.42
After the acquisition, FIA operated its business affairs with
no significant changes. Mr. Rafanello remained FIA's president
and CEO. At this time, FIA had 70 to 75 employees and financed $50
million of new equipment leases per year.43
Federal became FIA's source of equity financing, making funds
available in the form of short-term intercompany loans. FIA had
a $40 million line of credit with CFSLA, which it used to obtain
funds for the purchase of equipment. Loans made under this credit
line were secured by the equipment and the lease revenues.
FIA achieved higher residual values after its acquisition by
Federal than prior to the acquisition.
C. Petitioner's Acquisition of FIA
On December 29, 1988, Norwest Leasing, Inc. (NLI), one of
petitioner's affiliates, made an exploratory proposal to purchase
42
Mr. Rafanello testified that the 25-percent premium was
paid for FIA's intangible assets.
43
By 1988, FIA financed more than $100 million of new
equipment leases.
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FIA's assets. The proposal contemplated a purchase price premium
of $2 to $5 million above FIA's net asset value44 which, at the
time, was approximately $17.5 million. The proposal also stated
that NLI would pay FIA's $15 million intercompany debt to Federal.
By early February 1989, petitioner had decided it was willing
to pay only a $1 million premium above book value for FIA's
assets. Petitioner thereafter negotiated an additional price
reduction of $400,000 due to fluctuations in the bond market
(which increased the cost of funding the acquisition).
Finally, on March 31, 1989, Norwest Financial Resources
(NFR), another of petitioner's affiliates, entered into a purchase
agreement (the March Agreement) with FIA and Commercial in which
it agreed to acquire substantially all of FIA's receivables and
assets.45 NFR specifically agreed to acquire FIA's approximately
44
The term "net asset value" refers to the book value or
stockholders' equity of a company that appears on its balance
sheet. Net asset value is a reference for determining how much a
potential buyer might be willing to pay for assets on a going-
concern basis.
45
The March Agreement defines "Receivables" and "Assets"
as follows:
The term "Receivables" shall mean the operating leases
and the underlying equipment or other property subject
to such operating leases owned by the Company on the
Closing Date; the leasing receivables (including
leases, fair market value leases and direct finance
leases), conditional sale contracts, secured loans and
other commercial finance receivables of the Company on
(continued...)
-74-
$100 million worth of equipment held under operating leases and
leasing, and other commercial finance receivables, and to assume
the nonrecourse indebtedness and other liabilities of
approximately $52 million to which such assets were subject. The
acquired assets represented over 98 percent of FIA's total assets.
45
(...continued)
the Closing Date; and any instruments or collateral
securing the same and any equipment or property leased
or otherwise financed and files and other records owned
or in the possession of the Company or any of its
affiliates relating thereto. Such receivables shall
include (but not be limited to) all lease agreements,
conditional sale contracts, notes, evidences of
indebtedness, personal guarantees, corporate
guarantees, letters of credit and other documents
representing or backing up such receivables.
Receivables shall not, in any event, include Excluded
Assets.
The term "Assets" shall mean the Receivables; equipment
or other property held in inventory for future sale or
lease; all furniture, fixtures, equipment and the
Company's rights in leasehold improvements; leasing and
lending transactions in process for prospective lessees
or borrowers and the related files, applications and
other documentation; the Company's general partnership
interests in partnerships and co-ownership interests in
participation or like arrangements, its rights to
receive fees, distributions and other revenues
therefrom in the future, and any rights it has under
management or supplier agreements related thereto; and
any other assets owned by the Company on the Closing
Date, other than Excluded Assets.
The "Excluded Assets" that NFR did not acquire consisted
solely of notes receivable and any other amounts due FIA from its
affiliates and other related parties as of the closing date. As
of Dec. 31, 1988, notes receivable were $192,708, and amounts due
FIA from its affiliates or other related parties were $540,520.
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The March Agreement included the following provision with regard
to goodwill (the goodwill provision):
It is understood that there is no good
will [sic] or similar intangible assets
included in the purchase and sale covered by
this Agreement and that no part of the purchase
price shall be attributed or allocated in any
way to good will [sic].
In addition, the March Agreement allowed NFR to designate an
affiliate (or affiliates) to complete the purchase. NFR designated
NLI and Dial Bank (Dial), NFR's State banking subsidiary.
Consequently, on June 12, 1989, NLI and Dial completed the purchase
from FIA and Commercial in an arm's-length transaction.46 NLI and
Dial paid $77,952,168 and $63,504,452, respectively, for a total
purchase price of $141,456,620. The purchase price was calculated
as follows:
Stockholder's equity (based on historical balance sheet
values, before purchase accounting adjustments)
- Excluded assets
+ FIA notes payable to Commercial or its affiliates
+ Income taxes (as shown on historical balance sheet)
+ Other liabilities NFR did not specifically assume
+ $390,000 ($100,000 for use of trade name and $290,000 for
noncompete agreement)
___________________________________________________
= Total purchase price per purchase agreement
46
While NFR actually entered into the March Agreement and
designated NLI and Dial to complete the purchase, these entities
were affiliates of petitioner, and for convenience we sometimes
refer to petitioner as the purchaser of FIA's assets.
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Petitioner paid $100,000 in consideration for the right of NFR (or
its affiliates) to use the FIA name (or any similar name) for a
period of 5 years, and $290,000 for a covenant not to compete by
FIA and Commercial, also for a period of 5 years. Pursuant to an
agreement separate from the March Agreement, petitioner made a
$210,000 payment to Mr. Rafanello in consideration for his
agreement not to compete for a period of 3 years.47
Moreover, petitioner was given the opportunity to employ some
of FIA's marketing staff and equipment experts, many of whom had 15
or more years of experience in the medical equipment leasing
industry. As of June 8, 1989, 23 of FIA's 65 employees became NLI
employees. (Mr. Rafanello did not become an employee of NLI or any
of its affiliates after the acquisition.)
Petitioner intended to fund the acquisition by issuing
commercial paper. Funds so obtained were to be transferred by
petitioner to NLI as intercompany debt and to Dial as a combination
of debt and shareholder equity. Petitioner calculated that the
lease revenues would provide a 15-percent rate of return on the
amount petitioner provided to Dial as shareholders' equity, plus a
profit from the cost of money it lent to NLI and Dial as
intercompany debt. Petitioner expected the overall yield on the
47
Any amortization deductions petitioner claimed with
respect to the $100,000, the $290,000, and the $210,000 are not
in dispute.
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FIA leases to be 11.49 percent annually. The purchase price set
forth in the March Agreement was subject to reduction in the event
that the yield on the leases, computed as of February 28, 1989, was
less than 11.49 percent. The purchase price was to be reduced by
the amount needed to produce an 11.49-percent yield.48 However, no
purchase price adjustments were subsequently needed.
D. Petitioner's 1989 Return
On its 1989 return, petitioner allocated $131,513,038 of the
$141,456,620 it paid for FIA's assets to the lease portfolio. None
of the purchase price was allocated to goodwill. The present
dispute centers around the correctness of petitioner's allocation.
E. Notice of Deficiency
Respondent determined that petitioner overstated the fair
market value of (and thus its basis in) the lease portfolio by
$1,328,618, which respondent determined should be allocated to
goodwill, going-concern value, or other nonamortizable intangible
assets.
48
The required yield of 11.49 percent meant that lease
rents, plus book residual values, less nonrecourse debt payments,
when discounted to present value of 11.49 percent, had to equal
$39,788,569. If the discounted present value using 11.49 percent
was less than $39,788,569, the purchase price was to be reduced
by the amount of the difference.
-78-
Discussion
Preliminarily, we note that we are not bound by the
representation made in the goodwill provision of the March
Agreement, namely, that petitioner did not acquire any goodwill in
its purchase of FIA's assets. It is well established that the
substance of a transaction, rather than its form, governs the tax
consequences. Garcia v. Commissioner, 80 T.C. 491, 498 (1983)
(citing Commissioner v. Court Holding Co., 324 U.S. 331 (1945));
see also Gregory v. Helvering, 293 U.S. 465 (1935); Golsen v.
Commissioner, 54 T.C. 742, 754 (1970), affd. 445 F.2d 985 (10th
Cir. 1971).
F. Residual Value
The parties agree that the residual value method under section
1060 is appropriate in this case. Under section 1060,
consideration is allocated to four classes of assets in descending
order of priority: Class I (e.g., cash and demand deposits); class
II (e.g., certificates of deposit, Federal securities, readily
marketable stock and securities, and foreign currency); class III
(e.g., accounts receivable, equipment, buildings, land, and
covenants not to compete); and class IV (goodwill and going-concern
value). Sec. 1.1060-1T(a)(1), (b)(1), (d), Temporary Income Tax
-79-
Regs., 53 Fed. Reg. 27039-27040 (July 18, 1988).49 After being
reduced by the amount of class I assets, consideration is allocated
among assets in class II in proportion to the fair market values of
such assets on the purchase date, then among class III assets in
proportion to the fair market values of such assets on that date.
Sec. 1.1060-1T(d)(2), Temporary Income Tax Regs., supra. The
amount of consideration so attributed to an asset in classes I
through III may not exceed the fair market value of the asset on
the purchase date. All remaining consideration, or residual
consideration, must be allocated to class IV assets. See, e.g.,
East Ford, Inc. v. Commissioner, T.C. Memo. 1994-261.
Petitioner did not allocate any portion of the purchase price
to class IV assets. If we determine that petitioner overvalued the
FIA lease portfolio on its 1989 tax return, then the difference
between the fair market of the lease portfolio and the purchase
price must be allocated to class IV assets.
Petitioner claims it neither acquired a trade or business when
it purchased FIA's assets, nor paid a premium for FIA's assets, nor
acquired goodwill. Respondent, on the other hand, contends that
49
This temporary regulation was amended on Jan. 16, 1997.
See 62 Fed. Reg. 2267 (Jan. 16, 1997). Because the amended
regulation is effective for asset acquisitions completed on or
after Feb. 14, 1997, it is inapplicable herein.
-80-
petitioner acquired a trade or business,50 paid a premium, and
acquired goodwill. The parties presented expert witnesses to value
the lease portfolio and thereby determine whether petitioner paid
for any goodwill or going-concern value when it purchased FIA's
assets.
G. Expert Witnesses
As the trier of fact, we must weigh the evidence presented by
the experts in light of their demonstrated qualifications in
addition to all other credible evidence. Estate of Christ v.
Commissioner, 480 F.2d 171, 174 (9th Cir. 1973), affg. 54 T.C. 493(1970). However, we are not bound by the opinion of any expert
witness when that opinion is contrary to our judgment. Estate of
Kreis v. Commissioner, 227 F.2d 753, 755 (6th Cir. 1955), affg.
T.C. Memo. 1954-139; Chiu v. Commissioner, 84 T.C. 722, 734 (1985).
We may accept or reject expert testimony as we find appropriate in
our best judgment. Helvering v. National Grocery Co., 304 U.S.
282, 294-295 (1938); Seagate Tech., Inc. & Consol. Subs. v.
Commissioner, 102 T.C. 149, 186 (1994).
Petitioner claims that the value of the lease portfolio is
$134,383,364, while respondent contends that the value is
50
Respondent points to the fact that in its Application
to the Board of Governors of the Federal Reserve System,
petitioner sought approval "to acquire substantially all of the
assets and assume substantially all of the liabilities (to
unrelated parties) of a going concern". (Emphasis added.)
-81-
$130,184,420. The $4,198,944 difference between the parties'
valuations is explained by the different discount rates used by
their experts (respondent's expert used a 15.6-percent discount
rate, while petitioner's expert used an 11.5-percent discount
rate).
1. Petitioner's Expert
Petitioner's expert, Peter S. Huck, of American Appraisal
Associates, has an M.B.A. from Marquette University and is a senior
member of the American Society of Appraisers. He wrote a direct
report and testified regarding the fair market value of FIA's lease
portfolio.51 Using the discounted cash-flow method, he determined
a $134,383,364 value for the FIA lease portfolio on June 12, 1989,
by taking the sum of scheduled lease payments and book residual
values, less third-party debt service payments, and then discounted
the final amount to present value using an 11.5-percent rate.52 To
the result of that calculation, $45,460,848, Mr. Huck added the
principal balance of the debt associated with the leases, for a
51
At trial, Mr. Huck acknowledged that the transaction
herein involved a lease portfolio but "included a business--
aspects of a business."
52
In selecting an 11.5-percent discount rate, Mr. Huck
relied upon the following: (1) The Annual Percentage Rate (APR)
on FIA lease transactions for the first and second half of 1989;
(2) the relationship between the leases' APR and 5-year
Government bonds; (3) the 11.49-percent yield specified in the
March Agreement; and (4) the rates used in other lease
transactions in the marketplace at the time of the transaction.
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total value of $134,383,364.53 Mr. Huck testified that the 11.5-
percent discount rate he determined was based on the "receivable
yield amount" or "receivable yield". In his view, the 11.5-percent
discount rate is consistent with the 11.49-percent yield on the
leases discussed in the March Agreement.
Mr. Huck based his analysis on financing for the net
receivables with both debt and equity. He concluded that, under
the residual method, the purchase price ($141,456,620) was less
than the sum of the fair market value of the lease receivables and
the other tangible assets acquired ($144,343,582), and hence no
portion of the purchase price should be allocated to goodwill or
going-concern value.
2. Respondent's Expert
Respondent's expert, David N. Fuller, of Business Valuation
Services, Inc., has an M.B.A. from Southern Methodist University.
He is a chartered financial analyst and an accredited senior
appraiser certified by the American Society of Appraisers. Mr.
Fuller wrote a rebuttal report54 and testified regarding the fair
53
Mr. Huck initially made a mathematical error of
approximately $700,000 (with regard to cash inflow) but
subsequently corrected the error.
54
Mr. Fuller only prepared a rebuttal report because he
believed the information petitioner provided contained
insufficient and questionable data to determine a precise value
for the lease portfolio. Based on the record, we believe the
(continued...)
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market value of the FIA lease portfolio. He determined that the
fair market value of FIA's lease portfolio, as of June 12, 1989,
did not exceed $130,184,42055 ($4,198,944 less than Mr. Huck's
valuation). Consequently, Mr. Fuller attributed $1,328,618 of the
purchase price to goodwill. Mr. Fuller arrived at the value for
the lease portfolio through his "sensitivity" analysis by applying
a 15.6-percent rate to discount the same cash-flow Mr. Huck used
(lease payments plus book residual values less nonrecourse debt
service payments). The 15.6-percent rate represented the cost of
equity capital, which Mr. Fuller computed using the capital asset
pricing model. This analysis was based on the assumption that, with
regard to a hypothetical buyer, the portion of the lease portfolio
not financed by nonrecourse debt would be financed entirely by
equity.
Mr. Fuller opined that his 15.6-percent rate compares
favorably with the 15-percent rate of return on equity that FIA
54
(...continued)
information provided to both experts may have been, to a certain
extent, unreliable.
55
Mr. Fuller believed that the value of FIA's lease
portfolio could be less than $130,184,420 but was unable to
refine this belief due to lack of data (as discussed supra note
54). His value of $130,184,420 for the FIA lease portfolio, when
added to the agreed value of $9,943,582 for FIA's other assets
acquired by petitioner (the noncompete agreement with FIA and
Commercial, the license to use the FIA name, and the other
assets) totals $140,128,002, or $1,328,618 less than the purchase
price.
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generally exceeded (both before and after its acquisition by
Federal) and the 15-percent rate of return on equity that
petitioner projected its proposed acquisition of FIA would produce.
In sum, Mr. Fuller testified that Mr. Huck overvalued FIA's
lease portfolio by approximately $4 to $5 million, which results in
approximately $1.2 to $2.2 million in intangible assets.
3. Critique of Experts
Not unexpectedly, each expert criticized his colleague's
analysis. The following points highlight these disparate
perspectives.
Mr. Fuller opined that Mr. Huck simply used the portfolio's
expected yield (the rate at which petitioner expected the portfolio
to earn income) as the appropriate discount rate. Use of the
portfolio's expected yield, he insisted, assumes that no other
assets are necessary to realize that yield and treats the portfolio
as the equivalent of a fixed-income instrument. According to Mr.
Fuller, Mr. Huck ignored the fact that petitioner purchased a going
concern; the purchase included the FIA portfolio in addition to
other FIA assets, and the right to hire FIA's expert personnel (who
originated the equipment leases and turned the residual value into
profits). The presence of these other business assets, in Mr.
Fuller's opinion, was necessary to produce income at the yield
rate. Mr. Fuller contended that the 11.49-percent yield required
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by the March Agreement, while providing a mechanism for a downward
adjustment to the purchase price, was not indicative of the
appropriate discount rate.
Mr. Huck countered these arguments by reiterating that he did
not simply rely on the expected yield rate but used several factors
(enumerated supra note 52) to reach his conclusion. These factors,
he believed, clearly indicate that an 11.5-percent discount rate
represents the current market rate for comparable assets.
Mr. Fuller also believed that instead of using a cash inflow
analysis, Mr. Huck should have used a cash-flow analysis (referring
to the net cash-flow generated after considering all expenses and
necessary adjustments). And, according to Mr. Fuller, Mr. Huck
erred by not using the capital asset pricing model to determine the
appropriate discount rate to be applied to cash-flow attributable
to invested capital.56 Finally, Mr. Fuller criticized Mr. Huck for
failing to include capital charges in his analysis.57
56
Mr. Huck testified that he did not use the capital
asset pricing model because he considered it inappropriate
herein.
57
Mr. Fuller testified that the premise of a capital
charge is that other assets besides the asset being valued (such
as the lease portfolio herein) are necessary to produce the
business cash-flow. Capital charges take into account the
presence of these other assets by assigning a portion of the
cash-flow to them, leaving only the cash-flow attributable to the
asset being valued. Mr. Fuller did not take this approach in his
report (which would have had the effect of reducing the value of
(continued...)
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Mr. Huck criticized Mr. Fuller's rebuttal report, claiming:
(1) Rather than doing an independent valuation, Mr. Fuller merely
used Mr. Huck's analysis and applied an incorrect discount rate
(equity rate of return) to those numbers; (2) Mr. Fuller did not
consider recourse debt in determining cash-flow, but rather assumed
that any portion of the purchase price not funded with nonrecourse
debt would be funded with equity; and (3) a typical buyer of the
lease portfolio would finance its acquisition with a combination of
nonrecourse debt, recourse debt, and equity. While Mr. Huck
discounted "gross" cash-flows (net only of nonrecourse debt) based
on the market rate for such assets (which reflected the required
blended cost of capital), Mr. Fuller discounted the same cash-flows
using an equity rate. These cash-flows did not consider recourse
debt service, operating expenses, and taxes. Because Mr. Fuller
did not apply his equity rate against equity cash-flows, Mr. Huck
believes that Mr. Fuller's analysis is seriously flawed. Simply
put, Mr. Huck claims that Mr. Fuller used an equity rate for
purposes of discounting the lease portfolio's cash-flows, whereas
those cash-flows included a return on debt. In Mr. Huck's view,
Mr. Fuller should have based his discount rate on the market
receivable yield which accounts for the expected debt leveraging.
57
(...continued)
the portfolio below $130,184,420) because he did not believe he
had sufficient information to do so.
-87-
Mr. Fuller acknowledged at trial that normally a purchaser
would not finance the acquisition of a lease portfolio with 100
percent equity. He admitted that if a mixture of debt and equity
were used, he would be forced to lower the 15.6-percent discount
rate he had determined. However, Mr. Fuller believed that the net
cash-flow from FIA's lease portfolio is, for the most part, an
equity cash-flow to the holder of the net equity investment in the
portfolio, which requires an equity rate of return to properly
discount it to present value.
Finally, petitioner criticized Mr. Fuller's use of the 25-
percent premium Commercial paid in 1986 as another basis for
determining the value of FIA's intangible assets in 1989.
Petitioner first complains that Mr. Fuller ignored industry
practice, which is intended to reflect the negotiated value of
intangible assets as an amount over and above net asset value. And
second, petitioner maintains, circumstances were different in 1986
and 1989 because when Commercial purchased FIA in 1986, it acquired
the services of Mr. Rafanello, FIA's most important employee,
whereas petitioner did not acquire Mr. Rafanello's services in
1989.
H. Conclusion
We have considered the qualifications and experience of the
parties' experts, as well as the substance and reasoning of their
reports. The difference in their respective valuations of FIA's
-88-
leasehold portfolio is explained by the different discount rates
they used (15.6 percent by respondent's expert, Mr. Fuller; 11.5
percent by petitioner's expert, Mr. Huck). As discussed above,
both expert reports are susceptible to criticism. While we find
Mr. Huck's analysis generally sound, Mr. Fuller established that
Mr. Huck's 11.5-percent discount rate should be adjusted upward.
Both experts admitted at trial the inexactitude of their
methodologies: Mr. Huck conceded that, in light of the imprecise
nature of valuing assets, the appropriate discount rate herein
could be anywhere from 11.5 to 13 percent; and Mr. Fuller conceded
that his 15.6-percent discount rate could be reduced somewhat to
properly reflect debt and equity financing. Thus, in consideration
of all the evidence presented, and in light of both experts'
forthright flexibility, we adopt 13 percent as the appropriate
discount rate herein.58
Because other issues remain to be resolved in these
consolidated cases,
Appropriate orders
will be issued.
58
We expect the parties' Rule 155 computations to utilize
the 13-percent discount rate to determine the exact value of the
lease portfolio and any remaining value to be attributed to
goodwill or going-concern value. We expect the parties to
correct, in their Rule 155 computations, any overstatement of
cash inflows and mathematical errors Mr. Huck made.